What's On Your Mind, Mr. Buffett ? 2017

"We are prone to overvaluing complexity. In reality, simplicity makes all the difference

Shane Parrish of Farnam Street on the art of reading, investing and multidisciplinary thinking

Published 7 years ago on Jun 12, 2017 16 minutes Read
Photographs: N Mahalakshmi

Most of the time, he thinks about thinking. At other times, he reads and writes. Meet Shane Parrish whose blog Farnam Street — named in homage to where Berkshire Hathaway’s HQ is located — is known for ‘mastering the best of what other people have already figured out’.  Starting out as an investor, Parrish found his calling in curating content that is timeless. What he does for a living now is quite an interesting career turn for someone who wanted to be a spy when he was a kid. Though he is an MBA himself, Parrish feels that B-schools are largely fee-collection agencies and one does not really pick up much substance there. In this interview with Outlook Business, Ottawa-based Parrish talks about his evolution as a voracious reader and the interesting conversations that he has had over the years. By now, Parrish has gotten quite accustomed to hearing, “I just love your blog”. And at Omaha during the Berkshire Hathaway Annual Meeting, given the familiarity, that must have happened quite frequently as it does when our photo shoot is in progress, at the downtown Hilton.

>>> Can you explain the art of reading? You call it active reading, how do you do that?
Well, passive reading is when you pick up a certain kind of work and skim over it with your eyes. Active reading allows you to engage with the author. You can think about active reading as writing in the margins, folding down the page corners on pages you want to return to, or engaging intellectually with what you are reading. I think those are the keys to getting a good experience out of a book.

Active reading is the first step towards the engagement of your whole brain. However, it has to be in harmony with not only reflecting and thinking about it or writing about it, but also in terms of drawing abstractions and then putting them into practice.

>>> What’s the best investment book you have ever read?
While I was pursuing my MBA, people would tell me that I could get more out of Warren’s [Buffett] letters than out of an MBA. I’ve lived that. I think there are a lot of unusual insights in Berkshire Hathaway Letters to Shareholders and they’re presented very clearly in a way that even a layman can understand the principles. I learnt a lot, not only in terms of how to communicate but also about business, about how the world operates, incentives, people… if you read those letters, it takes a while. And if you read it once, that’s okay. The second and third time is where you really start to get some deeper insights on how Buffett thinks about valuing businesses, how he thinks about competitive advantage, etc. 

>>>Tell us more about that insightful Knowledge Project podcast with Alexander Shelley
The Knowledge Project is the most irregular podcast in the world, which comes out once in three months. And this started as a way to introduce people to conversations I was having already. It’s been an amazing experience to record these conversations that have no constraints around what can be talked about. One of my favourite interviews was the one with Alexander Shelley, the conductor of the national orchestra in Canada. That podcast was a different experience for me, especially to talk to somebody who conducts an orchestra and to learn what he thinks when he’s going onto the stage; to learn about how the different parts of the instruments fit together; and how the melody is in the music; and the theory behind some of the music. It was all such an eye opener for me. I learnt things such as when you lead an orchestra, it all depends on where you stand. There is a contrast factor. If you’re playing the flute and are in that section, most of what you hear is the flute. Thus, you rely on the conductor to tell you when to pick up, when to slow it down because you can’t hear with the same precision as other people can. So whatever section you are in at the orchestra, makes you feel like it is the most important one, which is why you rely on somebody outside of that to give you an objective sense of timing and sequencing. Now, Shelley did something I found fascinating — he would get everybody to stand out at the front. And that way they see how different the instrument sounds in the front versus from where they are playing. That experience relates to management, where different parts of an organisation need to work in harmony with one another. That way people have a different aperture into what you’re trying to do. Whatever project a person works on is the most important one to him and as a manager, you have to find out a way to blend that into the broader picture. 

>>> Could you reconstruct mental models for us with a couple of examples?
Mental models are an abstraction of reality. When you are creating a reliable model to understand how the world works, that is repeatable over time. It is fascinating because then I can explain what happened and I can also predict what happens. A very simple example of that is gravity. For instance, if I pick up your camera and drop it, then we know what is going to happen. If we see a broken camera on the ground, we can say that either somebody dropped it or it fell off the table and we can say this with a high degree of probability. We know a variable that will help us predict things in the future with reliability, we have the same variable that helps us explain what has happened in the past. 

Charlie [Munger] has taught us that there are two different types of mental models. He teaches us that first is the human misjudgement model, which is the way we fool ourselves and those are reliable and repeatable. Thus, they can explain, to some extent, what happened. The second model is about how the knowledge of multiple disciplines such as physics and biology can apply to solving problems in life. He’s generally applied these principles to investing. What I’ve tried to do is make them more widely known, to open them up to people outside of investing and to encourage a different type of thinking.

If you think about our education system, it’s very niche. You need to specialise in something to get a job. What do you miss when you have a highly specialised education? You miss the broader world. There is a Japanese proverb that talks about the frog in the well who thinks there is nothing in the mighty ocean and that’s what happens in America. As you start specialising in a field after high school, your focus becomes more and more narrow. That’s good for the first few years of your employment. You can work three or four years as an engineer and then all of a sudden you are promoted to managing people and then just a little bit of this broader world comes into play. Now you’re making decisions that impact other people. There is incentive, psychology, personal relationships in the context of the company and of how the business operates. If you don’t have that knowledge, then you’re at a disadvantage. If you do have it, then you have fewer blindspots. And that’s what you’re trying to eliminate — blindspots. 

Another good example is thinking of relationships. My friend Peter Kaufman has a belief that there are four types of relationships — win-win, win-lose, lose-lose and lose-win. But only one of these relationships is sustainable over time and that is a win-win relation. Biology tells us that if you want to survive, then you have to be sustainable over time. So now we can think about how we enter into relationships with partners — spouses, kids, colleagues, customers. We want all these relationships to be win-win, because if it is not, then they are fragile. When that happens people look for an exit. Relationships become more transactional and such relationships don’t survive over a long period of time. 

Another example would be the contrast factor. So Peter Atkins in his book The Fours Laws That Drive The Universe, talks about the act of sneezing. When you sneeze in a library, you send some sort of energy in the library and it has a huge impact, people will look at you. On the contrary, when you sneeze with the same vigour in a public place as you did in that library, nobody hears it. Because there is so much else going on. This relates well to how you think about business or for that matter sports. A coach, for example, has several decisions to make on the field — Do I match up my best player against their best player? What advantage do I get out of that? Do I get all of the energy that goes in the system? Does that become valuable to me? Or should my second best player play against their best player? I don’t know the answer to these questions but the contrast is really interesting to think about how that applies in business. There too, you ask questions such as do you want to compete with Google or do you want to compete with somebody who is easier to compete with? If you are putting the same amount of effort, then you probably want to go where there is a higher degree of contrast. But a lot of these are individual choices. 

>>> Is there a systematic way to develop a higher order of thinking?
I try to teach this to my kids. I encourage them to ask “why” but I also ask them, “What do you think will happen if you do this?”. They are only six- and seven-years-old so encouraging a higher order of thinking at such a young age has had a good impact on changing their behaviour. This is done by getting them to think before they do things and allowing them to explain by making them curious. Asking such questions pushes people to engage their brain and think. It’s encouraging people in subtle ways, especially adults, because they don’t take too well to that. 

Munger says that the human mind is like an egg. What gets in once, just gets sealed off. The first thing that fits our mind, that doesn’t conflict, doesn’t mean it’s the optimal solution. But it satisfies us and that’s when we stop thinking and that is a terrible idea. So Munger has outlined a two-step framework for making decisions which are incredibly useful. He asks what are the variables that govern the situation that you’re involved in and then how might you be fooling yourself? That’s a very effective framework because that forces you to think through things. It forces you to acknowledge that the world needs you to reflect on certain decisions and it gives you an opportunity to ask do I really understand this? Am I in my circle of competence? 

One big difference between investing and operating businesses is that when you’re operating a business, you can’t sit and wait for a fat pitch, I mean you can position yourself to take advantage of it when you have, but you just can’t not decide because you don’t like what’s happening. But if you are not in that circle of competence, you can take another path to decide it — you can acknowledge with humility that you lack the knowledge and experience to make the decision and reach out to a friend for advice. And then you could ask yourself — Am I fooling myself? Is my data reliable? Am I overconfident? Am I over valuing a small piece of information that is easily accessible to other people by thinking it’s unique?

>>> What are the most common misconceptions about value investing?
A lot of people are trying to be something they are not and a lot of them want to be Warren Buffett and Charlie Munger. But what Buffett and Munger have done has worked for them as individuals. After all, everybody has to be their own individual and I think Guy Spier had a good book about this — The Education of A Value Investor. The book was about Spier’s journey of emulating Warren Buffett and in the end concluding that he cannot be Buffett but he can be himself. Buffett and Munger are heroes but copying them is not going to get anybody anywhere. Their own investment process has worked at a certain period of time and in a certain context and they have shifted over time. They have gone from buying cigar butts to buying good businesses and to buying whole businesses now. They have an opportunity cost that allows them to deploy capital into a public market, and into a private market and into operating businesses. Most of us just focus on this public market aspect as if it’s the only thing that matters but the fact is that they have three choices. That increases the opportunity cost of capital and prevents them from doing silly things in the stock market. 

>>> What are some of your own investment-related beliefs that have changed over a period of time?
I used to believe that I wanted to be this great value investor, investing only in companies that a two-year-old could operate. But the real world is messier than that. Running a business has taught me that it is difficult, competitive and people are malicious. Buying companies that are perfectly operated at a multiple of four or six does not exist. As a teenager and an outsider to a company, I thought companies were idiots for making some of the decisions that they took. When I began working, I realised that those were indeed great decisions given the information that they had.

The problem is not the decision, it is the information flow. Information in an organisation goes through 10 or 15 filters. How do we acknowledge these filters? Another mental model is called ‘Map And Territory’, where investors mistake the map, which is the balance sheet and the income statement, as the territory. We mistake this piece of paper for telling us numbers about what’s actually happening in the business and the competitive position of the business. Enron is a clear example of this. A lot of investors get hoodwinked into thinking that the map, which is the financial statement, represents reality. You need to understand that the terrain is not the map and you need to know when the map and the terrain differ and figuring that out is one of the keys to investing.

>>> There is this one quote by Andy Benoit — “Most geniuses, especially leaders, get it right not by deconstructing intricate complexities but by exploiting unrecognised simplicities.” Are there any such counter-intuitive points that great companies or great investors have demonstrated?
As individuals, we are prone to overvaluing complexity because we think we are smarter and that we understand certain complex things that other people don’t. In reality, simplicity makes all the difference. Napoleon used simplicity when he was giving orders. That was one of the reasons he was so dominant on the battlefield. He was giving his troops very simple orders because he knew that they will be filtered through people and they would still be simple when they came out. Complex orders filtered through a chain of command almost never work. 

Now going over to the second part of your question, when you look at a company, you want to look at whether the company can self-correct. Do they have a feedback loop where they can adapt based on the feedback that they’re getting from the market? A lot of companies think that they are right and the market will adjust, but the humble ones try to create a flywheel which is autocatalytic. I would say the same for Amazon. The outputs of Amazon are now becoming the inputs and that’s how they just keep getting better and better. They are quick to adjust and that’s part of the reason that they are so dominant. They have a ‘customer first’ mindset, that allows you not to have an ego. I think the feedback loop model is much better, where you remove people’s egos and focus on the customer instead. 

>>> Is there any other way of figuring out companies that are self-correcting? Would you agree that the moat around consumer brands will be seriously threatened in the future?
You have to understand the company’s value proposition, how they behave with the customers and that is part of an investor’s job. Consumer brands in North America are definitely in for a lot of trouble, we are just seeing the beginning of what will be a long structural decline in the power of these brands in the next few decades. Today, buying habits are changing as in people are going lesser and lesser to physical stores and are shopping more online. That gives Amazon enormous power, not only pricing power but it also gives them an additional power which they didn’t have before. You can now match households to buying patterns, to brands and target specific people and try to move them away from a brand. Wal-Mart can put a generic brand on the shelf next to Colgate but that’s not really high value. But I can send you an email saying I know you are a Colgate shopper but we’re going to give you a new sample of a toothpaste we have created; it tastes just like Colgate. Now you are doing a targeted marketing campaign to an individual with a purchasing history of years or even decades. 

We have seen this with Ulta, which is a cosmetics company. Amazon hasn’t really turned on that tap yet but I think when they do, the AmazonBasics brand will become incredibly valuable. For example, if you’re going to buy a 24-pack of Duracell batteries and they’re charging $19, then as you click ‘add to cart’ you get a pop-up that shows the same product under the Amazon brand for $8.99. I think gradually these brands will erode and some will stay. Identifying the ones that will stay and become more valuable is probably key and part of that would be aspirational brands.

>>> Can you give a few examples of multidisciplinary thinking?
It’s just how you structure your thinking. We did a case study in University. It was on an Eastern European airline and the man had 99% of his networth in it and he had to determine whether he wanted to sell his company or whether he wanted to continue operating it. The chapter we were assigned this study in was about low-cost strategy and that’s the answer the teacher wanted. That was a very linear way of thinking. Then we asked the following questions — What are the odds that he can become a low-cost operator? What do the employees think? Are they committed? Can they go up a hill? Are they ready to back this man? What can he bring in as strategic or financial or operating or personal knowledge? What are his contacts? What’s his life like? What does he want to do? 

Then we started thinking about these things in a more holistic way. We determined that he should sell because the odds of him becoming a low-cost provider were low. The employees were all ageing and over the hill. His labour costs were high. His contract renewals were coming up, we thought about it from different perspectives. That was my first personal insight into multidisciplinary thinking. And I walked away from that experience wondering who is Charlie Munger and where can I find more about him.

I think an incredibly disciplined way to think about things is to force yourself into not only the domain that you specialise in, but also to look at a problem through different lenses. And a lot of times, it could mean looking at it through your counter party’s eyes. Even that alone can add a dimension of multidisciplinary thinking. It’s really about relativity. It all comes down to the guy on the train with the ball. So if you’re standing on a train with a ball, it doesn’t look like the ball is moving. If you’re standing outside of that frame, the ball is moving as fast as the train. Let’s take another, if I asked you how fast we are moving right now, you would say that we are just sitting at a table but the earth is spinning around the sun, thousands of miles an hour and so how you look at a situation or problem determines what you see.