Coyote Blog

Yes, I am like an addict on Tesla but I find the company absolutely fascinating.  Books and HBS case studies will be written on this saga some day (a couple are being written right now but seem to be headed for Musk hagiography rather than a real accounting ala business classics like Barbarians at the Gate or Bad Blood).

I still stand by my past thoughts here, where I predicted in advance of results that 3Q2018 was probably going to be Tesla's high water mark, and explained the reasons why.  I won't go into them all.  There are more than one.  But I do want to give an update on one of them, which is the growth and investment story.

First, I want to explain that I have nothing against electric vehicles.  I actually have solar panels on my roof and a deposit down on an EV, though it is months away from being available.  What Tesla bulls don't really understand about the short position on Tesla is that most of us don't hate on the concept -- I respect them for really bootstrapping the mass EV market into existence.  If they were valued in the market at five or even ten billion dollars, you would not hear a peep out of me.  But they are valued (depending on the day, it is a volatile stock) between $55 to $65 billion.

The difference in valuation is entirely due to the charisma and relentless promotion by the 21st century's PT Barnum -- Elon Musk.  I used to get super excited by Musk as well, until two things happened.  One, he committed what I consider outright fraud in bailing out friends and family by getting Tesla to buy out SolarCity when SolarCity was days or weeks from falling apart.  And two, he started talking about things I know about and I realized he was totally full of sh*t.  That is a common reaction from people I read about Musk -- "I found him totally spellbinding until he was discussing something I am an expert in, and I then realized he was a fraud."

Elon Musk spins great technology visions.  Like Popular Mechanics magazine covers from the sixties and seventies (e.g. a flying RV! a mile long blimp will change logging!) he spins exciting visions that geeky males in particular resonate with.  Long time readers will know I identify as one of this tribe -- my most lamented two lost products in the marketplace are Omni Magazine and the Firefly TV series.  So I see his appeal, but I have also seen his BS -- something I think a lot more people have caught on to after his embarrassing Boring Company tunnel reveal.

Anyway, after a couple thousand words of introduction, here is the update:  In my last post linked above, I argued that Tesla is a growth company that is not investing in growth.  Sure, it is seeing growth in current quarters due to investments made over the last decade, but there is little evidence it is actually spending money to do anything new.  It stopped managing itself like a growth company trying to maintain its first-mover advantage.

Tesla has explicitly chosen to pursue a strategy that needs a TON of capital.  Everyone understands, I think, that building a new major automobile franchise takes a ton of investment -- that's why they are not popping up all the time.  But Tesla actually has made choices that increase the capital needed even beyond these huge numbers.  Specifically, they chose not just to manufacture cars, but to also own the sales and service network and to own the fueling network.  Kia was the last major new brand in the US that I can remember, but when it started it relied on 3rd parties to build and operate the dealer/service network and relied on Exxon and Shell to build out and operate the fueling network.  So Tesla has pursued a strategy that they need all the capital of Kia and of the Penske auto group and of Exxon.  Eek.

And for years, they were valiantly trying to pull it off.  They created showrooms in malls and created a new online selling process.  They built some service locations but as has been proven of late, not enough.  They built a supercharger network.  It was a gutsy call that seemed to be paying off.

And then something weird happened.  Somewhere in late 2017 or early 2018 they stopped raising capital and greatly slowed down both R&D and capital investment.

• They slowed expanding the service network at the very time that their installed base of cars was going up exponentially and they were getting bad press for slow service.  Elon Musk promised that Tesla would create its own body shops but nothing has been done on this promise.
• They slowed the Supercharger network expansion at the same time their installed base has dramatically increased and at the same time new competitive networks were begun by major players like Volkswagen.
• They stopped expanding the Model 3 production line at the same time it was clear the current factory could produce only about 5,000 cars per day (with some quality tradeoffs at that) and Musk continued to promise 10,000 a day
• They promised production in China by the end of this year but so far the only investment has been a groundbreaking ceremony in a still muddy field
• They promised huge European sales but only just now got European regulatory approval for sales, dragging their feet for some reason on this approval despite lots of new EV competition starting to hit the European market.
• They pumped up excitement with new product concepts like the semi and the coupe and the pickup truck but there is no evidence they have a place to build them or even have started to tool up.
• Everyone thinks of Tesla as having leadership in battery technology but that is the one area they have actually outsourced, to Panasonic.
• Through all of this, through all these huge needs for capital and despite Tesla's souring stock price and fanboy shareholders begging to throw money at the company, they have not raised any capital for a year.

Since my initial post, we have seen a few new pieces of news

1. Tesla still has not raised capital and in fact faces a $1 billion bond repayment in just over 30 days
2. Tesla admitted that it has not even started working on a refreshed design for the aging Model S and X, despite increasing EV competition coming at this high end from Audi, Porche, and others.  These refreshes should have been started years ago.
3. In fact, Tesla announced it was cutting back on production of the S and X.  Ostensibly this was to focus on the Model 3.  Most skeptics think this is BS, and the real reason is falling demand.  But it doesn't matter -- growth companies with great access to the capital markets don't make these kinds of tradeoffs.  This is further proof that Tesla is no longer managing itself like a growth company.  These cuts are particularly troubling because the S and X are where Tesla gets most of its gross margins -- the Model 3 margins are much worse.
4. Tesla laid off 7% of its work force.  Again, this is not the act of a company that is behind in implementing its growth initiatives, growth initiatives that perhaps 80% of its stock market valuation depends on.

Tesla has always had an execution problem, or more rightly an over-promising problem.  But it was still actually investing and doing stuff, even if it was disorganized and behind in doing so.  Now, however, it is a company valued as an exponential growth company that is no longer managing itself like a growth company.  It has billions of investments that are overdue -- in new products, in product refreshes, in the service network, in a second generation supercharger -- that should have been started 2-3 years ago and for which there isn't any major activity even today.

As a disclosure, Tesla stock is one of the most dangerous in the world to trade, either way.  You really need to understand it before you trade it and no one really understands it.  I have a couple of long-dated put options on Tesla that I consider more of a bar bet than anything else.  I also have a couple of cheap short-dated calls as I usually do in the runup to the quarterly Tesla earnings call.  Musk is great at the last minute stock pump during earnings call week, and the stock often pops only to fall soon afterwards as people dig into the numbers.  But again, these are "investments" that are less than 0.1% of my portfolio.

Postrcript:  When I wrote "Tesla is a growth company that is not investing in growth" I was picturing the Jim Cramer cameo in Ironman -- "That's a weapons company that doesn't make any weapons!"  Of course it took a work of fiction to see Jim Cramer advocate for the short side.  Doubly ironic given Musk sometimes styles himself as the real life Tony Stark.

I am not actually active in the residential home market, so I can (without losing any money) call market tops and bottoms from semi-random variables.  In 2005, I wrote here about a possible housing top when I overheard a dentist tell a doctor about all he money he was making flipping raw land  (I will apologize to dentists here, but when I studied investing at HBS 30 years ago I had a professor who would ask the class, for a bad investment, "who do we sell this to?"  Answer:  Doctors!   And if it is a really, really bad investment, who do we sell this to? Dentists!)

Anyway, I was out on my super-dorky but easy-on-the-knees and fun to ride elliptical scooter the other day and stopped to take a picture of a quiet intersection near my home:

I only got seven of the signs in my picture, but there were eight different open house notices for homes all within an easy walk of this location.  Reminded me of 2009.

Postscript:  By the way, I always feel bad about joking at the expense of doctors and dentists and their investments, so I will share one of my personal great moments in investment savvy.  In 1984 I graduated as a mechanical engineer that had a lot of background in programming and micro-computers (my specialty was control theory and something awkwardly called interfacing microprocessors with mechanical devices, which we just call "robotics" today).  I had lots of good job offers, and most were for about the same amount of money except one outlier that did not pay nearly as much but instead paid in all these crappy pieces of paper called options.  Hah!  I wasn't falling for that, and I turned them down and worked for real money.  That company I turned down was Microsoft and just the options they offered in the offer letter, I remember calculating once, would be worth more today than all my cumulative lifetime earnings to date.

When politicians argue about small business growth, they argue about stuff like taxes and access to capital and, god help me, completely irreverent (to small business) stuff like the ExIm Bank.

I would argue that there has been a fundamental shift in the economy relative to small business over the last four years, but it has nothing to do with any of that stuff.  I would summarize this shift as follows:

Ten years ago, most of my company's free capacity was used to pursue growth opportunities and refine operations.  Over the last four years or so, all of our free capacity has been spent solely on compliance.

Let me step back and define some terms.  What do I mean by "free capacity?"  In a small, privately-held company, almost all the improvement initiatives spring from the head of, or must heavily involve, the owner.  That would be me.  I have some very capable staff, but when we do something new, it generally starts with me.

So OK, our free capacity is somewhat limited by my personal capacity as owner and President.   But actually, I have a head full of ideas for improving the company.  I'd like to do some new things with training that takes advantage of streaming video.  I'd like to add some customer service screening to our application process.  But my time turns out not to be the only limit -- and this is one of those things that HBS definitely did not teach me.

In the real world, there are only so many new things I can introduce and train my line managers to do, and that they can then pass down to their folks.  An organization can only accept a limited amount of new things (while still doing the old things well).  This is what I mean by "free capacity"  -- the ability to digest new things.

Over the last four years or so we have spent all of this capacity on complying with government rules.  No capacity has been left over to do other new things.  Here are just a few of the things we have been spending time on:

• Because no insurance company has been willing to write coverage for our employees (older people working seasonally) we were forced to try to shift scores of employees from full-time to part-time work to avoid Obamacare penalties that would have been larger than our annual profits.  This took a lot of new processes and retraining and new hiring to make work.  And we are still not done, because we have to get down another 30 or so full-time workers for next year
• The local minimum wage movement has forced us to rethink our whole labor system to deal with rising minimum wages.  Also, since we must go through a time-consuming process to get the government agencies we work with to approve pricing and fee changes, we have had to spend an inordinate amount of time justifying price increases to cover these mandated increases in our labor costs.  This will just accelerate in the future, as the President's contractor minimum wage order is, in some places, forcing us to raise camping prices by an astounding 20%.
• Several states have mandated we use e-Verify on all new employees, which is an incredibly time-consuming addition to our hiring process
• In fact, the proliferation of employee hiring documentation requirements has forced us through two separate iterations of a hiring document tracking and management system
• The California legislature can be thought of as an incredibly efficient machine for creating huge masses of compliance work.    We have to have a whole system to make sure our employees don't work over their meal breaks.  We have to have detailed processes in place for hot days.  We have to have exactly the right kinds of chairs for our employees.  We have to put together complicated shifts to meet California's much tougher overtime rules.  Just this past year, we had to put in a system for keeping track of paid sick days earned by employees.  We have two employee manuals:  one for most of the country and one just for California and all its requirements (it has something like 27 flavors of mandatory leave employers must grant).  The list goes on and on.  So much so that in addition to all the compliance work, we also spent a lot of work shutting down every operation of ours in California, narrowing down to just 3 contracts today.  There has been one time savings though -- we never look at any new business opportunities in CA because we have no desire to add exposure to that state.

Does any of this add value?  Well, I suppose if you are one who considers it more important that companies make absolutely sure they offer time off to stalking victims in California than focus on productivity, you are going to be very happy with what we have been working on.  Otherwise....

I fully understand the dangers of extrapolating from one data point**, but for folks who are scratching their head over recent plateauing of productivity gains and reduced small business origination numbers, you might look in this direction.

By the way, it strikes me that regulatory compliance issues set a minimum size for business viability.  You have to be large enough to cover those compliance issues and still make money.  What I see happening is that as new compliance issues are layered on, that minimum size rises, like a rising tide slowly drowning companies not large enough to keep their head above water.  We are keeping up, but at times it feels like the water is lapping at our chin.

**Unrelated Postscript:  I have found that in the current media/political world, people love to have only one data point.  Why?  Well, with two data points you are are stuck with the line those points define.  With just one, you can draw any line you want in any direction with any slope.

In short, don't ever ever ever take my investment advice.  However, I will note that when I tongue-in-cheek called the market top on May 27, the S&P closed at 2123 and has not closed higher than 2128 since.

The reason market timing is virtually impossible is because the actual timing can be so skewed .  You can be sure the market is overvalued but it can take years for that to play out, particularly when governments (e.g. US, China) are pumping liquidity into the markets to keep them afloat.

A good example is China.  I (and many other much smarter people) were recognizing the China market was overvalued years ago, but had one shorted the China market back then you would have been short-squeezed into oblivion before the actual crash came about this year.

While fundamental investing isn't worthless, the effects of fundamentals seem to get easily swamped by government actions, such that predicting government actions is far more important to investment success than figuring out corporate fundamentals.  I learned to tear apart company financials from one of the best back at HBS, but I have no ability to figure out when the Fed will or will not stop dumping money into the markets.  So I buy a few index funds and try not to look at them too much.

The tech site Engadget directed me to this article on Visual FX and CGI as a "must-read".  What I found was one of the odder economics and business hypotheses I have encountered lately.

The article begins by relating that VFX and digital effects specialty houses all lose money, even when they are providing effects for wildly profitable movies (e.g. Avengers) and purports to explain why this should be.  The author believes that this is a result of Hollywood purposely criticizing the artistry of VFX movies as a way to keep returns in the VFX companies down (and thus increase the returns of film producers).

As the debate surrounding what visual effects are worth rages on, it is clear that the studios themselves have an interest in perpetuating the myth that VFX are the product of clinical assembly lines and the results are equally lifeless and mechanical. Blaming computers for the dumbing down of movies has become a journalistic trope that is bandied about to squeeze the one part of the Hollywood machine that has no union or organizational skill to push back. The right hand asserts they are something not worth paying top dollar for, while the left lines up an interminable roster of VFX-based box office juggernauts for the foreseeable future.

The author goes so far as to say that Avatar was denied the best picture Oscar specifically to support the anti-VFX sentiment and keep returns of VFX companies down (emphasis added).

In 2010, James Cameron’s Avatar became the highest grossing film of all time just 41 days after its release, raking in an incredible $2.7 billion by the end of its run. Weta Digital, the VFX studio that created the majority of the visual effects, along with Lightstorm Entertainment, invested years in developing the tools and talent necessary to create Cameron’s almost entirely computer generated vision, with the cost of making the film rumored to be upwards of $500 million. Cameron had promised to show the world what visual effects could do and he succeeded. The results were universally lauded as visually stunning and unparalleled.

Yet, rather famously, the film and Cameron were snubbed that year at the Academy Awards, both for Best Picture and Best Director. The blame was laid at the feet of the critical success of The Hurt Locker. However, awarding Avatar the Academy’s highest honor would have been acknowledging visual effects as not only lucrative, but high art as well, worthy of its astronomical price tag. And that was a bargaining chip Hollywood was unwilling to concede to an industry it continues to hold hostage with threats of outsourcing to unskilled laborers around the globe.

This hypothesis seems outlandish, and in fact the author never really provides any evidence whatsoever for her hypothesis.   At least equally likely is that Hollywood insiders are snobbish and conservative and reject new approaches to film-making in a way that the public does not.  Or it could be that Avatar wasn't a very good movie (go try to watch it again today, you will be surprised what a yawner it is).  So why are VFX companies really losing money on profitable films?   Let's take a step back, because there is a useful business lesson buried in here somewhere.  I think.

This discussion is a sub-set of an age-old business problem -- how do rents in a supply chain get divided up?   Think of the billion plus dollars the new Avengers movie will make.  Everyone in the supply chain for making that movie, from the actors to the caterers to the VFX houses to the distribution companies believe their contribution has immense value, and that they should be getting a solid cut of the profits.  But profits in a supply chain are not divided up based on some third party assessing value, they are divided up by negotiation.  And the results of that negotiation depend on a lot of factors -- the number of competitors, the uniqueness of the service, regulatory rules, etc.  The most visible example of this sort of negotiation we see frequently in the news is in sports, where players and team owners are explicitly negotiating the division of the end revenue pie between themselves.

If we return to the article, the author actually gives us a hint of the true dynamic that is likely bringing down VFX profits.

The international subsidies-driven business model under which VFX companies operate has been well documented. In pursuit of tax rebates offered by various governments to produce films in their jurisdiction, studios insist that VFX companies open branches in these locations or reduce their bids by the amount of the subsidy in question. Even as studios, directors, and audiences demand the latest in cutting edge technology, VFX houses must underbid one another to get the work and many have been shuttered due to operational losses in the wake of explosive blockbuster budgets. The cost of research and development, shrinking schedules, and the unlimited changes that are the building blocks of every tentpole film, are shouldered entirely by VFX houses.

This is the best clue we get to the real problem.  Here is what I infer from this paragraph:

1. This is a high fixed cost industry.  There are enormous up-front investments in research into new techniques and large investments in the latest technology, which presumably must be constantly refreshed because it has a short half-life before it is out of date.  The situation is worsened by government policy, which provides incentives for VFX companies to build extra capacity in multiple countries, losing economy of scale benefits from large concentrated production facilities.    One would presume from this that these companies' marginal cost of output, say 15 seconds of finished effects, is way way below their total costs.
2. There is rivalry among VFX companies that seem to have excess capacity, such that bidding for work is very aggressive.  In such situations (think American railroads in the late 19th century) competitors lower prices down to marginal cost to keep their capacity and their trained people working.  Over time, of course, this leads to numerous bankruptices

I will add a third point which the author fails to cover.  To do so I will return to one of my favorite things I learned at Harvard Business School (HBS).  At HBS, in the first two days of strategy class, we studied two very different business cases.  The first was of a water meter manufacturer, a dead boring predictable unsexy business.  The second was a semiconductor company, which was hip and cool and really sexy.  It turned out that the water meter company coined money.  The semiconductor business was in and out of bankruptcy.

Why?  Well the water meter company had limited investment (made the same meters the same way for decades) and made most of its money off the replacement market, where it had no competitors since users pretty much had to replace with the same meter.  The semiconductor business had numerous shifting competitors and was constantly trying to scrape up enough investment money to keep up with shifting technology.  But there was one more difference.  By being sexy, tons of people wanted to be in the semiconductor business. They got non-monetary benefits from being in it (ie it was cool and interesting).  When there is an industry where lots of people are getting into the business for reasons other than making money, look out!  The profits are probably going to be terrible.   This is why most restaurants fail.  The business-for-sale listings are awash in brew pubs.   The aviation industry was like this for years, and I would argue this also suppresses rents in farming.

I don't know this for a fact, but I would bet that the VFX industry attracts a lot of people because it is sexy.  Yes, like a lot of programming, the actual work is detailed and dull.  But if the coding is detailed and dull, would you rather be doing it for Exxon's new back-office system or to put Ironman on the big screen (and have your name deep into the film credits, seen by the dozen or so people who hang around waiting for the Marvel Easter egg at the end)?

This is why I think a conspiracy theory to believe Hollywood is dissing the artistry of VFX movies as a way to keep VFX company rents down is silly.  It is totally unnecessary to explain the bad rents.  Had you told me it was a high investment business with huge fixed costs and much lower marginal costs and alot of rivalry driven by participants who piled into the business because it was sexy, I would have told you to stop right there and I could have immediately predicted poor returns and bankruptcies.

So what can VFX companies do?  I have no idea.  The first idea I would offer them is branding.  If you are buried deep in the supply chain and want to increase your bargaining power, one way to do it is to develop a brand with the end consumer.   If consumers suddenly latch on to, say, the CoyoteFX brand as being innovative or better in some way, such that they might be more likely to go to a movie with CoyoteFX sequences, then CoyoteFX now has a LOT more power in negotiations with producers.  Dolby Sound is a great example -- you probably don't even know what it is but movies used to advertise they had it.  Certain camera technologies like Panavision are another, where movies actually sold themselves in part on the features of one member of their supply chain.  As a digital house, Pixar effectively did this -- so well in fact its brand actually was bigger than Disney's (its distributor) for a while, and Disney was forced to buy them.  This does not happen just in movies.  I just bought a car that advertised it had a premium Bose sound system.  The car maker doesn't advertise who made, say, the fuel tanks, so my guess is that Bose, via branding, gets a better cut of the supply chain than does the fuel tank maker.

Grade inflation is back in the news, as the Harvard Crimson reports that the median grade at Harvard is an A-.  This is clearly absurd.  It reminds me of some of the old Olympics judging where they had a 10 point scale but everyone scored between 9.7 and 9.9.  The problem is not necessarily that the mean is skewed, but that there is almost no room left to discriminate between high and low performance.

There is one potential way to combat this, and it was invented by colleges themselves.  Consider grading in high school.  My kids go to a very tough-grading private school where A's are actually hard to get.  The school sends (for Arizona) a fairly high percentage of its students to Ivy and Ivy-level schools, but the school produces someone with a perfect 4.0 only once every four or five years.  Compare that to our local public school, that seems to produce dozens of perfect 4.0's every year -- in fact since it adds a point for honors classes, it produces a bunch of 5.0's.

Colleges understand that a 3.7 from Tough-grading High may be better than a 5.0 from We-have-a-great-football-team High.  They solve this by demanding that when high schools provide them with a transcript, it also provide them with data on things like the distribution of grades.

Employers should demand something similar from colleges.  This is a little harder for employers, since colleges seem to be allowed to legally collude on such issues while employers can get sued over it.  But it seems perfectly reasonable that an employer should demand, say, not only the student's grade for each class but also the median and 90th percentile grades given in that same class.  This will allow an employer to see how the school performed relative to the rest of the class, which is really what the employer cares about.  And schools that have too many situations where the student got an A, the median was an A, and the 90th percentile was an A may get punished over time with less interest from the hiring community.

One way to get this going is for an influential institution to start printing transcripts this way.  The right place to start would be a great institution that feels it has held the line more on grade inflation.  My alma mater Princeton claims to be in this camp, and I would love to see them take leadership on this (the campus joke at Princeton during the Hepatitis C outbreak there was that at Harvard it would have been Hepatitis A).

Postcript - An alternate grading system from Harvard Business School:  When I was at HBS, they did not give A's and B's.  We had three grades called category I, II, and III.   By rule, the professor gave the top 15% of the class category I, the bottom 10% category III, and everyone else got a category II.  I actually thought this was a hell of a system.  It discriminated at the top, and provided just enough fear of failure to keep people from slacking.

The New York Times has a long article on  Harvard Business School's effort to change its culture around women.  Given that both my wife and I attended, albeit 25 years ago, I have a few thoughts.

• I thought the article was remarkably fair given that it came from the NYT.  Men who are skeptical of the program actually are allowed to voice intelligent objections, rather than just be painted as Neanderthals
• I would have abhorred the forced gender indoctrination program, as much for being boring as for being tangential.  I am fortunate I grew up when I did, before such college group-think sessions were made a part of the process everywhere.  I would presume most of these young folks are now used to such sessions from their undergrad days.   I would not have a problem having an honest and nuanced discussion about these issues with smart people of different backgrounds, but I thought the young man they quoted in the article said it really well -- there is just no payoff to voicing a dissenting opinion in such sessions where it is clear there is a single right answer and huge social and even administrative penalties for saying the wrong thing.
• I went to HBS specifically because I loved the confrontational free-for-all of the classes.   It was tailor-made to my personality and frankly I have never been as successful at anything before or since as I was at HBS.   I say this only to make it clear that I have a bias in favor of the HBS teaching process.   I do think there is an issue that this process does not fit well with certain groups.  These folks who do not thrive in the process are not all women (foreign students can really struggle as well) but they are probably disproportionately women.  So I was happy to see that rather than dumb down the process, they are working to help women be more successful and confident in it.
• It is interesting to see that the school still struggles to get good women professors.  When I was there, the gap between the quality of men and women professors was staggering.  The men were often older guys who had been successful in the business and finance world and now were teaching.  The women were often young and just out of grad school.  The couple of women professors I had my first year were weak, probably the two weakest professors I had.  In one extreme case our female professor got so jumbled up in the numbers that the class demanded I go down and sort it out, which I finally did.  I thought it was fun at the time, but now I realize how humiliating it was.
• To some extent, the school described in the article seems a different place than when I was there.  They describe a school awash in alcohol and dominated by social concerns.  This may be a false impression -- newspapers have a history of exaggerating college bacchanalia.   At the time I was there, Harvard did not admit many students who did not have at least 2 years of work experience, such that the youngest students were 24 and many were in their 30's and 40's.  A number were married and some even had children.   To be there, they not only were paying a lot of money but they were quitting paying jobs.  The school was full of professionals who were there for a purpose.  I had heard that HBS had started to admit more students right out of college -- perhaps that is a mistake.
• The fear by the women running the school that women would show up on Halloween wearing "sexy pirate" costumes represents, in my mind, one of the more insidious aspects of this new feminist paternalism (maternalism?) aimed at fellow women.  Feminism used to be about empowering women to make whatever choices they want for their lives.   Now it is increasingly about requiring women to make only the feminist-approved choices.
• I actually wrote a novel where the protagonist was a confident successful female at HBS.   So I guess I was years ahead of the curve.

Postscript:  Below the fold is an excerpt from my novel.  In it, the protagonist Susan describes how an HBS class works and shares my advice for being successful at HBS.

Continue reading ‘Harvard Business School and Women’ »

When I was at HBS, a bunch of us who sat in the back row (the "skydeck" in HBS parlance) would play buzzword bingo based on the class discussion.

Google books has a way of querying their books database for word frequency.  I laughed when I saw this chart for "incentivize."  It's the hockey stick!

I tell folks all the time that  99% of the time the problem with bad governance is not bad people in the government (or at least not bad before they entered government) but bad incentives and information.

Take the recent public reaction against the new TSA search procedures.  Its not that everyone in the TSA aspired for a job where they could grope stranger's nads.  Its that the incentives in government make risk management impossible.

Let's look first at the cost side.  How much do internal TSA evaluation and incentive systems value

• protection of individual rights and privacy
• stewardship of taxpayers money

Can we safely say close to zero?  I don't think anyone at the TSA is being denied promotion because they were insufficiently concerned with the fourth amendment.

So what is it that does matter in their incentive system?  I would argue that they have one single, overriding concern -- to avoid an incident for which they can be retroactively blamed as being insufficiently diligent.   If you are confused about how this incentive might arise, Conservatives need only look at themselves.  How many of you have pounded Janey Napolitano for being insufficiently diligent, for example in her "the system worked as it was supposed to" comments.

I spent a lot of time at HBS, in consulting at McKinsey, and in corporate life worrying about incentive systems.  And the absolute first rule, in my mind, is to ignore the official incentive system and explore what really drives behavior.  For example, a company might have a finely balanced set of published performance measures, but if the last three promotions all went to the person who sucked up the most to the boss, the latter will likely influence behavior much more than the published system.

The same is true at the TSA.  I have no idea what their official performance metrics are.  But to a large extent these metrics are irrelevant anyway in an environment where it's impossible to be fired and salaries and promotions have more to do with seniority than performance.   In this environment, unofficial incentives are going to be very powerful, and I am virtually positive the overriding such incentive is avoiding blame due to lack of diligence.

So we should not be surprised if the TSA runs out of control with its diligence in a way that is unchecked by any considerations of cost, privacy, or risk management.  This incentive is so powerful that the only way to override it is either through executive leadership or legislative action.  We'll see if we get either, but trashing privacy and the fourth amendment tend to be bipartisan hobbies so I am not wildly confident much will change.

This is one of the better simple explanations of both the appeal and hidden risk of CDO's. The example, which is short and is worth working through, ends this way:

Suppose that we misspecified the underlying probability of mortgage default and we later discover the true probability is not .05 but .06.  In terms of our original mortgages the true default rate is 20 percent higher than we thought--not good but not deadly either.  However, with this small error, the probability of default in the 10 tranche jumps from p=.0282 to p=.0775, a 175% increase.  Moreover, the probability of default of the CDO jumps from p=.0005 to p=.247, a 45,000% increase!

The dark magic of structured finance conjured many low-risk securities out of many risky securities.  Like all dark magic, however, the conjuring came at a price because if you didn't get the spell exactly correct it was easy to create something much more risky and dangerous than you were likely to have ever imagined.

As an ex-engineer who used to do a lot of operations analysis as well as post-disaster failure analysis, this shares a central theme that I have found in many such failures -- people tend to overestimate their own knowledge.

Coming in to a class at HBS, the professor had us all do a 20 question survey.  It asked us questions like "what is the population of Argentina" and then asked us to give the lowest and highest number we thought it would be such that the answer had a 95% chance of being in that range.  Based on this, only one of our 20 answers should have been out of my limits.  About eight of the answers were out of my ranges.  It was a really good lesson in overestimating one's knowledge.

Which leaves me with a thought -- if we define a large part of the problem as overestimating our understanding of a certain phenomenon, from your observation of the Obama administration and its personalities, what gives you any confidence that a new lager of government regulators will solve this problem?

I just finished "The Box," which is a history of container shipping.  Never has any book I have read elicited so many laughs from my family.  Nothing says "geek" like reading a book about shipping containers.

But, for those of you who might similarly be turned off by the subject matter as unpromising, I can say this is easily one of the most interesting business books I have ever read.    It is fascinating to see how the entire economics of an industry can be changed not by some arcane advance in silicon, but by a metal box.  In a period of about 20 years, the entire merchandise shipping business, which had remained virtually unchanged for thousands of years, was completely reinvented.  Every ship and every port had to be replaced.  Moreover, these changes resonated far beyond shipping, as they enabled much of the global manufacturing revolution of the last generation.

Because pre-container shipping and transport were so highly regulated, the book provides a great window on how regulation affects innovation, and vice versa.  It also focuses quite a bit on how unions and in particular union work rules affected industry economics, and how these unions reacted to change in the industry.

And of course, the book allows us to look at any number of interesting business strategy issues:

• Is being a first mover an advantage, or a disadvantage?  Sea-Land reaped a number of first mover advantages, but it also got hurt badly when a number of the earlier investment choices they made turned out to be wrong.  Several late movers, who invested after ship designs had been through two or three generations, did quite well.  Others did not.
• Who makes money investing into this kind of change?  A few early SeaLand investors made out well, the equivalent of angel investors, but later investors did poorly.  And it is not at all clear that anyone making massive, billion dollar investments ever really made great returns.  Like the airline industry, the industry quickly hit over-capacity and prices dropped.  It is clear shippers won big, but did it really make sense for anyone to invest in this business?  The best strategy I can come up with was followed by Maersk, which basically sat out until late and then bought up assets on the cheap out of bankruptcy from early participants.

This situation was reminiscent of a business case I had at HBS about the beginnings of the high fructose corn syrup (HFCS) market.  It was run as a computer simulation among teams.  Basically, almost not matter what everyone did, the industry ended up in over-capacity and everyone lost money.  The only successful strategy was the Wargames approach ("the only winning move is not to play').

Jane Galt makes a case against industrial animal husbandry, a position which she argues is not inconsistent with being a libertarian or classical liberal.  While I don't get as worked up about such practices as cruel, I don't think it is inconsistent for a libertarian to be so concerned.  And I don't rule out that I would be just as worked up if I were more informed about what was going on.

However, what really caught me eye was this:

This is an approximate description of what happens to industrially
farmed chickens . . . lifted, mind you, from a business school case
aimed at helping industrial farms be more efficient, by using rose
coloured chicken contact lenses to cut down on the need for debeaking
'em.

I can attest that this was indeed a real case that we studied at Harvard Business School*.  In fact, it so freaked me out at the time as a concept that I included it in my most recent novel.  From BMOC [warning, profanity lurks ahead]:

Poor, boring, earnest Julian
was always prepared, because he was always terrified, scared to death
that one night slacking off might somehow destroy his future Career
(always with a capital-C), and therefore future Life, much like the
fear of catching AIDS from a one night stand.  Julian participated
(unfortunately) all too much in class, droning on in that irritating
voice of his, advocating positions as spectacularly expected as
Susan's were non-conformist.

Julian,
therefore, was not really a candidate to get cold-called to open the
class discussion, particularly this late in the year.  However, it
was clear to everyone in the room, particularly the professor, that
Julian longed to open a case.  Every day Julian would look at
the professor with this hopelessly wistful expression, only to be
followed by a look of desolation when someone else was chosen.

So
today, letting Julian open was in the same spirit as the homecoming
queen giving a pity-fuck on the last day of high school to the geek
who has been mooning and sighing over her for four years.  And right
at this
moment, Julian had the same surprised and ecstatic look on his face
that the geek would have.

But it was not just the site of
Julian creaming all over himself at his chance to open that had Susan
longing for the piranha button.  Some satanic twist of fate had
Julian Rogers earnestly and painstakingly laying out a strategy and
plan for the new product roll out of ... contact lenses for chickens.
Contact fucking lenses for Christ-sake chickens.  Right this very
second he was outlining his sales pitch to chicken farmers,
explaining how putting contacts in chicken's eyes will somehow
reduce the number of chickens that have to have their beak cut off.
Did she hear that right?  This had to be a joke "“ but no,
everyone seemed to be taking it seriously, and certainly Julian was
taking it deadly seriously.

* I know those anti-capitalists out there will be using this as evidence that business school is crafted to keep us cold and heartless.  HBS consisted of studying 2-3 cases per day for about 200 days a year, which means that over two years one might read a thousand business cases.  This case was more in the spirit of breaking the monotony of yet another case on brass vs. plastic water meters rather than part of a consistent attempt to make us cold and heartless.

A reader sends this one in, after reading my book BMOC.  One of the characters in the book is a business man who has a knack for monetizing wacky business models  (one example:  providing free fountains to malls in exchange for being able to harvest the coins out of them).  The book is named after his new company called BMOC, which specializes in making teens popular.

This caused a reader to send me this web site for FakeYourSpace.com.  They are selling popularity their own way, by providing you comments and visits from hot and cool friends on your MySpace pages.  Sort of sock puppetry for teens.

Welcome to Fake Your Space. You have found a new and
exciting service which offers help to all the men and women out there
who don't feel like they are popular enough on social networking sites
such as MySpace, Facebook, and Friendster.
If you are tired of seeing everyone else with the hottest friends and
want some hotties of your own, then this is the place for you.

LOL.  Wish I had thought of it for my book.  Below the fold is the business model for BMOC, which I thought was crazy enough:

Continue reading ‘Wacky Business Models’ »

As a way to celebrate the holidays and perhaps compensate for a more relaxed pace of blogging for a while, I am beginning a serialization of my new novel BMOC.  If there is interest, I will keep it going for a while.  So, lets get started.  Enjoy!  (You didn't really feel like doing any real work today, did you?).   By the way, for you prospective business school students, though it may seem un-serious, embodies my best advice for you.  Chapters 3 and 4 continue here.

chapter one

Robert
Gladstone, multi-millionaire CEO of the M Group, looked around the
room at his fellow conspirators and longed for the piranha
button. 

Continue reading ‘BMOC, Chapters 1 and 2’ »

Asymmetrical Information comments on Greg Mankiw by observing:

Harvard scores lowest in student satisfaction *and* enjoys the highest yield (%
of students admitted who attend) of any leading American university. How can the
same institution be so desirable and so disliked at the same time?

The data presented for is for the undergraduate school and my experience is with the graduate school of business, but I think some of my experience can still help answer this question.

At the time I attended, I was sure that the Harvard Business School (HBS) was the best place for me to attend.  I still think that is true.  First, it had (and has) a great reputation with both people hiring for jobs and the general public.  The Harvard diploma has power, power that hasn't lessened even 20 years later.  Second, it had a style that worked well for me personally.  I sat in on classes at other business schools, but HBS classes had an interactive, and often combative, style that I loved and thrived in.  Yes there was work, but the workload never was worse than my undergraduate school.  I would not change my decision.

That being said, while I have showered my undergraduate school with cash, Harvard has not gotten one dime from me.  Because as an institution, it sucked.  It had an incredible arrogance to it, often stating publicly that its customer was NOT the students, but was the businesses who hired its graduates and society at large.  And this was the attitude at the business school, which I was often told was the most student-friendly part of Harvard.  My college roommate Brink Lindsey apparently had a similar experience at Harvard Law, as he was part of a group that founded N.O.P.E., which stood for Not One Penny Ever (to Harvard).

At every turn, one ran into petty, stupid stuff that did nothing to contribute to the educational experience but were frustrating as hell.  The faculty was often arrogant and the administrative and housing staff uncaring. 

At the risk of sounding petty, I will share two examples.  These are small things, but are representative of hundreds of similar experiences over two years. 

• At winter break the first year, we were all given a "gift" of a coffee table book about Harvard.  Then, next spring, we all found a $100 charge on our spring term bill for this "gift"
• My Harvard dorm room had a broken heater in my second year.  It got so cold that ice formed on the inside of the windows.  After weeks of trying, we finally got a maintenance guy to come out.  He set a thermometer down in the center of the room and stared at it for ten minutes.  Then he picked it up and started to leave.  "Why are you leaving?" I asked.  He replied "Because its 53 degrees in here.  State law does not require us to fix the heating until it falls below 50."  I finally had to go to Walmart and buy several space heaters.  Several weeks later I was ticketed by the campus police for having a fire hazard -- too many space heaters.

I do not think it an exaggeration to say that had Harvard scoured every post office in the country for employees, it could not manage to provide worse customer service day-to-day.

And I think this is the answer to the paradox.  If you can tolerate the faculty arrogance, you can get a great education, but Universities are more than just a school.  For most students, Harvard is also their landlord, their only restaurant choice, their local police force, etc. etc.  And for all these other functions, they are terrible.

There is a price one pays for slipping into the Harvard Business School through some mysterious hole in the Harvard admissions process:  From time to time, one must be ready to be humbled by their peers.  Of course, with nearly 900 people in a graduating class, one expects someone in that group to distinguish themselves at some point.  However, this large groups is somehow indistinct - at HBS one spends most of their time with 90 people in their "section", spending the vast majority of waking hours, both in class and in the pub, with this group.  After a couple of years with the same 90 people, one gets the overwhelming impression of normality -- these people are just as full of shit as anyone else I have gotten to know.

So it is both expected and with some surprise that I have begun to see these 90 people start making headlines.  My section-mates have distinguished themselves as executives and industry leaders and entrepreneurs  and lifestyle writers and business writers and fashion moguls and artists even as the notorious.  Humiliating levels of fame and success seem to be the rule among these ostensibly ordinary people.

This week, however, another member of our 90-person section (1989-B, on the off chance you are a fellow alum and were wondering) has gone to the next level.  This week Time magazine named Jim Balsillie, CEO of RIM (the Blackberry people) to their list of the 100 most influential people.  Wow.  Congratulations Jim.  The bad news is we are all totaled humbled about our own success trajectories in comparison.  The good news is that Jim will obviously "draw fire" away from the rest of us when Harvard comes looking for money.  Its a funny combination of old and new to think about the CEO of Lili Pulitzer and the CEO of Blackberry sitting next to each other all through our first year.

Postscript:  By the way, for those of you who may be tempted to put me on suicide watch, I am pretty much joking, though not about my section mates - they are all as awesome as portrayed here -- but about any dissatisfaction with my career.  Several times in my life I have been presented with opportunities to pursue high-profile wealth.  In most cases, I have turned these down, with zero regrets.  In fact, since one of the first of these rejected opportunities involved following Jeff Skilling from McKinsey to Enron, I really, really have no regrets.   Each day I am out visiting my operations at some National Park or other, I will think about the rest of you filling out your TPS reports.

UPDATE:  Welcome to fellow sectionmate Karen Page, author of numerous Amazon 5-star rated books on food, wine and becoming a chef, who links to me today (oops, Karen is slipping - a few of the books only have 4-1/2 stars).  Not only is Karen part of that vast section B conspiracy to make me feel inadequate, she also has a much cooler blog than mine.

Steven Metcalf has an interesting article in Slate on the state of Harvard University.  And, if you don't really care about what messes the twits from Harvard are making of the place (and I don't blame you) it is also a good look at problems in universities in general.  My favorite passage is this one:

From Bradley's descriptions"”and from my own experience"”academia has devolved into a series of now highly routinized acts of flattery, so carefully attended to that one out-of-place word is enough to fracture dozens of egos.

One only has to observe the shrill and over-the-top reactions to some of Lawrence Summers recent remarks to have this ring true.

I actually have several connections to Harvard.  As a high school senior, I was fortunate to have my choice of Ivy League schools, and I chose Princeton over Harvard, in large part because it was obvious even then that the Harvard's graduate schools and faculty egos took precedence over teaching undergraduates.  At Princeton I got to know Neil Rudenstine, then provost of Princeton and later President of Harvard.  Rudenstine was basically far too good a man to run Harvard, sort of like sending Mother Theresa in to run Haiti.  The faculty devoured him, and drove him to a breakdown.

More recently, I attended the Harvard Business School (HBS).  Many of you who are unfamiliar with Harvard would likely assume that the b-school was the snobbiest and most condescending arm of the university.  In fact, the opposite was the case -- the B-school was both isolated from and looked down on by the rest of the university, its isolation reinforced and symbolized by the river that separates HBS from the rest of the campus.  Many an outsider have commented on how approachable HBS students and faculty are as compared to the rest of the university, which is ironic since most of the rest of the university, busy polishing their egalitarian credentials, condescendingly denigrate HBS students for being, well, grubby capitalists rather than lofty intellectuals like themselves.  As a result, HBS crew teams were routinely booed through the entire Head of the Charles regatta, and HBS graduates are booed by the rest of the university at every graduation ceremony.

As a result, Princeton gets much of my time and love and attention and, well, money, while Harvard gets nada. 

Update:  I am reminded that this last feeling about Harvard is not limited to the B-school.  My good libertarian college roommate Brink Lindsey (I wish he would start blogging again) tells me that when he was at Harvard Law, a group of his friends formed N.O.P.E., which stood for Not One Penny Ever [to Harvard].

Roy Soifer recently suggested, as reported in Photon Courier, that the percentage of Harvard Business School graduates going to Wall Street jobs can be used as a reverse indicator of the market (i.e. lots of graduates going to Wall Street means the market is peaking and due for a fall).

As a graduate of that HBS in 1989, I have a few thoughts.  First, the vast majority of HBS graduates go into Wall Street, consulting, or the corporate world.  The relative popularity of these three destinations tends to vary over time.  To some extent this variation is due to what's "hot", and to some extent its due to simply to what jobs are available and what recruiters are showing up on campus. 

Second, though pride urges me to agree with this statement from Photon Courier, I really can't:

But one would hope that MBAs from a leading school--who have certainly studied business cycles--would reflect more on the principle of "buy low, sell high" before deciding among their various offers.

When I graduated from HBS, I don't remember having a clue what I wanted to do.  Its all fine and good to talk about trying to get in early on a growth sector, but that implies I am taking a job to maximize NPV of future incomes.  If that were the case, I would have gone to Wall Street, or remained a consultant.  But I also would have probably hated it.

A more interesting HBS graduate job indicator for me has been "how has the jobs people have evolved since they graduated".  When I graduated, everyone seemed to be investment bankers and consultants.  At our fifth year reunion, everyone was posturing as to how successful they had been, how far they had risen, etc.  Most people were still in the same type jobs, with only a few outliers who had switched careers already.  Our tenth reunion was totally different.  At our tenth, no one talked about their job - everyone talked about their kids.  The contrast was dramatic.  Many people were in different careers, including a number who were testing the dot-com waters. 

At the fifteenth reunion, everyone seemed much more relaxed.  Job performance stress at from the fifth and family starting stress at the tenth were mostly gone.  Many, many people (including me) had their own businesses, and few of these were ones anyone would have predicted;  I don't think anyone was a consultant anymore.  Here are a few examples just from our 90-person section of businesses graduates are running now:

• A camping business
• A children's media business
• A stereo equipment business
• A women's clothing business  (and don't miss this)
• A cooking and cookbook empire
• A succesful electronics startup

My observation - very few were the types of businesses that come recruiting at HBS.

My parting observation about career choices through life comes from Dan Simmons' great Hyperion series, where the prophet Aenea gives here famously concise advice to humanity:

Choose Again.

Certainly true with careers.