Reading Roundup: February 2024
This month we read:
Fooling Some of the People All of the Time by David Einhorn
A Diary Of A Very Bad Year by Anonymous Hedge Fund Manager
The Founder’s Mentality by Chris Zook and James Allen
No Higher Honor: Saving the USS Samuel B. Roberts in the Persian Gulf by Bradley Peniston
The Southwest Airlines Way by Jody Gittell
Living with a SEAL: 31 Days Training with the Toughest Man on the Planet by Jesse Itzler
Fooling Some of the People All of the Time by David Einhorn
While David Einhorn has a somewhat different investment style than us (he’s a fellow value investor, but applies it differently), I always enjoy learning from him. Fooling Some of the People All of the Time is an entertaining saga about his battle against Allied Capital; a specialty lender that Einhorn had a short bet against from 2002 to 2008. The book is Einhorn’s account of what turned out to be obvious fraud at Allied Capital.
I find it helpful to study the extremes; both very good and very bad businesses. Obviously the goal for us is to buy more of the former and none of the latter. Allied Capital falls squarely into the companies we seek to avoid. There were myriad red flags at Allied in the early 2000s, some of the most notable ones were:
Beware of misaligned incentive structures. The ultimate problem at Allied was very simple; they made a bunch of stupid loans that were unlikely to ever be repaid. It cost the SBA (and subsequently, U.S. tax payers) tens of millions of dollars. At Allied’s most problematic/fraudulent subsidiary - BLX Capital - the underwriters worked for loan originators. This means that if an underwriter denied a loan it hurt their bosses bonus. To no ones surprise, almost any loan got approved, which filled BLX’s balance sheet with junk loans that never had a chance to be repaid. Management was laser focused on origination because that’s how they earned their annual bonuses, and it was obviously a misaligned incentive structure for long-term investors.
Follow the cash. Allied never produced reliable cash from operating its business. It paid a handsome dividend yield but could only afford it by selling its good assets or issuing new shares. This was obvious to anyone looking at the financial statements; but it was ignored by retail investors who were solely enticed by a juicy headline dividend yield. It amounted to a house of cards; once all the good assets were sold off, it was clear the company couldn’t cover it’s dividend and the stock collapsed. Shareholders could have avoided being dragged down by following a cash-in-cash-out approach that we’ve written about.
There are lots of other entertaining learnings about the failings of the regulatory bodies in the U.S. and I’d highly recommend reading the book.
Dan
A Diary Of A Very Bad Year by Anonymous Hedge Fund Manager
Matt Levine, one of my favorite financial writers, recommended this book to Barry Ritholtz in January. The book is a series of conversations between Keith Gessen and an anonymous hedge fund manager (“HFM”) that took place between 2007 and 2009.
Gessen is a novelist (“All the Sad Young Literary Men”) and editor at the literary magazine n + 1. He self proclaims no interest in finance, economics, or the people those fields attract. But by late 2007 the sub-prime crisis had become too big to ignore and would soon affect every American, whether they wanted it to or not.
The book reads like lively, often funny, and refreshingly candid dinner conversation. Much like Levine, HFM is able to explain complicated subjects simply and clearly.
What stands out to me is the clarity of HFM’s analysis in the heat of the moment. The interviews took place concurrently with the events discussed. HFM is not benefiting from hindsight.
How does he do it? HMF focuses his analysis on incentives and human nature. Instead of dwelling on the specifics of the TARP legislation or the minutiae of AAA securitizations, he zooms out and thinks about each of the players incentives.
For example, here is how HFM explains the creation of so many investment grade CDOs:
But what happened is, you had the creation of so many vehicles designed to buy that paper, the triple-A, the double-A, all the CDO paper…that the dynamic flipped around. It was almost as if the demand for that paper created the mortgages…
So what happened is this machine, let’s call it, a big machine that wanted to gobble up, you know, rated paper—needed to be fed. There were people who could make a lot of money feeding the machine, and they were like, “We need to keep originating mortgages, and feeding them to the machine,” and if you have a robot bid, you tend to get a bubble. Someone is hungry for paper, paper will be created. And that’s almost never a good thing that lending decisions are being driven by the fact that many, many steps down the chain there’s just someone who wants to buy paper.
Listen to enough Buffett and Munger and you’ll see a similar pattern of thinking. Know the details, but don’t get bogged down in them. See the bigger picture by focusing on the incentives.
Matt
The Founder’s Mentality by Chris Zook and James Allen
The Founders Mentality is about tactics management teams can use to avoid to avoid sliding from a rapidly growing insurgent into a struggling bureaucracy. It’s a little “consultant-y” for my taste (not surprising given it’s written by two partners from Bane & Co.) but it still provides a useful framework that can be applied to investing.
The authors frame the four stages of a company in terms of benefits to scale and benefits to a “founders mentality”. The goal is to become a “scale insurgent”, or a business that keeps the hunger, agility, and scrappiness of a startup while benefitting from scale advantages that protect its competitive position. Amazon is about as good of an example of a business that went from insurgent to scale insurgent as I can think of.
The usual path of a company is from insurgent to stable incumbent (slow growing, losing its fire, but still profitable) to a struggling bureaucracy (no growth, bloated, etc.). Few attain scale insurgency. Public companies that achieve scale insurgency are almost certain to have stocks that perform very well, and it’s helpful for investors to ask themselves what quadrant a company falls in that they’re studying and how likely the company is to move to a different quadrant (either in a good or bad direction). The book provides a useful base rate and qualitative description of the types of companies in each quadrant. Unsurprisingly, it’s important for companies wishing to attain scale insurgency to operate with an owners mindset, have a clear and focused mission, and maintain a relentless focus on the front lines of their business. The book expands on each of these areas in detail.
Another useful takeaway that has been directly relevant in recent years is that it is common for companies to rapidly, and unexpectedly, go from rapidly growing insurgent to incumbent. This is called the “stall out”. When the brakes are slammed on growth it usually means a collapsing stock price. We’ve seen this time and again with fast growing companies in the public markets. Companies are often rapidly growing, and highly valued, until suddenly they’re not. The result can be jarring for investors.
We love businesses that grow, but this dynamic is why we tend to shy away from anything growing too rapidly.
Dan
No Higher Honor: Saving the USS Samuel B. Roberts in the Persian Gulf by Bradley Peniston
No Higher Honor tells the story of the USS Samuel B. Roberts, a US Navy guided missile frigate, which hit a mine in the Persian Gulf at the height of the Iran-Iraq war in 1988.
I picked this book up to continue my December foray into the shipping industry. It proved timely as Houthi rebels began to attack ships in the Red Sea. History doesn’t repeat, but it does rhyme.
By 1984 Iran and Iraq had been at war for four years. Despite years of slaughter the conflict was a stalemate. Hoping to lure a western power into the conflict, Iraq began to attack Iranian shipping interests in the Persian gulf. Iraq wanted to provoke Iran to close the Strait of Hormuz, which the US had warned would provoke its own response. Iran left the strait open but began to attack Iraqi ships and Kuwaiti ships carrying Iraqi oil.
“Seventy-one ships were hit in 1984, 47 the following year, and 111 the year after that. Few of the big tankers actually sank, thanks to their spill-proofed double hulls, but dozens were declared total losses.”
By 1986 Kuwait asked President Reagan for protection. Kuwait’s fleet was re-flagged under the stars and stripes and became entitled to the US Navy’s protection. In 1988 the Roberts was sent to the Persian gulf to escort Kuwaiti convoys as a part of Operation Ernest Will.
The year prior, an Iraqi fighter jet had mistaken a US warship in the Gulf and fired two missiles at her, killing 37 US sailors. Damage control was at the top of Paul Rinn’s mind as he assumed command over the Roberts.
“From the outset, Cdr. Paul Rinn emphasized damage control, an area that is often neglected until a unit enters its theater of operations—when it is far too late for rigorous training.”
“Normally, commanders detail the most experienced people to operations and weaponry billets, leaving damage control to relatively junior officers. Rinn chose a different course, assigning a senior lieutenant to develop a rigorous training regimen that involved the entire crew. Officers and enlisted sailors alike were rotated through a variety of specialty schools dedicated to damage control. These steps paid rich dividends when the Roberts was finally tested.”
Rinn’s preparation proved vital when the Roberts found herself in the middle of an Iranian minefield. “In attempting to move clear of the mines, the ship detonated a 253-pound charge and absorbed incredible damage.”
“The explosion grabbed the frigate and shook it from stem to stern. The ship flexed, flipping Gibson backward out of his chair. Superhot gasses rushed through a hole in the hull, setting fires at the ship’s very core. A wall of seawater followed within seconds, ripping open fuel tanks and flooding the engine room. Far above, a ball of flame erupted from the ship’s stack, and fiery chunks of debris rained down on the deck.”
The bravery, training, and quick thinking of the Robert’s crew saved her after a 24 hour fight against fires and leaks.
President Reagan authorized Operation Praying Mantis in response. It was a 24 hour war between American and Iran and the largest naval battle since WW2.
“The day’s final tally: the U.S. Navy had sunk one Iranian frigate, one patrol boat, and three Boghammars; eliminated two oil platforms-cumradar picket stations; and put another frigate out of action. No fleet had lost such a large fraction of its fighting force in a single battle since Leyte Gulf in 1944.”
“Operation Praying Mantis was a watershed battle in naval warfare as well. It was the first clash between groups of warships since World War II, and it featured the first missile duel between surface forces. Moreover, it was the first test of a new way of war that depended as much on electronic networks as it did on ordnance.”
There are several lessons to learn from this book.
The importance of preparation, especially the un-sexy stuff like damage control that you almost never need to use anyway (until you do when it’s all you care about). I’m reminded of Munger’s quip that an ounce of prevention isn’t worth a pound of cure, but a ton of cure.
The importance of leadership. He asked his men to risk their lives to save their ship. Rinn’s men followed his commands because they respected him and followed his example, not because they feared him.
The simplest things can have the biggest impact even though our imaginations naturally drift to the complex. Mines are the cheapest, simplest, and easiest naval weapons to deploy. “Since World War II, mines had damaged more U.S. warships than missiles, guns, and bombs combined.” The Roberts “had warded off warships and warplanes only to fall victim to a far more primitive weapon. A military empowered by and enamored of technology had demonstrated its inability to grapple with low-tech warfare.” This is repeating right now with drones in Ukraine and the Red Sea.
There is nothing new. I did not realize that the events unfolding today in the Red Sea were similar to those that occurred in the Persian Gulf 35+ years ago. To understand the present you must understand history.
Matt
The Southwest Airlines Way by Jody Gittell
Until recently, Southwest Airlines was the exception to the rule that airlines could not be good investments. Though the business has stumbled in recent years, it’s operating model is still worth studying and the stock has still been a tremendous performer going back several decades.
The book was written in the early 2000s, when the gap between Southwest and other airlines was as wide as ever. At the time, Southwest had such an advantage as a low cost operator that it could earn superior profits while charging lower prices. Many competitors tried to copy the operational elements of Southwest’s model in an effort to close the gap. Some of the well known practices of Southwest were (and are) utilizing a single type of aircraft to simplify and standardize maintenance and training and flying point-to-point instead of using a hub and spoke model. These strategies are easy to point out and, in theory, easy for competitors to copy to some degree. The problem was competitors failed to copy the most important aspect of Southwest, it’s culture and operating ethos.
The real secret to Southwest’s success was their cooperative and flexible culture. Pilots helped load bags when things got busy. Gate agents communicated relentlessly with maintenance technicians, pilots, and the ground crew. There was no discernible hierarchy or functional silos. Teams were measured with shared goals, not competing priorities. Management encouraged problem solving instead of hiding problems.
All of these individual tactics, and more, resulted in a high level of “relational coordination” which in turn enabled a low operating cost structure that incumbents could not emulate. The company operates in a very similar manner to Toyota, who pioneered lean manufacturing techniques that also emphasize a culture of respect and continuous improvement.
The book is a great resource for evaluating the cultural aspects of a business. These are harder to glean than quantitative financial measures (though they are arguably more important) but still can usually be discerned based on what management measures and how they write and speak to shareholders.
Dan
Living with a SEAL: 31 Days Training with the Toughest Man on the Planet by Jesse Itzler
I decided to re-read Living With A SEAL after I recommended it to a friend. It is a short, fun read about David Goggins.
Jesse Itzler, the author, is an interesting guy. He’s a self-made billionaire who co-founded Marque Jet and Zico Coconut Water. He is also a rapper, wrote and sang the New York Knicks theme song "Go NY Go, and owns the Atlanta Hawks. He married fellow self-made billionaire Sara Blakely, the founder of Spanx.
In Jesse’s free time he runs ultramarathons and never shirts from a challenge. At a 24 hour race in San Diego he saw David Goggins. This was many years before Goggins was famous. Then, Goggins was an active duty SEAL who ran ultramarathons on the weekend. Goggin’s grit and endurance impressed Jesse so much that Jesse cold called Goggins after the race and invited him to live with him and train him for a month. Jesse’s attitude was that if he could get just 1% of the mental fortitude that Goggins had, he’d be exponentially better for it.
Goggin’s one rule was that Jesse had to do everything and anything that Goggins demanded. This included chopping a hole in an iced-over lake and jumping in and doing over 1,000 push-ups in a single day.
One of Goggin’s key principles is that when you want to quit, you’re only at 40% of your capacity. The mind is often our biggest limiter. We can learn to push past our artificial limits through discipline and consistency.
The book is a fun mix of Jesse’s business stories, Goggin’s insane workouts, and Sara’s response to all of it.
Matt
Do you have a “stranded” 401(k) from a past job that is neglected and unmanaged? Eagle Point offer separately managed accounts to retail investors, and 401(k) rollovers are often a good fit for our long-term approach. If you would like to invest with Eagle Point Capital or connect with us, please email info@eaglepointcap.com.
The Best Of The Rest
Morningstar: Top 10 Wealth Destroying Fund Families Over The Past 10 Years. No surprise who is number one.
“The investment environment in the coming years will feature higher interest rates than those we saw in 2009-21. Different strategies will outperform in the period ahead, and thus a different asset allocation is called for.”
“I love Hayek’s word malinvestment, because of the validity of the idea behind it: in low return times, investments are made that shouldn’t be made; buildings are built that shouldn’t be built; and risks are borne that shouldn’t be borne.”
Masters In Business: David Einhorn - Market Structures Are Broken.
Value After Hours: John Huber. Huber returns to VAH and riffs on the opposing ideas of punch card investing and coffee can investing.
WSJ: Stocks Are Forever. That Doesn’t Mean Now Is the Time to Buy. “Someone who put $1,000 in the S&P 500 in December 2019—when the first infections occurred in Wuhan, China—and reinvested dividends would have made 6.8% annualized after inflation and had $1,299 by the end of last year. That return is bang in line with the annualized return investors have received in the stock market since 1802.”
David Heinemeir Hansson: The reality of the Danish fairytale. “But to pine for a society like the Danish purely on the basis of the benefits is delusional. These benefits are fenced by a myriad of compromises and obligations.”
Norges Bank Investment Management interviews the CEO of Domino’s Pizza.
Barron’s: Philip Morris Stock Stands to Get a Boost From Earnings. “Philip Morris stock looks cheap. It trades at just 14 times 12-month forward earnings, a 30% discount to its five-year average and only slightly higher than where it has typically found a bottom during that period.”
Andrew Walker: LSXMK/SIRI. Andrew covers this special situation well. We also wrote about it here.
Do you have a “stranded” 401(k) from a past job that is neglected and unmanaged? Eagle Point offer separately managed accounts to retail investors, and 401(k) rollovers are often a good fit for our long-term approach. If you would like to invest with Eagle Point Capital or connect with us, please email info@eaglepointcap.com.
Disclosure: The author, Eagle Point Capital, or their affiliates may own the securities discussed. This blog is for informational purposes only. Nothing should be construed as investment advice. Please read our Terms and Conditions for further details.