On Common Sense on Mutual Funds

I recently finished reading Common Sense on Mutual Funds – New Imperatives for the Intelligent Investor – by John C. Bogle.

Below are key excerpts from this book that I found to be insightful:

Investing is an act of faith. We entrust our capital to corporate stewards in the faith—at least with the hope—that their efforts will generate high rates of return on our investments. When we purchase corporate America’s stocks and bonds, we are professing our faith that the long-term success of the U.S. economy and the nation’s financial markets will continue in the future.

To state the obvious, the long-term investor who pays least has the greatest opportunity to earn most of the real return provided by the stock market.

In my view, market timing and rapid turnover—both by and for mutual fund investors—betray both a lack of understanding of the economics of investing and an infatuation with the process of investing.

My guidelines also respect what I call the four dimensions of investing: (1) return, (2) risk, (3) cost, and (4) time. When you select your portfolio’s long-term allocation to stocks and bonds, you must make a decision about the real returns you can expect to earn and the risks to which your portfolio will be exposed. You must also consider the costs of investing that you will incur. Costs will tend to reduce your return and/or increase the risks you must take. Think of return, risk, and cost as the three spatial dimensions—the length, breadth, and width—of a cube. Then think of time as the temporal fourth dimension that interplays with each of the other three. For instance, if your time horizon is long, you can afford to take more risk than if your horizon is short, and vice versa.

Rule 1: Select Low-Cost Funds…Rule 2: Consider Carefully the Added Costs of Advice…Rule 3: Do Not Overrate Past Fund Performance…Rule 4: Use Past Performance to Determine Consistency and Risk…Rule 5: Beware of Stars…Rule 6: Beware of Asset Size…Rule 7: Don’t Own Too Many Funds…Rule 8: Buy Your Fund Portfolio—And Hold It.

No matter what fund style you seek, you should emphasize low-cost funds and eschew high-cost funds. And, for the best bet of all, you should consider indexing in whichever style category you want to include.

There are three major reasons why large size inhibits the achievement of superior returns: the universe of stocks available for a fund’s portfolio declines; transaction costs increase; and portfolio management becomes increasingly structured, group-oriented, and less reliant on savvy individuals.

Four principal problems are created by this overemphasis on marketing. First, it costs mutual fund shareholders a great deal of money— billions of dollars of extra fund expenses—which reduces the returns received by shareholders. Second, these large expenditures not only offer no countervailing benefit in terms of shareholder returns, but, to the extent they succeed in bringing additional assets into the funds, have a powerful tendency to further reduce fund returns. Third, mutual funds are too often hyped and hawked, and trusting investors may be imperiled by the risks assumed by, and deluded about the potential returns of, the funds. Lastly, and perhaps most significant of all, the distribution drive alters the relationship between investors and funds. Rather than being perceived as an owner oi the fund, the shareholder is perceived as a mere customer of the adviser.

On a closing note, on leadership:

To wrap up this litany, I put before you—both tentatively and humbly—a final attribute of leadership: courage. Sometimes, an enterprise has to dig down deep and have the courage of its convictions—to “press on,” regardless of adversity or scorn. Vanguard has been a truly contrarian firm in its mutual structure, in its drive for low costs and a fair shake for investors, in its conservative investment philosophy, in market index funds, and in shunning hot products, marketing gimmicks, and the carpet-bombing approach to advertising so abundantly evident elsewhere in this industry today. Sometimes, it takes a lot of courage to stay the course when fickle taste is in the saddle, but we have stood by our conviction: In the long run, when there is a gap between perception and reality, it is only a matter of time until reality carries the day.

A recommended read in the areas of investing and leadership.

On The Most Important Thing

I recently finished reading The Most Important Thing – Uncommon Sense for the Thoughtful Investor – by Howard Marks.

Below are key excerpts from the book that I found particularly insightful:

Few people have what it takes to be a great investors. Some can be taught, but not everyone… and those who can be taught can’t be taught everything. Valid approaches work some of the time but not all. And investing can’t be reduced to an algorithm and turned over to a computer. Even the best investors don’t get it right every time.

Because investing is at least as much art as it is science, it’s never my goal—in this book or elsewhere—to suggest it can be routinized. In fact. one of the things I most want to emphasize is how essential it is that one’s investment approach be intuitive and adaptive rather than be fixed and mechanistic.

Second-level thinking is deep, complex and convoluted. The second level thinker takes a great many things into account: What is the range of likely future outcomes? Which outcome do I think will occur? What’s the probability I’m right? What does the consensus think? How does my expectation differ from the consensus? How does the current price for the asset comport with the consensus view of the future, and with mine? Is the consensus psychology that’s incorporated in the price too bullish or bearish? What will happen to the asset’s price if the consensus turns out to be right, and what if I’m right?

Return alone—and especially return over short periods of time—says very little about the quality of investment decisions. Return has to be evaluated relative to the amount of risk taken to achieve it. And yet, risk cannot be measured. Certainly it cannot be gauged on the basis of what “everybody” says at a moment in time. Risk can be judged only by sophisticated, experienced second-level thinkers.

The road to long-term investment success runs through risk control more than through aggressiveness. Over a full career, most investors’ results will be determined more by how many losers they have, and how bad they are, than by the greatness of their winners. Skillful risk control is the mark of the superior investor.

The pendulum swing regarding attitudes toward risk is one of the most powerful of all. In fact, I’ve recently boiled down the main risks in investing to two: the risk of losing money and the risk of missing opportunity. It’s possible to largely eliminate either one, but not both. In an ideal world, investors would balance these two concerns. But from time to time, at the extremes of the pendulum’s swing, one or the other predominates.

What weapons might you marshal on your side to increase your odds? Here are the ones that work for Oaktree: a strongly held sense of intrinsic value. insistence on acting as you should when price diverges from value. • enough conversance with past cycles—gained at first from reading and talking to veteran investors, and later through experience—to know that market excesses are ultimately punished, not rewarded. a thorough understanding of the insidious effect of psychology on the investing process at market extremes. a promise to remember that when things seem “too good to be true,” they usually are. willingness to look wrong while the market goes from misvalued to more misvalued (as it invariably will), and • like-minded friends and colleagues from whom to gain support (and for you to support).

To boil it all down to just one sentence, I’d say the necessary condition for the existence of bargains is that perception has to be considerably worse than reality. That means the best opportunities are usually found among things most others won’t do. After all, if everyone feels good about something and is glad to join in, it won’t be bargain-priced.

What We Learn from a Crisis—or Ought To: Too much capital availability makes money flow to the wrong places…When capital goes where it shouldn’t, bad things happen…hen capital is in oversupply, investors compete for deals by accepting low returns and a slender margin for error…Widespread disregard for risk creates great risk…Inadequate due diligence leads to investment losses…In heady times, capital is devoted to innovative investments, many of which fail the test of time…Hidden fault lines running through portfolios can make the prices of seemingly unrelated assets move in tandem…Psychological and technical factors can swamp fundamentals…Markets change, invalidating models…Leverage magnifies outcomes but doesn’t add value…Excesses correct.

On a closing note:

Thus, it’s our goal to do as well as the market when it does well and better than the market when it does poorly. At first blush that may sound like a modest goal, but it’s really quite ambitious.

A must read in the area of investing.

On Lenin’s Tomb

I recently finished reading the Pulitzer Prize winning book: Lenin’s Tomb – The Last Days of the Soviet Empire – by David Remnick.

Below are key excerpts from this masterpiece:

In the years after Stalin’s death, the state was an old tyrant slouched in the comer with cataracts and gallstones, his muscles gone slack. He The state was nearly senile, but still dangerous enough. He still kept the key to the border gate in his pocket and ruled every function of public life. Now and then he had fits and the world trembled.

When Brezhnev shoved Khrushchev out of power, the state M had the means to squash what little freedom it had allowed. The censors went through the libraries with razor blades and slashed from the bound copies of Novy Mir Solzhenitsyn’s One Day in the Life of Ivan Denisovich…The regime would rather kill its brightest children than give way.

“It is perfectly obvious that the lack of the proper level of democratization of Soviet society was precisely what made possible both the cult of personality and the violations of the law, arbitrariness, and repressions of the thirties—to be blunt, real crimes based on the abuse of power. Many thousands of members of the Party and nonmembers were subjected to mass repressions. That, comrades, is the bitter truth. Serious damage was done to the cause of socialism and the authority of the Party, and we must speak bluntly about this. This is essential for the final and irreversible assertion of Lenin’s ideal of socialism. ‘The guilt of Stalin and those close to him before the Party and the people for the mass repressions and lawlessness that were permitted are immense and unforgivable…even now we still encounter attempts to ignore sensitive questions of our history, to hush them up, to pretend that nothing special questions of our history, to hush them up, to pretend that nothing special happened. We cannot agree with this, it would be a neglect of historical truth, disrespect for the memory of those who found themselves innocent victims of lawlessness and arbitrariness.”

But Gorbachev had not finished. There was a reason for his revelation. It tied out that he had saved his confession for traditional ends. “I’ve been told more than once that it is time to stop swearing allegiance to socialism,” he was saying now. “Why should I? Socialism is my deep conviction, and I will promote it as long as I can talk and work.” By late 1990, political opinion polls showed that only a minority of Soviet people—not more than 20 percent—still shared Gorbachev’s faith in the efficacy of socialism. But attempts to turn away from the “socialist choice” were inconceivable to Gorbachev—a betrayal, a “counterrevolution on the sly.”

But things had changed. The sharp ideological divisions within the Party had now become an open secret, an open struggle, and the trick was to get the support of powerful liberals within the structure. Three old friends—Yuri Afanasyev, Nikolai Shmelyov, and Yuri Karyakin—brought to the Nineteenth Special Party Conference, in June 1988, a petition demanding Karpinsky’s rehabilitation. With the help of his old acquaintances Aleksandr Yakovlev and Boris Pugo, the tactic worked. By the next year, Len Karpinsky was in the regular rotation as a columnist at Moscow News—a golden boy, he says, “of a certain age.”

The Communist Party apparatus was the most gigantic mafia the world has ever known. It guarded its monopoly on power with a sham consensus and constitution and backed it up with the force of the KGB and the Interior Ministry police. There were also handsome profits. The Party had so obviously socked away money abroad and sold off” national resources—including the country’s vast gold reserves—that just after the collapse of the August coup, the Party’s leading financial officer took a look into the future and threw himself off” a high balcony to his death.

But Gorbachev knew that he could not conduct a genuine investigation into the Partv’s corruption. First, the Party, of which he was the head, would sooner kill him than allow it. Second, even if he could carry out such an investigation, Gorbachev would be faced with the obvious embarrassment: the depths of the Party’s rot. Instead, taking a page from Andropov’s style manual, he made a grand symbolic gesture. Yuri Churbanov, Brezhnev’s son-in-law and a deputy chief of the Interior Ministry, was indicted and tried son-in-law and a deputy chief og the Interior Ministry, was indicted and tried for accepting more than $1 million in bribes while working in Uzbekistan…But just as he could never distance himself enough from a discredited ideology, Gorbachev’s inability to jettison the Party nomenklatura and his political debts to the KGB spoiled his reputation over time in the eyes of a people who had grown more and more aware of the corruption and deceit in their midst.

At first, the Kremlin had not seemed so threatened by the Baltic republics. They were, after all, a “special case,” minuscule states absorbed into the Soviet Union more than twenty years after the Bolshevik Revolution…But the Baltic example became the model not for the revitalization of the Union, but rather for its collapse. In the three years it took to win independence, the Baits were never violent, only stubborn. It was that very temperament—Sakharov’s calm confidence on a mass scale—that characterized their revolution. None of the other republics organized quite so well or thought with such precision and cool.

The idea that the individual was of absolute value appeared in Russia only in the nineteenth century via Western influences, but it was stunted because there was no civic society. This is why human rights was never an issue. The principle was set out very clearly by Metropolitan Illarion in the eleventh century in his ‘Sermon on Law and Grace,’ in which he makes clear that grace is higher than law; you see the same thing today in our great nationalists like Prokhanov—their version of grace is higher than the law. The law is somehow inhuman, abstract. The attempts to revise this principle were defeated. The Russian Revolution was a reaction of absolute simplification. Russia found its simplistic and fanatic response and conquered its support. What we are living through now is a breakthrough. We are leaving the Middle Ages.’

“When Mikhail Sergeyevich rejected the 500 Days program he was rejecting the last chance for a civilized transition to a new order,” Aleksandr Yakovlev told me. “It was probably his worst, most dangerous mistake, because what followed was nothing less than a war.”

And just as a change in consciousness in the people had led to this incredible resistance, one could not rule out that even the conspirators had evolved beyond their ancestors. They had the same Stalinist impulses, but not the core of cruelty, the willingness to flood the city in blood, call it a victory for socialism, and then go off” to a midnight screening of Happy Guys. They could pick up the pistol, but not always shoot it. They were bullies, and bullies could be called on their bluff”.

But without Yeltsin, Gorbachev might well have dallied more than he did, the radical democrats Gorbachev might never have found a single, strong leader, the coup might have succeeded. As much as they had come to despise each other, Gorbachev and Yeltsin were linked in history.

What he hopes for now, he said, was not a new empire, not the resuscitation of a great power, but simply the development of “a normal country.” It was time to join in that process. After a life that had reflected the agonies of the old regime—a communist youth, the war, prison, the camps, the battle with the Kremlin. forced exile—now, at the age of seventy-five, he was completing the circle. He had tickets to return home. “Even at the worst tunes. I knew I would be coming home.” he said. “It was crazy. No one believed it. But I knew I would come home to die in Russia.”

A highly recommended read in the areas of history and world politics.

On Den Of Thieves

I recently finished reading Den Of Thieves – by Pulitzer Price Winner, James B. Stewart.

Below are key excerpts from the book that I found to be particularly insightful:

Even now it is hard to grasp the magnitude and the scope of the crime that unfolded, beginning in the mid-1970s, in the nation’s markets and financial institutions. It dwarfs any comparable financial crime, from the Great Train Robbery to the stock-manipulation schemes that gave rise to the nation’s securities laws in the first place. The magnitude of the illegal gains was so large as to be incomprehensible to most laymen.

Nor were these isolated incidents. Only in its scale and potential impact did the Milken-led conspiracy dwarf others. Financial crime was commonplace on Wall Street in the eighties. A common refrain among nearly every defendant charged in the scandal was that it was unfair to single out one individual for prosecution when so many others were guilty of the same offenses, yet weren’t charged. The code of silence that allowed crime to take root and flourish on Wall Street, even within some of the richest and most respected institutions, continues to protect many of the guilty. To dwell on the ill-gotten gains of individuals, however, is to risk missing the big picture. During this crime wave, the ownership of entire corporations changed hands, often forcibly, at a clip never before witnessed. Household names—Carnation, Beatrice, General Foods, Diamond Shamrock—vanished in takeovers that spawned criminal activity and violations of the securities laws.

Nor should the financial implications of these crimes, massive though they are, obscure the challenge they posed to the nation’s law-enforcement capabilities, its judicial system, and ultimately, to the sense of justice and fair play that is a foundation of civilized society. If ever there were people who believed themselves to be so rich and powerful as to be above the law. They were to be found in and around Wall Street in the mid-eighties. If money could buy justice in America, Milken and Drexel were prepared to spend it, and spend it they did. They hired the most expensive, sophisticated, and powerful lawyers and public-relations advisors, and they succeeded to a frightening degree at turning the public debate into a trial of government lawyers and prosecutors rather than of those accused of crimes. But they failed, thanks to the sometimes heroic efforts of underpaid, overworked government lawyers who devoted much of their careers to uncovering the scandal, especially Charles Carberry and Bruce Baird, in the Manhattan U.S. attorney’s office, and Gary Lynch, the head of enforcement at the Securities and Exchange Lynch, the head of enforcement at the securities and exchange ness of crime on Wall Street after a decade of lax enforcement sometimes overwhelmed their resources. Not everyone who should have been prosecuted has been, and mistakes were made. Yet their overriding success in prosecuting the major culprits and reinvigorating the securities laws is a tribute to the American system of justice.

For Levine, the experience only reinforced his view that without extraordinary measures, he was never going to realize his grand ambitions. Not that he was particular surprised. As he told Wilkis constantly, he was convinced that everyone was using inside information to get ahead: the game was rigged.

The causes of the boom were probably as much psychological as financial, though many economic explanations have been offered to explain the sudden, almost frenzied effort to buy existing companies rather than create new ones. Throughout the 1970s, investors had focused on company earnings, and the corresponding price/ earnings ratios, as a measure of value. With an economy ravaged by post-Vietnam War and OPEC-induced inflation, high tax rates, and soaring interest rates, profits had been meager. So stock prices Stayed low even as inflation pushed the value of income-producing assets ever higher. Coupled with low-priced assets was the tax code’s very generous treatment of interest payments on debt. Corporate dividends paid on stock aren’t deductible; interest payments on debt are fully deductible. Buying assets with borrowed funds meant shifting much of the cost to the federal government. The election of Ronald Reagan in 1980 sent a powerful “anything goes” message to the financial markets. One of the first official acts of the Reagan Justice Department was to drop the government’s massive ten-year antitrust case against IBM. Bigness apparently wasn’t going to be a problem in the new era of unbridled capitalism. Suddenly, economies of scale could be realized in already oligopolistic industries such as oil, where mergers wouldn’t even have been considered in the Carter years.

Yet history offers little comfort. The famed English jurist Sir Edward Coke wrote as early as 1602 that “fraud and deceit abound in these days more than in former times.” Wall Street has shown itself peculiarly susceptible to the notion, refined by Milken and Boesky and their allies, that reward need not be accompanied by risk. Perhaps no one will ever again dominate the financial world like Milken with his junk bonds. But surely a pied piper will emerge in some other sector. Over time, the financial markets have shown remarkable e resilience and an ability to curb their own excesses. Yet they are surprisingly vulnerable to corruption from within. If nothing else, the scandals of the 1980s underscore the importance and wisdom of the securities laws and their vigorous enforcement. The Wall Street criminals were consummate evaluators of risk—and the equation as they saw it suggested little likelihood of getting caught.

A highly recommended read in the area of finance.

On The Law

I have recently finished reading the classic The Law by Frederic Bastiat, translated by Patrick James Stirling. While short in terms of length, this book is filled with wisdom and guidance on the fundamentals principles of law, and the role of governments.

The main premise of the book:

The law perverted! The law and, in its wake, all the collective forces of the nation. The law, I say, not only diverted from its proper direction, but made to pursue one entirely contrary! The law becomes the tool of every kind of avarice. instead of being its check! The law guilty of that very iniquity which it was its mission to punish! Truly, this is a serious fact, if it exists. and one to which I feel bound to call the attention of my fellow citizens.

On What Is Law?

What, then, is law? As I have said elsewhere, it is the collective organization of the individual right to lawful defense. Nature, or rather God, has bestowed upon every one of us the right to defend his person. his liberty, and his property, since these are e three constituent or preserving elements of life; elements, each of which is rendered complete by the others, and cannot be understood without them. For what are our faculties, but the extension of our personality? and what is property, but an extension of our faculties? If every man has the right of defending. even by force, his person, his liberty, and his property, a number of men have the right to combine together, to extend, to organize a common force, to provide regularly for this defense. Collective right, then, has its principle, its reason for existing, its lawfulness, in individual right; and the common force cannot rationally have any other end, or any other mission, than that of the isolated forces for which it is substituted. Thus, as the force of an individual cannot lawfully touch the person, the liberty, or the property of another individual – for the same reason, the common force cannot lawfully be used to destroy the person, the liberty, or the property of individuals or of classes.

On A Just and Enduring Government

So long as personal safety was ensured, so long as labor was free, and the fruits of labor secured against all unjust attacks, no one would have any difficulties to contend with in the State. When prosperous. we should not, it is true, have to thank the State for our success; but when unfortunate, we should no more think of taxing it with our disasters, than our peasants think of attributing to it the arrival of hail or of frost. We should know it only by the inestimable blessing of Safety.

On Perverted Law Causes Conflict

Yes, as long as it is admitted that the law may be diverted from its true mission, that it may violate property instead of securing it. everybody will be wanting to manufacture law, either to defend himself against plunder. or to organize it for his own profit. The political question will always be prejudicial, predominant, and absorbing; in a word there will be fighting around the door of the Legislative Palace.

Slavery and Tariffs Are Plunder

That of slavery and that of tariffs; that is. precisely the only two questions in which. contrary to the general spirit of this republic. law has taken the character of a plunderer. Slavery is a violation, sanctioned by law of the rights of the person. Protection is a violation perpetrated by the law upon the rights of property; and certainly it is very remarkable that, in the midst of so many other debates, this double legal scourge, the sorrowful inheritance of the Old World, should be the only one which can, and perhaps will, cause the rupture of the Union.

On Legal Plunder Has Many Names

Now, legal plunder may be exercised in an infinite multitude of ways. Hence come an infinite multitude of plans for organization; tariffs, protection, perquisites, gratuities. encouragements, progressive taxation. gratuitous instruction, right to labor, right to profit, right to wages, right to assistance, right to instruments of labor, gratuity of credit, etc.. etc. And it is all these plans, taken as a whole, with what they have in common, legal plunder, which takes the name of socialism.

On Law Is a Negative Concept

They fulfill a mission whose harmlessness is evident, whose utility is palpable, and whose legitimacy is not to be disputed. This is so true that, as a friend of mine once remarked to me, to say that the aim of the law is to cause justice to reign, is to use an expression which is not rigorously exact. It ought to be said, the aim of the law is to prevent injustice from reigning. In fact, it is not justice which has an existence of its own, it is injustice. The one results from the absence of the other.

On Socialists Fear All Liberties

What sort of liberty should be allowed to men? Liberty of conscience? — But we should them all profiting by the permission to become atheists. Liberty of education?…Liberty of labor?…The liberty of trade?…Liberty of association?…You must see, then, that the socialist democrats cannot in conscience allow men liberty, because, by their own nature, they tend in every instance to all kinds of degradation and demoralization.

On Politics and Economics

It is not true that the mission of the law is to regulate our consciences, our ideas, our will, our education, our sentiments, our works, our exchanges, our gifts, our enjoyments. Its mission is to prevent the rights of one from interfering with those of another, in any one of these things. Law, because it has force for its necessary sanction, can only have as its lawful domain the domain of force, which is justice. And as every individual has a right to have recourse to force only in cases of lawful defense, so collective force, which is only the union of individual forces, cannot be rationally used for any other end. The law, then, is solely the organization of individual rights, which existed before legitimate defense. Law is justice.

On Proof of an Idea

And have I not experience on my side? Cast your eye over the globe. Which are the happiest, the most moral, and the most peaceable nations? Those where the law interferes the least with private activity; where the Government is the least felt; where individuality has the most scope, and public opinion the most influence: where the machinery of the administration is the least important and the least complicated; where taxation is lightest and least unequal, popular discontent the least excited and the least justifiable; where the responsibility of individuals and classes is the most active, and where, consequently, if morals are not in a perfect state, at any rate they tend incessantly to correct themselves: where transactions. meetings, and associations are the least fettered: where labor, capital and production suffer the least from artificial displacements; where mankind follows most completely its own natural course; where the thought of God prevails the most over the inventions of men; those, in short, who realize the most nearly this idea — That within the limits of right, all should flow from the free, perfectible, and voluntary action of man; nothing be attempted by the law or by force. except the administration of universal justice.

On Now Let Us Try Liberty

God has implanted in mankind, also, all that is necessary to enable it to accomplish its destinies. There is a providential social physiology, as well as a providential human physiology. The social organs are constituted so as to enable them to develop harmoniously in the grand air of liberty. Away, then, with quacks and organizers! Away with their rings, and their chains, and their hooks, and their pincers! Away with their artificial methods! Away with their social workshops. their governmental whims, their centralization, their tariffs, their universities. their State religions, their gratuitous or monopolizing banks, their limitations, their restrictions, their moralizations, and their equalization by taxation! And now, after having vainly inflicted upon the social body so many systems, let them end where they ought to have begun – reject all systems, and make trial of liberty — of liberty, which is an act of faith in God and in His work.

A must read in the areas of law, government and business/economics.


On Barbarians At The Gate

I recently finished reading Barbarians at the Gate – The Fall of RJR Nabisco by Bryan Burrough and John Helyar. This book has been on my reading list for quite some time, and I finally (and very gladly) was able to read it.

First on the merger of Standard Brands and Nabisco:

Nevertheless, Johnson was intrigued. He got together with Schaeberle and liked the man. In a matter of weeks the two executives agreed to merge their companies. Nabisco Brands, as the new company would be called, was formed in a $1.9 billion stock swap in 1981, at the time one of the larger mergers of consumer-product companies. Technically, it was a marriage of equals. But that was considered so much chin music. Everyone knew Nabisco, with dominant brands such as Ritz and Oreo, was the more powerful company. Everyone knew who would be in charge.

And the ascent of Ross Johnson to the top position of the combined entity:

As the smoke cleared, Johnson emerged triumphant, both inside and outside Nabisco. As far as Schaeberle and the board were concerned, he could do no wrong. That year Schaeberle rewarded Johnson by ceding him the title of chief executive. Nabisco’s huge new research center was about to be unveiled, and Johnson, in a spasm of flattery, repaid the favor by naming it the Robert M. Schaeberle Technology Center. Schaeberle was moved. The Merry Men thought it was a brilliant way to put Schaeberle out to pasture. A man who lad his name on a building, they reasoned, might as well be dead.

Despite the increased scope of responsibilities and breadth of company activities Johnson was already thinking beyond Nabisco brands:

If Johnson grew indifferent toward Nabisco, it was because he could no longer see much of a future in it. The cookie wars has changed his thinking; he regarded the battle with Frito-Lay and P&G not as a final victory, but as the successful deflection of a shot fired across his bow. There would be another giant like Procter & Gamble—maybe even P&G itself—that would come after him again. Nabisco, after all, had fatal weaknesses. No amount of work was going to revitalize its aging bakeries anytime soon. Johnson, in fact, never bothered to formulate any kind of master plan for reshaping Nabisco. Years of scrambling had soured him on long-range planning. Instead he spent his time enjoying the high life, putting out corporate fires as they flared, and waiting. Someone had once codified the Standard Brands culture into twenty Johnsonisms. Number thirteen was “Recognize that ultimate success comes from opportunistic, bold moves which, by definition, cannot be planned.” On a spring day in 1985, less than a year after being tapped Nabisco’s chief, Johnson took a call from J. Tylee Wilson, chairman and chief executive officer of RJ Reynolds Industries, the North Carolina-based tobacco giant. Would Johnson be interested in getting together for lunch? Maybe, Wilson said, they could do some business.

On a parallel, Reynolds was thriving and generating more cash than it knew what to do with:

Life was good then. Reynolds’s Winston, Salem, and Camel were three of the top four bestselling cigarette brands. Prince Albert remained the top-selling pipe tobacco, and a brand called Days Work was the top chewing tobacco. Americans were smoking like chimneys. In 1960, 58 percent of all men and 36 percent of all women smoked. It was often said that Reynolds’s only problem was how to turn out cigarettes fast enough and how to ship all that money back to Wachovia Bank. In one respect, it was true. From a corporate executive’s point of view, Reynolds had too much cash on its hands. In 1956 the company amended its charter to allow it for the first time to buy nontobacco businesses.

Thus came the idea of merging the two businesses:

The talks, in fact, rekindled within weeks. A small army of Wall Street lawyers and investment bankers were brought in, and, the directors having been convinced, Reynolds agreed in principle to acquire Nabisco for cash. The lone sticking point was the price. Then, during the negotiations, Nabisco stock began rising, a sure sign that word of the talks had leaked. Johnson took it as an opportunity to wheedle more money out of Wilson. At $80 a share, Wilson said he could go no further. “Well,” Johnson said, “you’re not gonna get a deal at eighty bucks.” The logjam broke when Wilson agreed to throw in preferred stock, which brought the price to $85 a share, or $4.9 billion, at the time the largest merger ever to take place outside the oil industry.

Despite the fact that the anti-tobacco lawsuits were being settled for lower than expected amounts, RJR Nabisco’s stock was not moving up as expected, thus further persuading Johnson of the idea that a leveraged LBO is the way to unlock the true value that exists within the company:

The case mounted by Anthony Cipollone was considered among the strongest ever brought against the tobacco industry; the plaintiff’s lawyers had unearthed a raft of damaging documents. A tobacco victory, Johnson reasoned, would give his stock a real pop. When the jury finally delivered a verdict, it broke tobacco’s unbeaten streak—but just barely, clearing the industry of conspiracy and awarding only $400,000 in damages. “A tip for Tony Cipollone,” Johnson chortled, and waited for RJR Nabisco’s stock to spike up. It didn’t. Johnson’s office became a wailing wall where everybody came to cry about the injustice of it all. Horrigan was particularly bitter; he had predicted the stock would climb at least six points. “The market never going to give us its due,” Henderson complained. “The equity markets just aren’t a suitable capital structure for some companies.” Arguing to take stock from public hands was in fact the intellectual basis for an LBO, although no one openly advocated it at the time. Horrigan thought Johnson would never go private. “The problem with the company going private,” he said to himself, “is that nobody would pay any attention to him.”

The time was ripe for LBO’s, and the reasons:

In the five years before Ross Johnson decided to pursue his buyout, LBO activity totaled $181.9 billion, compared to $11 billion in the six years before that. A number of factors combined to fan the frenzy. The Internal Revenue Code, by making interest but not dividends deductible from taxable income, in effect subsidized the trend. That got LBOs off the ground. What made them soar was junk bonds. Of the money raised for any LBO, about 60 percent, the secured debt, comes in the form of loans from commercial banks. Only about 10 percent comes from the buyer itself For years the remaining 30 percent—the meat in the sandwich—came from a handful of major insurance companies whose commitments sometimes took months to obtain. Then, in the mid-eighties, Drexel Burnham began using high-risk “junk” bonds to replace the insurance company funds. The firm’s bond czar, Michael Milken, had proven his ability to raise enormous amounts of these securities on a moment’s notice for hostile takeovers. Pumped into buyouts, Milken’s junk bonds became a high-octane fuel that transformed the LBO industry from a Volkswagen Beetle into a monstrous drag racer belching smoke and fire.

As the bankers got involved in the process, Johnson could feel that he was losing control of the company, and that everyone was in it to grab a share of profits for themselves:

Johnson remained in his office, shocked at the turn in events. He couldn’t talk to Gutfreund or Cohen; they seemed too pleased at laving shown Kravis the price of messing with them. He couldn’t talk to Kravis, who, in Johnson’s words, was “pissing fire.” Just seventeen hours earlier, he had managed to get a peace treaty. He hadn’t wanted to invite Strauss or Cohen or any of the Wall Streeters. The whole thing had fallen apart over greed—pure and simple greed. And now, the piece de resistance, his own partners were launching a $20 billion bid without even bothering to tell him. He felt like the man who entered the casino in a tuxedo one night and emerged the next morning in rags. Far worse, Johnson realized, he had lost all control of his fate…Everyone, he reflected, was out to get something for themselves. The directors, with their petty concerns about pensions and auto insurance. Kravis and his investment bankers and their fees. Salomon and its bonds. And now Frank Benevento wanted $24 million. There was no bloody way Benevento was getting anywhere near $24 million, Johnson thought. He told him to bill the company for whatever he wished. The matter would be dealt with when things returned to normal.

The media quickly paid attention to this, and this also affected the employees productivity during that time:

In an editorial headlined, “Why the RJR circus is so dangerous,” Business Week reflected the business establishment’s distress. “This spectacle is not just unseemly—it is dangerous,” it held. “It is precisely this sort of behavior that plays into the hands of those who want to shackle the free market with unnecessary regulation. LBOs, including a potential RJR deal, should stand or fall on their financial and economic merits, not on the childish behavior of the principals.” For all the high-level handwringing, few felt the effects of the escalating fight as keenly as RJR Nabisco’s employees. In Atlanta, office workers sat during lunch periods glumly reading the daily news summaries the company issued. Isolated, irritated, and uncertain of their futures, the staff spent its days consumed with following the events on Wall Street, its spare time channeled into producing anti-Johnson propaganda.

A three pronged bidding war for RJR Nabisco was on:

The public the bidding for RJR Nabisco seemed frenzied, the emergence of a third bidding group transforming it into a wide-open race. But in the subdued hallways and offices of Lazard Freres and Dillon Read, there was no such enthusiasm. To the board’s advisers, the First Boston bid was hardly good news. Few among them had any confidence that Maher’s troops would come back in eight days with a concrete proposal.

KKR was the winner at the end:

Five minutes later discussion inside the boardroom ebbed. “Time is running out,” Hugel said. “Call for a motion.” Marty Davis spoke first. “I move we award to KKR.” “Second,” said John Macomber. “All in favor,” Hugel said. Hands filled the air. “All opposed?” So hands. “The vote,” Hugel said, “is unanimous.

Johnson semi-retired a rich man:

Johnson officially resigned that day, pulling the chord on his $53 million golden parachute.* His fanciest Gulfstream jet yet, ordered before the LBO battle, flew him to Jupiter on its maiden voyage. Johnson released a final statement before leaving: “The process we commenced last October has benefited the company’s shareholders and has proven the financial strength of our varied businesses.”

The shareholders’ were also enriched through the process, although not all of them happy about the proceeding:

Yet in the world’s greatest concentration of RJR shareholders— Winston-Salem, North Carolina—they weren’t thanking Johnson even as the money gushed into town. No sooner had Kravis won than signs began popping up: “Good-bye Ross, Hello KKR.” Nearly $2 billion of checks arrived there in the late-February mail. Now, more than ever, Winston-Salem was “the city of reluctant millionaires.” The river of money had washed away the last of RJR’s stock. Local brokers and bankers who managed people’s money got calls from distraught clients. “I won’t sell my stock,” more than one sobbed. “Daddy said don’t ever sell the RJR stock.” They were patiently told they had to. They were told the world had changed. No sooner had the checks arrived than out-of-town “financial consultants” descended on Winston-Salem to advise its residents on how best to spend their new riches. In leaflets tucked under windshields in the Reynolds parking lot, in pesky phone calls, in seminars at the Holiday Inn, stockbrokers offered to help people reinvest their windfall in the market. The frequent, incredulous response: “You want me to buy stock?”

KKR may have won the battle for RJR Nabisco, but it had lost the war in its investment going sour:

To its credit, Kohlberg Kravis wriggled out of its fix. In July 1990, it announced a $6.9 billion refinancing package, enabling it to buy back the junk bonds and substitute less onerous forms of debt. The costly maneuver probably assured that, as a buyout, RJR would neither be a free-fall disaster nor a windfall profit for Kohlberg Kravis. Whatever the case, it assured big paydays for the bankers and lawyers who reconfigured the original deal: another $250 million in fees. For Kravis ultimate success, it was clear, was years away. To make matters worse, Philip Morris, sensing RJR’s vulnerability, moved in for the kill, pummeling the company in a number of key markets. It expanded its sales force, undercut Reynolds on pricing, and attacked its strong discount brand, Doral, with two new off-price brands of its own. Analysts predicted RJR’s cigarette volume could fall 7 percent to 8 percent in 1989, while Philip Morris gained volume. “Philip Morris is eating our lunch,” Cliff Robbins of Kohlberg Kravis acknowledged in October 1989. “Marlboro is an unstoppable machine. We have a lot to do.”

There are many lessons within this story that extend beyond RJR Nabisco, namely:

  1. In a sense it had. Johnson was a product of his times, as surely as R. J. Reynolds was of his. The Roaring Eighties were a new gilded age, where winning was celebrated at all costs. “The casino society” Felix Rohatyn once dubbed it. The investment bankers were part croupiers, part alchemists. They conjured up wild schemes, pounded out new and more outlandish computer runs to justify them, then twirled their temptations before executives in a “devil dance.” That, at any rate, is what Johnson took to calling it. Depending on one’s viewpoint, the “dance” Johnson initiated at RJR will go down as either the high point or the low point of an era. It wasn’t an accident that RJR Nabisco should provide that moment. In its final decade Reynolds had become less a great company than a great dream machine. Its torrent of tobacco money allowed egos to run wild and fantasies to become true. Paul Sticht could walk with kings. Ed Horrigan could live like kings. Directors could be treated like kings…The founders of both RJR and Nabisco would have utterly failed to understand what was going on here. It is not so hard, in the mind’s eye, to see R. J. Reynolds and Adolphus Green wandering through the carnage of the LBO war. They would turn to one another, occasionally so much about what came out of their computers and so little about what came out of their factories? Why were they so intent on breaking up instead of building up? And last: What did this all have to do with doing business?

  2. To some, this saga wasn’t just about the fall of RJR Nabisco but the rise of an “I’ve got mine” ethos that would permeate every corner of corporate America. Even partners at once-staid accounting firms came to see themselves more as croupiers than auditors. Paul Volcker, who was chairman of Arthur Andersen in its dying days, believes its accountants became accomplices to Enron because they were so envious of such clients’ riches. As Volcker explained it, “The accountants felt like, ‘We’re as good as they are and we’re doing all the work.’ The general atmosphere was, ‘Money is out there for the taking.'” Reverbrations from the RJR buyout would also long be felt all up and down Wall Street. The deal went so badly for KKR and was attacked so vehemently by politicians that LBO firms pulled in their horns and eschewed mega-deals for years thereafter.

  3. The ensuing period is eerily reminiscent of the early 1990s-post RJR hangover, which raises a question: does anyone on Wall Street ever really learn anything? Colin Blaydon isn’t so sure. “When there’s a situation like this and everyone comes piling into a market they don’t fully understand, the financial markets always overshoot,” he says. “There are a lot of parallels to the world of the bubble that gave us RJR Nabisco.” Be assured, however, that the Barbarians are out there just beyond the gate, licking their wounds, biding their time, waiting for their next chance to storm the gates.

One of the best business books I have read to date, both in terms of content and delivery. A must read.

The Innovator’s Solution

It is hard to read any business article, blog, journal or magazine without coming across the word innovation. And while the profile of this topic has risen to prominence in the last few years, it is one that has been thoroughly studied particularly by professor Clayton M. Christensen. He is considered by many as “the architect of and the world’s foremost authority on disruptive innovation.” A few years ago, I read his seminal book in that area – The Innovator’s Dilemma, and recently I finished reading his second – The Innovator’s Solution which he co-authored with Michael E. Raynor.

Below are the key lessons from it that I wanted to share with you.

On the premise of the book:

If I wanted to start a company that could become significant and successful and ultimately topple the firms that now lead an industry, how could I do it? If indeed there are predictable reasons why businesses stumble, we might then help managers avoid those causes of failure and help them make decisions that predictably lead to successful growth. This is The Innovator’s Solution.

This is a book about how to create new growth in business. Growth is important because companies create shareholder value through profitable growth. Yet there is powerful evidence that once a company’s core business has matured, the pursuit of new platforms for growth entails daunting risk. Roughly one company in ten is able to sustain the kind of growth that translates into an above-average increase in shareholder returns over more than a few years. Too often the very attempt to grow causes the entire corporation to crash. Consequently, most executives are in a no-win situation: equity markets demand that they grow, but it’s hard to know how to grow. Pursuing growth the wrong way can be worse than no growth at all.

Can innovation be made predictable? Can it be turned into a process?

What can make the process of innovation more predictable? It does not entail learning to predict what individuals might do. Rather, it comes from understanding the forces that act upon the individuals involved in building businesses—forces that powerfully influence what managers choose and cannot choose to do. Rarely does an idea for a new-growth business emerge fully formed from an innovative employee’s head. No matter how well articulated a concept or insight might be, it must be shaped and modified, often significantly, as it gets fleshed out into a business plan that can win funding from the corporation. Along the way, it encounters a number of highly predictable forces. Managers as individuals might indeed be idiosyncratic and unpredictable, but they all face forces that are similar in their mechanism of action, their timing, and their impact on the character of the product and business plan that the company ultimately attempts to implement. Understanding and managing these forces can make innovation more predictable.

We often admire the intuition that successful entrepreneurs seem to have for building growth businesses. When they exercise their intuition about what actions will lead to the desired results, they really are employing theories that give them a sense of the right thing to do in various circumstances. These theories were not there at birth; They were learned through a set of experiences and mentors earlier in life. If some people have learned the theories that we call intuition, then it is our hope that these theories also can be taught to others. This is our aspiration for this book. We hope to help managers who are trying to create new-growth businesses use the best research we have been able to assemble to learn how to match their actions to the circumstances in order to get the results they need. As our readers use these ways of thinking over and over, we hope that the thought processes inherent in these theories can become part of their intuition as well.

On the difference between sustaining innovation and disruptive innovation and the associate strategies associated with each:

We must emphasize that we do not argue against the aggressive pursuit of sustaining innovation…Almost always a host of similar companies enters an industry in its early years, and getting ahead of that crowd—moving up the sustaining-innovation trajectory more decisively than the others—is critical to the successful exploitation of the disruptive opportunity. But this is the source of the dilemma: Sustaining innovations are so important and attractive, relative to disruptive ones, that the very best sustaining companies systematically ignore disruptive threats and opportunities until the game is over. Sustaining innovation essentially entails making a better mousetrap. Starting a new company with a sustaining innovation isn’t necessarily a bad idea: Focused companies sometimes can develop new products more rapidly than larger firms because of the conflicts and distractions that broad scope often creates. The theory of disruption suggests, however, that once they have developed and established the viability of their superior product, entrepreneurs who have entered on a sustaining trajectory should turn around and sell out to one of the industry leaders behind them. If executed successfully, getting ahead of the leaders on the sustaining curve and then selling out quickly can be a straightforward way to make an attractive financial return…A sustaining-technology strategy is not a viable way to build new-growth businesses, however. If you create and attempt to sell a better product into an established market to capture established competitors’ best customers, the competitors will be motivated to fight rather than to flee. This advice holds even when the entrant is a huge corporation with ostensibly deeper pockets than the incumbent.

On where disruptive innovation occurs:

Because new-market disruptions compete against nonconsumption, the incumbent leaders feel no pain and little threat until the disruption is in its final stages. In fact, when the disruptors begin pulling customers out of the low-end of the original value network, it actually feels good to the leading firms, because as they move up-market in their own world, for a time they are replacing the low-margin revenues that disruptors steal, with higher-margin revenues from sustaining innovations.

We call disruptions that take root at the low-end of the original or mainstream value network low-end disruptions…New-market disruptions induce incumbents to ignore the attackers, and low-end disruptions motivate the incumbents to flee the attack.

And why do executives of existing companies segment markets counterproductively?

There are at least four reasons or countervailing forces in established companies that cause managers to target innovations at attribute-based market segments that are not aligned with the way that customers live their lives. The first two reasons—the fear of focus and the demand for crisp quantification—reside in companies’ resource allocation processes. The third reason is that the structure of many retail channels is attribute focused, and the fourth is that advertising economics influence companies to target products at customers rather than circumstances.

How can this be resolved?

Identifying disruptive footholds means connecting with specific jobs that people—your future customers—are trying to get done in their lives. The problem is that in an attempt to build convincing business cases for new products, managers are compelled to quantify the opportunities they perceive, and the data available to do this are typically cast in terms of product attributes or the demographic and psychographic profiles of a given population of potential consumers. This mismatch between the true needs of consumers and the data that shape most product development efforts leads most companies to aim their innovations at nonexistent targets. The importance of identifying these jobs to be done goes beyond simply finding a foothold. Only by staying connected with a given job as improvements are made, and by creating a purpose brand so that customers know what to hire, can a disruptive product stay on its growth trajectory.

On extracting growth from nonconsumption (new-market disruption pattern):

1. The target customers are trying to get a job done, but because they lack the money or skill, a simple, inexpensive solution has been beyond reach.

2. These customers will compare the disruptive product to having nothing at all. As a result, they are delighted to buy it even though it may not be as good as other products available at high prices to current users with deeper expertise in the original value network. The performance hurdle required to delight such new-market customers is quite modest.

3. The technology that enables the disruption might be quite sophisticated, but disruptors deploy it to make the purchase and use of the product simple, convenient, and foolproof. It is the “foolproofedness” that creates new growth by enabling people with less money and training to begin consuming.

4. The disruptive innovation creates a whole new value network. The new consumers typically purchase the product through new channels and use the product in new venues.

On what makes competing against nonconsumption so hard for existing companies?

In a very insightful stream of research, Harvard Business School Professor Clark Gilbert has helped us understand the fundamental mechanism that causes the established competitors in an industry to consistently cram the disruptive technology into the mainstream market. With that understanding, Gilbert also provides guidance to established company executives on how to avoid this trap, and capture the growth created by disruption instead. Gilbert’s work, fortunately, not only defines an innovator’s dilemma but suggests a way out. The solution is twofold: First, get top-level commitment by framing an innovation as a threat during the resource allocation process. Later, shift responsibility for the project to an autonomous organization that can frame it as an opportunity.

On determining the right scope for the business:

When the functionality and reliability of a product are not good enough to meet customers’ needs, then the companies that will enjoy significant competitive advantage are those whose product architectures are proprietary and that are integrated across the performance-limiting interfaces in the value chain. When functionality and reliability become more than adequate, so that speed and responsiveness are the dimensions of competition that are not now good enough, then the opposite is true. A population of non-integrated, specialized companies whose rules of interaction are defined by modular architectures and industry standards holds the upper hand. At the beginning of a wave of new-market disruption, the companies that initially will be the most successful will be integrated firms whose architectures are proprietary because the product isn’t yet good enough. After a few years of success in performance improvement, those disruptive pioneers themselves become susceptible to hybrid disruption by a faster and more flexible population of non-integrated companies whose focus gives them lower overhead costs.

On how to avoid commoditization:

1. The low-cost strategy of modular product assemblers is only viable as long as they are competing against higher-cost opponents. This means that as soon as they drive the high-cost suppliers of proprietary products out of a tier of the market, they must move up-market to take them on again in order to continue to earn attractive profits.

2. Because the mechanisms that constrain or determine how rapidly they can move up-market are the performance-defining subsystems, these elements become not good enough and are flipped to the left side of the disruption diagram.

3. Competition among subsystem suppliers causes their engineers to devise designs that are increasingly proprietary and interdependent. They must do this as they strive to enable their customers to deliver better performance in their end-use products than the customers could if they used competitors’ subsystems.

4. The leading providers of these subsystems therefore find themselves selling differentiated, proprietary products with attractive profitability.

5. This creation of a profitable, proprietary product is the beginning, of course, of the next cycle of commoditization and de-commoditization.

A reminder that integrated companies possess a strategic advantage in their ability to respond to changes of value across the value chain:

To the extent that an integrated company such as IBM can flexibly couple and decouple its operations, rather than irrevocably sell off operations, it has greater potential to thrive profitably for an extended period than does a nonintegrated firm such as Compaq. This is because the processes of commoditization and de-commoditization are continuously at work, causing the place where the money will be to shift across the value chain over time.

The concept of core competency, which is often used to determine which part of the value chain to keep in-house, is misguiding:

Core competence, as it is used by many managers, is a dangerously inward-looking notion. Competitiveness is far more about doing what customers value than doing what you think you’re good at. And staying competitive as the basis of competition shifts necessarily requires a willingness and ability to learn new things rather than clinging hopefully to the sources of past glory. The challenge for incumbent companies is to rebuild their ships while at sea, rather than dismantling themselves plank by plank while someone else builds a new. faster boat with what they cast overboard as detritus.

To successfully build and manage growth businesses you need the right people, processes and values:

Executives who are building new-growth businesses therefore need to do more than assign managers who have been to the right schools of experience to the problem. They must ensure that responsibility for making the venture successful is given to an organization whose processes will facilitate what needs to be done and whose values can prioritize those activities. The theory is that the requirements of an innovation need to fit with the host organization’s processes and values, or the innovation will not succeed.

On managing the strategy development process:

In every company there are two simultaneous processes through which strategy comes to be defined. Figure 8-1 suggests that both of these strategy-making processes—deliberate and emergent—are always operating in every company. The deliberate strategy-making process is conscious and analytical. It is often based on rigorous analysis of data on market growth, segment size, customer needs, competitors’ strengths and weaknesses, and technology trajectories. Strategy in this process typically is formulated in a project with a discrete beginning and end, and then implemented “top down.”…Emergent strategy, which as depicted in figure 8-1 bubbles up from within the organization, is the cumulative effect of day-to-day prioritization and investment decisions made by middle managers, engineers, salespeople, and financial staff. These tend to be tactical, day-to-day operating decisions that are made by people who are not in a visionary, futuristic, or strategic state of mind…When the efficacy of a strategy that was developed through an emergent process is recognized, it is possible to formalize it, improve it, and exploit it, thus transforming an emergent strategy into a deliberate one. Emergent processes should dominate in circumstances in which the future is hard to read and in which it is not clear what the right strategy should be. This is almost always the case during the early phases of a company’s life. However, the need for emergent strategy arises whenever a change in circumstances portends that the formula that worked in the past may not be as effective in the future. On the other hand, the deliberate strategy process should be dominant once a winning strategy has become clear, because in those circumstances effective execution often spells the difference between success and failure.

On the execution of the strategy, three points of leverage:

1. Carefully control the initial cost structure of a new-growth business, because this quickly will determine the values that will drive the critical resource allocation decisions in that business.

2. Actively accelerate the process by which a viable strategy emerges by ensuring that business plans are designed to test and confirm critical assumptions using tools such as discovery-driven planning.

3. Personally and repeatedly intervene, business by business, exercising judgment about whether the circumstance is such that the business needs to follow an emergent or deliberate strategy-making process. CEOs must not leave the choice about strategy process to policy, habit, or culture.

General rules of thumbs relating to the financial management of growth businesses:

  • Launch new-growth businesses regularly when the core is still healthy —when it can still be patient for growth—not when financial results signal the need.
  • Keep dividing business units so that as the corporation becomes increasingly large, decisions to launch growth ventures continue to be made within organizational units that can be patient for growth because they are small enough to benefit from investing in small opportunities.
  • Minimize the use of profit from established businesses to subsidize losses in new-growth businesses. Be impatient for profit: There is nothing like profitability to ensure that a high-potential business can continue to garner the funding it needs, even when the corporation’s core businesses turn sour.

On a concluding note:

Many successful companies have disrupted once. A few, including IBM, Intel, Microsoft, Hewlett-Packard, Johnson & Johnson, Kodak, Cisco, and Intuit, have disrupted several times. Sony did it repeatedly between 1955 and 1982, before its engine of disruption got shut down. To our knowledge, no company has been able to build an engine of disruptive growth and keep it running and running. That reality has made this a risky book for us to write: Few business books say “Do this; no one’s ever done it before.” But there is little choice. Creating and sustaining successful growth has, historically speaking, vexed some great managers. Given the existence of principles but no precedent, we have simply done our best to suggest how successful growth can be created and sustained. We have offered an integrated body of theory derived from the successes and the failures of hundreds of different companies, each of which has illuminated a different aspect of the innovator’s dilemma. And so we now pass the baton to you, in the hope that you will find our efforts to be a valuable foundation upon which to build your own innovator’s solution.

I highly recommend this book, as a follow-on to Clayton’s earlier work.


Titan – The Life of John D. Rockefeller, Sr.

The name Rockefeller is ingrained within both American History and Business, but why so? This is the question that set me on the quest to read the National Bestseller, Titan – The Life Of John D. Rockefeller, Sr. by Ron Chernow.

Below are key highlights from this masterpiece that I wanted to share.

John D. Rockefeller’s began displaying and developing his business acumen at a young age:

Though only dimly aware of such distant developments, John D. Rockefeller already seemed a perfect specimen of homo economicus. Even as a boy, he bought candy by the pound, divided it into small portions, then sold it at a tidy profit to his siblings. By age seven, encouraged by his mother, he was dropping gold, silver, and copper coins that he earned into a blue china bowl on the mantel. John’s first business coup came at age seven when he shadowed a turkey hen as it waddled off into the woods, raided its nest, and raised the chicks for sale. To spur his enterprise, Eliza gave him milk curds to feed the turkeys, and the next year he raised an even larger brood. As an old man. Rockefeller said, “To this day, I enjoy the sight of a flock of turkeys, and never miss an opportunity of studying them.”

The same was also true for his attachment to his religious beliefs:

John D. Rockefeller was drawn to the church, not as some nagging duty or obligation but as something deeply refreshing to the soul. The Baptist church of his boyhood provides many clues to the secrets of his character. As a young man. he was raised on a steady diet of maxims, grounded in evangelical Protestantism, that guided his conduct. Many of his puritanical attitudes, which may seem antiquated to a later generation, were merely the religious commonplaces of his boyhood. Indeed, the saga of his monumental business feats is inseparable from the fire-and-brimstone atmosphere that engulfed upstate New York in his childhood.

These two elements formed the two pillars of his life:

He possessed a sense of calling in both religion and business, with Christianity and capitalism forming the twin pillars of his life…When challenges to orthodoxy arose in later decades, he stuck by the spiritual certainties of his boyhood…The church gave Rockefeller the community of friends he craved and the respect and affection he needed.

The role he had to play within his family, tough him responsibility:

Of course, this boyhood responsibility took its toll on John D., who experienced little of the spontaneous joy or levity of youth. Growing up as a miniature adult, burdened with duties. He developed an exaggerated sense of responsibility that would be evident throughout his life. He learned to see himself as a reluctant savior, taking charge of troubled situations that needed to be remedied.

On his entry to the Oil sector:

Tramping the banks. Rockefeller beheld the satanic new world bequeathed by the oil boom, an idyllic valley blackened with derricks and tanks, engine houses and ramshackle huts, thickly crowded together in a crazy-quilt pattern…Rockefeller represented the second, more rational stage of capitalist development, when the colorful daredevils and pioneering speculators give way, as Max Weber wrote, to the “men who had grown up in the hard school of life. calculating and daring at the same time, above all temperate and reliable, shrewd and completely devoted to their business, with strictly bourgeois opinions and principles.”

One of the keys to his business success was that he kept cash on hand, and allies in the banking sectors – which were essential particularly during the times of crisis:

It is impossible to comprehend Rockefeller’s breathtaking ascent without realizing that he always moved into battle backed by abundant cash. Whether riding out downturns or coasting on booms, he kept plentiful reserves and won many bidding contests simply because his war chest was deeper…To have orchestrated such a rapid campaign required a long relationship of trust with the banks.

Rockefeller believed in the importance of balanced work ethic:

Rockefeller bridled at the notion that he was a business-obsessed drudge, a slave to the office. “I know of nothing more despicable and pathetic than a man who devotes all the waking hours of the day to making money for money’s sake,” he recorded in his memoirs. He worked at a more leisurely pace than many other executives, napping daily after lunch and often dozing in a lounge chair after dinner. To explain his extraordinary longevity he later said, doubtless overstating the matter, “I’m here because I shirked: did less work, lived more in the open air, enjoyed the open air, sunshine and exercise.”

On his skillful negotiation skills:

One of Rockefeller’s strengths in bargaining situations was that he figured out what he wanted and what the other party wanted and then crafted mutually advantageous terms. Instead of ruining the railroads, Rockefeller tried to help them prosper, albeit in a way that fortified his own position.

One of his shortcomings was that he remained silent in the face of criticism, which haunted him particularly during the public relation battles he fought:

Only in the twilight of life did Rockefeller realize how poorly his taciturnity had served him in business battles. This was especially true during the SIC furor, which evolved into a political and public-relations battle. By remaining silent in the face of criticism, he thought he would seem confident and secure in his integrity—in fact, he seemed guilty and arrogantly evasive. Throughout his career. Rockefeller endured abuse with so much equanimity that Flagler once shook his head and said, “John, you have a hide like a rhinoceros! “

On his view of capitalism, and how he linked it to his religious beliefs:

In a critical distinction, he viewed competitive capitalism—and not capitalism per se—as producing a vulgar materialism and rapacious business practices that dissolved the bonds of human brotherhood. In a state of ungoverned competition, selfish individuals tried to maximize their profits and thereby impoverished the entire industry What the American economy needed instead were new cooperative forms (trusts, pools, monopolies) that would restrain grasping individuals for the general good. Rockefeller thus tried to reconcile trusts with Christianity, claiming that cooperation would end the egotism and materialism abhorrent to Christian values. It was an ingenious rationalization. While religion did not lead him to the concept of trusts, it did enable him to invest his vision of cooperation with a powerful moral imperative.

On his leadership skills and beliefs:

Even as a young man, Rockefeller was extremely composed in a crisis. In this respect, he was a natural leader: The more agitated others became, the calmer he grew.

Far more than a technocrat, Rockefeller was an inspirational leader who exerted a magnetic power over workers and especially prized executives with social skills.

Few outsiders knew that one of Rockefeller’s greatest talents was to manage and motivate his diverse associates. As he said, “It is chiefly to my confidence in men and my ability to inspire their confidence in me that I owe my success in life.” He liked to note that Napoleon could not have succeeded without his marshals. Free of an autocratic temperament. Rockefeller was quick to delegate authority and presided lightly, genially, over his empire, exerting his will in unseen ways. At meetings. Rockefeller had a negative capability: The quieter he was, the more forceful his presence seemed, and he played on his mystique the resident genius immune to petty concerns.

Rockefeller placed a premium on internal harmony and tried to reconcile his contending chieftains. A laconic man, he liked to canvass everyone’s opinion before expressing his own and then often crafted a compromise to maintain cohesion. He was always careful to couch his decisions as suggestions or questions.

On philanthropy:

Yet by the 1880s, Rockefeller had already formulated certain core principles for his bequests many of them stemming from beliefs he had long entertained as a businessman. For instance, like other industrialists he worried that charity fostered dependence and pauperized recipients…The most important concept Rockefeller bequeathed to philanthropy was that of wholesale giving, as opposed to small, scattershot contributions…Another cardinal principle of Rockefeller philanthropy was to rely upon expert opinion.

On Standard Oils’, the set of companies he started:

In a sense, John D. Rockefeller simplified life for the authors of antitrust legislation. His career began in the infancy of the industrial boom, when the economy was still raw and unregulated. Since the rules of the game had not yet been encoded into law, Rockefeller and his fellow industrialists had forged them in the heat of combat. With his customary thoroughness, Rockefeller had devised an encyclopedic stock of anti-competitive weapons. Since he had figured out every conceivable way to restrain trade, rig markets, and suppress competition, all reform-minded legislators had to do was study his career to draw up a comprehensive antitrust agenda.

Standard Oil had taught the American public an important but paradoxical lesson: Free markets, if left completely to their own devices, can wind up terribly unfree. Competitive capitalism did not exist in a state of nature but had to be defined or restrained by law. Unfettered markets tended frequently toward monopoly or, at least, toward unhealthy levels of concentration, and government sometimes needed to intervene to ensure the full benefits of competition. This was particularly true in the early stages of industrial development. This notion is now so deeply embedded in our laws that it has become all but invisible to us. replaced by secondary debates over the precise nature or extent of antitrust enforcement.

If Tarbell gave an oversimplified account of Standard Oil’s rise, her indictment was perhaps the more forceful for it. In the trust’s collusion with the railroads, the intricate system of rebates and drawbacks, she found her smoking gun, the irrefutable proof that Rockefeller’s empire was built by devious means. She was at pains to refute Rockefeller’s defense that everybody did it. “Everybody did not do it,” she protested indignantly “In the nature of the offense everybody could not do it. The strong wrested from the railroads the privilege of preying upon the weak, and the railroads never dared give the privilege save under the promise of secrecy.”

The following two excerpts summarize Rockefeller’s life and contributions:

The loftiest encomium to Rockefeller’s impact in this field came from Winston Churchill, who wrote shortly before Rockefeller’s death: When history passes its final verdict on John D. Rockefeller, it may well be that his endowment of research will be recognized as a milestone in the progress of the race. For the first time, science was given its head: longer term experiment on a large scale has been made practicable, and those who undertake it are freed from the shadow of financial disaster. Science today owes as much to the rich men of generosity and discernment as the art of the Renaissance owes to the patronage of Popes and Princes. Of these rich men, John D. Rockefeller is the supreme type.

The fiercest robber baron had turned out to be the foremost philanthropist Rockefeller accelerated the shift from the personal, ad-hoc charity that had traditionally been the province of the rich to something both more powerful and more impersonal. He established the promotion of knowledge, especially scientific knowledge, as a task no less important than giving alms to the poor or building schools, hospitals, and museums. He showed the value of expert opinion, thorough planning, and competent administration in nonprofit work, setting a benchmark for professionalism in the emerging foundation field. By the time Rockefeller died, in fact, so much good had unexpectedly flowered from so much evil that God might even have greeted him on the other side, as the titan had so confidently expected all along.

On a concluding note:

Although Junior moved into Kykuit after Rockefeller’s death, he knew that his father was inimitable, and so he decided to retain the Jr. after his name. As he was often heard to say in later years, “There was only one John D. Rockefeller.”

Attorney Samuel Untermver issued this paean to the elusive witness he had interrogated: “Next to our beloved President, he was our country’s biggest citizen. It was he who visualized as did no other man the use to which great wealth could wisely be put. Because of him the world is a better place in which to live. Blessed be the memory of World Citizen No. 1.”

After reading this book, I can definitely say that the question I had has been answered. A highly recommended read from a historical, humanitarian and business perspectives. If you are looking to learn more about the Oil/Energy side of the story, I strongly recommend reading The Prize: The Epic Quest for Oil, Money and Power by Daniel Yergin.

On Reign Of Error

I just finished reading the next book on our reading list, within the Houston Nonfiction Book Club that I am part of, Reign of Error – The Hoax of the Privatization Movement and the Danger to America’s Public Schools by Diane Ravitch.

While one might not agree with every argument advanced by the author, your view about the education system will definitely be challenged by this book regardless on your current stance with respect to the public vs. private education debate. This book invoked within me similar feelings of transformation as did Naomi Klein‘s highly recommended, The Shock Doctrine, a few years ago.

The purpose of this book is in essence to answer four questions about education:

First, is American education in crisis? Second, is American education failing and declining? Third, what is the evidence for the reforms now being promoted by the federal government and adopted in many states: Fourth, what should we do to improve our schools and the lives of children?

Diane begins, by setting the background for her work:

In Hollywood films and television documentaries, the battle lines are clearly drawn. Traditional public schools are bad; their supporters are apologists for the unions. Those who advocate for charter schools, virtual schooling, and “school choice” are reformers; their supporters insist they are championing the rights of minorities. They say they are leaders of the civil rights movement of our day. It is a compelling narrative, one that gives us easy villains and ready-made solutions. It appeals to values Americans have traditionally cherished—choice, freedom, optimism, and a latent distrust of government. There is only one problem with this narrative. It is wrong. Public education is not broken. It is not failing or declining. The diagnosis is wrong, and the solutions of the corporate reformers are wrong. Our urban schools are in trouble because of concentrated poverty and racial segregation. But public education as such is not “broken.” Public education is in a crisis only so far as society is and only so far as this new narrative of crisis has destabilized it. The solutions proposed by the self-proclaimed reformers have not worked as promised. They have failed even by their own most highly valued measure, which is test scores. At the same time, the reformers’ solutions have had a destructive impact on education as a whole.

Her premise to advance education is to reverse our current path:

Stop doing the wrong things. Stop promoting competition and choice as answers to the very inequality that was created by competition and choice. Stop the mindless attacks on the education profession. A good society requires both a vibrant private sector and a responsible public sector. We must not permit the public sector to be privatized and eviscerated. In a democracy, important social goals require social collaboration. We must work to establish programs that improve the lives of children and families. To build a strong educational system, we need to build a strong and respected education profession. The federal government and states must develop policies to recruit, support, and retain career educators, both in the classroom and in positions of leadership. If we mean to conquer educational inequity, we must recognize that the root causes of poor academic performance are segregation and poverty, along with inequitably resourced schools. We must act decisively to reduce the causes of inequity. We know what good schools look like, we know what great education consists of. We must bring good schools to every district and neighborhood in our nation. Public education is a basic public responsibility: we must not be persuaded by a false crisis narrative to privatize it. It is time for parents, educators, and other concerned citizens to join together to strengthen our public schools and preserve them for future generations. The future of our democracy depends on it.

The language being used to drive the privatization effort is intentionally misleading:

If the American public understood that reformers want to privatize their public schools and divert their taxes to pay profits to investors, it would be hard to sell the corporate idea of reform. If parents understood that the reformers want to close down their community schools and require them to go shopping for schools, some far from home, that may or may not accept their children, it would be hard to sell the corporate idea of reform. If the American public understood that the very concept of education was being disfigured into a mechanism to apply standardized testing and sort their children into data points on a normal curve, it would be hard to sell the corporate idea of reform. If the American public understood that their children’s teachers will be judged by the same test scores that label their children as worthy or unworthy, it would be hard to sell the corporate idea of reform. If the American public knew how inaccurate and unreliable these methods are, both for children and for teachers, it would be hard to sell the corporate idea of reform. And that is why the reform message must be rebranded to make it palatable to the public.

The movement towards privatization of education is a bi-partisan effort:

Perhaps the most curious development over the three decades from A Nation at Risk to the 2012 report of the Council on Foreign Relations was this: what was originally seen in 1983 as the agenda of the most libertarian Republicans—school choice—had now become the agenda of the establishment, both Republicans and Democrats. Though there was no new evidence to support this agenda and a growing body of evidence against it, the realignment of political forces on the right and the left presented the most serious challenge to the legitimacy and future of public education in our nation’s history.

While there has been an increased focused on more testing and standardization, the quality of education has suffered:

Surely, there is value in structured, disciplined learning, whether in history, literature, mathematics, or science; students need to learn to study and to think; they need the skills and knowledge that are patiently acquired over time. Just as surely, there is value in the activities and projects that encourage innovation. The incessant demand for more testing and standardization advances neither.

Diane then goes on to outline, sixteen claims/fallacies that the reformers have been promoting to advance their privatization agenda, and below I will highlight three of them:

First, the fallacy surrounding high school graduation rates:

CLAIM: The nation has a dropout crisis, and high school graduation rates are falling. REALITY: high school graduation rates are at an all-time high…If college completion is important as an investment in the knowledge and skills of our population (and not just as a credential), then we must encourage and enable students to persist. If we treated education as both an economic good for the ongoing development of our nation and a basic human right, then public higher education would be subsidized by the state and freely available to all who choose to pursue a degree. That’s about as likely to happen as becoming first in the world in degree completion by 2020, but it would move us closer to the latter goal.

Second, the fallacy around the academic challenges in poorer schools are attributable to the ineffectiveness of their teachers:

CLAIM: Poverty is an excuse for ineffective teaching and failing schools. REALITY: Poverty is highly correlated with low academic achievement…The reformers’ belief that fixing schools will fix poverty has no basis in reality, experience, or evidence. It delays the steps necessary to heal our society and help children. And at the same time, it castigates and demoralizes teachers for conditions they did not cause and do not control.

Third, the fallacy that charter schools are the solution to the educational challenges of America:

CLAIM: Charter schools will revolutionize American education by their freedom to innovate and produce dramatically better results.REALITY Charter schools run the gamut from excellent to awful and are, on average, no more innovative or successful than public schools.

Before transitioning from the fallacies, to the solutions, the author reminds us again that poverty is not a problem that education alone can address:

There is no example in which an entire school district eliminated poverty by reforming its schools or by replacing public education with privately managed charters and vouchers. If the root causes of poverty are not addressed, society will remain unchanged. Some poor students will get the chance to go to college, but the vast majority who are impoverished will remain impoverished. The current reform approach is ineffective at eliminating poverty or improving education. It may offer an escape hatch for some poor children, as public schools always have, but it leaves intact the sources of inequality. The current reform approach does not alter the status quo of deep poverty and entrenched inequality…We need broader and deeper thinking. We must decide if we truly want to eliminate poverty and establish equal educational opportunity We must decide if we truly want to build a society with liberty and justice for all. If that is our true purpose, then we need to move on two fronts, changing society and improving schools at the same time.

Diane, then goes on to detail an eleven point action plan, of which I have highlighted six below:

  • Provide good prenatal care for every pregnant woman.
  • Make high-quality early childhood education available to all children.
  • Every school should have a full, balanced. and rich curriculum, including the arts, science, history, literature, civics, geography, foreign languages, mathematics.  and physical education.
  • Reduce class sizes to improve student achievement and behavior.
  • Insist that teachers, principals, and superintendents be professional educators.
  • Devise actionable strategies and specific goals to reduce racial segregation and poverty.

On a concluding note:

Genuine school reform must be built on hope, not fear; on encouragement, not threats; on inspiration, not compulsion; on trust, not carrots and sticks; on belief in the dignity of the human person, not a slavish devotion to data; on support and mutual respect, not a regime of punishment and blame. To be lasting, school reform must rely on collaboration and teamwork among students, parents, teachers, principals and local communities. Despite its faults, the American system of democratically controlled schools has been the mainstay of our communities and the foundation for our nation’s success. We must work together to improve our public schools. We must extend the promise of equal educational opportunity to all the children of our nation. Protecting our public schools against privatization and saving them for future generations of American children is the civil rights issue of our time.

A very highly recommended read.

On Free To Choose

I recently finished reading Free To Choose – A Personal Statement – by Milton and Rose Friedman.

Below are key excerpts from the book that I found particularly insightful:

1- “Economic freedom is an essential requisite for political freedom. By enabling people to cooperate with one another without coercion or central direction, it reduces the area over which political power is exercised. In addition, by dispersing power, the free market provides an offset to whatever concentration of political power may arise. The combination of economic and political power in the same hands is a sure recipe for tyranny.”

2- “The experience of recent years—slowing growth and declining productivity—raises a doubt whether private ingenuity can continue to overcome the deadening effects of government control if we continue to grant ever more power to government, to authorize a “new class” of civil servants to spend ever larger fractions of our income supposedly on our behalf. Sooner or later—and perhaps sooner than many of us expect—an ever bigger government would destroy both the prosperity that we owe to the free market and the human freedom proclaimed so eloquently in the Declaration of Independence.”

3- “Prices perform three functions in organizing economic activity: first, they transmit information; second, they provide an incentive to adopt those methods of production that are least costly and thereby use available resources for the most highly valued purposes; third, they determine who gets how much of the product – the distribution of income. These three functions are closely interrelated.”

4- “Our society is what we make it. We can shape our institutions. Physical and human characteristics limit the alternatives available to us. But none prevents us, if we will, from building a society that relies primarily on voluntary cooperation to organize both economic and other activity, a society that preserves and expands human freedom, that keeps government in its place, keeping it our servant and not letting it become our master.”

5- “The ballot box produces conformity without unanimity; the marketplace, unanimity without conformity. That is why it is desirable to use the ballot box, so far as possible, only for those decisions where conformity is essential.”

6- “Freedom cannot be absolute. We do live in an interdependent society. Some restrictions on our freedom are necessary to avoid other, still worse, restrictions. However, we have gone far beyond that point. The urgent need today is to eliminate restrictions, not add to them.”

7- “In one respect the System has remained completely consistent throughout. It blames all problems on external influences beyond its control and takes credit for any and all favorable occurrences. It thereby continues to promote the myth that the private economy is unstable, while its behavior continues to document the reality that government is today the major source of economic instability.”

8- “The waste is distressing, but it is the least of the evils of the paternalistic programs that have grown to such massive size. Their major evil is their effect on the fabric of our society. They weaken the family; reduce the incentive to work, save, and innovate; reduce the accumulation of capital; and limit our freedom. . These are the fundamental standards by which they should be judged.”

9- “A society that puts equality—in the sense of equality of outcome—ahead of freedom will end up with neither equality nor freedom. The use of force to achieve equality will destroy freedom, and the force, introduced for good purposes, will end up in the hands of people who use it to promote their own interests…Freedom means diversity but also mobility. It preserves the opportunity for today’s disadvantaged to become tomorrow’s privileged and, in the process. enables almost everyone, from top to bottom, to enjoy a fuller and richer life.”

10- “We believe that the growing role that government has played in financing and administering schooling has led not only to enormous waste of taxpayers’ money but also to a far poorer educational system than would have developed had voluntary cooperation continued to play a larger role…We have tried in this chapter to outline a number of constructive suggestions…These proposals are visionary but they are not impracticable…We shall not achieve them at once. But insofar as we make progress toward them—or alternative programs directed at the same objective—we can strengthen the foundations of our freedom and give fuller meaning to equality of educational opportunity.”

11- “Insofar as the government has information not generally available about the merits or demerits of the items we ingest or the activities we engage in, let it give us the information. But let it leave us free to choose what chances we want to take with our own lives.”

12- “When unions get higher wages for their members by restricting entry into an occupation, those higher wages are at the expense of other workers who find their opportunities reduced. When government pays its employees higher wages, those higher wages are at the expense of the taxpayer. But when workers get higher wages and better working conditions through the free market, when they get raises by firms competing with one another for the best workers, by workers competing with one another for the best jobs, those higher wages are at nobody’s expense. They can only come from higher productivity, greater capital investment, more widely diffused skills.”

13- “Five simple truths embody most of what we know about inflation: 1. Inflation is a monetary phenomenon arising from a more rapid increase in the quantity of money than in output (though, of course, the reasons for the increase in money may be various) 2. In today’s world government determines—or can determine -the quantity of money. 3. There is only one cure for inflation: a slower rate of increase in the quantity of money. 4. It takes time—measured in years, not months—for inflation to develop; it takes time for inflation to be cured. 5. Unpleasant side effects of the cure are unavoidable.”

14- “We have been misled by a false dichotomy: inflation or unemployment. That option is an illusion. The real option is only whether we have higher unemployment as a result of higher inflation or as a temporary side effect of curing inflation.”

15- “The two ideas of human freedom and economic freedom working together came to their greatest fruition in the United States. Those ideas are still very much with us. We are all of us imbued with them. They are part of the very fabric of our being. But we have been straying from them. We have been forgetting the basic h that the greatest threat to human freedom is the concentration of power, whether in the hands of government or anyone else. We have persuaded ourselves that it is safe to grant power, provided it is for good purposes.”


Omar Halabieh

Free To Choose