15. 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 any
machine invented till date.
What does DCF teach you?
21. Warren Edward
Buffett
And he will be your teacher for a good part of this course.
22. 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 the
words, focus a bit on the highlighted text.
23. “The domestic textile industry operates
in a commodity business, competing in a
world market in which substantial excess
capacity exists.
24. “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]
25. “Over the years we had the option of
making large capital expenditures in the
textile operation that would have allowed
us to somewhat reduce variable costs...
Each proposal to do so looked like an
immediate winner...
26. “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...
27. “But the promised benefits from these
textile investments were illusory...
28. “Many of our competitors, both domestic
and 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...
29. “Viewed individually, each company’s
capital investment decision appeared cost-
effective and rational..
30. “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)...
31. “Thus, we faced a miserable choice: huge
capital investment would have helped to
keep our textile business alive, but would
have left us with terrible returns on ever-
growing amounts of capital...
32. “After the investment, moreover, the
foreign competition would still have
retained a major, continuing advantage in
labor costs...
33. “A refusal to invest, however, would make
us increasingly non-competitive, even
measured against domestic textile
manufacturers...
34. And so, Mr. Buffett shut down the textile
business of Berkshire Hathaway
But what about cost accountants and their idea of “shut down point?”
35. What’s the problem with people who only use DCF or
Cost Accounting concepts like “shut down point?
36. To a Man with a Hammer, Everything Looks Like a Nail
37. “[Buffett] knew that the huge
productivity increases that would
come from a better machine
introduced into the production of a
commodity product...
38. “would all go to the benefit of the
buyers of the textiles. Nothing was
going to [come to us] as owners...
39. “That’s such an obvious concept
– that there are all kinds of
wonderful new inventions that
give you nothing as owners...
40. “except the opportunity to
spend a lot more money in a
business that’s still going to be
lousy...
41. “The money still won’t come to
you. All of the advantages from
great improvements are going to
flow through to the customers…
42. “Conversely, if you own the only
newspaper in town and they were to
invent more efficient ways of composing
the newspaper...
43. “then when you got rid of the old
technology and got new, fancy
computers, then all of the savings would
come right through to the bottom line...
44. “In all cases, the people who sell the
machinery – and even the internal
bureaucrats urging you to buy the
equipment...
45. “show you
projections with
the amount you’ll
save at current
prices with the
new technology...
46. “However, they don’t do
the second step of the
analysis – which is to
determine how much is
going to stay home and
how much is just going to
flow through to the
customer…
47. “I’ve never seen a
single projection
incorporating that
second step in my
life. And I see them
all the time...
48. “Rather, they always
read: “This capital
outlay will save you
so much money
that it will pay for
itself in three
years…”
payback period
49. “So you keep buying things that will pay
for themselves in three years…
50. “And after twenty years of doing it,
somehow you’ve earned a return of only
about four percent per annum. That’s the
textile business...
51. “And it isn’t that the machines weren’t
better. It’s just that the savings didn’t go
to you...
52. “The cost reductions came through all
right. But the benefit of the cost
reductions didn’t go to the guy who
bought the equipment...
53. “It’s such a simple idea. It’s so basic. And
yet it’s so often forgotten.”
56. “All the wisdom in the
world is not to be found in
one little academic
department.
That would be a disastrous
way to think and operate.”
If all you have is one tool,
you will tend to overuse it.
61. “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?
63. Actions that are rational at the individual level, if copied, become irrational at the group level.
http://en.wikipedia.org/wiki/Prisoner's_dilemma
64. “In a business selling a
commodity-type product, it's
impossible to be a lot smarter
than your dumbest
competitor.”
66. 1 2 3 4 5 6
Opportunity Cost [Microeconomics]
He compared his prospective investment for efficiency improvement in textile with those in newspaper
and candy.
And the IRRs were LOWER in Candy and Newspaper. But he was going to RETAIN ALL OF THE BENEFIT of
the investment in candy and newspaper and none of it in textiles.
67. 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 be
spent was small in comparison with money already spent.
68. 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 I
can’t write it off.”
71. A mental model is
a representation
inside your head of
an external reality
You observe something and then you try to relate to it a model inside your
head.
74. “One can train a man so
that he has at his disposal a
list or repertoire of the
possible actions that could
be taken under the
circumstances...
75. “A person who is new at the
game does not have
immediately at his disposal a
set of possible actions to
consider, but has to construct
them on the spot, ... a time-
consuming and difficult mental
task...
76. “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.
77. “A large part of the
difference between the
experienced decision
maker and the novice in
these situations is not
any particular intangible
like “judgment” or
“intuition”...
78. “If one could open the
lid, so to speak, and see
what was in the head of
the experienced
decision-maker, one
would find that he
had. . . at his disposal...
79. “repertoires of possible
actions; that he had. . .
checklists of things to think
about before he acted; and
that he had mechanisms in his
mind to evoke these, and
bring these to his conscious
attention when the situations
for decisions arose.
80. “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 you
will use your experience (direct and vicarious) to relate what you see in the world to what’s on your list
of mental models.
The expert KNOWS what he has to do e.g. an experienced fire fighter- what appears to be intuition and
gut feel and blink, is actually based on experience and models.
81. To think much better,
you’ll need a checklist of
mental models
82. These mental models will come
from multiple disciplines
Economics, Psychology, Accounting, Chemistry, Physics, Mathematics, Engineering and
Evolutionary Biology.
86. Because the human
mind is like the
human egg
As soon as a sperm enters the egg, there’s an automatic shut-off device that bars other sperms from getting in.
88. Is commodity price
rise bad for
commodity users?
Example: steel price hike and its effect on auto
89. “You’ve got to have
models in your
head. And you’ve got
to array your
experience – both
vicarious and direct
– on this latticework
of models...
90. “Students who just try to
remember and pound back
what is remembered, well,
they fail in school and fail in
life.You’ve got to hang
experience on a latticework
of models in your head.”
96. “You don't have to
pee on an electric
fence to learn not to
do it.”
97.
98. “The man who does
not read great books
has no particular
advantage over a
man who cannot
read them.” - Mark
Twain
99. “We learn more from
the great business
magazines than we do
anywhere else...
100. “It's such an easy
shorthand way of getting a
vast variety of business
experience just to riffle
through issue after issue
after issue covering a great
variety of businesses...
101. “And if you get the mental
habit of relating what you're
reading to the basic
structure of the underlying
ideas [i.e. mental models]
being demonstrated, you'll
gradually accumulate some
wisdom about investing.”
102. “If you want to get smart,
the question you’ve got to
ask is why? why? why? And
you relate the answers to a
structure of deep
theory.” [Mental Models]
103. 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
104. “If you want to rise in the
world above others you just
must use the mental model
framework in a checklist style
fashion - otherwise it will be
an unequal contest like that
of a one-legged man in an ass
kicking contest.”
115. 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]
116. e.g. penny stocks, IPOs, cocaine, time
shares, overpriced-insurance, ANY
product or service with a FAT
commission behind it
119. Ricardo’s idea: Comparative advantage
Trade 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?
120. “Firms of old standing vied one with the
other in foisting unremarkable rubbish on
the guileless investor.” – from an article
on investment bankers published in
1894.
121. “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.
140. One of history’s greatest
swindlers
Ponzi scheme is also
called the pyramid
scheme
141. A non-sustainable
business model involving
the exchange of money
primarily for enrolling
other people into the
scheme, usually without
any product or service
being delivered.
142. 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.
143. Functional Equivalents?
chain letters, robbing peter to pay paul, greater fools, venture cap (partly), yield traps in RIETS and other stocks, multi-level
marking (Amway), pension funds (EMBEDDED PONZI), Floats
146. The Red Queen Effect
In Lewis Carroll’s “Through the Looking Glass,” the Red Queen seizes Alice by the hand and
draggs her, faster and faster, on a frenzied run through the countryside, but no matter how
fast they run they always stay in the same place. Alice is understandably puzzled, and says,
“Well in our country you'd generally get to somewhere else - if you ran very fast for a long
time as we've been doing.” “A slow sort of country!” Says the Queen. “Now, here, you see, it
takes all the running you can do, to keep in the same place. If you want to get somewhere
else, you must run at least twice as fast as that!”
147. 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 being
eaten, interact. Frogs might evolve longer tongues, for fly-catching purposes; flies might evolve faster flight, to escape. Flies might
evolve an unpleasant taste, or even excrete poisons that damage the frogs, and so on. We’ll pick one (hypothetical) possibility. If a
frog has a particularly sticky tongue, it will find it easier to catch flies. But if flies have particularly slippery bodies, they will find it
easier to escape, even if the tongue touches them. Imagine a stable situation in which a certain number of frogs live on a pond and
eat 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. It
will do well, compared with other frogs, and genes for extra sticky tongues will spread through the frog population. At first, a larger
proportion of flies gets eaten. But the ones who don’t get eaten will be the more slippery ones, so genes for extra slipperiness will
spread through the fly population. After a while, there will be the same number of frogs on the pond as before, and the same
proportion of flies will be eaten each year. It looks as if nothing has changed – but the frogs have got stickier tongues, and the flies
have got more slippery bodies.”
148. “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 blood
count normalized and his symptoms improved; he felt rejuvenated—“like a new man [on] a wonderful drug.” But the response was
short-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 no
response. Leukemia cells had fully recolonized his bone marrow and blood and invaded his spleen. Mayfield’s cancer had become
resistant 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 the
disease might simply shift its foot, switching one vulnerability for another. We were locked in a perpetual battle with a volatile
combatant. When CML cells kicked Gleevec away, only a different molecular variant would drive them down, and when they
outgrew that drug, then we would need the next-generation drug. If the vigilance was dropped, even for a moment, then the weight
of the battle would shift. In Lewis Carroll’s Through the Looking-Glass, the Red Queen tells Alice that the world keeps shifting so
quickly under her feet that she has to keep running just to keep her position. This is our predicament with cancer: we are forced to
keep running merely to keep still.”
149. 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 buy
eight hamburgers, then (d) you have had no real income from your investment, no matter how much
it 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 least
if measured by the criterion of a positive real investment return to owners. This “hurdle rate” the
return on equity that must be achieved by a corporation in order to produce any real return for its
individual owners—has increased dramatically in recent years. The average tax-paying investor is
now running up a down escalator whose pace has accelerated to the point where his upward
progress is nil.”
150. A Bad
Business =
Running Up
on a Down
Escalator
“The worst business of all is the one that grows a lot, where you’re forced
to grow just to stay in the game at all and where you’re re-investing the
capital at a very low rate of return.”
151. Ben Graham’s Frozen Corporation
Frozen Corporation was a metaphorical company whose charter prohibited
it from ever paying out anything to its owners or ever being liquidated or
sold.
And Graham’s question was, “What is such an enterprise worth?”
152. Munger
Identifies
Functional
Equivalents of
Frozen
Corporation
“I think there is a class of business where the eventual “cash back” part of
the equation tends to be an illusion. There are businesses like that – where
you just constantly keep-pouring it in and pouring it in, but where no cash
ever comes back.”
153. Market Cap:
Rs 4,800 cr.
Market Cap:
Rs 23 cr.
Company never made any real profits
Distributed dividends came not through real earnings but from new cash
provided by stockholders and lenders.
Rapid obsolescence = High Maintenance Capex
155. Take a look at this commercial. It has all the attributes of an effective
commercial. See for yourself:
YouTube - Awesome "Buckle Up" PSA Commercial
http://www.youtube.com/watch?v=m6ZKVdKTWww
156. The PSA commercial on previous slide was persuasive, but was it right? Take a look at this:
YouTube - Sam Peltzman on the Peltzman Effect
http://www.youtube.com/watch?v=7IB2xRfRHOA
Peltzman effect - Wikipedia, the free encyclopedia
http://en.wikipedia.org/wiki/Peltzman_effect
The Peltzman effect is a contributing factor in the explanation of Smeed's Law, an empirical observation that traffic fatality rates in many countries are
correlated 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 rewarded
students 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 more
about this from:
http://en.wikipedia.org/wiki/Perverse_incentive
157. 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
158. “You can either
control the
price, or the
supply, but not
BOTH!”
See “Will Indian
Steel Disappear?”
Black Markets
License raj
Ration shops
http://www.blonnet.com/2004/08/31/stories/2004083100111100.htm
If you fix price too low, supply will vanish!
If you fix the supply (e.g. license raj) and then try to impose price controls
also, you will see a black market emerge.
Low price of diesel vs petrol vs CNG
Smugglers and black marketeers vs. Arbitrageurs
