August 2023 - Capital Returns by Edward Chancellor

We dive into an investing book that covers the capital cycle. In summary, the best time to invest in a sector is actually when capital is leaving or has left.

Tech Themes

1. Amazon. Marathon understands that the world moves in cycles. During the internet bubble of the late 1990s the company refused to invest in a lot of speculative internet companies. “At the time, we were unable to justify the valuations of any of these companies, nor identify any which could safely say would still be going strong in years to come.” In August of 2007, however, several years after the internet bubble burst, they noticed Amazon again. Amazon’s stock had rebounded well from the lows of 2001 and was roughly flat from its May 1999 valuation. Sales had grown 10x since 1999 and while they recognized it had a tarnished reputation from the internet bubble, it was actually a very good business with a negative working capital cycle. On top of this, the reason the stock hadn’t performed well in the past few years was because they were investing in two new long-term growth levers, Amazon Web Services and Fulfillment by Amazon. I’m sure Marathon underestimated the potential for these businesses but we can look back now and know how exceptional and genius these margin lowering investments were at the time.

2. Semis. Nothing paints a more clear picture of cyclicality than semiconductors. Now we can debate whether AI and Nvidia have moved us permanently out of a cycle but up until 2023, Semiconductors was considered cyclical. As Marathon notes: “Driven by Moore’s law, the semiconductor sector has achieved sustained and dramatic performance increases over the last 30years, greatly benefiting productivity and the overall economy. Unfortunately, investors have not done so well. Since inception in 1994, the Philadelphia Semiconductor Index has underperformed the Nasdaq by around 200 percentage point, and exhibited greater volatility…In good times, prices pick up, companies increase capacity, and new entrants appear, generally from different parts of Asia (Japan in the 1970s, Korea in 1980s, Taiwan in the mid1990s, and China more recently). Excess capital entering at cyclical peaks has led to relatively poor aggregate industry returns.” As Fabricated Knowledge points out the 1980s had two brutal Semiconductor cycles. First, in 1981, the industry experienced severe overcapacity, leading to declining prices while inflation ravaged through many businesses. Then in 1985, the US semiconductor business declined significantly. “1985 was a traumatic moment for Intel and the semiconductor industry. Intel had one of the largest layoffs in its history. National Semi had a 17% decrease in revenue but moved from an operating profit of $59 million to an operating loss of -$117 million. Even Texas Instruments had a brutal period of layoffs, as revenue shrank 14% and profits went negative”. The culprit was Japanese imports. Low-end chips had declined significantly in price, as Japan flexed its labor cost advantage. All of the domestic US chip manufacturers complained (National Semiconductor, Texas Instruments, Micron, and Intel), leading to the 1986 US-Japan Semiconductor Agreement, effectively capping Japanese market share at 20%. Now, this was a time when semiconductor manufacturing wasn’t easy, but easier than today, because it focused mainly on more commoditized memories. 1985 is an interesting example of the capital cycle compounding when geographic expansion overlaps with product overcapacity (as we had in the US). Marathon actually preferred Analog Devices, when it published its thesis in February 2013, highlighting the complex production process of analog chips (physical) vs. digital, the complex engineering required to build analog chips, and the low-cost nature of the product. “These factors - a differentiated product and company specific “sticky” intellectual capital - reduce market contestability….Pricing power is further aided by the fact that an analog semiconductor chip typically plays a very important role in a product for example, the air-bag crash sensor) but represents a very small proportion of the cost of materials. The average selling price for Linear Technology’s products is under $2.” Analog Devices would acquire Linear in 2017 for $14.8B, a nice coda to Marathon’s Analog/Linear dual pitch.

3. Why do we have cycles? If everyone is playing the same business game and aware that markets come and go, why do we have cycles at all. Wouldn’t efficient markets pull us away from getting too hyped when the market is up and too sour when the market is down? Wrong. Chancellor gives a number of reasons why we have a capital cycle: Overconfidence, Competition Neglect, Inside View, Extrapolation, Skewed Incentives, Prisoner’s Dilemma, and Limits to Arbitrage. Overconfidence is somewhat straightforward - managers and investors look at companies and believe they are infallible. When times are booming, managers will want to participate in the boom, increasing investment to match “demand.” In these decisions, they often don’t consider what their competitors are doing, but rather focus on themselves. Competition neglect takes hold as managers enjoy watching their stock tick up and their face be splattered across “Best CEO in America” lists. Inside View is a bit more nuanced, but Michael Mauboussin and Daniel Kahneman have written extensively on it. As Kahneman laid out in Thinking, Fast & Slow: “A remarkable aspect of your mental life is that you are rarely stumped … The normal state of your mind is that you have intuitive feelings and opinions about almost everything that comes your way. You like or dislike people long before you know much about them; you trust or distrust strangers without knowing why; you feel that an enterprise is bound to succeed without analyzing it.” When you take the inside view, you rely exclusively on your own experience, rather than other similar situations. Instead, you should take the outside view and assume your problem/opportunity/case is not unique. Extrapolation is an extremely common driver of cycles, and can be seen all across the investing world after the recent COVID peak. Peloton, for example, massively over-ordered inventory extrapolating out pandemic related demand trends. Skewed incentives can include near-term EPS targets (encourages buybacks, M&A), market share preservation (encourages overinvestment), low cost of capital (buy something with cheap debt), analyst expectations, and champion bias (you’ve decided to do something and its no longer attractive, but you do it anyway because you got people excited about it). The Prisoner’s Dilemma is also a form of market share preservation/expansion, when your competitor may be acting much more aggressively and you have to decide whether its worth the fight. Limits to Arbitrage is almost an extension of career risk, in that, when everyone owns an overvalued market, you may actually hurt your firm by actively withholding even if it makes investment sense. That’s why many firms need to maintain a low tracking error against indexes, which can naturally result in concentrations in the same stocks.

Business Themes

1. Capital Cycle. The capital cycle has four stages: 1. New entrants attracted by prospect of high returns: investor optimistic 2. Rising competition causes returns to fall below cost of capital: share price underperforms 3. Business investment declines, industry consolidation, firms exit: investors pessimistic 4. Improving supply side causes returns to rise above the cost of capital: share price outperforms. The capital cycle reveals how competitive forces and investment behavior create predictable patterns in industries over time. Picture it as a self-reinforcing loop where success breeds excess, and pain eventually leads to gain. Stage 1: The Siren Song - High returns in an industry attract capital like moths to a flame. Investors, seeing strong profits and growth, eagerly fund expansions and new entrants. Optimism reigns and valuations soar as everyone wants a piece of the apparent opportunity. Stage 2: Reality Bites - As new capacity comes online, competition intensifies. Prices fall as supply outpaces demand. Returns dip below the cost of capital, but capacity keeps coming – many projects started in good times are hard to stop. Share prices begin to reflect the deteriorating reality. Stage 3: The Great Cleansing - Pain finally drives action. Capital expenditure is slashed. Weaker players exit or get acquired. The industry consolidates as survivors battle for market share. Investors, now scarred, want nothing to do with the sector. Capacity starts to rationalize. Stage 4: Phoenix Rising - The supply-side healing during the downturn slowly improves industry economics. With fewer competitors and more disciplined capacity, returns rise above the cost of capital. Share prices recover as improved profitability becomes evident. But this very success plants the seeds for the next cycle. The genius of understanding this pattern is that it's perpetual - human nature and institutional incentives ensure it repeats. The key is recognizing which stage an industry is in, and having the courage to be contrarian when others are either too optimistic or too pessimistic.

2. 7 signs of a bubble. Nothing gets people going more than Swedish Banking in the 2008-09 financial crisis. Marathon called out its Seven Deadly Sins of banking in November 2009, utilizing Handelsbanken as a positive reference, highlighting how they avoided the many pitfalls that laid waste to their peers. 1. Imprudent Asset-Liability mismatches on the balance sheet. If this sounds familiar, its because its the exact sin that took down Silicon Valley Bank earlier this year. As Greg Brown lays out here: “Like many banks, SVB’s liabilities were largely in the form of demand deposits; as such, these liabilities tend to be short term and far less sensitive to interest rate movement. By contrast, SVB’s assets took the form of more long-term bonds, such as U.S. Treasury securities and mortgage-backed securities. These assets tend to have a much longer maturity – the majority of SVB’s assets matured in 10 years or more – and as a result their prices are much more sensitive to interest rate changes. The mismatch, then, should be obvious: SVB was taking in cash via short-term demand deposits and investing these funds in longer-term financial instruments.” 2. Supporting asset-liability mismatches by clients. Here, Chancellor calls out foreign currency lending, whereby certain European banks would offer mortgages to Hungarians in swiss francs, to buy houses in Hungary. Not only were these banks taking on currency risk, they were exposing their customers to it and many didn’t hedge the risk out appropriately. 3. Lending to “Can’t Pay, Won’t Pay” types. The financial crisis was filled with banks lending to subprime borrowers. 4. Reaching for growth in unfamiliar areas. As Marathon calls out, “A number of European banks have lost billions investing in US subprime CDOs, having foolishly relied on “experts” who told them these were riskless AAA rated credits.” 5. Engaging in off-balance sheet lending. Many European banks maintained "Structured Investment Vehicles” that were off-balance sheet funds holding CDOs and MBSs. At one point, it got so bad that Citigroup tried the friendship approach: “The news comes as a group of banks in the U.S. led by Citigroup Inc. are working to set up a $100 billion fund aimed at preventing SIVs from dumping assets in a fire sale that could trigger a wider fallout.” These SIVs held substantial risk but were relatively unknown to many investors. 6. Getting sucked into virtuous/vicious cycle dynamics. As many European banks looked for expansion, they turned to lending into the Baltic states. As more lenders got comfortable lending, GDP began to grow meaningfully, which attracted more aggressive lending. More banks got suckered into lending in the area to not miss out on the growth, not realizing that the growth was almost entirely debt fueled. 7. Relying on the rearview mirror. Marathon points out how risk models tend to fail when the recent past has been glamorous. “In its 2007 annual report, Merrill Lunch reported a total risk exposure - based on ‘a 95 percent confidence interval and a one day holding period’ - of $157m. A year later, the Thundering Herd stumbled into a $30B loss!”

3. Investing Countercyclically. Björn Wahlroos exemplified exceptional capital allocation skills as CEO of Sampo, a Finnish financial services group. His most notable moves included perfectly timing the sale of Nokia shares before their collapse, transforming Sampo's property & casualty insurance business into the highly profitable "If" venture, selling the company's Finnish retail banking business to Danske Bank at peak valuations just before the 2008 financial crisis, and then using that capital to build a significant stake in Nordea at deeply discounted prices. He also showed remarkable foresight by reducing equity exposure before the 2008 crisis and deploying capital into distressed commercial credit, generating €1.5 billion in gains. Several other CEOs have demonstrated similar capital allocation prowess. Henry Singleton at Teledyne was legendary for his counter-cyclical approach to capital allocation. He issued shares when valuations were high in the 1960s to fund acquisitions, then spent the 1970s and early 1980s buying back over 90% of Teledyne's shares at much lower prices, generating exceptional returns for shareholders. As we saw in Cable Cowboy, John Malone at TCI (later Liberty Media) was masterful at using financial engineering and tax-efficient structures to build value. He pioneered the use of spin-offs, tracking stocks, and complex deal structures to maximize shareholder returns while minimizing tax impacts. Tom Murphy at Capital Cities demonstrated exceptional discipline in acquiring media assets only when prices were attractive. His most famous move was purchasing ABC in 1985, then selling the combined company to Disney a decade later for a massive profit. Warren Buffett at Berkshire Hathaway has shown remarkable skill in capital allocation across multiple decades, particularly in knowing when to hold cash and when to deploy it aggressively during times of market stress, such as during the 2008 financial crisis when he made highly profitable investments in companies like Goldman Sachs and Bank of America. Jamie Dimon at JPMorgan Chase has also proven to be an astute capital allocator, particularly during crises. He guided JPMorgan through the 2008 financial crisis while acquiring Bear Stearns and Washington Mutual at fire-sale prices, significantly strengthening the bank's competitive position. D. Scott Patterson has shown excellent capital allocation skills at FirstService. He began leading FirstService following the spin-off of Colliers in 2015, and has compounded EBITDA in the high teens via strategic property management acquistions coupled with large platforms like First OnSite and recently Roofing Corp of America. Another great capital allocator is Brad Jacobs. He has a storied career building rollups like United Waste Systems (acquired by Waste Services for $2.5B), United Rentals (now a $56B public company), XPO logistics which he separated into three public companies (XPO, GXO, RXO), and now QXO, his latest endeavor into the building products space. These leaders share common traits with Wahlroos: patience during bull markets, aggression during downturns, and the discipline to ignore market sentiment in favor of fundamental value. They demonstrate that superior capital allocation, while rare, can create enormous shareholder value over time.

   Dig Deeper

• Handelsbanken: A Budgetless Banking Pioneer

• ECB has created 'toxic environment' for banking, says Sampo & UPM chairman Bjorn Wahlroos

• Edward Chancellor part 1: ‘intelligent contrarians’ should follow the capital cycle

• Charlie Munger: Investing in Semiconductor Industry 2023

• Amazon founder and CEO Jeff Bezos delivers graduation speech at Princeton University

January 2023 - Ride of a Lifetime by Bob Iger

This month we look at the recent history of Disney and its famous leader, Bob Iger.

Tech Themes

1. Creative Trust. Bob began his career at ABC Television, eventually working his way into ABC Sports and their newly acquired Entertainment and Sports Programming Network (ESPN). Their Bob came under the toutalege of Roone Arledge, a famous broadcast executive known for his commitment to storytelling, and his lack of compassion for sub-par work. Bob saw first hand how Roone would get close to the start of production, only to make several last minute tweaks to the overall program, sometimes throwing out all of the work that had been done to offer the audience a better program. Bob understood this creative process was messy and inefficient, but crucial to producing high quality programming. After ABC was acquired by Capital Cities, Tom Murphy and Dan Burke promoted Iger into a new role as head of ABC entertainment. Upon being handed a stack of 40 scripts on his first day, Bob wondered what he was even supposed to be looking for in a script. “I started to realize over time, though, that I’d internalized a lot by watching Roone tell stories all those years.” In his first season as president, Iger decided to go ahead with an off-putting, creepy drama directed by David Lynch called Twin Peaks. At one point, Murphy was so concerned about airing the show, that he told Bob, “You can’t air this. If we put it on television, it will kill our company’s reputation.” Iger pushed back, enthralled that the creative community love the risk the network was taking. A 1990 New York Times article spells out the risky show’s language: “The offending usage was in a Wall Street Journal story about Robert Iger, a bold television producer: ''Even if 'Twin Peaks' caves in, it has already won ABC new cache in Hollywood as the hands-off network, eager for ideas that are daring and different.'' Iger learned early, it pays to take big and bold risks, especially with the creative community.

2. Bob Iger and Steve Jobs. One of the first things Bob Iger did when he became CEO of Disney was call Steve Jobs. Disney’s prior CEO, Michael Eisner, had spent years arguing a battle for who had the better legal position in the Disney-Pixar distribution relationship. Pixar had succeeded everyone’s wildest dreams with films like Toy Story, A Bug’s Life, and Finding Nemo, but Disney wanted full control of Pixar’s characters and the rights to film sequels. Iger describeds the kerfuffle: “Steve’s animosity toward Disney was too deep-rooted. The rift that had opened between Steve and Michael [Eisner] was a clash between two strong-willed people whose companies’ fortunes were going in different directions. When Disney Animation began to slip even further, Steve became more haughty with Michael because he flet we needed him more, and Michael hated that Steve had the upper hand.” Iger, ever the flatterer discussed with Jobs how he loved his iPod and wanted to put Disney shows on future generations of the device. Steve responded by showing Iger the new iPhone prototype they were developing. They agreed on a deal and Iger strode on stage at the iPod video launch in 2005. In his first board meeting as official CEO, Iger proposed buying Pixar. The company was half owned by Steve Jobs, who had bought it from his friend and Star Wars creator George Lucas for a measly $5 million (plus several $20-30m equity checks). After receiving approval from the board to look at an acquisition, Iger called Jobs from his car phone: “I’ve been thinking about our respective futures, What do you think about the idea of Disney buying Pixar?” Jobs responded - “You know, that’s not the craziest idea in the world.” A few weeks later, the two sat in the Apple boardroom sketching a simple pros and cons list on the whiteboard. For all of the math and financial analysis that goes into an acquisition, its hilariously to envision Steve and Bob doing what anyone would do to analyze an acquisition. “Two hours later, the pros were meager and the cons were abundant, even if a few of them, in my estimation were quite petty…’A few solid pros are more powerful than dozens of cons,’ Steve said." The agreement was negotiated an in 2006, Disney acquired Pixar for a $7.4B equity value. Right before the merger was announced, Steve took Bob for a walk around Apple’s campus, and told him that his cancer had returned. “He told me the cancer was now in his liver and he talked about the odds of beating it. He was going to do whatever it took to be at his son Reed’s high school graduation, he said. When he told me that was four years away, I felt devestated. It was impossible to be having these two conversations - about Steve facing his impending death and about the deal we were supposed to be closing in minutes - at the same time.” The deal ultimately closed and Jobs became Disney’s largest shareholder and a board member at the company, during which Disney’s stock performed very well.

3. BamTECH. When Iger became CEO, he launched a three part plan to return Disney to the top of media and creativity. The plan was clear: “1) We needed to devote most of our time and capital to the creation of high quality branded content. 2) We needed to embrace technology to the fullest extent, first by using it to enable the creation of higher quality products, and then to reach more consumers in amore modern, more relevant ways. 3) We needed to become a truly global company.” If Pixar, Marvel, and Lucasfilm were an answer to part one, BAMTech was the answer to part two. Baseball Advanced Media Technologies was a company founded by Major League Baseball in 2000 to build out a digital radio streaming service for overseas listeners to the MLB playoffs. MLB Advanced Media was funded by a $1 million investment by each of its 30 teams for four consecutive years. Following a successful launch, BAMTech decided to try streaming live video of baseball games and launched MLB.tv, which soon became a major leader in streaming. Other leagues began to pay attention and soon the NHL had signed up BAMTech as its streaming partner, taking a 10% stake in the company. Soon ESPN, HBO, and the PGA Tour all signed on too. Disney used BAMTech as a back-end partner for the launch of its WatchESPN platform in 2010. So it was a natural extension for Iger, fresh off the massive success of the Pixar, Marvel, and Lucasfilm acquisitions, to try to buy the company. In 2015, BAMTech was officially spun out of the MLB, and in August 2016, Walt Disney acquired 33% of the company in August 2016 for $1B, valuing the streaming platform at $3B. In 2017, it upped its stake to 75% for another $1.58B, then in August 2021 it acquired the NHL’s 10% interest. Finally, it bought the remaining 15% interest from the MLB for $828m in October 2022. Amazing companies can come from anywhere. Based on some simple rough math, the MLB earned a 23% IRR on initial $120m investment from 2000 to 2022, a 28x return.

Business Themes

1. The Guide of Experience. Its clear that Bob Iger was molded into an incredible businessman through a series of experiences that almost no one could predict would create to such a compelling leader. Because Iger began in the TV industry at ABC, he began the habit of waking up absurdly early, a trait shared by many successful leaders. “To this day, I wake nearly every morning at four-fifteen, though now I do it for selfish reasons: to have time to think and read and exercise before the demands of the day take over.” After moving over to sports, Bob learned the importance of high quality from Roone Arledge, but he also developed one of his greatest traits, finding compromise among competing interests. “In 1979, the World Table Tennis Championships were being held in Pyongyang, North Korea. Roone called me into his office one day and said, ‘This is going to be interesting. Let’s cover it on Wide World of Sports.’ I thought he was joking. He surely knew it would be impossible to secure the rights to an event in North Korea. He wasn’t joking. I then embarked on a worldwide pursuit to secure the rights. After a few months of intense negotiations, we were on the eve of closing the deal when I received a call from someone on the Asian desk in the U.S. State Department. ‘Everything you are doing with them is illegal,’ he said. ‘You’re in violation of strict U.S. Sanctions against doing any business with North Korea…’ I eventually arrived at a workoaround that involved securing the rights not through the host country but through the World Table Tennis Federation. The North Korean government, though we were no longer paying them, still agreed to let us in, and we became the first U.S. media team to enter North Korea in decades - a historic moment in sports broadcasting.” When ABC was purchased by Capital Cities, Bob began his relationship with Dan Burke and Tom Murphy. Warren Buffett famously praised the pair: “Tom Murphy and [his long-time business partner] Dan Burke were probably the greatest two-person combination in management that the world has ever seen or maybe ever will see.” Iger learned tons about business, acquisitions, budgeting, and decentralized management from Tom and Dan. They also gave Iger numerous opportunities to prove himself and take risks, like the Twin Peaks launch. Later, when Cap Cities was acquired by Disney, Iger gained a front-row seat to Michael Eisner’s leadership style. Eisner was once regarded as one of the best CEOs in the world, but languished as the stress of managing a massive company caused him to become increasingly defensive and depressed. Despite sharing a complicated relationship, Iger learned a lot about managing Disney from Eisner, including what he didn’t want to do once he got the role. In hindsight, its no surprise that Iger became the leader he became, even though it wasn’t clear as it was unfolding.

2. A tale of M&A. Although Disney sticks in people’s minds as a family friendly media company, its sprawling empire has grown to include ABC, ESPN, Marvel, the Simpsons, Star Wars, Pixar, Marvel, Hotstar, National Geographic, Hulu, 20th Century Studios, X-Men, Deadpool, Fx, Disney World, Disney Cruise Line, and Disney+. This empire was constructed through many M&A deals. The first major M&A deal was the 1995 $19B Disney, Capital Cities merger, which was the second largest corporate takeover (to KKR’s RJR Nabisco LBO) ever. Warren Buffett became one of the largest shareholders of Disney, which he sold over the next few years, only to massively miss out on the growth of ESPN and eventually the content domination that Iger began. The deal took a while to digest, and vastly expanded Disney’s operations. Eisner’s legendarily poor hire of talent agent Michael Ovitz compounded pressures, and Eisner relied even more heavily on Disney’s Strategic Planning group to make corporate decisions. From 1995 to 2005, Disney’s stock increased only 25%, and Eisner was forced out in a brutal, public proxy battle. Once Iger took over, he collapsed the Strat Planning department under rising star Kevin Mayer, and began the series of acquisitions that marked his tenure. After Pixar, Iger turned to Marvel, which was stumbling along as a comic book and toy producer to a shrinking population of interested buyers. Despite its relatively small size, Marvel had a fascinating corporate history. In the late 80’s, Ron Perelman, billionaire businessman, bought Marvel for a mere $82m. However, after the comic book boom faded, Marvel fell into bankruptcy, and Icahn stepped in to buy Marvel’s distressed debt eventually becoming chairman of the board through a protracted legal process. At the last second, Ike Perlmutter and Avi Arad, managers of the largest susidiary of Marvel, Toy Biz, proposed a better offer to the bankruptcy court, and eventually wrestled control away from both Perelman and Icahn. By the time Disney came knocking in 2008, Marvel was beginning to produce its own films, after several successful Spider-Man and X-men films. While a lot of Disney executives believed Marvel was too edgy for Disney, Iger took a longer term view and bought the company for $4B, which has clearly paid off. Alongside the acquisition of Marvel, Disney invested about $100m for a 30% stake in a new streaming service created by NBC and News Corp called Hulu. Next, Iger turned to Lucasfilm, the maker of Star Wars. George Lucas was very reluctant to sell to Disney, and it took four and half years of convincing: “We went over and over the same ground - George saying he couldn’t just hand over his legacy, me saying we couldn’t buy it and not control it - and twice walked away from the table and called the deal off. (We walked the first time and George walked the second).” Eventually, Disney acquired Lucasfilm for $4.05B, another great content acquisition that has worked out well. While Iger is credited with these amazing acquisitions, his latest and biggest acquisition has raised the most questions for Disney. In 2017, Disney announced it would buy 20th Century Fox for $52B in stock, and the assumption of $13.7B of Fox’s net debt. However, the deal faced a long regulatory approval process, during which the US Justice Department ruled in favor of AT&T buying Time Warner. With what seemed like a favorable M&A environment, Comcast entered the fray, proposing an all cash bid at $35 a share or $64B. Disney upped its offer to $38 a share, half in cash and half in stock. Fox accepted Disney’s new bid (of $71B), and Disney closed the deal in March of 2019. While the deal did bring X-men, Deadpool, Fantastic Four, the Simpsons, Family Guy, it added $19B of debt to its balance sheet. In addition, Disney spent time selling Fox’s Sky ownership to Comcast, and the regional sports networks owned by Fox. These divestitures were necessary for the regulatory approval of the deal and netted Disney $24B ($15B from Sky and $9.6B from the sports networks). Covid through Disney for a loop, and its higher leverage from the Fox deal, caused the elimination of its dividend, and an obvious massive reduction to its parks business. Time will tell if the Fox Deal yields the same great results that Pixar, Marvel, and Lucasfilm produced - I wonder if this wasn’t too big for the integration risk entailed.

3. Walt Proxy. Disney has a rich history in not only animated characters but business characters as well. The company has repeatedly been subject to proxy battles. Iger’s first proxy battle began slowly then grew into a massive public boardroom debate. In 2002, Roy E. Disney and Stanley Gold, expressed their disappointment in Michael Eisner’s choices as CEO of Disney, sending a letter to the board demanding his removal. Eisner retailiated, “turning to the company’s governance guidlines regarding board member tenure, which stipulated that board members had to retire at age seventy-two. Rather than telling Roy himself, though, Michael had the chairman of the board’s nominating committee inform him that he would not be allowed to stand for reeelection and would be retired as of the next shareholders meeting in March 2004.” Roy began a public campaign called “Save Disney” where he called for Michael’s retirement and for him to rejoin the board. At the same time, Comcast launched a hostile bid for Disney. While Comcast would eventually find its content companion in NBC/Universal years later, this bid added heat to the situation. Comcast was unable to complete its bid, but the shareholder vote still turned out poorly for Eisner, with 43% of shareholders withholding support for him as CEO. He was promptly stripped of his chairman title, and in the fall of 2004, announced his resignation at the end of his contract in 2006. Fast forward to 2023, and Disney is back in the proxy battle world, this time facing up against Nelson Peltz, the famous activist investor. Under scrutiny are Disney’s acquisition of Fox, its exorbitant streaming losses, the cancellation of its dividend, the massive debt load it carries, and its large Netflix-competing content spend. The board recently announced that Iger would come back as CEO, despite clearly saying his time was over in the book. Iger’s successor, Bob Chapek, had a terrible run as Disney CEO, including shutting down the company, a public row with the State of Florida and Scarlett Johansson, and a centralization process that took control away from the creatives. I guess the Ride of a Lifetime is not over.

   Dig Deeper

• The Complete History Of Walt Disney World, Part 1 (1960s-1996)

• Bob Iger: I felt a sense of obligation to return to Disney as CEO

• Steve Jobs and John Lasseter interview on Pixar (1996)

• Tom Murphy Interview | Michael Eisner Interview | Bob Iger Interview 2011

• Restore the Magic Trian Partners Presentation

March 2022 - Invent and Wander by Jeff Bezos

This month we go back to tech giant Amazon and review all of Jeff Bezos’s letters to shareholders. This book describes Amazon’s journey from e-commerce to cloud to everything in a quick and fascinating read!

Tech Themes

1. The Customer Focus. These shareholder letters clearly show that Amazon fell in love with its customer and then sought to hammer out traditional operational challenges like cycle times, fulfillment times, and distribution capacity. In the 2008 letter, Bezos calls out: "We have strong conviction that customers value low prices, vast selection, and fast, convenient delivery and that these needs will remain stable over time. It is difficult for us to imagine that ten years from now, customers will want higher prices, less selection, or slower delivery." When a business is so clearly focused on delivering the best customer experience, with completely obvious drivers, its no wonder they succeeded. The entirety of the 2003 letter, entitled "What's good for customers is good for shareholders" is devoted to this idea. The customer is "divinely discontented" and will be very loyal until there is a slightly better service. If you continue to offer lower prices on items, more selection of things to buy, and faster delivery - customers will continue to be happy. Those tenants are not static - you can continually lower prices, add more items, and build more fulfillment centers (while getting faster) to keep customers happy. This learning curve continues in your favor - higher volumes mean cheaper to buy, lower prices means more customers, more items mean more new customers, higher volumes and more selection force the service operations to adjust to ship more. The flywheel continues all for the customer!

2. Power of Invention. Throughout the shareholder letters, Bezos refers to the power of invention. From the 2018 letter: "We wanted to create a culture of builders - people who are curious, explorers. They like to invent. Even when they're experts, they are "fresh" with a beginner's mind. They see the way we do things as just the way we do things now. A builder's mentality helps us approach big, hard-to-solve opportunities with a humble conviction that success can come through iteration: invent, launch, reinvent, relaunch, start over, rinse, repeat, again and again." Bezos sees invention as the ruthless process of trying and failing repeatedly. The importance of invention was also highlighted in our January book 7 Powers, with Hamilton Helmer calling the idea critical to building more and future S curves. Invention is preceded by wandering and taking big bets - the hunch and the boldness. Bezos understands that the stakes for invention have to grow, too: "As a company grows, everything needs to scale, including the size of your failed experiments. If the size of your failures isn't growing, you're not going to be inventing at a size that can actually move the needle." Once you make these decisions, you have to be ready to watch the business scale, which sounds easy but requires constant attention to customer demand and value. Amazon's penchant for bold bets may inform Andy Jassy's recent decision to spend $10B making a competitor to Elon Musk/SpaceX's Starlink internet service. This decision is a big, bold bet on the future - we'll see if he is right in time.

3. Long-Term Focus. Bezos always preached trading off the short-term gain for the long-term relationship. This mindset shows up everywhere at Amazon - selling an item below cost to drive more volumes and give consumers better prices, allowing negative reviews on sites when it means that Amazon may sell fewer products, and providing Prime with ever-faster and free delivery shipments. The list goes on and on - all aspects focused on building a long-term moat and relationship with the customer. However it's important to note that not every decision pans out, and it's critical to recognize when things are going sideways; sometimes, you get an unmistakable punch in the mouth to figure that out. Bezos's 2000 shareholder letter started with, "Ouch. It's been a brutal year for many in the capital markets and certainly for Amazon.com shareholders. As of this writing, our shares are down more than 80 percent from when I wrote you last year." It then went on to highlight something that I didn't see in any other shareholder letter, a mistake: "In retrospect, we significantly underestimated how much time would be available to enter these categories and underestimated how difficult it would be for a single category e-commerce companies to achieve the scale necessary to succeed…With a long enough financing runway, pets.com and living.com may have been able to acquire enough customers to achieve the needed scale. But when the capital markets closed the door on financing internet companies, these companies simply had no choice but to close their doors. As painful as that was, the alternative - investing more of our own capital in these companies to keep them afloat- would have been an even bigger mistake." During the mid to late 90s, Amazon was on an M&A and investment tear, and it wasn't until the bubble crashed that they looked back and realized their mistake. Still, optimizing for the long term means admitting those mistakes and changing Amazon's behavior to improve the business. When thinking long-term, the company continued to operate amazingly well.

Business Themes

1. Free Cash Flow per Share. Despite historical rhetoric that Bezos forewent profits in favor of growth, his annual shareholder letters continually reinforce the value of upfront cash flows to Amazon's business model. If Amazon could receive cash upfront and manage its working capital cycle (days in inventory + days AR - days AP), it could scale its operations without requiring tons of cash. He valued the free cash flow per share metric so intensely that he spent an entire shareholder letter (2004) walking through an example of how earnings can differ from cash flow in businesses that invest in infrastructure. This maniacal focus on a financial metric is an excellent reminder that Bezos was a hedge fund portfolio manager before starting Amazon. These multiple personas: the hedge fund manager, the operator, the inventor, the engineer - all make Bezos a different type of character and CEO. He clearly understood financials and modeling, something that can seem notoriously absent from public technology CEOs today.

2. A 1,000 run home-run. Odds and sports have always captivated Warren Buffett, and he frequently liked to use Ted Williams's approach to hitting as a metaphor for investing. Bezos elaborates on this idea in his 2014 Letter (3 Big Ideas): "We all know that if you swing for the fences, you're going to strike out a lot, but you're also going to hit some home runs. The difference between baseball and business, however, is that baseball has a truncated outcome distribution. When you swing, no matter how well you connect with the ball, the most runs you can get is four. In business, every once in a while, when you step up to the plate, you can score one thousand runs. This long-tailed distribution of returns is why its important to be bold. Big winners pay for so many experiments." AWS is certainly a case of a 1,000 run home-run. The company incubated the business and first wrote about it in 2006 when they had 240,000 registered developers. By 2015, AWS had 1,000,000 customers, and is now at a $74B+ run-rate. This idea also calls to mind Monish Pabrai's Spawners idea - or the idea that great companies can spawn entirely new massive drivers for their business - Google with Waymo, Amazon with AWS, Apple with the iPhone. These new businesses require a lot of care and experimentation to get right, but they are 1,000 home runs, and taking bold bets is important to realizing them.

3. High Standards. How does Amazon achieve all that it does? While its culture has been called into question a few times, it's clear that Amazon has high expectations for its employees. The 2017 letter addresses this idea, diving into whether high standards are intrinsic/teachable and universal/domain-specific. Bezos believes that standards are teachable and driven by the environment while high standards tend to be domain-specific - high standards in one area do not mean you have high standards in another. This discussion of standards also calls back to Amazon's 2012 letter entitled "Internally Driven," where Bezos argues that he wants proactive employees. To identify and build a high standards culture, you need to recognize what high standards look like; then, you must have realistic expectations for how hard it should be or how long it will take. He illustrates this with a simple vignette on perfect handstands: "She decided to start her journey by taking a handstand workshop at her yoga studio. She then practiced for a while but wasn't getting the results she wanted. So, she hired a handstand coach. Yes, I know what you're thinking, but evidently this is an actual thing that exists. In the very first lesson, the coach gave her some wonderful advice. 'Most people,' he said, 'think that if they work hard, they should be able to master a handstand in about two weeks. The reality is that it takes about six months of daily practice. If you think you should be able to do it in two weeks, you're just going to end up quitting.' Unrealistic beliefs on scope – often hidden and undiscussed – kill high standards." Companies can develop high standards with clear scope and corresponding challenge recognition.

Dig Deeper

• Jeff Bezo’s Regret Minimization Framework

• Andy Jassy on Figuring Out What's Next for Amazon

• Amazon’s Annual Reports and Shareholder Letters

• Elements of Amazon’s Day 1 Culture

• AWS re:Invent 2021 Keynote

June 2021 - Letters to the Nomad Partnership 2001-2013 (Nick Sleep's and Qais Zakaria's Investor Letters)

This month we review a unique source of information - mysterious fund manager Nick Sleep’s investment letters. Sleep had an extremely successful run and identified several very interesting companies and characteristics of those companies which made for great investments. He was early to uncover Amazon, Costco, and others - riding their stocks into the stratosphere over the last 20 years. These letters cover the internet bubble, the 08/09 crisis, and all types of interesting businesses across the world.

The full letters can be found here

Tech Themes

1. Scale Benefits Shared. Nick Sleep’s favored business model is what he calls Scale Benefits Shared. The idea is straight forward and appears across industries. Geico, Amazon, and Costco all have this business model. Its simple - companies start with low prices and spend only on the most important things. Over time as the company scales (more insured drivers, more online orders, more stores) they pass on the benefits of scale to the customer with even further lower prices. The consumer then buys more with the low-cost provider. This has a devastating effect on competition - it forces companies to exit the industry because the one sharing the scale benefits has to become hyper-efficient to continue to make the business model work. “In the case of Costco scale efficiency gains are passed back to the consumer in order to drive further revenue growth. That way customers at one of the first Costco stores (outside Seattle) benefit from the firm’s expansion (into say Ohio) as they also gain from the decline in supplier prices. This keeps the old stores growing too. The point is that having shared the cost savings, the customer reciprocates, with the result that revenues per foot of retailing space at Costco exceed that at the next highest rival (WalMart’s Sam’s Club) by about fifty percent.” Jeff Bezos was also very focused on this, his 2006 annual letter highlighted as much: “Our judgment is that relentlessly returning efficiency improvements and scale economies to customers in the form of lower prices creates a virtuous cycle that leads over the long-term to a much larger dollar amount of free cash flow, and thereby to a much more valuable Amazon.com. We have made similar judgments around Free Super Saver Shipping and Amazon Prime, both of which are expensive in the short term and – we believe – important and valuable in the long term.” So what companies today are returning scale efficiencies with customers? One recent example is Snowflake - which is a super expensive solution but is at least posturing correctly in favor of this model - the recent earnings call highlighted that they had figured out a better way to store data, resulting in a storage price decrease for customers. Fivetran’s recent cloud data warehouse comparison showed Snowflake was both cheaper and faster than competitors Redshift and Bigquery - a good spot to be in! Another example of this might be Cloudflare - they are lower cost than any other CDN in the market and have millions of free customers. Improvements made to the core security+CDN engine, threat graph, and POP locations result in better performance for all of their free users, which leads to more free users, more threats, vulnerabilities, and location/network demands - a very virtuous cycle!

2. The Miracle of Compound Growth & Its Obviousness. While appreciated in some circles, compounding is revered by Warren Buffett and Nick Sleep - it’s a miracle worth celebrating every day. Sleep takes this idea one step further, after discussing how the average hold period of stocks has fallen significantly over the past few decades: “The fund management industry has it that owning shares for a long time is futile as the future is unknowable and what is known is discounted. We respectfully disagree. Indeed, the evidence may suggest that investors rarely appropriately value truly great companies.” This is quite a natural phenomenon as well - when Google IPO’d in 2004 for a whopping $23bn, were investors really valuing the company appropriately? Were Visa ($18Bn valuation, largest US IPO in history) and Mastercard ($5.3Bn valuation) being valued appropriately? Even big companies like Apple in 2016 valued at $600Bn were arguably not valued appropriately. Hindsight is obvious, but the durability of compounding in great businesses is truly a myth to behold. That’s why Sleep and Zakaria wound down the partnership in 2014, opting to return LP money and only own Berkshire, Costco, and Amazon for the next decade (so far that’s been a great decision!). While frequently cited as a key investing principle, compounding in technology, experiences, art, and life are rarely discussed, maybe because they are too obvious. Examples of compounding (re-investing interest/dividends and waiting) abound: Moore’s Law, Picasso’s art training, Satya Nadella’s experience running Bing and Azure before becoming CEO, and Beatles playing clubs for years before breaking on the scene. Compounding is a universal law that applies to so much!

3. Information Overload. Sleep makes a very important but subtle point toward the end of his letters about the importance of reflective thinking:

   BBC Interviewer: “David Attenborough, you visited the North and South Poles, you witnessed all of life in-between from the canopies of the tropical rainforest to giant earthworms in Australia, it must be true, must it not, and it is a quite staggering thought, that you have seen more of the world than anybody else who has ever lived?”

   David Attenborough: “Well…I suppose so…but then on the other hand it is fairly salutary to remember that perhaps the greatest naturalist that ever lived and had more effect on our thinking than anybody, Charles Darwin, only spent four years travelling and the rest of the time thinking.”

   Sleep: “Oh! David Attenborough’s modesty is delightful but notice also, if you will, the model of behaviour he observed in Charles Darwin: study intensely, go away, and really think.”

   There is no doubt that the information age has ushered in a new normal for daily data flow and news. New information is constant and people have the ability to be up to date on everything, all the time. While there are benefits to an always-on world, the pace of information flow can be overwhelming and cause companies and individuals to lose sight of important strategic decisions. Bill Gates famously took a “think week” each year where he would lock himself in a cabin with no internet connection and scan over hundreds of investment proposals from Microsoft employees. A Harvard study showed that reflection can even improve job performance. Sometimes the constant data flow can be a distraction from what might be a very obvious decision given a set of circumstances. Remember to take some time to think!

Business Themes

1. Psychological Mistakes. Sleep touches on several different psychological problems and challenges within investing and business, including the role of Social Proof in decision making. Social proof occurs when individuals look to others to determine how to behave in a given situation. A classic example of Social Proof comes from an experiment done by Psychologist, Stanley Milgram, in which he had groups of people stare up at the sky on a crowded street corner in New York City. When five people were standing and looking up (as opposed to a single person), many more people also stopped to look up, driven by the group behavior. This principle shows up all the time in business and is a major proponent in financial bubbles. People see others making successful investments at high valuations and that drives them to do the same. It can also drive product and strategic decisions - companies launching dot-com names in the 90’s to drive their stock price up, companies launching corporate venture arms in rising markets, companies today deciding they need a down-market “product-led growth” engine. As famed investor Stan Druckenmiller notes, its hard to sit idly by while others (who may be less informed) crush certain types of investments: “I bought $6 billion worth of tech stocks, and in six weeks I had lost $3 billion in that one play. You asked me what I learned. I didn’t learn anything. I already knew that I wasn’t supposed to do that. I was just an emotional basketcase and I couldn’t help myself. So maybe I learned not to do it again, but I already knew that.”

2. Incentives, Psychology, and Ownership Mindset. Incentives are incredibly powerful in business and its surprisingly difficult to get people to do the right thing. Sleep spends a lot of time on incentives and the so-called Principal-Agent Conflict. Often times the Principal (Owner, Boss, Purchaser, etc.) may employ an Agent (Employee, Contractor, Service) to accomplish something. However the goals and priorities of the principal may not align with that agent. As an example, when your car breaks down and you need to go to a local mechanic to fix it, you (the principal) want to find someone to fix the car as well and as cheaply as possible. However, the agent (the mechanic) may be incentivized to create the biggest bill possible to drive business for their garage. Here we see the potential for misaligned incentives. After 5 years of really strong investment results, Sleep and Zakaria noticed a misaligned incentive of their own: “Which brings me to the subject of the existing performance fee. Eagle-eyed investors will not have failed but notice the near 200 basis point difference between gross and net performance this year, reflecting the performance fee earned. We are in this position because performance for all investors is in excess of 6% per annum compounded. But given historic performance, that may be the case for a very long time. Indeed, we are so far ahead of the hurdle that if the Partnership now earned pass-book rates of return, say 5% per annum, we would continue to “earn” 20% performance fees (1% of assets) for thirty years, that is, until the hurdle caught up with actual results. During those thirty years, which would see me through to retirement, we would have added no value over the money market rates you can earn yourself, but we would still have been paid a “performance fee”. We are only in this position because we have done so well, and one could argue that contractually we have earned the right by dint of performance, but just look at the conflicts!” They could have invested in treasury bonds and collected a performance fee for years to come but they knew that was unfair to limited partners. So the duo created a resetting fee structure, that allowed LPs to claw back performance fees if Nomad did not exceed the 6% hurdle rate for a given year. This kept the pair focused on driving continued strong results through the life of the partnership.

3. Discovery & Pace. Nick Sleep and Qais Zakaria looked for interesting companies in interesting situations. Their pace is simply astounding: “When Zak and I trawled through the detritus of the stock market these last eighteen months (around a thousand annual reports read and three hundred companies interviewed)…” Sleep and Zakaria put up numbers: 55 annual reports per month (~2 per day), 17 companies interviewed per month (meeting every other day)! That is so much reading. Its partially unsurprising that after a while they started to be able to find things in the annual reports that piqued their interest. Not only did they find retrospectively obvious gems like Amazon and Costco, they also looked all around the world for mispricings and interesting opportunities. One of their successful international investments took place in Zimbabwe, where they noticed significant mispricing involving the Harare Stock Exchange, which opened in 1896 but only started allowing foreign investment in 1993. While Nomad certainly made its name on the Scaled efficiencies shared investment model, Zimbabwe offered Sleep and Zakaria to prioritize their second model: “We have little more than a handful of distinct investment models, which overlap to some extent, and Zimcem is a good example of a second model namely, ‘deep discount to replacement cost with latent pricing power.’” Zimcem was the country’s second-largest cement producer, which traded at a massive discount to replacement cost due to terrible business conditions (inflation growing faster than the price of cement). Not only did Sleep find a weird, mispriced asset, he also employed a unique way of acquiring shares to further increase his margin of safety. “The official exchange rate at the time of writing is Z$9,100 to the U$1. The unofficial, street rate is around Z$17,000 to the U$1. In other words, the Central Bank values its own currency at over twice the price set by the public with the effect that money entering the country via the Central Bank buys approximately half as much as at the street rate. Fortunately, there is an alternative to the Central Bank for foreign investors, which is to purchase Old Mutual shares in Johannesburg, re-register the same shares in Harare and then sell the shares in Harare. This we have done.“ By doing this, Nomad was able to purchase shares at a discounted exchange rate (they would also face the exchange rate on sale, so not entirely increasing the margin of safety). The weird and off the beaten path investments and companies can offer rich rewards to those who are patient. This was the approach Warren Buffett employed early on in his career, until he started focusing on “wonderful businesses” at Charlie Munger’s recommendation.

Dig Deeper

• Overview of Several Scale Economies Shared Businesses

• Investor Masterclass Learnings from Nick Sleep

• Warren Buffett & Berkshire’s Compounding

• Jim Sinegal (Costco Founder / CEO) - Provost Lecture Series Spring 2017

• Robert Cialdini - Mastering the Seven Principles of Influence and Persuasion

April 2021 - Innovator's Solution by Clayton Christensen and Michael Raynor

This month we take another look at disruptive innovation in the counter piece to Clayton Christensen’s Innovator’s Dilemma, our July 2020 book. The book crystallizes the types of disruptive innovation and provides frameworks for how incumbents can introduce or combat these innovations. The book was a pleasure to read and will serve as a great reference for the future.

Tech Themes

1. Integration and Outsourcing. Today, technology companies rely on a variety of software tools and open source components to build their products. When you stitch all of these components together, you get the full product architecture. A great example is seen here with Gitlab, an SMB DevOps provider. They have Postgres for a relational database, Redis for caching, NGINX for request routing, Sentry for monitoring and error tracking and so on. Each of these subsystems interacts with each other to form the powerful Gitlab project. These interaction points are called interfaces. The key product development question for companies is: “Which things do I build internally and which do I outsource?” A simple answer offered by many MBA students is “Outsource everything that is not part of your core competence.” As Clayton Christensen points out, “The problem with core-competence/not-your-core-competence categorization is that what might seem to be a non-core activity today might become an absolutely critical competence to have mastered in a proprietary way in the future, and vice versa.” A great example that we’ve discussed before is IBM’s decision to go with Microsoft DOS for its Operating System and Intel for its Microprocessor. At the time, IBM thought it was making a strategic decision to outsource things that were not within its core competence but they inadvertently gave almost all of the industry profits from personal computing to Intel and Microsoft. Other competitors copied their modular approach and the whole industry slugged it out on price. The question of whether to outsource really depends on what might be important in the future. But that is difficult to predict, so the question of integration vs. outsourcing really comes down to the state of the product and market itself: is this product “not good enough” yet? If the answer is yes, then a proprietary, integrated architecture is likely needed just to make the actual product work for customers. Over time, as competitors enter the market and the fully integrated platform becomes more commoditized, the individual subsystems become increasingly important competitive drivers. So the decision to outsource or build internally must be made on the status of product and the market its attacking.

2. Commoditization within Stacks. The above point leads to the unbelievable idea of how companies fall into the commoditization trap. This happens from overshooting, where companies create products that are too good (which I find counter-intuitive, who thought that doing your job really well would cause customers to leave!). Christensen describes this through the lens of a salesperson “‘Why can’t they see that our product is better than the competition? They’re treating it like a commodity!’ This is evidence of overshooting…there is a performance surplus. Customers are happy to accept improved products, but unwilling to pay a premium price to get them.” At this time, the things demanded by customers flip - they are willing to pay premium prices for innovations along a new trajectory of performance, most likely speed, convenience, and customization. “The pressure of competing along this new trajectory of improvement forces a gradual evolution in product architectures, away from the interdependent, proprietary architectures that had the advantage in the not-good-enough era toward modular designs in the era of performance surplus. In a modular world, you can prosper by outsourcing or by supplying just one element.” This process of integration, to modularization and back, is super fascinating. As an example of modularization, let’s take the streaming company Confluent, the makers of the open-source software project Apache Kafka. Confluent offers a real-time communications service that allows companies to stream data (as events) rather than batching large data transfers. Their product is often a sub-system underpinning real-time applications, like providing data to traders at Citigroup. Clearly, the basis of competition in trading has pivoted over the years as more and more banking companies offer the service. Companies are prioritizing a new axis, speed, to differentiate amongst competing services, and when speed is the basis of competition, you use Confluent and Kafka to beat out the competition. Now let’s fast forward five years and assume all banks use Kafka and Confluent for their traders, the modular sub-system is thus commoditized. What happens? I’d posit that the axis would shift again, maybe towards convenience, or customization where traders want specific info displayed maybe on a mobile phone or tablet. The fundamental idea is that “Disruption and commoditization can be seen as two sides of the same coin. That’s because the process of commoditization initiates a reciprocal process of de-commoditization [somewhere else in the stack].”

3. The Disruptive Becomes the Disruptor. Disruption is a relative term. As we’ve discussed previously, disruption is often mischaracterized as startups enter markets and challenge incumbents. Disruption is really a focused and contextual concept whereby products that are “not good enough” by market standards enter a market with a simpler, more convenient, or less expensive product. These products and markets are often dismissed by incumbents or even ceded by market leaders as those leaders continue to move up-market to chase even bigger customers. Its fascinating to watch the disruptive become the disrupted. A great example would be department stores - initially, Macy’s offered a massive selection that couldn’t be found in any single store and customers loved it. They did this by turning inventory three times per year with 40% gross margins for a 120% return on capital invested in inventory. In the 1960s, Walmart and Kmart attacked the full-service department stores by offering a similar selection at much cheaper prices. They did this by setting up a value system whereby they could make 23% gross margins but turn inventories 5 times per year, enabling them to earn the industry golden 120% return on capital invested in inventory. Full-service department stores decided not to compete against these lower gross margin products and shifted more space to beauty and cosmetics that offered even higher gross margins (55%) than the 40% they were used to. This meant they could increase their return on capital invested in inventory and their profits while avoiding a competitive threat. This process continued with discount stores eventually pushing Macy’s out of most categories until Macy’s had nowhere to go. All of a sudden the initially disruptive department stores had become disrupted. We see this in technology markets as well. I’m not 100% this qualifies but think about Salesforce and Oracle. Marc Benioff had spent a number of years at Oracle and left to start Salesforce, which pioneered selling subscription, cloud software, on a per-seat revenue model. This meant a much cheaper option compared to traditional Oracle/Siebel CRM software. Salesforce was initially adopted by smaller customers that didn’t need the feature-rich platform offered by Oracle. Oracle dismissed Salesforce as competition even as Oracle CEO Larry Ellison seeded Salesforce and sat on Salesforce’s board. Today, Salesforce is a $200B company and briefly passed Oracle in market cap a few months ago. But now, Salesforce has raised its prices and mostly targets large enterprise buyers to hit its ambitious growth initiatives. Down-market competitors like Hubspot have come into the market with cheaper solutions and more fully integrated marketing tools to help smaller businesses that aren’t ready for a fully-featured Salesforce platform. Disruption is always contextual and it never stops.

Business Themes

1. Low-end-Market vs. New-Market Disruption. There are two types of established methods for disruption: Low-end-market (Down-market) and New-market. Low-end-market disruption seeks to establish performance that is “not good enough” along traditional lines, and targets overserved customers in the low-end of the mainstream market. It typically utilizes a new operating or financial approach with structurally different margins than up-market competitors. Amazon.com is a quintessential low-end market disruptor compared to traditional bookstores, offering prices so low they angered book publishers while offering unmatched convenience to customers allowing them to purchase books online. In contrast, Robinhood is a great example of a new-market disruption. Traditional discount brokerages like Charles Schwab and Fidelity had been around for a while (themselves disruptors of full-service models like Morgan Stanley Wealth Management). But Robinhood targeted a group of people that weren’t consuming in the market, namely teens and millennials, and they did it in an easy-to-use app with a much better user interface compared to Schwab and Fidelity. Robinhood also pioneered new pricing with zero-fee trading and made revenue via a new financial approach, payment for order flow (PFOF). Robinhood makes money by being a data provider to market makers - basically, large hedge funds, like Citadel, pay Robinhood for data on their transactions to help optimize customers buying and selling prices. When approaching big markets its important to ask: Is this targeted at a non-consumer today or am I competing at a structurally lower margin with a new financial model and a “not quite good enough” product? This determines whether you are providing a low-end market disruption or a new-market disruption.

2. Jobs To Be Done. The jobs to be done framework was one of the most important frameworks that Clayton Christensen ever introduced. Marketers typically use advertising platforms like Facebook and Google to target specific demographics with their ads. These segments are narrowly defined: “Males over 55, living in New York City, with household income above $100,000.” The issue with this categorization method is that while these are attributes that may be correlated with a product purchase, customers do not look up exactly how marketers expect them to behave and purchase the products expected by their attributes. There may be a correlation but simply targeting certain demographics does not yield a great result. The marketers need to understand why the customer is adopting the product. This is where the Jobs to Be Done framework comes in. As Christensen describes it, “Customers - people and companies - have ‘jobs’ that arise regularly and need to get done. When customers become aware of a job that they need to get done in their lives, they look around for a product or service that they can ‘hire’ to get the job done. Their thought processes originate with an awareness of needing to get something done, and then they set out to hire something or someone to do the job as effectively, conveniently, and inexpensively as possible.” Christensen zeroes in on the contextual adoption of products; it is the circumstance and not the demographics that matter most. Christensen describes ways for people to view competition and feature development through the Jobs to Be Done lens using Blackberry as an example (later disrupted by the iPhone). While the immature smartphone market was seeing feature competition from Microsoft, Motorola, and Nokia, Blackberry and its parent company RIM came out with a simple to use device that allowed for short productivity bursts when the time was available. This meant they leaned into features that competed not with other smartphone providers (like better cellular reception), but rather things that allowed for these easy “productive” sessions like email, wall street journal updates, and simple games. The Blackberry was later disrupted by the iPhone which offered more interesting applications in an easier to use package. Interestingly, the first iPhone shipped without an app store (but as a proprietary, interdependent product) and was viewed as not good enough for work purposes, allowing the Blackberry to co-exist. Management even dismissed the iPhone as a competitor initially. It wasn’t long until the iPhone caught up and eventually surpassed the Blackberry as the world’s leading mobile phone.

3. Brand Strategies. Companies may choose to address customers in a number of different circumstances and address a number of Jobs to Be Done. It’s important that the Company establishes specific ways of communicating the circumstance to the customer. Branding is powerful, something that Warren Buffett, Terry Smith, and Clayton Christensen have all recognized as durable growth providers. As Christensen puts it: “Brands are, at the beginning, hollow words into which marketers stuff meaning. if a brand’s meaning is positioned on a job to be done, then when the job arises in a customer’s life, he or she will remember the brand and hire the product. Customers pay significant premiums for brands that do a job well.” So what can a large corporate company do when faced with a disruptive challenger to its branding turf? It’s simple - add a word to their leading brand, targeted at the circumstance in which a customer might find themself. Think about Marriott, one of the leading hotel chains. They offer a number of hotel brands: Courtyard by Marriott for business travel, Residence Inn by Marriott for a home away from home, the Ritz Carlton for high-end luxurious stays, Marriott Vacation Club for resort destination hotels. Each brand is targeted at a different Job to Be Done and customers intuitively understand what the brands stand for based on experience or advertising. A great technology example is Amazon Web Services (AWS), the cloud computing division of Amazon.com. Amazon invented the cloud, and rather than launch with the Amazon.com brand, which might have confused their normal e-commerce customers, they created a completely new brand targeted at a different set of buyers and problems, that maintained the quality and recognition that Amazon had become known for. Another great retail example is the SNKRs app released by Nike. Nike understands that some customers are sneakerheads, and want to know the latest about all Nike shoe drops, so Nike created a distinct, branded app called SNKRS, that gives news and updates on the latest, trendiest sneakers. These buyers might not be interested in logging into the Nike app and may become angry after sifting through all of the different types of apparel offered by Nike, just to find new shoes. The SNKRS app offers a new set of consumers and an easy way to find what they are looking for (convenience), which benefits Nike’s core business. Branding is powerful, and understanding the Job to Be Done helps focus the right brand for the right job.

Dig Deeper

• Clayton Christensen’s Overview on Disruptive Innovation

• Jobs to Be Done: 4 Real-World Examples

• A Peek Inside Marriott’s Marketing Strategy & Why It Works So Well

• The Rise and Fall of Blackberry

• Payment for Order Flow Overview

• How Commoditization Happens

January 2021 - Technological Revolutions and Financial Capital: The Dynamics of Bubbles and Golden Ages by Carlota Perez

This month we read Carlota Perez’s understudied book covering the history of technology breakthroughs and revolutions. This book marries the role of financing and technology breakthrough so seamlessly in an easy to digest narrative style.

Tech Themes

1. The 5 Technology Revolutions. Perez identifies the five major technological revolutions: The Industrial Revolution (1771-1829), The Age of Steam and Railways (1829-1873), The Age of Steel, Electricity and Heavy Engineering (1875-1918), The Age of Oil, the Automobile and Mass Production (1908-1974), and The Age of Information and Telecommunications (1971-Today). When looking back at these individual revolutions, one can recognize how powerful it is to view the world and technology in these incredibly long waves. Many of these periods lasted for over fifty years while their geographic dispersion and economic effects fully came to fruition. These new technologies fundamentally alter society - when it becomes clear that the revolution is happening, many people jump on the bandwagon. As Perez puts it, “The great clusters of talent come forth after the evolution is visible and because it is visible.” Each revolution produces a myriad of change in society. The industrial revolution popularized factory production, railways created national markets, electricity created the power to build steel buildings, oil and cars created mass markets and assembly lines, and the microprocessor and internet created amazing companies like Amazon and Airbnb.

2. The Phases of Technology Revolution. After a decently long gestation period during which the old revolution has permeated across the world, the new revolution normally starts with a big bang, some discovery or breakthrough (like the transistor or steam engine) that fundamentally pushed society into a new wave of innovation. Coupled with these big bangs, is re-defined infrastructure from the prior eras - as an example, the Telegraph and phone wires were created along the initial railways, as they allowed significant distance of uninterrupted space to build on. Another example is electricity - initially, homes were wired to serve lightbulbs, it was only many years later that great home appliances came into use. This initial period of application discovery is called the Irruption phase. The increasing interest in forming businesses causes a Frenzy period like the Railway Mania or the Dot-com Boom, where everyone thinks they can get rich quick by starting a business around the new revolution. As the first 20-30 years of a revolution play themselves out, there grows a strong divide between those who were part of the revolution and those who were not; there is an economic, social, and regulatory mismatch between the old guard and the new revolution. After an uprising (like the populism we have seen recently) and bubble collapse (Check your crystal ball), regulatory changes typically foster a harmonious future for the technology. Following these changes, we enter the Synergy phase, where technology can fully flourish due to accommodating and clear regulation. This Synergy phase propagates outward across all countries until even the lagging adopters have started the adoption process. At this point the cycle enters into Maturity, waiting for the next big advance to start the whole process over again.

3. Where are we in the cycle today? We tweeted at Carlota Perez to answer this question AND SHE RESPONDED! My question to Perez was: With the recent wave of massive, transformational innovation like the public cloud providers, and the iPhone, are we still in the Age of Information? These technological waves are often 50-60 years and yet we’ve arguably been in the same age for quite a while. This wave started in 1971, exactly 50 years ago, with Intel and the creation of the microprocessor. Are we in the Frenzy phase with record amounts of investment capital, an enormous demand for early stage companies, and new financial innovations like Affirm’s debt securitizations? Or have we not gotten to the Frenzy phase yet? Is the public cloud or the iPhone the start of a new big bang and we have overlapping revolutions for the first time ever? Obviously identifying the truly breakthrough moments in technology history is way easier after the fact, so maybe we are too new to know what really is a seminal moment. Perez’s answer, though only a few words, fully provides scope to the question. Perez suggests we are still in the installation phase (Irruption and Frenzy) of the new technology and that makes a lot of sense. Sure, internet usage is incredibly high in the US (96%) but not in other large countries. China (the world’s largest country by population) has only 63% using the internet and India (the world’s second-largest country) has only 55% of its population using the internet. Ethiopia, with a population of over 100M people only has 18% using the internet. There is still a lot of runway left for the internet to bloom! In addition, only recently have people been equipped with a powerful computing device that fits in their pocket - and low-priced phones are now making their way to all parts of the world led by firms like Chinese giant Transsion. Added to the fact that we are not fully installed with this revolution, is the rise of populism, a political movement that seeks to mobilize ordinary people who feel disregarded by the elite group. Populism has reared its ugly head across many nations like the US (Donald Trump), UK (Brexit), Brazil (Bolsonaro) and many other countries. The rise of populism is fueled by the growing dichotomy between the elites who have benefitted socially and monetarily from the revolution and those who have not. In the 1890’s, anti-railroad sentiment drove the creation of the populist party. More recently, people have become angry at tech giants (Facebook, Google, Amazon, Apple, Twitter) for unfair labor practices, psychological manipulation, and monopolistic tendencies. The recent movie, the Social Dilemma, which suggests a more humane and regulatory focused approach to social media, speaks to the need for regulation of these massive companies. It is also incredibly ironic to watch a movie about how social media is manipulating its users while streaming a movie that was recommended to me on Netflix, a company that has popularized incessant binge-watching through UX manipulation, not dissimilar to Facebook and Google’s tactics. I expect these companies to get regulated soon -and I hope that once that happens, we enter into the Synergy phase of growth and value accruing to all people.

Yes, I do. I will find the time to reply to you properly. But just quickly, I think installation was prolonged by QE &casino finance; we are at the turning point (the successful rise of populism is a sign) and maybe post-Covid we'll go into synergy.

— Carlota Perez (@CarlotaPrzPerez) January 17, 2021

Business Themes

1. The role of Financial Capital in Revolutions. As the new technology revolutions play themselves out, financial capital appears right alongside technology developments, ready to mold the revolution into the phases suggested by Perez. In the irruption phase, as new technology is taking hold, financial capital that had been on the sidelines waiting out the Maturity phase of the previous revolution plows into new company formation and ideas. The financial sector tries to adopt the new technology as soon as possible (we are already seeing this with Quantum computing), so it can then espouse the benefits to everyone it talks to, setting the stage for increasing financing opportunities. Eventually, demand for financing company creation goes crazy, and you enter into a Frenzy phase. During this phase, there is a discrepancy between the value of financial capital and production capital, or money used by companies to create actual products and services. Financial capital believes in unrealistic returns on investment, funding projects that don’t make any sense. Perez notes: “In relation to the canal Mania of the 1790s, disorder and lack of coordination prevailed in investment decisions. Canals were built ‘with different widths and depths and much inefficient routing.’ According to Dan Roberts at the Financial Times, in 2001 it was estimated that only 1 to 2 percent of the fiber optic cable buried under Europe and the United States had so far been turned on.” These Frenzy phases create bubbles and further ingrain regulatory mismatch and political divide. Could we be in one now with deals getting priced at 125x revenue for tiny companies? After the institutional reckoning, the Technology revolution enters the Synergy phase where production capital has really strong returns on investment - the path of technology is somewhat known and real gains are to be made by continuing investment (especially at more reasonable asset prices). Production capital continues to go to good use until the technology revolution fully plays itself out, entering into the Maturity phase.

2. Casino Finance and Prolonging Bubbles. One point that Perez makes in her tweet, is that this current bubble has been prolonged by QE and casino finance. Quantitative easing is a monetary policy where the federal reserve (US’s central bank) buys government bonds issued by the treasury department to inject money into the financial ecosystem. This money at the federal reserve can purchase bank loans and assets, offering more liquidity to the financial system. This process is used to create low-interest rates, which push individuals and corporations to invest their money because the rate of interest on savings accounts is really really low. Following the financial crisis and more recently COVID-19, the Federal Reserve lowered interest rates and started quantitative easing to help the hurting economy. In Perez’s view, these actions have prolonged the Irruption and Frenzy phases because it forces more money into investment opportunities. On top of quantitative easing, governments have allowed so-called Casino Capitalism - allowing free-market ideals to shape governmental policies (like Reagan’s economic plan). Uninterrupted free markets are in theory economically efficient but can give rise to bad actors - like Enron’s manipulation of California’s energy markets after deregulation. By engaging in continual quantitative easing and deregulation, speculative markets, like collateralized loan obligations during the financial crisis, are allowed to grow. This creates a risk-taking environment that can only end in a frenzy and bubble.

3. Synergy Phase and Productive Capital Allocation. Capital allocation has been called the most important part of being a great investor and business leader. Think about being the CEO of Coca Cola for a second - you have thousands of competing projects, vying for budget - how do you determine which ones get the most money? In the investing world, capital allocation is measured by conviction. As George Soros’s famous quote goes: “It's not whether you're right or wrong, but how much money you make when you're right and how much you lose when you're wrong.” Clayton Christensen took the ideas of capital allocation and compared them to life investments, coming to the conclusion: “Investments in relationships with friends and family need to be made long, long before you’ll see any sign that they are paying off. If you defer investing your time and energy until you see that you need to, chances are it will already be too late.” Capital and time allocation are underappreciated concepts because they often seem abstract to the everyday humdrum of life. It is interesting to think about capital allocation within Perez’s long-term framework. The obvious approach would be to identify the stage (Irruption, Frenzy, Synergy, Maturity) and make the appropriate time/money decisions - deploy capital into the Irruption phase, pull money out at the height of the Frenzy, buy as many companies as possible at the crash/turning point, hold through most of the Synergy, and sell at Maturity to identify the next Irruption phase. Although that would be fruitful, identifying market bottoms and tops is a fool’s errand. However, according to Perez, the best returns on capital investment typically happen during the Synergy phase, where production capital (money employed by firms through investment in R&D) reigns supreme. During this time, the revolutionary applications of recently frenzied technology finally start to bear fruit. They are typically poised to succeed by an accommodating regulatory and social environment. Unsurprisingly, after the diabolic grifting financiers of the frenzy phase are exposed (see Worldcom, Great Financial Crisis, and Theranos), social pressures on regulators typically force an agreement to fix the loopholes that allowed these manipulators to take advantage of the system. After Enron, the Sarbanes-Oxley act increased disclosure requirements and oversight of auditors. After the GFC, the Dodd-Frank act mandated bank stress tests and introduced financial stability oversight. With the problems of the frenzy phase "fixed” for the time being, the social attitude toward innovation turns positive once again and the returns to production capital start to outweigh financial capital which is now reigned in under the new rules. Suffice to say, we are probably in the Frenzy phase in the technology world, with a dearth of venture opportunities, creating a massive valuation increase for early-stage companies. This will change eventually and as Warren Buffett says: “It’s only when the tide goes out that you learn who’s been swimming naked.” When the bubble does burst, regulation of big technology companies will usher in the best returns period for investors and companies alike.

Dig Deeper

• The Financial Instability Hypothesis: Capitalist Processes and the Behavior of the Economy

• Bubbles, Golden Ages, and Tech Revolutions - a Podcast with Carlota Perez

• Jeff Bezos: The electricity metaphor (2007)

• Where Does Growth Come From? Clayton Christensen | Talks at Google

• A Spectral Analysis of World GDP Dynamics: Kondratieff Waves, Kuznets Swings, Juglar and Kitchin Cycles in Global Economic Development, and the 2008–2009 Economic Crisis

June 2020 - Bad Blood by John Carreyrou

This month we review John Carreyrou’s chilling story of the epic meltdown of a company, Theranos. We explore bad decision making, the limits of technology and the importance of strong corporate governance. The saddest thing and the reason Bad Blood hits so hard is that Theranos was a startup that seemed to have everything: a breakthrough blood analyzer, tons of funding, excellent board representation, and a smart, visionary female CEO. But underneath, it was a twisted cult of distrust with an evil leader.

Tech Themes

1. The limits of technology. Sometimes technology sounds too good to be true. Theranos’ Edison and miniLab blood analyzers were supposed to tell you everything you could ever want to know about your blood. But they didn’t work and never had a shot to work. Stanford professor Phyllis Gardener even told Elizabeth Holmes (Theranos’ founder/CEO) early-on that an early patch-like design of the product would never work: “[Holmes] just kind of blinked and nodded and left. It was just a 19-year-old talking who’d taken one course in microfluidics, and she thought she was gonna make something of it.” It was debunked by almost every scientist as wild fantasy even prior to its commercial use and subsequent fall from grace. There is something so human about wanting to believe there are no limits to technology. In today’s day of fake technology marketing, it’s easy for messaging to slowly take over a company if left unchecked. Think about Snap’s famous declaration, “Snap Inc. is a camera company.” or Dropbox’s S-1 mission statement: “Unleash the world’s creative energy by designing a more enlightened way of working.” These statements ignore what these businesses fundamentally do - advertising and storage. Sometimes there are massive leaps forward, like the transistor, networked computing, and the internet, but even these took many many years to push to fruition. When humans hear a compelling pitch, it is natural to want to remove those limits of technology because the result is so astounding, but we have to remain skeptical or risk another Theranos.

2. The reality distortion field. Elizabeth Holmes was obsessed with Steve Jobs. Mired in this deep fixation, she also managed to subscribe to one of Jobs’ interesting habits: the reality-distortion field. While we’ve discussed the reality distortion field before in relation to Jobs, Holmes seemed to take it to a new level. Jobs would demand something incredible be done and a lot of times his amazing team could come up with the solution. Holmes also believed this but failed to consider two things: fundamental biology and her team. Biology, at its core, is just not as flexible as the hardware and software that Apple was building. Jobs demanded an excellent product, Holmes demanded a biological impossibility. Beyond searching to enable a biological impossibility, which to be frank, can pop up after years of research (see CRISPR), Holmes operated the Theranos cult as a dictator, ruthlessly seeking out dissenters and punishing or firing them. While Jobs challenged his team repeatedly while being a huge asshole, the team, for the most part, stayed in tact (Phil Schiller, Tony Fadell, Jony Ive, Scott Forstall, and Eddy Cue). There were certainly those who got fired or left, but Holmes active rooting out of non-believers severely limited the chances of success at the company. The additional levels of secrecy were even extreme for a stealth technology startup. Startup founders need to drink the kool-aid sometimes, it comes with being visionary, but getting so drunk on power and image can only lead to personal and business demise as was the case with Theranos.

3. When startups turn bad. Tons of startups fail, but only a few turn truly malicious. Theranos was one of those few. The company tested people’s blood and gave individuals fake, untested medical results, including indicators of cancer diagnoses! Even when reviewing other major business failures and frauds - Jeff Skilling at Enron and Bernie Madoff’s Ponzi Scheme - nothing compares to Theranos. While it could be argued that Enron and Madoff’s schemes did more and broader financial hurt to society, at least they were never physically endangering individuals. The only comparisons that may be warranted are Boeing and the Fyre Festival. The brainchild of famous clown, Billy McFarland, the Fyrefest certainly endangered people by marooning them on an island with little food. Furthermore, Boeing’s incredibly incoherent internal review process which knowingly led to the production of a faulty airline software system, also endangered people - including two flights that crashed because of its system. Did Elizabeth Holmes set out to build a dangerous device, knowingly defraud investors, and endanger the public? Probably not. It was one decision after another. It was firing CFO Henry Mosley who called out fake projections; it was hiring Boies Schiller to pressure former employees; it was enlisting Sunny Balwani to “run” the company. It was what Clayton Christensen calls marginal thinking - the idea that the incremental bad decision or the incremental costs of doing something frequently outweigh the full costs of doing something. The incremental cost of firing the CFO who wouldn’t make fake numbers was simply easier than facing the difficult reality that the product sucked, and they had pushed through too much investor money to start again. When things turn bad, at startups or other businesses, a trail of marginal decision making can normally be found.

Business Themes

1. The Pressure to Succeed. Stress seems to be a part of business, but the pressure can sometimes get too big to handle. Public companies, in particular, face growth targets from wall street analysts and investors. One earnings miss or even a more modest beat than expected can completely derail a stock (See pluralsight and alteryx graphs to the right). Public company CEOs and CFOs can be fired or have compensation withheld for poor stock performance. So when a young hot biotechnology startup wanted to launch a partnership with Walgreens, Dr. J and the Walgreens team were more than ready to fast track the potential partnership. Despite not being allowed to use the bathroom, see the lab or see a partial demo of the product, Walgreens pushed through a deal so that longtime competitor, CVS, wouldn’t get the deal. As then head of the Theranos/Walgreens pilot said, "We can’t not pursue this. We can’t risk a scenario where CVS has a deal with them in six months and it ends up being real.” When the partnership was announced, even the press release sounded oddly formulaic: “Theranos’ proprietary laboratory infrastructure minimizes human error through extensive automation to produce high quality results.” There was no demo. There was no product. There was only pressure at Walgreens to beat CVS and pressure at Theranos to make something from a fake device.

2. The Importance of Corporate Governance. Corporate Governance has historically rarely been discussed outside of academic settings but has come into sharper focus over the past few years. Some have recently tried to bring some of the prominent corporate governance issues such as member compensation and option grants for executives to the forefront. Warren Buffet even commented on boards in his 2019 annual shareholder letter: “Director compensation has now soared to a level that inevitably makes pay a subconscious factor affecting the behavior of many non-wealthy members. Think, for a moment, of the director earning $250,000-300,000 for board meetings consuming a pleasant couple of days six or so times a year. And job security now? It’s fabulous. Board members may get politely ignored, but they seldom get fired. Instead, generous age limits – usually 70 or higher – act as the standard method for the genteel ejection of directors.” Boards are meant to help guide the company through strategic challenges, ensure the business is focused on the right things, and evaluate the CEO. Theranos’ Board of Directors was a laughable hodgepodge of old white men: George P. Shultz (former U.S. Secretary of State), William Perry (former U.S. Secretary of Defense), Henry Kissinger (former U.S. Secretary of State), Sam Nunn (former U.S. Senator), Bill Frist (former U.S. Senator and heart-transplant surgeon), Gary Roughead (Admiral, USN, retired), James Mattis (General, USMC), Richard Kovacevich (former Wells Fargo Chairman and CEO), and Riley Bechtel. The average age of the directors in 2012 was ~72 years old and few of these men could offer real strategic guidance in pursuing novel biotechnology. On top of that, as Carreyrou points out, “In December 2013, [Holmes] forced through a resolution that assigned one hundred votes to every share she owned, giving her 99.7% of the voting rights.” George Shultz even said later in a deposition, “We never took any votes at Theranos. It was pointless. Elizabeth was going to decide whatever she decided.” The episode brings more clarity to those CEOs and companies who hide behind their Board of Directors, who promise governance for investors, but rarely deliver on anything beyond pandering to the CEO’s whims. In another ludicrous comparison, Apple and Steve Jobs specifically have also been accused of shoddy corporate governance. In 2007, Apple famously backdated Jobs options, allowing him to make an instant profit, and did not even bother to report that it had issued the options. The best companies are not immune, and investors and employees should be aware of the qualifications and monetary interests of a company’s board members.

3. Search and Destroy. Only the Paranoid Survive, right? Wrong. There is such thing as too much paranoia. When you combine that paranoia with a manipulative persona, you get Elizabeth Holmes. It’s hard to believe that any startup or founder would need the level of security and secrecy that dominated the culture at Theranos. The list of weird security and legal gray areas include: personal security for Holmes, laboratory developed tests (instead of FDA approved tests), copious and vigorously enforced NDAs, siloed teams with no communication, and false representation in the media. Organizations are often secret and many startups operate in stealth to not give away details to competitors. Some larger companies launch new divisions in separate locations from their office, like Amazon a9. The Company hired private investigators (through its powerful law firm Boies Schiller) to threaten and track former employees including Erika Chung and Tyler Schulz. Tyler Schulz, grandson of board member George Schulz, was one of the key informants to author John Carreyrou. After he accused Elizabeth and Sunny of lying and potentially harming patients, he resigned and tried to convince his grandfather that it was all a sham. His grandfather agreed to speak with him one-on-one and at the end of the conversation surprised Tyler with two attorneys from Boies Schiller who almost forced Tyler to sign a confidentiality agreement. Tyler refused, which eventually led to the publication of Carreyrou’s first article. As early board member Avie Tevanian put it, “I had seen so many things that were bad go on. I would never expect anyone would behave the way that she behaved as a CEO. And believe me, I worked for Steve Jobs. I saw some crazy things. But Elizabeth took it to a new level.” Again, sadly, while Theranos may be the pinnacle of secrecy, paranoia and threatening behavior, eBay recently fired six employees for threatening online reviewers. On top of sending live spiders to the reviewers’ household, eBay team members would knock on their doors day or night, to scare the reviewers. How could these employees think this was ok? How could Elizabeth partake in this threatening and manipulative behavior? As Organizational Behavior professor Roderick Kramer reminds us: “‘Reality’ is not a fixed entity but rather a tissue of facts, impressions, and interpretations that can be manipulated and perverted by clever and devious businesses and governments.” Theranos’ fake Edison tests are reminiscent of Enron’s fake trading floor, where 70 low level employees once pretended to be busy to impress wall street analysts. Paranoia and secrecy are powerful weapons when left unchecked, and clearly Theranos' wielded those weapons to the fullest extent.

Dig Deeper

• HBO Documentary: “The Inventor: Out for Blood in Silicon Valley” has many interviews and deep analysis on Theranos

• When Paranoia Makes Sense by Organizational Behavior Professor Roderick Kramer

• Theranos criminal trial set to begin March 9, 2021

• Ex-Theranos CEO Elizabeth Holmes says 'I don't know' 600-plus times in never-before-broadcast deposition tapes

• Holmes’ famous Mad Money Interview: “First they think you're crazy, then they fight you, and then all of a sudden you change the world.”

• Theranos’ still active Twitter account