Cost of machinery: Rs 10 cr. Expected life of machine: 10 years Annual savings: Rs 2.50 cr. p.a. Expected residual value of the machine: Rs 1 cr. Cost of capital: 15% p.a. Accept or reject?You are the CFO of a textile company which manufactures commodity yarn and operates in an extremely competitive market.Both industry, and your company, earns sub par return on capital.A textile machinery manufacturer approaches you with a proposal to sell you a new type of textile machine, which is more efficient than anymachine invented till date.What does DCF teach you?
Warren Edward BuffettAnd he will be your teacher for a good part of this course.
Why did he do it?Buffett does not have an MBA :-)How did he solve the problem? Let’s read his own words. And as I read thewords, focus a bit on the highlighted text.
“The domestic textile industry operatesin a commodity business, competing in aworld market in which substantial excess capacity exists.
“Much of the trouble we experienced was attributable, both directly and indirectly, to competition from foreign countries whose workers are paid a small fraction of the U.S. minimum wage...Commodity + Excess Capacity due to Competition = Perfect Competition [Microeconomics]
“Over the years we had the option of making large capital expenditures in thetextile operation that would have allowed us to somewhat reduce variable costs... Each proposal to do so looked like an immediate winner...
“Measured by standard return-on-investment tests, in fact, these proposals usually promised greater economic beneﬁts than would have resulted from comparable expenditures in our highly- proﬁtable candy and newspaper businesses...
“But the promised beneﬁts from these textile investments were illusory...
“Many of our competitors, both domesticand foreign, were stepping up to the same kind of expenditures and, once enough companies did so, their reduced costs became the baseline for reduced prices industrywide...
“Viewed individually, each company’scapital investment decision appeared cost- effective and rational..
“Viewed collectively, the decisionsneutralized each other and were irrational (just as happens when each person watching a parade decides he can see a little better if he stands on tiptoes)...
“Thus, we faced a miserable choice: huge capital investment would have helped tokeep our textile business alive, but wouldhave left us with terrible returns on ever- growing amounts of capital...
“After the investment, moreover, the foreign competition would still haveretained a major, continuing advantage in labor costs...
“A refusal to invest, however, would make us increasingly non-competitive, even measured against domestic textile manufacturers...
And so, Mr. Buffett shut down the textile business of Berkshire HathawayBut what about cost accountants and their idea of “shut down point?”
What’s the problem with people who only use DCF or Cost Accounting concepts like “shut down point?
To a Man with a Hammer, Everything Looks Like a Nail
“[Buffett] knew that the hugeproductivity increases that wouldcome from a better machineintroduced into the production of acommodity product...
“would all go to the beneﬁt of thebuyers of the textiles. Nothing wasgoing to [come to us] as owners...
“That’s such an obvious concept – that there are all kinds of wonderful new inventions that give you nothing as owners...
“except the opportunity to spend a lot more money in abusiness that’s still going to be lousy...
“The money still won’t come toyou. All of the advantages fromgreat improvements are going toﬂow through to the customers…
“Conversely, if you own the onlynewspaper in town and they were toinvent more efﬁcient ways of composingthe newspaper...
“then when you got rid of the oldtechnology and got new, fancycomputers, then all of the savings wouldcome right through to the bottom line...
“In all cases, the people who sell the machinery – and even the internal bureaucrats urging you to buy the equipment...
“show you projections withthe amount you’ll save at current prices with thenew technology...
“However, they don’t dothe second step of theanalysis – which is todetermine how much isgoing to stay home andhow much is just going toﬂow through to thecustomer…
“I’ve never seen asingle projectionincorporating thatsecond step in mylife. And I see themall the time...
“Rather, they always read: “This capital outlay will save you so much money that it will pay for itself in three years…”payback period
“So you keep buying things that will payfor themselves in three years…
“And after twenty years of doing it,somehow you’ve earned a return of onlyabout four percent per annum. That’s thetextile business...
“And it isn’t that the machines weren’tbetter. It’s just that the savings didn’t goto you...
“The cost reductions came through allright. But the beneﬁt of the costreductions didn’t go to the guy whobought the equipment...
“It’s such a simple idea. It’s so basic. Andyet it’s so often forgotten.”
“Viewed collectively, the decisions neutralized each other and were irrational (just as happens when each person watching a parade decides he can see a little better if he stands on tiptoes)... Buffett’s metaphor of the parade is the functional equivalent of which mental model?
1 2 3 4 5 6 Opportunity Cost [Microeconomics]He compared his prospective investment for efficiency improvement in textile with those in newspaperand candy.And the IRRs were LOWER in Candy and Newspaper. But he was going to RETAIN ALL OF THE BENEFIT ofthe investment in candy and newspaper and none of it in textiles.
1 2 3 4 5 6 Contrast Effect [Psychology]Did not fall for the “throwing good money after bad” trap even though the money to bespent was small in comparison with money already spent.
1 2 3 4 5 6 Commitment & Consistency [Psychology]Sunk costs are irrelevant. He did not think “Oh I have already invested so much. Now Ican’t write it off.”
Buffett used aframework ofmental modelsfrom multiple disciplines
A mental model is a representation inside your head of an external realityYou observe something and then you try to relate to it a model inside yourhead.
Mental Models are his idea Herb Simon Nobel Laureate
Simon inﬂuencedCharlie Munger about mental models
“One can train a man sothat he has at his disposal alist or repertoire of thepossible actions that couldbe taken under thecircumstances...
“A person who is new at thegame does not haveimmediately at his disposal aset of possible actions toconsider, but has to constructthem on the spot, ... a time-consuming and difﬁcult mentaltask...
“The decision maker of experience has at his disposal a checklist of things to watch out for before ﬁnally accepting a decision.”Expert ﬁre ﬁghters, chess grandmasters seek patterns.
“A large part of thedifference between theexperienced decisionmaker and the novice inthese situations is notany particular intangiblelike “judgment” or“intuition”...
“If one could open thelid, so to speak, and seewhat was in the head ofthe experienceddecision-maker, onewould ﬁnd that hehad. . . at his disposal...
“repertoires of possibleactions; that he had. . .checklists of things to thinkabout before he acted; andthat he had mechanisms in hismind to evoke these, andbring these to his consciousattention when the situationsfor decisions arose.
“Most of what we do is to get people ready to act in situations of encounter consists of drilling in these lists into them sufﬁciently deeply so that they will be evoked quickly at the time of the decision.”That’s my job - to train you to think in a checklist style. Your checklist will have mental models, and youwill use your experience (direct and vicarious) to relate what you see in the world to what’s on your listof mental models.The expert KNOWS what he has to do e.g. an experienced ﬁre ﬁghter- what appears to be intuition andgut feel and blink, is actually based on experience and models.
To think much better,you’ll need a checklist of mental models
These mental models will come from multiple disciplinesEconomics, Psychology, Accounting, Chemistry, Physics, Mathematics, Engineering andEvolutionary Biology.
http://www.thebrain.comMy latticework of mental models
About 20 models from psychology will becomebehavioral ﬁnance
“You dont have to pee on an electricfence to learn not to do it.”
“The man who doesnot read great books has no particular advantage over a man who cannot read them.” - Mark Twain
“We learn more fromthe great businessmagazines than we doanywhere else...
“Its such an easyshorthand way of getting avast variety of businessexperience just to rifﬂethrough issue after issueafter issue covering a greatvariety of businesses...
“And if you get the mentalhabit of relating what yourereading to the basicstructure of the underlyingideas [i.e. mental models]being demonstrated, youllgradually accumulate somewisdom about investing.”
“If you want to get smart,the question you’ve got toask is why? why? why? Andyou relate the answers to astructure of deeptheory.” [Mental Models]
To acquire general wisdom, you also need: 3.Full attribution ethos; and 4.Extreme reductionism (like in algebra) to understand lollapalooza outcomes e.g. 2x + 6y = 12 can be reduced to x + 3y = 6.If you don’t attribute the models you are using to the discipline you are grabbing them from, you get a sloppy ﬁling system in your brain.Lollapaloooza = 1+1 = 3 e.g like in a chain reaction - critical mass - a model from physics.Working backwards from lollapalooza
“If you want to rise in theworld above others you justmust use the mental modelframework in a checklist stylefashion - otherwise it will bean unequal contest like thatof a one-legged man in an asskicking contest.”
Exception # 2: Raise price, use extra money to bribe the intermediaries Incentives: [Economics]Incentive-caused bias (“whose bread I eat, his song I sing”): [Psychology]
e.g. penny stocks, IPOs, cocaine, time shares, overpriced-insurance, ANY product or service with a FAT commission behind it
The FUNCTIONAL EQUIVALENTS of Boiler RoomsApplication of CIALDINI
What’s all this got to do with this guy? David Ricardo
Ricardo’s idea: Comparative advantageTrade beneﬁts trading partners. Trade is NOT a zero-sum game But when intermediaries are bribed massively, does it not become the functional equivalent of a zero-sum game?
“Firms of old standing vied one with theother in foisting unremarkable rubbish onthe guileless investor.” – from an article on investment bankers published in 1894.
“foisting unremarkable rubbish on the guileless investor...Examples of how even now, under the inﬂuence of fat incentives,investment bankers bring fraud companies to market.
One of history’s greatestswindlersPonzi scheme is alsocalled the pyramidscheme
A non-sustainablebusiness model involvingthe exchange of moneyprimarily for enrollingother people into thescheme, usually withoutany product or servicebeing delivered.
The answer comes from mathematics. You will eventually run out of greater fools. What happened to dot coms?Ponzi Scheme is a special case of which MENTAL MODEL already discussed?See the POWER of using a mental model framework? You KNOW WHAT WILL HAPPEN.You become a BETTER predictor of future - u get an advantage over the rest of humanity who don’t see ponzi’s where u can see them...Tiny advantages, magniﬁed over a long time make huge differences in eventual outcomes - compound interest.
Functional Equivalents?chain letters, robbing peter to pay paul, greater fools, venture cap (partly), yield traps in RIETS and other stocks, multi-levelmarking (Amway), pension funds (EMBEDDED PONZI), Floats
The Red Queen EffectIn Lewis Carroll’s “Through the Looking Glass,” the Red Queen seizes Alice by the hand anddraggs her, faster and faster, on a frenzied run through the countryside, but no matter howfast they run they always stay in the same place. Alice is understandably puzzled, and says,“Well in our country youd generally get to somewhere else - if you ran very fast for a longtime as weve been doing.” “A slow sort of country!” Says the Queen. “Now, here, you see, ittakes all the running you can do, to keep in the same place. If you want to get somewhereelse, you must run at least twice as fast as that!”
From Deep Simplicity:“Kauffman is particularly fond of describing this in terms of an imaginary species of frog that feeds on an imaginary species of ﬂy,and we will follow his example. There are lots of ways in which the frogs, who want to eat ﬂies, and the ﬂies, who want to avoid beingeaten, interact. Frogs might evolve longer tongues, for ﬂy-catching purposes; ﬂies might evolve faster ﬂight, to escape. Flies mightevolve an unpleasant taste, or even excrete poisons that damage the frogs, and so on. We’ll pick one (hypothetical) possibility. If afrog has a particularly sticky tongue, it will ﬁnd it easier to catch ﬂies. But if ﬂies have particularly slippery bodies, they will ﬁnd iteasier to escape, even if the tongue touches them. Imagine a stable situation in which a certain number of frogs live on a pond andeat a certain proportion of the ﬂies around them each year…”“...Because of a mutation (or even just through the natural variations between individuals) a frog developes an extra sticky tongue. Itwill do well, compared with other frogs, and genes for extra sticky tongues will spread through the frog population. At ﬁrst, a largerproportion of ﬂies gets eaten. But the ones who don’t get eaten will be the more slippery ones, so genes for extra slipperiness willspread through the ﬂy population. After a while, there will be the same number of frogs on the pond as before, and the sameproportion of ﬂies will be eaten each year. It looks as if nothing has changed – but the frogs have got stickier tongues, and the ﬂieshave got more slippery bodies.”
“In August 2000, Jerry Mayfield, a forty-one-year-old Louisiana policeman diagnosed with CML, began treatment with Gleevec.Mayfield’s cancer responded briskly at first. The fraction of leukemic cells in his bone marrow dropped over six months. His bloodcount normalized and his symptoms improved; he felt rejuvenated—“like a new man [on] a wonderful drug.” But the response wasshort-lived. In the winter of 2003, Mayfield’s CML stopped responding. Moshe Talpaz, the oncologist treating Mayfield in Houston,increased the dose of Gleevec, then increased it again, hoping to outpace the leukemia. But by October of that year, there was noresponse. Leukemia cells had fully recolonized his bone marrow and blood and invaded his spleen. Mayfield’s cancer had becomeresistant to targeted therapy.”… “Even targeted therapy, then, was a cat-and-mouse game. One could direct endless arrows at the Achilles’ heel of cancer, but thedisease might simply shift its foot, switching one vulnerability for another. We were locked in a perpetual battle with a volatilecombatant. When CML cells kicked Gleevec away, only a different molecular variant would drive them down, and when theyoutgrew that drug, then we would need the next-generation drug. If the vigilance was dropped, even for a moment, then the weightof the battle would shift. In Lewis Carroll’s Through the Looking-Glass, the Red Queen tells Alice that the world keeps shifting soquickly under her feet that she has to keep running just to keep her position. This is our predicament with cancer: we are forced tokeep running merely to keep still.”
Inﬂation = Running Up on a Down Escalator“If you (a) forego ten hamburgers to purchase an investment; (b) receive dividends which, after tax,buy two hamburgers; and (c) receive, upon sale of your holdings, after-tax proceeds that will buyeight hamburgers, then (d) you have had no real income from your investment, no matter how muchit appreciated in dollars. You may feel richer, but you won’t eat richer.High rates of inﬂation create a tax on capital that makes much corporate investment unwise—at leastif measured by the criterion of a positive real investment return to owners. This “hurdle rate” thereturn on equity that must be achieved by a corporation in order to produce any real return for itsindividual owners—has increased dramatically in recent years. The average tax-paying investor isnow running up a down escalator whose pace has accelerated to the point where his upwardprogress is nil.”
A Bad Business = Running Up on a Down Escalator“The worst business of all is the one that grows a lot, where you’re forcedto grow just to stay in the game at all and where you’re re-investing thecapital at a very low rate of return.”
Ben Graham’s Frozen CorporationFrozen Corporation was a metaphorical company whose charter prohibitedit from ever paying out anything to its owners or ever being liquidated orsold.And Graham’s question was, “What is such an enterprise worth?”
Munger Identiﬁes Functional Equivalents of Frozen Corporation“I think there is a class of business where the eventual “cash back” part ofthe equation tends to be an illusion. There are businesses like that – whereyou just constantly keep-pouring it in and pouring it in, but where no cashever comes back.”
Market Cap: Rs 4,800 cr. Market Cap: Rs 23 cr.Company never made any real proﬁtsDistributed dividends came not through real earnings but from new cashprovided by stockholders and lenders.Rapid obsolescence = High Maintenance Capex
Take a look at this commercial. It has all the attributes of an effectivecommercial. See for yourself:YouTube - Awesome "Buckle Up" PSA Commercialhttp://www.youtube.com/watch?v=m6ZKVdKTWww
The PSA commercial on previous slide was persuasive, but was it right? Take a look at this:YouTube - Sam Peltzman on the Peltzman Effecthttp://www.youtube.com/watch?v=7IB2xRfRHOAPeltzman effect - Wikipedia, the free encyclopediahttp://en.wikipedia.org/wiki/Peltzman_effectThe Peltzman effect is a contributing factor in the explanation of Smeeds Law, an empirical observation that traffic fatality rates in many countries arecorrelated with the number of vehicle registrations per capita, and differing safety standards do not appear to be signiﬁcant.Peletzman effect is a mental model which tells you to not ignore the second or third order effects like the designer of the incentive scheme which rewardedstudents a $1 for catching a rat on campus after all other efforts to get rid of the rats failed. Well, pretty soon, the students were breeding rats…People not only respond to incentives, sometimes one’s well-intentioned decisions result in perverse outcomes. We call that “perverse incentives.” Read moreabout this from:http://en.wikipedia.org/wiki/Perverse_incentive
Functional Equivalents?• ! ❑ ! oral Hazard M▼!❑ !ncentive compensation based on wrong parameters I! • ! ❑ ! tock Options S! • ! ❑ ! ommission on total proﬁts C! • ! ❑ ! op Line T! • ! ❑ ! arket Share M! • ! ❑ ! eturn on Capital R
“You can either control the price, or the supply, but not BOTH!” See “Will Indian Steel Disappear?” Black Markets License raj Ration shopshttp://www.blonnet.com/2004/08/31/stories/2004083100111100.htmIf you ﬁx price too low, supply will vanish!If you ﬁx the supply (e.g. license raj) and then try to impose price controlsalso, you will see a black market emerge.Low price of diesel vs petrol vs CNGSmugglers and black marketeers vs. Arbitrageurs
See the connections betweenmental models from multiple disciplines?