In this model there are three moving parts, going through these we can start to see how the conflicts emerge and where the opportunity to create an alternative point of view may reside.

So we have Earnings – the elemental building blocks of any investment. Into this balloon is grouped everything that drives the fundamental earnings of individual companies – it’s a rich interplay between interest rates, inflation, demographics, innovation, legal process, tax treatments etc. The net result is a single number that defines the return on any investment. Needless to say, when we extrapolate this number into the future, the resulting ‘forecast’ earnings can be plagued with uncertainty – this is a big part of the risk bit of any investment.

Flows determine arguably the cleanest dataset in the capitalist world – price. Through the process of buying and selling an asset, good or service, a clearing price is set. And while prices can be distorted by fair means or foul, they can also be directly measured, compared and analysed. Price is the clearest expression of the herd as regards expectations for Earnings – so while interpretation of movements in flows and prices may be subjective, the underlying data is not.

The net outcome of flows is Valuation. It is the amount that the market is prepared to pay for the expected earnings on an investment – and is a result of the demand and supply of that investment on the market.  Note that unlike earnings or flows, valuation is a derived, it is not directly observable as a distinct element in its own right. The implied valuation of an investment may change according to movements in its price but it is uncertain as to whether this is a result of changes in investor’s risk preferences, earnings expectations or some completely unrelated factor.

Circling back, how does this help addressing conflicts of interest in finance?  Taking a leaf out of Dan’s book, we can use the model to take the first step and recognise what the conflict looks like. Then once we understand where the conflict emanates from we can look at alternatives that do not suffer from the essential conflicts or may help to address them.

So what does the conflict look like? There are a essentially two issues here:

1) Access to information – As we have seen, in order for investors to be derive informed views about earnings expectations and how the market is pricing these, they must have easy access to the information. The accessibility to information varies by country and market – for example in the US, information is relatively more mobile than in the UK or Australia. In these latter jurisdictions, some market platforms are conflicted by a profit motive which leads to asymmetric distribution of information.

2) Alignment of interests - The majority of people do not have the time nor expertise to directly manage their on-market investments – they require assistance. The conflict arises from within that the industry structure that has grown to provide this expertise. The issue is one of alignment with the end investor.

Typically, an analysis of the investment industry conflict will look to the remuneration structure of financial planners – but the issue is much broader than that. A quick example from my own experience might illustrate (ie. if I’m pointing a finger at anyone, it is at myself).

Let’s take a look at valuation. An investment banker when structuring a new investment offering looks to relative prices to determine valuations. The thing that really matters is whether this investment compares favourably to the rest of the market. Any such valuation is based on my expectations for earnings and how the market will price those earnings into the future. Remember I get paid to sell you this investment, not to make sure it performs according to my forecasts.

Now we could similarly look at how funds management is a relative business, or how independent research companies are compromised by their remuneration structures, the point is that there are few mechanisms that promote the alignment of participants with the interests of investors.

So how can information technologies assist?  In short, through promoting accountability and by enabling the establishment of a truly aligned research and analysis model.

Make information more freely available

In an age where data is mobile at negligible cost, there should be no material impediment to allowing market data to move freely. We should be able to analyse flows as well as price and integrate analysis of economic data and other variables with relative ease.

In short, there is a public good to ensuring information is made widely available to all. It is one way that artificial distortions in price can be addressed. The extraction of monopoly profits for ‘ownership’ of such market information is clear evidence of undue influence by established interests. This is the simplest conflict of interest that can be addressed.

Encourage people to become more independent

Communication technologies are leading to a rapid evolution in the approach to education through online resources. The increasing sophistication of video tutorials and interactive real-world examples opens the way for real alternatives to be developed that will enable those that have the desire to increase their expertise when it comes to the finance sector. This is another way of promoting greater accountability.

Encourage truly independent analysis

Cheaper and more efficient communication can also assist by establishing alternatives for accessing research and analysis from within the current investment industry structure. Social media technologies offer the scale for more ‘aligned’ solutions to become viable. For example, there is the opportunity to establish an alternative research and analysis model that is not subject to conflicts because it is not reliant on income from those that sell goods and services for its survival. For those investors that require assistance, there is at least one truly independent source of research and analysis.

Conclusion

The emergence of product-comparison and swarm-purchasing-power sites is but the start of a move towards shifting more power to the consumer. As the technological blow torch gets applied to more information based industries, the likelihood is that those that rely on the current industry structure to protect their franchises will be challenged. I’m hoping the initiative we are working on will be part of the new landscape…

Now granted this is a survey of financial advisors only, so the responses may be paint a particularly advisor heavy view of reality – but still the picture makes some intuitive sense. Advisors struggle to get their clients to focus on their investment plans, as these same clients are being distracted by the torrent of bad news and what governments are (not?) doing to resolve the problems.

If we were to assume that the majority of the clients are of a baby boomer vintage, then maybe it’s reasonable for them to be more concerned about the immediate vagaries of the market and government policy. Investing for the long term is a different proposition when you are in asset liquidation mode.

In essence, Investment Rule #1 stems from the principle that it is harder to accumulate capital than it is to lose it.

Taking our lead from James Montier (here or in PDF here), a large, realised loss gives us the purest definition of ‘risk’:

“The permanent impairment of capital can arise from three sources 1) valuation risk – you pay too much for an asset 2) fundamental risk – there are underlying problems with the asset that you are buying 3) financing risk – leverage.”

It is the probability of one or all of these risks being realised, thereby giving rise to a permanent loss of capital, that must be understood in making an investment.

(Note that permanent loss of capital does not require that an investment falls to zero – it includes mark-to-market losses that are realised for whatever reason.)

We will explore the various types of risks in latter notes – for the moment there are some key things to consider with respect to this particular rule:

1) Size an investment according to its expected volatility - Given an understanding of the risk and reward around any investment, the actual size of a position should be scaled according to the range of outcomes that could arise. In other words, if there is a reasonable probability of an investment falling in value by a relatively large percentage, then the investment should be a smaller proportion of your portfolio. In this way, the risk of large ‘permanent’ losses is reduced.

2) Use leverage sparingly, if at all – Leverage, by definition, will increase the volatility of returns on an investment, so point 1 immediately applies. Leverage will also introduce another party into your investment decisions. And unless you have remarkable powers of persuasion, they are unlikely to have the same risk appetite as you – as one particularly apt financial proverbs goes “a banker will gladly lend you an umbrella, until it starts raining”. Keep leverage in investing for those occasions where the odds are heavily stacked in your favour.

3) Invest according to your time horizon -  Illiquid investments, whether they be small cap equities or farmland destined to be rezoned, require patient capital. More patient, than most investors are capable of. The point is that the horizon of an investment must be matched to its nature. Selling an illiquid investment in haste, rarely maximises its return.

4) Always assume the worst – This is perhaps the most important part of this rule and yet the hardest to apply. While humanity has a great capacity to imagine the future, my sense is that most of us are optimists. We at least hope for the best, if not expect it. Without this faculty, the world would probably be a pretty dreary place – assuming we had climbed far enough up the food chain to recognise it was cold and grey and lacking in iPads…

The point is that in investing, to stack the odds in our favour, we should always assume the worst. This will clearly cut down the investment universe – you will miss crazy investment successes, but let’s face it, you would have probably missed them anyway. (The best risk/reward investments are most often those that relate to your direct experience. If you hear about a great investment from the shoe shine, you are more likely to be the poor sod who provides the ‘exit strategy’ for those closer to the action.)

But most importantly you are more likely to miss the duds. And remember it is the failures that will destroy investment performance.

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Now as to my hit this week, that was via an equity investment where I had ignored point 4. In essence, I had disregarded the warning signs (and they were sufficient for an investor who ‘assumes the worst’). It all came down to how one interprets the communiques from management but that is for rule #2…

February 2009

One of the things I always tell startups is a principle I learned from Paul Buchheit: it’s better to make a few people really happy than to make a lot of people semi-happy. I was saying recently to a reporter that if I could only tell startups 10 things, this would be one of them. Then I thought: what would the other 9 be?

When I made the list there turned out to be 13:

1. Pick good cofounders.

Cofounders are for a startup what location is for real estate. You can change anything about a house except where it is. In a startup you can change your idea easily, but changing your cofounders is hard. [1] And the success of a startup is almost always a function of its founders.

2. Launch fast.

The reason to launch fast is not so much that it’s critical to get your product to market early, but that you haven’t really started working on it till you’ve launched. Launching teaches you what you should have been building. Till you know that you’re wasting your time. So the main value of whatever you launch with is as a pretext for engaging users.

3. Let your idea evolve.

This is the second half of launching fast. Launch fast and iterate. It’s a big mistake to treat a startup as if it were merely a matter of implementing some brilliant initial idea. As in an essay, most of the ideas appear in the implementing.

4. Understand your users.

You can envision the wealth created by a startup as a rectangle, where one side is the number of users and the other is how much you improve their lives. [2] The second dimension is the one you have most control over. And indeed, the growth in the first will be driven by how well you do in the second. As in science, the hard part is not answering questions but asking them: the hard part is seeing something new that users lack. The better you understand them the better the odds of doing that. That’s why so many successful startups make something the founders needed.

5. Better to make a few users love you than a lot ambivalent.

Ideally you want to make large numbers of users love you, but you can’t expect to hit that right away. Initially you have to choose between satisfying all the needs of a subset of potential users, or satisfying a subset of the needs of all potential users. Take the first. It’s easier to expand userwise than satisfactionwise. And perhaps more importantly, it’s harder to lie to yourself. If you think you’re 85% of the way to a great product, how do you know it’s not 70%? Or 10%? Whereas it’s easy to know how many users you have.

6. Offer surprisingly good customer service.

Customers are used to being maltreated. Most of the companies they deal with are quasi-monopolies that get away with atrocious customer service. Your own ideas about what’s possible have been unconsciously lowered by such experiences. Try making your customer service not merely good, but surprisingly good. Go out of your way to make people happy. They’ll be overwhelmed; you’ll see. In the earliest stages of a startup, it pays to offer customer service on a level that wouldn’t scale, because it’s a way of learning about your users.

7. You make what you measure.

I learned this one from Joe Kraus. [3] Merely measuring something has an uncanny tendency to improve it. If you want to make your user numbers go up, put a big piece of paper on your wall and every day plot the number of users. You’ll be delighted when it goes up and disappointed when it goes down. Pretty soon you’ll start noticing what makes the number go up, and you’ll start to do more of that. Corollary: be careful what you measure.

8. Spend little.

I can’t emphasize enough how important it is for a startup to be cheap. Most startups fail before they make something people want, and the most common form of failure is running out of money. So being cheap is (almost) interchangeable with iterating rapidly. [4]But it’s more than that. A culture of cheapness keeps companies young in something like the way exercise keeps people young.

9. Get ramen profitable.

“Ramen profitable” means a startup makes just enough to pay the founders’ living expenses. It’s not rapid prototyping for business models (though it can be), but more a way of hacking the investment process. Once you cross over into ramen profitable, it completely changes your relationship with investors. It’s also great for morale.

10. Avoid distractions.

Nothing kills startups like distractions. The worst type are those that pay money: day jobs, consulting, profitable side-projects. The startup may have more long-term potential, but you’ll always interrupt working on it to answer calls from people paying you now. Paradoxically, fundraising is this type of distraction, so try to minimize that too.

11. Don’t get demoralized.

Though the immediate cause of death in a startup tends to be running out of money, the underlying cause is usually lack of focus. Either the company is run by stupid people (which can’t be fixed with advice) or the people are smart but got demoralized. Starting a startup is a huge moral weight. Understand this and make a conscious effort not to be ground down by it, just as you’d be careful to bend at the knees when picking up a heavy box.

12. Don’t give up.

Even if you get demoralized, don’t give up. You can get surprisingly far by just not giving up. This isn’t true in all fields. There are a lot of people who couldn’t become good mathematicians no matter how long they persisted. But startups aren’t like that. Sheer effort is usually enough, so long as you keep morphing your idea.

13. Deals fall through.

One of the most useful skills we learned from Viaweb was not getting our hopes up. We probably had 20 deals of various types fall through. After the first 10 or so we learned to treat deals as background processes that we should ignore till they terminated. It’s very dangerous to morale to start to depend on deals closing, not just because they so often don’t, but because it makes them less likely to.

Having gotten it down to 13 sentences, I asked myself which I’d choose if I could only keep one.

Understand your users. That’s the key. The essential task in a startup is to create wealth; the dimension of wealth you have most control over is how much you improve users’ lives; and the hardest part of that is knowing what to make for them. Once you know what to make, it’s mere effort to make it, and most decent hackers are capable of that.

Understanding your users is part of half the principles in this list. That’s the reason to launch early, to understand your users. Evolving your idea is the embodiment of understanding your users. Understanding your users well will tend to push you toward making something that makes a few people deeply happy. The most important reason for having surprisingly good customer service is that it helps you understand your users. And understanding your users will even ensure your morale, because when everything else is collapsing around you, having just ten users who love you will keep you going.

• Likes Simple and Robust Valuation Approaches - answers should “scream at you”)
• Some Examples of Simple Valuations for Stock Markets include market cap to GDP, P/Es based on 10-year earnings, dividend yields vs. bond yields
• Importance of Organizing One’s Research According to 1) Reliability (eg current margins are better information than estimated margins 2 years from today) and 2) Underlying Strategic Assumption (does company have competitive advantage?)

Valuation Approaches:

• Asset-Based Valuation (can be applied to 70% of companies): industry is economically viable but no incumbent competitive advantage –> asset value (replacement costs) = earnings power value
• Earnings Power Valuation, Without Growth (can be applied to 20% of companies): industry is viable, firm enjoys sustainable competitive advantage (moat, franchise) but no/low growth
• Earnings Power Valuation, With Growth (can be applied to 5% of companies): industry is viable, firm enjoys sustainable competitive advantage (moat, franchise) and exhibits growth
• Liquidation Valuation (can be applied to 5% of companies): industry is NOT economically viable

Via the Tischendorf Letter...

Dickson G. Watts was the president of the New York Cotton Exchange from 1878 to 1880. His list of ‘Essential Qualities of the Speculator’ and ‘Laws Absolute” show the timeless value of his insight:

1. Self-Reliance. A man must think for himself, must follow his own convictions. George MacDonald says: “A man cannot have another man’s ideas any more than he can another man’s soul or another man’s body.” Self-trust is the foundation of successful effort.

2. Judgment. That equipoise, that nice adjustment of the faculties one to the other, which is called good judgment, is an essential to the speculator.

3. Courage. That is, confidence to act on the decisions of the mind. In speculation there is value in Mirabeau’s dictum: “Be bold, still be bold; always be bold.”

4. Prudence. The power of measuring the danger, together with a certain alertness and watchfulness, is very important. There should be a balance of these two, Prudence and Courage; Prudence in contemplation, Courage in execution. Lord Bacon says: “In meditation all dangers should be seen; in execution one, unless very formidable.” Connected with these qualities, properly an outgrowth of them, is a third, viz: promptness. The mind convinced, the act should follow. In the words of Macbeth; “Henceforth the very firstlings of my heart shall be the firstlings of my hand.” Think, act, promptly.

5. Pliability. The ability to change an opinion, the power of revision. “He who observes,” says Emerson, “and observes again, is always formidable.” The qualifications named are necessary to the makeup of a speculator, but they must be in well-balanced combination. A deficiency or an overplus of one quality will destroy the effectiveness of all. The possession of such faculties, in a proper adjustment is, of course, uncommon. In speculation, as in life, few succeed, many fail.

These are his ‘Laws Absolute’:

1. Never Overtrade. To take an interest larger than the capital justifies is to invite disaster. With such an interest a fluctuation in the market unnerves the operator, and his judgment becomes worthless.

2. Never “Double Up”; that is, never completely and at once reverse a position. Being “long,” for instance, do not “sell out” and go as much “short.” This may occasionally succeed, but is very hazardous, for should the market begin again to advance, the mind reverts to its original opinion and the speculator “covers up” and “goes long” again. Should this last change be wrong, complete demoralization ensues. The change in the original position should have been made moderately, cautiously, thus keeping the judgment clear and preserving the balance of the mind.

3. “Run Quickly,” or not at all; that is to say, act promptly at the first approach of danger, but failing to do this until others see the danger, hold on or close out part of the “interest.”

4. Another rule is, when doubtful, reduce the amount of the interest; for either the mind is not satisfied with the position taken, or the interest is too large for safety. One man told another that he could not sleep on account of his position in the market; his friend judiciously and laconically replied: “Sell down to a sleeping point.”

1) Research – never enter a position on a whim.  If you can’t point to the exact reasons for a position, then why be in it?

2) Risk – never bet the house.  The ‘chip away’ strategy is the trader’s variation on compound interest. Lotsa small wins will add up – without the pin risk of a single lottery play.