Reading Roundup: February 2023
This month we read:
Soul in the Game by Vitaliy Katsenelson
Skunk Works: A Personal Memoir of My Years of Lockheed by Ben Rich
Noise by Daniel Kahneman, Oliver Sibony and Cass R. Sunstein
Quit by Annie Duke
Soul in the Game by Vitaliy Katsenelson
Vitaliy Katsenelson is one of my favorite investors, and he’s also a prolific writer. Soul in the Game was his third book, and the first non-investing book, though there are myriad takeaways that can help anyone become a better investor.
Inspired by Nassim Taleb’s excellent book Skin in the Game, this book is Vitaliy’s reflections on how to live a fulfilling life. Two themes resonate throughout: discipline/rationality, and passion. Vitaliy offers up his battle-tested ways to appreciate what you have, re-frame problems in a more productive light, and other practical wisdom to help people deal with success and failure.
My favorite section of the book is the “Stoicism Operating System” which outlines a few dozen helpful tactics that anyone can adopt from the ancient Greek stoics. There are a lot of books written about Stoicism and most of the popular ideas can be directly applied to improving the emotional side of investing. The Stoics taught people how to be rational and tricks to deal with inherent human biases. Some of the most relevant concepts are:
Dichotomy of Control. This idea is directly related to Buffett’s “inner scorecard” analogy. You can only control things that are internal to yourself, and there is little use occupying your brain with worrying about things that are external. For example; investors can control their investment process and emotional response to short-term price fluctuations. Investors have no control over how the stock market prices their investments. By focusing on creating a good process and maintaining emotional equanimity, the likelihood of a good outcome are high over the long term. Obsessively worrying about things you can’t control (like daily stock price fluctuations or what the Federal Reserve is going to say at its next presser) is a good way to take your eye off the ball and make painful mistakes.
Event, Judgment, Reaction (EJR) Framework. Related to dichotomy of control, the EJR framework is a practical way to tame what can be overly emotional responses to problems. Vitaliy quotes Holocaust survivor Vikto Frankl who said:
"Between stimulus and response there is a space. In that space is our power to choose our response. In our response lies our growth and our freedom”.
While it doesn’t seem like a revolutionary change, by forcing yourself to insert judgement into how to respond to a negative event, you can calibrate your emotion and reaction to negative happenings.
Vitaliy regularly views setbacks as mini Stoic quizzes that allow him to implement the mental control frameworks that he finds so helpful. This is a great practice to adopt.
Maintaining control over your emotions and focusing on what you can control are easily two of the most important skills investors can practice, and they’re available to everyone - regardless of experience or intelligence level.
There are countless other quick tricks and methodologies in the book and anyone who reads it is one step closer to living a meaningful life.
Dan
Skunk Works: A Personal Memoir of My Years of Lockheed by Ben Rich
If you want to learn about the defense industry, Skunk Works is your book. It is a highly entertaining behind the scenes look at Skunk Works from Ben Rich, who ran it from 1975 to 1991.
Skunk Works is the official nickname for Lockheed Martin's Advanced Development Programs. It has produced some of the most advanced and effective aircraft that the world has ever seen, including the modern F-22 Raptor and F-35 Lightning. As I wrote in Playing Offense With The Defense Industry, Lockheed’s fighter jet franchise is one of its crown jewels. Skunk Works is responsible for its success and its wide moat.
The book focuses on the U-2 spy plane and SR-71 Blackbird which were built while Ben Rich was at Lockheed. These were groundbreaking, top secret aircraft that became mission-critical to national defense. The Blackbird was the first operational stealth aircraft (Skunk Works invented stealth) and had a radar cross section 100 times smaller than the much smaller F-14 Tomcat fighter built a decade later. Most of Skunk Works aircraft operated in secrecy for 8-10 years before the government even acknowledged their existence. It makes me wonder — what’s flying right now that we have no idea exists?
The obvious question for investors is, what made Skunk Works so successful? They didn’t have better engineers, more engineers, or better funding. The key was management, specifically minimal bureaucracy. Decentralization is a common theme from the most successful companies.
Skunk Works relied on a small group of proven, top-notch engineers to work together in close proximity to each other and their prototype to design new aircraft. Rich explained:
We were a small, intensely cohesive group consisting of about fifty veteran engineers and designers and a hundred or so expert machinists and shop workers.
My weights man talked to my structures man, and my structures man talked to my designer, and my designer conferred with my flight test guy, and they all sat two feet apart, conferring and kibitzing every step of the way. We trusted our people and gave them the kind of authority that was unique in aerospace manufacturing. Above all, I didn’t second-guess them.
In theory, this should have been an easy structure for competitors to replicate. In practice, it was impossible. It is extraordinarily difficult to change the culture of a large corporation and achieve the level of trust and buy-in required for a Skunk Works-like operation.
Ben Rich recounts how his boss and mentor talked him out of accepting Northrup Grumman’s offer to start up their own Skunk Works.
I laid out Northrop’s offer, and he closed his eyes and solemnly shook his head. “Goddam it, Ben, I don’t believe a word that guy said to you. I’ll bet my ranch against Northrop starting its own Skunk Works. Companies give it lip service because we’ve been so successful running ours. The bottom line is that most managements don’t trust the idea of an independent operation, where they hardly know what in hell is going on and are kept in the dark because of security.
Don’t kid yourself, a few among our own people resent the hell out of me and our independence. And even those in aerospace who respect our work know damned well that the fewer people working on a project, the less profit from big government contracts and cost overruns. And keeping things small cuts down on raises and promotions.
Hell, in the main plant they give raises on the basis of the more people being supervised; I give raises to the guy who supervises least. That means he’s doing more and taking more responsibility.
But most executives don’t think like that at all. Northrop’s senior guys are no different from all of the rest in this business: they’re all empire builders, because that’s how they’ve been trained and conditioned. Those guys are all experts at covering their asses by taking votes on what to do next. They’ll never sit still for a secret operation that cuts them out entirely.
Control is the name of the game and if a Skunk Works really operates right, control is exactly what they won’t get.”
Ben Rich sums it up succinctly at the end of the book:
Going “skunky” is a very practical way to take modest risks, provided that top management is willing to surrender oversight in exchange for a truly independent operation that can make everyone look good if its technology innovations really catch on, as with stealth. By keeping low overhead and modest investment, a Skunk Works failure is an acceptable research and development risk to top management.
The book covers other details too, including:
How the margins increase as defense programs mature and the contractors extract efficiencies;
How hiring qualified engineers with the requisite security clearance is challenge (and competitive advantage once they’re yours); and
How inflation affects defense contractors
The book also includes some comical and harrowing tales from the front lines of the cold war, like these:
We’ve all heard about surgeons leaving sponges or clamps inside bodies—but I know of a case in the main Lockheed plant where a workman left a vacuum cleaner inside the fuel tank of an Electra. The vacuum cleaner began banging around inside the fuel tank at ten thousand feet and the pilot landed safely before disaster struck.
Vito had a close call. The ground crew had put his poison cyanide pill in the wrong pocket. We were issued the pill in case of capture and torture and all that good stuff, but given the option whether to use it or not. But Carmen didn’t know the cyanide was in the right breast pocket of his coveralls when he dropped in a fistful of lemon-flavored cough drops. The cyanide pill was supposed to be in an inside pocket. Vito felt his throat go dry as he approached Moscow for the first time—who could blame him? So he fished in his pocket for a cough drop and grabbed the cyanide pill instead and popped it into his mouth. He started to suck on it. Luckily he realized his mistake in a split second and spit it out in horror before it could take effect. Had he bit down he would have died instantly and crashed right into Red Square. Just imagine the international uproar!
Overall I’d highly recommend this book to anyone interested in military aircraft or investing in the defense industry.
Matt
Noise by Daniel Kahneman, Oliver Sibony and Cass R. Sunstein
I would put any book written by Kahneman on the must-read list for virtually anyone interested in how the world works and how humans make decisions. For investors, they are the bedrock of why securities can occasionally become priced irrationally thanks to the litany of inherent biases in human brains.
Kahneman’s work revolves around why people make errors. There are two major sources of error in human judgements; bias and noise. In target shooting, bias would be if all shots are fired to the left of the target, and noise would be if the shots are sprayed randomly all over the place. Each condition results in shots that are off target and both sources of error are bad. Historically, bias has received the bulk of the attention, and Kahneman’s book Thinking, Fast and Slow, works to address ways to overcome or account for biases.
Noise in judgement is basically the equivalent of unwanted variability, especially when there is supposed to be repeatable, predictable judgements or outcomes. Examples of noise in the real world include: judges handing out vastly different sentence lengths for seemingly identical crimes, insurance underwriters pricing identical policies at widely different premiums, multiple hiring managers rating potential new hires very differently, and doctors coming up with wildly different treatment options and diagnoses for the same health problem.
Broadly speaking, any time you are exercising judgement you are introducing the chance for noise to creep in. Because noise, or variability, in decision making is harder to see and measure, it is often ignored. As Kahneman says; any time judgement is involved, noise is present, and there’s usually a lot more of it than you think.
Noise addresses ways to reduce noise in decision making, a process referred to as “decision hygiene”. To summarize the key findings from Kahneman’s research there are a handful of key elements that help reduce noise. To give yourself the best chance of overcoming noise in a group decision (as is often the case in business);
At the beginning of the decision making process, structure the decision into “mediating assessments”. This is just a fancy word for breaking big decisions down into smaller elements. Define the success and evaluation criteria for each element of the decision individually before looking at the whole thing.
Whenever possible, use the “outside view”, or base rates, to inform your decisions. Don’t get suckered into using the “inside view” right off the bat. You can read more about base rates in Kahneman’s other works.
Keep the assessment of individual elements as independent as possible. In business, this means having separate teams work on each element if feasible. Otherwise try to put your independent hat. The “wisdom of crowds” is usually correct – provided that the crowd is independent - which it often isn’t.
After you’ve evaluated each element of the decision independently come together to discuss each element, one at a time.
To make the final decision, delay intuition but don’t abandon it. Gut feel and experience, after completing the independent and logical assessment, are still worth something.
As Kahneman puts it:
hand washing does not prevent all diseases. Likewise, decision hygiene will not prevent all mistakes…(but) it addresses an invisible yet pervasive and damaging problem.
Certainly investors, and all decision makers, will be better off for having implemented some version of decision hygiene into their process.
Dan
Quit by Annie Duke
I’m an optimistic person by nature. So it was hard for me to pick up a book called Quit given my penchant for sticking with things. I’m very glad I didn’t let the title turn me away.
Annie Duke wrote one of my favorite books, Thinking in Bets, and recently released Quit. Duke argues that while, yes, having grit and sticking with goals can result in great achievement, it comes with a big caveat; sticking with the right things.
In the first few pages Duke puts it simply:
success does not lie in sticking to things. It likes in picking the right thing to stick to and quitting the rest.
The rest of the book is about figuring out what to quit so you can stick with what matters.
Duke walks through loads of examples of when people clearly should have quit – mountain climbers that summited Everest by pushing through when they should have turned around, and subsequently died on the way back; founders that should have quit when it was clear their business was not going to succeed, and they ended up incinerating far more investor money than necessary; people staying in jobs they clearly hate for far too long; investors holding on to a stock long after the investment thesis was busted – the list goes on and on.
Humans have a nagging habit of not being good at quitting when they should, and (like Kahneman’s work explains), it’s because of the way we are wired. Here are some of Duke’s tips for becoming better at quitting.
Set “kill criteria” before you are “in it”. For example, before starting a new job, promise yourself, if I am not more happy in 18 months, or if I haven’t achieved a specific measurable goal by then, I will find a new job. Or, if the business behind the stock doesn’t hit certain business metrics within three years, we will sell. It’s easier to define exit criteria before you are in the middle of a situation, so set them ahead of time and stick to them.
Avoid escalation of commitment. Often, when things don’t go their way, people double down instead of quitting. This is largely due to the sunk cost fallacy. How much time, money, resources, etc. you’ve put into something has nothing to do with whether or not it makes sense to stick with going forward; those are sunk costs.
Don’t set all or nothing goals. If you constantly set “finish line” goals, then stopping anywhere short of the finish line feels like failure, and it makes you more likely to press on when you shouldn’t. This induces escalation of commitment; if you are myopically focused on an arbitrary finish line, you often blind yourself just to get there, even if the finish line makes no sense anymore. Instead, measure your goals by progress from the starting line. This makes it easier to walk away because you can be proud of how far you’ve come, or what you’ve learned, even if the original goal isn’t worth pursuing anymore.
Solve the hard problems first (“Monkey’s before pedestals”). Don’t waste your time solving the easy parts of a problem or project first, only to run in to a road block at the end. If you tackle the hard part of an endeavor first, you’ll find out whether or not it’s worth pursuing, and it’ll be easier to walk away from if it’s not a worthwhile endeavor. This again helps avoid escalation of commitment to a losing effort.
Duke sums it up nicely at the end:
if we were to sum up everything that we’ve talked about in this book, is that when we quit, we fear two things: that we’ve failed, and that we’ve wasted our time, effort, or money.
We need to redefine what “failed” and “wasted” mean.
When we worry that quitting means we’ve failed, what exactly are we failing at? If you quit something that’s no longer worth pursuing, that’s not a failure. That’s a success.
Dan
The Best of the Rest
Pershing Square Holdings Annual Investor Presentation
Updates on Lowes, Universal Music Group, QSR, and more
Buffett’s Annual Shareholder Letter
Berkshire has paid a lot of taxes over the past decade: “had there been roughly 1,000 taxpayers in the U.S. matching Berkshire’s payments, no other businesses nor any of the country’s 131 million households would have needed to pay any taxes to the federal government. Not a dime.”
Vitaliy Katsenelson — Why we’re confident in our Charter investment
Chris Mayer - Footnotes to Phelps
“all businesses, regardless of their sector and the products and services they sell, should be judged as being in the free cash flow generating business”
If you would like to invest with Eagle Point Capital or connect with us, please email info@eaglepointcap.com. You can also find more information on our website. We recommend starting with our Fundamentals. Thank you for reading!
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