Multidisciplinary

Thinking

Cost of machinery: Rs 10 cr.

Expected life of machine: 10
years

Annual savings: Rs 2.50 cr. p.a.

Expected residual value of
the machine: Rs 1 cr.

Cost of capital: 15% p.a.

Accept or reject?
You are the CFO of a textile company which manufactures commodity yarn and operates in an extremely competitive market.
Both industry, and your company, earns sub par return on capital.
A textile machinery manufacturer approaches you with a proposal to sell you a new type of textile machine, which is more efficient than any machine invented till date.
What does DCF teach you?

Accept or reject?

Which
Tool
Did
You
Use?

!

DCF
Where discipline does DCF belong to?

Corporate Finance

What did he do?

He SHUT
DOWN the
Textile
Operation!

WTF?
Is he crazy? Who is this guy?

Why
did he
do it?

Buffett does not have an MBA :-)

How did he solve the problem? Lets read his own words. And as I read the words, focus a bit on the highlighted text.

The domestic textile industry operates

in a commodity business, competing in a
world market in which substantial excess
capacity exists.

Much of the trouble we experienced was

attributable, both directly and indirectly,
to competition from foreign countries
whose workers are paid a small fraction
of the U.S. minimum wage...

Commodity + Excess Capacity due to Competition = Perfect Competition [Microeconomics]

Over the years we had the option of

making large capital expenditures in the
textile operation that would have allowed
us to somewhat reduce variable costs...
Each proposal to do so looked like an
immediate winner...

Measured by standard return-oninvestment tests, in fact, these proposals

usually promised greater economic
benefits than would have resulted from
comparable expenditures in our highlyprofitable candy and newspaper
businesses...

But the promised benefits from these

textile investments were illusory...

Many of our competitors, both domestic

and foreign, were stepping up to the same
kind of expenditures and, once enough
companies did so, their reduced costs
became the baseline for reduced prices
industrywide...

Viewed individually, each companys

capital investment decision appeared costeffective and rational..

Viewed collectively, the decisions

neutralized each other and were irrational
(just as happens when each person
watching a parade decides he can see a
little better if he stands on tiptoes)...

Thus, we faced a miserable choice: huge

capital investment would have helped to
keep our textile business alive, but would
have left us with terrible returns on evergrowing amounts of capital...

After the investment, moreover, the

foreign competition would still have
retained a major, continuing advantage in
labor costs...

A refusal to invest, however, would make

us increasingly non-competitive, even
measured against domestic textile
manufacturers...

And so, Mr. Buffett shut down the textile

business of Berkshire Hathaway

But what about cost accountants and their idea of shut down point?

Whats the problem with people who only use DCF or

Cost Accounting concepts like shut down point?

To a Man with a Hammer, Everything Looks Like a Nail

[Buffett] knew that the huge

productivity increases that would
come from a better machine
introduced into the production of a
commodity product...

would all go to the benefit of the

buyers of the textiles. Nothing was
going to [come to us] as owners...

Thats such an obvious concept

that there are all kinds of
wonderful new inventions that
give you nothing as owners...

except the opportunity to

spend a lot more money in a
business thats still going to be
lousy...

The money still wont come to

you. All of the advantages from
great improvements are going to
flow through to the customers

Conversely, if you own the only

newspaper in town and they were to
invent more efficient ways of composing
the newspaper...

then when you got rid of the old

technology and got new, fancy
computers, then all of the savings would
come right through to the bottom line...

In all cases, the people who sell the

machinery and even the internal
bureaucrats urging you to buy the
equipment...

show you
projections with
the amount youll
save at current
prices with the
new technology...

However, they dont do

the second step of the
analysis which is to
determine how much is
going to stay home and
how much is just going to
flow through to the
customer

Ive never seen a

single projection
incorporating that
second step in my
life. And I see them
all the time...

Rather, they always

read: This capital
outlay will save you
so much money
that it will pay for
itself in three
years
payback period

So you keep buying things that will pay

for themselves in three years

And after twenty years of doing it,

somehow youve earned a return of only
about four percent per annum. Thats the
textile business...

And it isnt that the machines werent

better. Its just that the savings didnt go
to you...

The cost reductions came through all

right. But the benefit of the cost
reductions didnt go to the guy who
bought the equipment...

Its such a simple idea. Its so basic. And

yet its so often forgotten.

How
did he
decide?

Buffett doesnt suffer from

man with a hammer
syndrome

He used several
tools

All the wisdom in the

world is not to be found in
one little academic
department.

That would be a disastrous
way to think and operate.

!
!
!

If all you have is one tool,

you will tend to overuse it.

Buffett used several tools

from MULTIPLE disciplines

Buffett jumped
over
jurisdictional
boundaries of
multiple
disciplines

Which boundaries
did Buffett jump
over?

Which mental models did he employ from which disciplines?

1 2 3 4 5 6

Competition [Microeconomics]

Viewed collectively, the decisions neutralized each other

and were irrational (just as happens when each person
watching a parade decides he can see a little better if he
stands on tiptoes)...

Buffetts metaphor of the parade is

the functional equivalent of which
mental model?

1 2 3 4 5 6

Prisoners Dilemma [Game Theory]

Actions that are rational at the individual level, if copied, become irrational at the group level.
http://en.wikipedia.org/wiki/Prisoner's_dilemma

In a business selling a
commodity-type product, it's
impossible to be a lot smarter
than your dumbest
competitor.

1 2 3 4 5 6

Return on Capital [Accounting]

1 2 3 4 5 6

Opportunity Cost [Microeconomics]

He compared his prospective investment for efficiency improvement in textile with those in newspaper and candy.

And the IRRs were LOWER in Candy and Newspaper. But he was going to RETAIN ALL OF THE BENEFIT of the investment in candy and newspaper and none of it in textiles.

1 2 3 4 5 6

Contrast Effect [Psychology]

Did not fall for the throwing good money after bad trap even though the money to be spent was small in comparison with money already spent.

1 2 3 4 5 6

Commitment & Consistency [Psychology]

Sunk costs are irrelevant. He did not think Oh I have already invested so much. Now I cant write it off.

Buffett used a
framework of
mental models

from multiple
disciplines

Mental Models

Competition [Microeconomics]

Prisoners Dilemma [Game Theory]

Return on Capital [Accounting]

Opportunity Cost [Microeconomics]

Contrast Effect [Psychology]

Commitment & Consistency [Psychology]

A mental model is
a representation
inside your head of
an external reality

You observe something and then you try to relate to it a model inside your head.

Mental Models are his

idea
Herb Simon

Nobel Laureate

Simon influenced
Charlie Munger about
mental models

One can train a man so

that he has at his disposal a
list or repertoire of the
possible actions that could
be taken under the
circumstances...

A person who is new at the

game does not have
immediately at his disposal a
set of possible actions to
consider, but has to construct
them on the spot, ... a timeconsuming and difficult mental
task...

The decision maker of

experience has at his
disposal a checklist of
things to watch out for
before finally accepting a
decision.
Expert fire fighters, chess grandmasters seek patterns.

A large part of the

difference between the
experienced decision
maker and the novice in
these situations is not
any particular intangible
like judgment or
intuition...

If one could open the

lid, so to speak, and see
what was in the head of
the experienced
decision-maker, one
would find that he had. . .
at his disposal...

repertoires of possible
actions; that he had. . .
checklists of things to think
about before he acted; and
that he had mechanisms in his
mind to evoke these, and
bring these to his conscious
attention when the situations
for decisions arose.

Most of what we do is to
get people ready to act in
situations of encounter
consists of drilling in these
lists into them sufficiently
deeply so that they will be
evoked quickly at the time of
the decision.
Thats my job - to train you to think in a checklist style. Your checklist will have mental models, and you will use your experience (direct and vicarious) to relate what you see
in the world to whats on your list of mental models.

The expert KNOWS what he has to do e.g. an experienced fire fighter- what appears to be intuition and gut feel and blink, is actually based on experience and models.

To think much better,

youll need a checklist of
mental models

These mental models will come

from multiple disciplines

Economics, Psychology, Accounting, Chemistry, Physics, Mathematics, Engineering and Evolutionary Biology.

My latticework of mental models

http://www.thebrain.com

About 20 models
from psychology
will become
behavioral finance

Why do you need a

checklist?

Because the human

mind is like the
human egg

As soon as a sperm enters the egg, theres an automatic shut-off device that bars other sperms from getting in.

Mind jumps to
conclusions: First
conclusion bias

Is commodity price
rise bad for
commodity users?

Example: steel price hike and its effect on auto

Youve got to have

models in your head.
And youve got to
array your
experience both
vicarious and direct
on this latticework
of models...

Students who just try to

remember and pound back
what is remembered, well, they
fail in school and fail in life.
Youve got to hang experience
on a latticework of models in
your head.

To acquire general wisdom,

you need:

1.A checklist of mental
models

2.A good search engine in

your brain i.e. a system of
relating experience to the
models on your checklist

Youre not to going to get very far in

life based on what you already know...

Youre going to get ahead in life in what

you learn after you leave here. speaking to students at USC Law School

Direct Experience
&
Vicarious Experience

You don't have to

pee on an electric
fence to learn not to
do it.

The man who does

not read great books
has no particular
advantage over a
man who cannot
read them. - Mark
Twain

We learn more from

the great business
magazines than we do
anywhere else...

It's such an easy

shorthand way of getting a
vast variety of business
experience just to riffle
through issue after issue
after issue covering a great
variety of businesses...

And if you get the mental

habit of relating what you're
reading to the basic
structure of the underlying
ideas [i.e. mental models]
being demonstrated, you'll
gradually accumulate some
wisdom about investing.

If you want to get smart,

the question youve got to
ask is why? why? why? And
you relate the answers to a
structure of deep
theory. [Mental Models]

To acquire general wisdom, you also need:

3.Full attribution ethos; and

4.Extreme reductionism (like in algebra)
to understand lollapalooza outcomes

e.g. 2x + 6y = 12 can be reduced to

x + 3y = 6.
If you dont attribute the models you are using to the discipline you are grabbing them from, you get a sloppy filing system in your brain.

Lollapaloooza = 1+1 = 3 e.g like in a chain reaction - critical mass - a model from physics.
Working backwards from lollapalooza

If you want to rise in the

world above others you just
must use the mental model
framework in a checklist style
fashion - otherwise it will be
an unequal contest like that
of a one-legged man in an ass
kicking contest.

EXAMPLE

Quote: lets all play carefully guys so that we can all win a little!

Mental Model:

Zero-sum game

Key phrase:

FUNCTIONAL EQUIVALENT

Can you name a couple of functional equivalents to a zero-sum game in finance?

Overpriced

Is not an offer for sale in an overpriced IPO the functional equivalent of a zero-sum game?

A stock buyback at a bargain price

Is not a stock buyback at a bargain price the functional equivalent of a zero-sum game?

Day trading

Are not day traders, in aggregate, the functional equivalent of a group playing a zero-sum game?

EXAMPLE

Economic law: If you want to sell more, you

have to reduce the price. Provide two
exceptions.

Exception # 1: Luxury goods

Pavlovian Association: [Psychology]

Exception # 2: Raise price, use extra

money to bribe the intermediaries

Incentives: [Economics]

Incentive-caused bias (whose bread I
eat, his song I sing): [Psychology]

e.g. penny stocks, IPOs, cocaine, time

shares, overpriced-insurance, ANY
product or service with a FAT
commission behind it

The FUNCTIONAL EQUIVALENTS of Boiler Rooms

Application of CIALDINI

Whats all this got to do with this guy?

David Ricardo

Ricardos idea: Comparative advantage

!

Trade benefits trading partners. Trade

is NOT a zero-sum game
!

But when intermediaries are bribed

massively, does it not become the
functional equivalent of a zero-sum
game?

Firms of old standing vied one with the

other in foisting unremarkable rubbish on
the guileless investor. from an article
on investment bankers published in
1894.

foisting unremarkable rubbish on the

guileless investor...

Examples of how even now, under the influence of fat incentives, investment bankers bring fraud companies to market.

EXAMPLE

Feedback Loops
[Engineering]

Positive feedback:
Negative feedback: Nuclear Chain
Bathroom Gyeser reaction

Negative feedback loops: from physiology- Body temperature, blood clotting, digestive system- SELF CORRECTING

Functional Equivalents?

Positive - Spiral, runaway, vicious circle - business success - e.g. wall mart

Business Cycles- Negative Feedback

Business cycles - booms follow busts follow booms - Feedback loop, power of incentives (psychology), envy (psychology),
overoptimism (psychology), prisoners dilemma (game theory), Tobins Q (microeconomics).

Bank Runs (Positive Feedback)

Low prices and high

volumes feed on
each other
Dominant
newspaper
(Circulation and
advertising feed on
each other)

Positive Feedback

Business Cycles- Negative Feedback

Business cycles - booms follow busts follow booms - Feedback loop, power of incentives (psychology), envy (psychology),
overoptimism (psychology), prisoners dilemma (game theory), Tobins Q (microeconomics).

Bank Runs (Positive Feedbacks)

Bank runs

Leverage in positive feedback loops

EXAMPLE

Regression to the Mean

[Statistics]

Powerful model
applicable in a bell
curve world.

Coin flipping example

Mean as an attractor

Stock prices and Stock

returns

Bull markets and Bear
markets can obscure
mathematical laws,
they cannot repeal
them. Buffett

Notice Buffetts
extreme reductionism?

In the short run

the market is a
voting machine, but
in the long run its a
weighing machine.
- Ben Graham

Many shall be restored that are

now fallen and many shall fall that
are now in honor - Ben Graham
Quoting Horace

EXAMPLE

Define Ponzi Scheme

[Mathematics]

One of historys greatest

swindlers

Ponzi scheme is also
called the pyramid
scheme

A non-sustainable
business model involving
the exchange of money
primarily for enrolling
other people into the
scheme, usually without
any product or service
being delivered.

The answer comes from mathematics. You will eventually run out of greater fools. What happened to dot coms?
Ponzi Scheme is a special case of which MENTAL MODEL already discussed?
See the POWER of using a mental model framework? You KNOW WHAT WILL HAPPEN.
You become a BETTER predictor of future - u get an advantage over the rest of humanity who dont see ponzis where u can see them...
Tiny advantages, magnified over a long time make huge differences in eventual outcomes - compound interest.

Functional Equivalents?

chain letters, robbing peter to pay paul, greater fools, venture cap (partly), yield traps in RIETS and other stocks, multi-level marking (Amway), pension funds (EMBEDDED PONZI), Floats

EXAMPLE

The Red Queen Effect

In Lewis Carrolls Through the Looking Glass, the Red Queen seizes Alice by the hand and draggs her, faster and faster, on a frenzied run through the
countryside, but no matter how fast they run they always stay in the same place. Alice is understandably puzzled, and says, Well in our country you'd
generally get to somewhere else - if you ran very fast for a long time as we've been doing. A slow sort of country! Says the Queen. Now, here, you see,
it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!

From Deep Simplicity:

Kauffman is particularly fond of describing this in terms of an imaginary species of frog that feeds on an imaginary species of fly, and we will follow his example. There are lots of ways
in which the frogs, who want to eat flies, and the flies, who want to avoid being eaten, interact. Frogs might evolve longer tongues, for fly-catching purposes; flies might evolve faster
flight, to escape. Flies might evolve an unpleasant taste, or even excrete poisons that damage the frogs, and so on. Well pick one (hypothetical) possibility. If a frog has a particularly
sticky tongue, it will find it easier to catch flies. But if flies have particularly slippery bodies, they will find it easier to escape, even if the tongue touches them. Imagine a stable situation
in which a certain number of frogs live on a pond and eat a certain proportion of the flies around them each year

...Because of a mutation (or even just through the natural variations between individuals) a frog developes an extra sticky tongue. It will do well, compared with other frogs, and genes
for extra sticky tongues will spread through the frog population. At first, a larger proportion of flies gets eaten. But the ones who dont get eaten will be the more slippery ones, so
genes for extra slipperiness will spread through the fly population. After a while, there will be the same number of frogs on the pond as before, and the same proportion of flies will be
eaten each year. It looks as if nothing has changed but the frogs have got stickier tongues, and the flies have got more slippery bodies.

In August 2000, Jerry Mayfield, a forty-one-year-old Louisiana policeman diagnosed with CML, began treatment with Gleevec. Mayfields cancer responded briskly at first. The fraction of leukemic cells in his bone
marrow dropped over six months. His blood count normalized and his symptoms improved; he felt rejuvenatedlike a new man [on] a wonderful drug. But the response was short-lived. In the winter of 2003,
Mayfields CML stopped responding. Moshe Talpaz, the oncologist treating Mayfield in Houston, increased the dose of Gleevec, then increased it again, hoping to outpace the leukemia. But by October of that year, there
was no response. Leukemia cells had fully recolonized his bone marrow and blood and invaded his spleen. Mayfields cancer had become resistant to targeted therapy.

Even targeted therapy, then, was a cat-and-mouse game. One could direct endless arrows at the Achilles heel of cancer, but the disease might simply shift its foot, switching one vulnerability for another. We were
locked in a perpetual battle with a volatile combatant. When CML cells kicked Gleevec away, only a different molecular variant would drive them down, and when they outgrew that drug, then we would need the nextgeneration drug. If the vigilance was dropped, even for a moment, then the weight of the battle would shift. In Lewis Carrolls Through the Looking-Glass, the Red Queen tells Alice that the world keeps shifting so quickly
under her feet that she has to keep running just to keep her position. This is our predicament with cancer: we are forced to keep running merely to keep still.

Inflation

=

Running Up
on a Down
Escalator

If you (a) forego ten hamburgers to purchase an investment; (b) receive dividends which, after tax, buy two hamburgers; and (c) receive, upon sale of
your holdings, after-tax proceeds that will buy eight hamburgers, then (d) you have had no real income from your investment, no matter how much it
appreciated in dollars. You may feel richer, but you wont eat richer.

!High rates of inflation create a tax on capital that makes much corporate investment unwiseat least if measured by the criterion of a positive real

investment return to owners. This hurdle rate the return on equity that must be achieved by a corporation in order to produce any real return for its
individual ownershas increased dramatically in recent years. The average tax-paying investor is now running up a down escalator whose pace has
accelerated to the point where his upward progress is nil.

A Bad
Business =
Running Up
on a Down
Escalator
The worst business of all is the one that grows a lot, where youre forced to grow just to stay in the game at all and where
youre re-investing the capital at a very low rate of return.

Ben Grahams Frozen Corporation

Frozen Corporation was a metaphorical company whose charter prohibited it from ever paying out anything to its owners or
ever being liquidated or sold.

And Grahams question was, What is such an enterprise worth?

Munger
Identifies
Functional
Equivalents of
Frozen
Corporation

I think there is a class of business where the eventual cash back part of the equation tends to be an illusion. There are
businesses like that where you just constantly keep-pouring it in and pouring it in, but where no cash ever comes back.

A Drop of 95%

Company never made any real profits

Distributed dividends came not through real earnings but from new cash provided by stockholders and lenders.
Rapid obsolescence = High Maintenance Capex

EXAMPLE

Take a look at this commercial. It has all the attributes of an effective commercial. See for yourself:

!
YouTube - Awesome "Buckle Up" PSA Commercial
!

http://www.youtube.com/watch?v=m6ZKVdKTWww

The PSA commercial on previous slide was persuasive, but was it right? Take a look at this:

YouTube - Sam Peltzman on the Peltzman Effect

!http://www.youtube.com/watch?v=7IB2xRfRHOA
!
Peltzman effect - Wikipedia, the free encyclopedia
!
!
!
!
!

http://en.wikipedia.org/wiki/Peltzman_effect

The Peltzman effect is a contributing factor in the explanation of Smeed's Law, an empirical observation that traffic fatality rates in many countries are correlated with the number of
vehicle registrations per capita, and differing safety standards do not appear to be significant.
Peletzman effect is a mental model which tells you to not ignore the second or third order effects like the designer of the incentive scheme which rewarded students a $1 for catching a
rat on campus after all other efforts to get rid of the rats failed. Well, pretty soon, the students were breeding rats
People not only respond to incentives, sometimes ones well-intentioned decisions result in perverse outcomes. We call that perverse incentives. Read more about this from:
http://en.wikipedia.org/wiki/Perverse_incentive

Functional Equivalents?

! ! Moral Hazard!
! Incentive compensation based on wrong parameters!
!
! ! Stock Options!
!
! ! Commission on total profits!
!
! ! Top Line!
!
! ! Market Share!
!
! ! Return on Capital!

You can either

control the
price, or the
supply, but not
BOTH!
!

See Will Indian

Steel Disappear?
!

Black Markets
License raj
Ration shops
http://www.blonnet.com/2004/08/31/stories/2004083100111100.htm

If you fix price too low, supply will vanish!

If you fix the supply (e.g. license raj) and then try to impose price controls also, you will see a black market emerge.

!
Low price of diesel vs petrol vs CNG
!

Smugglers and black marketeers vs. Arbitrageurs

See the connections between

mental models from multiple
disciplines?

Thank you