Friday, October 10, 2014

The Halo Effect

After posting about the Collins book, Good to Great, some people mentioned the book The Halo Effect: . . . and the Eight Other Business Delusions That Deceive Managers by Phil Rosenzweig as a counter to it.

So of course, I got it and read it right away.  And it's a really good book.  I agree with a lot of what Rosenzweig says and this is one of the reasons why I generally don't read management "how-to" books.  If I do read them, I read them quickly and don't think much of them either way because, frankly, I have never really been all that interested in management.  I have never wanted to be a manager or CEO or anything like that at all.  Mostly, I read it to get corporate histories especially if they include case studies.  Ironically, I actually read them precisely for the "stories".  How to improve a business or build a great corporation, to me, is secondary and not all that important.  It's the stories that I want to read.  And it's this "story-telling" that Rosenzweig criticizes.  He says that many of these management books (like the Collins books) are not scientific studies but are just a bunch of great stories.  That's actually totally fine with me.

In any case, I enjoyed reading Good to Great, and think it was useful.

Amazon/Bezos Book
I also just finished reading The Everything Store: Jeff Bezos and the Age of Amazon.  This is a really good read and I think everyone should read it, even people who don't invest in internet companies.  The way Amazon is changing the world goes way beyond internet businesses so I think it's an important piece of the puzzle for anyone who wants to understand business and what's going on in the world now.

This is a really well-researched book and one of the better business profile books.  There are a lot of books that seem to have been thrown together over a single weekend with sources/information seemingly acquired in a bar nearby a company headquarters.  When Apple got hot, a few books came out that were like this; very little new or interesting information and anonymous sources spewing gossip (as if the author hung out in a bar for a few nights and talked to some lower level employees), but no real, substantive information.  (The Walter Isaacson book on Steve Jobs was really good, though).

This one is not like that at all.

One thing that is scary is that it seems like Bezos doesn't even want to raise prices at all.  Some people expected Amazon to lower prices and put everyone out of business and then later raise prices to make a ton of money.  But that seems not to be the case.  At one point in Amazon's history, they were actually contemplating raising prices.  But Bezos' model for Amazon was Sam Walton.  He really dug into his book, Sam Walton: Made in America.  Around the time Amazon was thinking about raising prices, Bezos met with Jim Sinegal of Costco and heard that they won't raise prices to make more money.   Apparently, after this meeting, he resolved never to raise prices for the sake of making money.    I did scratch my head at this part in the book thinking that Costco actually makes money and has a decent return on capital; why won't Amazon raise prices enough to at least make a little bit of money?

Bezos / Good to Great
Anyway, I went off on this tangent for a reason.  As I was reading the Bezos book, I was surprised that Bezos was deeply into Jim Collins and even had him come to Amazon to show them how Amazon can become a great company.

Apparently, a light went on at Amazon due to Collins' presentation (which was based on the then yet-to-be-released book, Good to Great).   The part that clicked with them was finding out what they were really good at and then developing it and get the flywheel moving.

Back to the book.

So what is the Halo Effect?

The Halo Effect
There is a good summary of the book on Wikipedia: Wiki: Halo Effect.
  1. The Halo Effect of the book's title refers to the cognitive bias in which the perception of one quality is contaminated by a more readily available quality (for example good-looking people being rated as more intelligent).[6] In the context of business, observers think they are making judgements of a company's customer-focus, quality of leadership or other virtues, but their judgement is contaminated by indicators of company performance such as share price or profitability. Correlations of, for example, customer-focus with business success then become meaningless, because success was the basis for the measure of customer focus.
There are other delusions (nine in total) that are summarized on the Wiki page.

I agree for the most part with what the book says about these cognitive biases and delusions, but I wouldn't go as far as to say that these biases make Collin's book and many business press articles worthless.  Rosenzweig doesn't go that far, but comes pretty close.

Any time someone says they want to investigate why some companies succeed and why others fail, I am going to be interested.  The methodology may not be perfect and there may be flaws in the assumptions.  But that doesn't really matter so much as just reading about what people did over the years; what worked and what hasn't can be interesting on it's own and you can make your own adjustments about the respective biases.  Rosenzweig uses Cisco as an example of how everyone thought it was such a wonderful company during the internet bubble (great customer service) and then the very same reporters talked about how lousy Cisco is (with horrible customer service) after the bubble popped  (I think most of us, though, recognized Cisco as a huge beneficiary of the internet bubble in a virtuous circle and had no doubt it would eventually reverse).

If you had access to some of the top CEO's in the country and you were able to have lunch or dinner with them, wouldn't you do it?  Of course you would.  And of course you would learn something from doing that a lot.

And of course you would be subject to all of the same biases discussed in Rosenzweig's book. You would be talking to people you see as successful, and they will tell you what they have done, but there is no way to tell what the cause and effect was (were employees happy because the company was successful and the stock prices (and therefore their 401-k's and stock options) were up a lot, or did happy employees create the success?

But you would still do it.   And you would still ask the same sort of questions.  And then you would make adjustments to what you hear  (and even those adjustments would reflect your own biases).

I guess what Rosenzweig has a problem with is how Collins simplifies and distills all of the case studies into a simple formula, but I think most readers read these books to get ideas and inspiration more than any sure-fire, fool-proof method of eternal success.

Managements Don't Matter / Nothing is Forever 
Rosenzweig also presents a study that shows that CEO's don't really matter as much as we think.  This may be true, but taking that to the extreme is not so great either because I don't think anyone would agree that the CEO doesn't matter.  I do think there are good CEO's and bad ones.  But that is not to say that good CEO's can't have bad results and vice versa.   He also points out that it is impossible to build a great company to stay great forever.  You can't build something to last.  He shows that previous excellent companies, companies built to last and good to great companies have done worse than the S&P 500 index, and the less favorable comps did better.  All companies go through a life cycle.  I agree with that too.

I personally believe more in CEO's than corporate cultures.  I would rather invest in a CEO I truly believe in (Warren Buffett, Jamie Dimon etc.) than a company known to have a strong culture of success (even though Goldman Sachs is one that I believe in strongly).

As an investor, I am highly skeptical of corporate cultures in general, unless it has been proven over multiple generations (like Goldman Sachs).  The fact that firms like Starbucks, Uniqlo (Fast Retailing), Dell and others floundered after their founders left (and they had to come back) makes me wonder about the importance of cultures versus CEO's.


Efficient Markets
Anyway, all this talk of CEO's not mattering too much and nothing can be built to last reminds me of the efficient market theory.  In the pure form of efficient market theory, the markets are too efficient for anyone to outperform.

That would make books like Intelligent Investor and Securities Analysis meaningless.  And all those Superinvestors (of Graham and Doddsville), Money Masters, the New Money Masters and the managers/traders in the various Market Wizards books by Jack Schwager would all be monkeys that just happened to flip a few heads in a row.

I haven't checked, but I tend to think that most of the managers covered in these books have done well over time, even after being featured in them (OK, maybe I said that about Good to Great and Rosenzweig has proven otherwise).  Sure, Tiger, Steinhardt and others closed shop after a bad year or two, but they closed out their careers with incredible track records.  I think there might have been some blowups in the commodities trading world (Richard Dennis?), but most people in the above books have gone on with great records (although increased size have lowered returns for many of them; the more common lesson in outperforming managers is that size kills performance).

Markets are Efficient Because Mutual Funds Don't Outperform?
One thing people keep pointing out is that markets are efficient because most mutual funds don't outperform.  This is something that I've been thinking about on and off for years.  Why do some people outperform while others don't?

Most mutual fund companies are asset gatherers.  Their primary goal is to increase earnings of the management company.   And we all know that increasing asset size makes it harder to outperform the market.

So at the asset management company level, they are incentivized to increase AUM.   They are paid a percentage of AUM so this makes sense.  If you want to increase earnings, you have to increase AUM.  It doesn't matter if it gets harder to manage as they don't get paid on performance.

At the fund manager level, managers don't want to diverge too much from the index.   If they stay more or less within a reasonable range of the index, they will be fine and won't get fired.  The risk/return is asymmetric in this case if you want to take big risk to outperform (OK to fail conventionally etc.).

So the asset management industry is often not even trying to outperform.  They are trying to maximize earnings to the management company.

Missing the Trees for the Forest
Anyway, I brought up this efficient market argument because the "CEO's don't matter" argument sort of reminds me of it.  When you look at the data overall, you might find that CEO's actually don't matter, just as if you looked at the performance of mutual fund managers (or research analyst buy/sell recommendations), you would think the market is efficient and fund managers don't matter.

Oftentimes, the big figure can obscure the little facts.

For example, back in 2000 when the stock market was trading at 30x p/e (or whatever it was), people concluded that stocks were not good investments.  That's sort of missing the trees for the forest because BRK and many other value stocks were trading at attractive levels.

CALPERs recently decided not to invest in hedge funds.   This may be the right choice for them; it seems like they couldn't allocate a meaningful amount to hedge funds and the cost of maintaining such a small percentage of the portfolio just didn't make sense.  That's totally reasonable.

On the other hand, I always hear figures about some hedge fund index and how that hasn't done too well.  There are a lot of hedge funds out there and most of them are probably no good.  But there are really good ones.  The problem with hedge funds, usually, is that the good ones are closed.  So again, I wouldn't look at the hedge fund index to decide whether hedge funds are good or not.  I would just look at funds individually and if there is a good one, invest in that and otherwise don't.    A lot of information is lost when you look at the various indices.

Likewise, if a study shows that the CEO doesn't really matter too much, that doesn't mean that much to me.  If you look at a big enough group, then bad industries or bad cycles can easily offset good CEO's and the sum of everything might make it look like CEO's don't matter.

Conclusion
Well, I don't know that there is a conclusion to this post.  I think the Halo book is a good one and very interesting.  The arguments make sense. But on the other hand, there is a bit of an "efficient market" sort of thing going on there too.

I like "stories" and I don't think there is anything particularly wrong with reading them as long as we understand the context and limitations of those stories.  I know I will keep reading articles in the business press, business books (not "how-to" books, but books about businesses and biographies of business people).


25 comments:

  1. A few quotes may be instructive here (though the first two are probably paraphrased):

    1. “If you take a management team with a reputation for brilliance and have them run a business with a reputation for poor economics, it is usually the reputation of the business that remains intact.”
    - Warren Buffett

    and

    2. “Ideally you invest in a business that is so great that it can be highly profitable even if an idiot runs it, because sooner or later one will.”
    - Warren Buffett

    --> I think there is a variant on this where Bill Gates says it and refers to a ham sandwich running the business.

    3. “ The basic message of Built to Last and other similar books is that good managerial practices can be identified and that good practices will be rewarded by good results. Both messages are overstated… On average the gap in corporate profitability and stock returns between the outstanding firms and the less successful firms studied in Built to Last shrank to almost nothing in the period following the study. The average profitability of the companies identified in the famous In Search of Excellence dropped sharply as well within a short time… Stories of how businesses rise and fall strike a chord with readers by offering what the human mind needs: a simple message of triumph and failure that identifies clear causes and ignores the determinative power of luck and the inevitability of regression [to the mean]. These stories induce and maintain an illusion of understanding…”
    - Daniel Kahneman, “Thinking Fast and Slow”

    --> The ethos here that we should be extremely careful from what we learn in ‘case studies’ and other things in the business press, seems to be a very good lesson. It doesn’t follow that we need to block everything out per se, just that we should be highly selective (much like our investment decisions). I think Bruce Greenwald and a few others fit the bill here. They generally agree with the Buffettisms and suggest investing in a company due to perceived management prowess is legitimate but fraught with peril. Certainly Greenwald has spent a lot of time analyzing the moves of Rupert Murdoch, in ‘Curse of the Mogul’, and not just because Murdoch is entertaining. People who are not as sophisticated at appraising strategy and investment merits will have their analyses overwhelmed by false positives.

    This shouldn’t be that surprising given how rare it is for a CEO to be expected to be capable to of generating exceptional returns from an average or worse business. (This is a tie-back to WEB’s first quote and it indicates that the base rate probability of managerial greatness is extremely low).

    And there is so much randomness in the socioeconomic world that we will frequently observe people to be doing ‘great things’ when they are really just lucky (i.e. in the business world there will be many ‘great performances’ for non great CEOs.) From a Bayesian perspective this makes identifying management brilliance quite challenging.

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  2. Why do you assume that corporate culture and great CEOs are mutually exclusive of each other?

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    1. Good point. I don't assume that, actually, but for the purposes of this discussion I just look at things as either/or. For example, I look at JPM currently as a Dimon entity, but Dimon has created a certain culture that reflects his philosophy and it is an important part of what JPM is today. Will the culture endure after Dimon leaves? I don't know. Same with Berkshire. BRK has a very specific and unique culture that reflects the values of Buffett/Munger. Will it survive post-Buffett? I don't know. I think it will for a time, but who knows for how long. I have no idea.

      From the other side, I really respect Goldman Sachs for their culture. I have watched them closely since the 1980's; have known people who have worked there, clients, ex-colleagues that left a company I worked at to go there and heard about it etc... And they do have a very winning culture that goes beyond the appeal of Blankfein. Which is obvious because the culture was in place way before him. Many comments (and books published) have been made about how the culture there has degraded and this may be true. But either way, at GS, both the CEO and culture are very important for their previous and continued success. But it sort of seems like the culture there is really strong and is more powerful than the CEO if you know what I mean; I don't even know if that makes sense... but that's sort of the way I feel about it.

      So yes, culture and CEO are really mutually exclusive, but when you look at things, sometimes it feels like it's the CEO (which admittedly is responsible for the culture in place), and sometimes it feels more like the culture (of course, which would be worthless without a good CEO).

      Anyway, you raise a good point, and I don't know how I would really separate that stuff scientifically...

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    2. oops, I meant culture and CEO really AREN'T mutuall exclusive, but...

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  3. Any thoughts on Robert Vitale as CEO at Post?

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  4. Hi,

    I don't have any particular insight into Vitale.

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  5. Any thoughts or interest in IBM at this level? Thanks.

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    1. Hi,
      IBM is certainly interesting, but the miss is disappointing. Buffett said that what he likes about IBM is that they set a 5 year plan and executed it and he thought it would do so again. It is clear now that they won't achieve their road map goal, and that's a problem.

      Until now it seemed like IBM's weakness had more to do with global economic weakness more than technological change (although that obviously is a factor too); we all know how China, Europe and the emerging markets are way weaker than we would have expected even recently.

      So if IBM's weakness is based on that sort of economic cycle issue, it wouldn't be too much of a concern and it would actually be a great opportunity if people dump IBM assuming that cyclical weakness is actually part of a bigger secular decline (which is happening too for sure in their legacy businesses).

      But the language on this release and earnings call make it seem like the shift in their sector is happening much faster than they thought and this persistent weakness is much more secular than they thought until recently. So it's clearly looking worse than before.

      I wouldn't exactly throw in the towel here, because I do think there is a lot of cyclical factors too depressing their results.

      We'll see what they have to say in January when they give their new guidance.

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  6. Any thoughts on owning AMZN here? Not a true value investment when viewing metrics. However, its a high margin business, with wide moat, will be around in 10+ years, and would have positive EPS if growth capex were reduced. Thanks in advance.

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    1. Hi, I am a huge fan of AMZN as a user, and I think Bezos is incredible. But I have never really been a fan of the stock. It seems like they are buying traffic to generate sales which is sort of easy to do, right? Buffett said that generating premiums in the insurance business is easy; just underprice it and you can be alone in a row boat in the middle of the ocean and they will come find you... or some such.

      The trick is to make that a profitable business. Having read the recent Bezos/Amazon book, it looks like they are not really planning to make money from their retail business; they want to make that up in other ways, monetizing the traffic via advertising, generating other businesses etc...

      So that is worrisome to me. Bezos is a huge fan of Sam Walton/Walmart and Costco (Sinegal), but those companies are very profitable and have decent returns on capital despite their aggressive pricing policy. We have yet to see that from AMZN.

      Sure, their other businesses may become huge and make AMZN a winner, but I have no real insight into that side of the business.

      For me, the best way to play AMZN is to buy stuff on the website...

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  7. Hi,

    My somewhat provocative takeaway from the book is that what Bezos really wants is get to the stars (as in "Space the final frontier"). He has a current net value of over 20 billion dollars and a space company, so if that's true than he got what he wanted, capital to achieve his dream. Amazon's profit is secondary.

    About the halo effect, a good book which goes in details about biases is Thinking Fast and Slow, which you might have read? It's a must read.

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    1. Yes, I havne't finishedit yet, but fast and slow is a great book.

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  8. If you could only own 5 positions for the next 10 years what would they be? BRK, MKL, GENIX, LMCA, FFH, CASH? Thanks in advance.

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    1. Hi,

      That's a very good question. I tend to like the things I write about here for the long term, but to pick five? Of course, they tend to be heavy on financials which may not be such a great idea. If I can only pick five and can't change for ten years, then I would obviously lean more towards the solid ones...

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  9. how do i contact you

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    Replies
    1. Hi,
      If you post an email address, I'll email you (and will delete the info here).

      Delete
  10. If you liked Halo Effect, check out “Hard Facts, Dangerous Half-Truths, and Total Nonsense: Profiting from Evidenced Based Management by Jeffrey Pfeffer and Robert Sutton. It includes some great detail on Davita and Harrah’s entertainment. I just included some of the highlights in an article on Davita I wrote for Seeking Alpha. The authors also did two great business case studies on Davita and Harvard you can get at HBR.org

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    Replies
    1. Thanks, I'll check it out. Nice article on SA.

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    2. Have you looked at /analyzed/thought about digital currencies (Bitcoin) as an asset class?
      I couldn't find anything in your archive of blogs.
      thanks in advance
      eagerly waiting for your next post (on any topic)

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    3. Hi,
      Not really. I never took it seriously. Maybe I'm wrong, but I don't really see the appeal. They say that the central bank / governments control currencies and that's no good so bitcoin must be better, but I don't understand that argument when most people who talk about bitcoin don't really understand what it is and why it is better than other currencies.

      A big bitcoin operator went bust because bitcoins basically disappeared in cyberspace (well, I actually don't really know what happened, but that's what the stories read like at the time). So if we can't really understand it, how can you trust it?

      At least government currencies are transparent in that sense. Yes, they are deflating the currencies but we see how much government debt there is, how much inflation there is etc. And when banks fail, we understand how the FDIC works etc... But for the bitcoin, I have no idea how any of it works.

      If you look at the fluctuations of it over the past year or few years, I have no idea what drives that valuation (other than to say maybe it's a bubble).

      Obviously, I would much rather own a stake in a decent business with good management; that way the managers can deal with inflation and other problems in the world.

      If the bitcoin went up or down 50% by next month, I would have no idea what drove it. I have no idea what the status of the bitcoin will be in 10 years or 20 years either.

      So to me, it's just a big, fat, "don't know".

      Maybe I'm wrong, but if I'm wrong on this one, I'll be OK.

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    4. Thanks for your thoughts
      In the future, i can see Bitcoin becoming the preferred payment method for e-commerce (I hate giving my credit card number for some trivial purchase), but might take yrs(?) for Bitcoin to overcome Paypal.
      btw- interesting documentary now available "The Rise and Rise of Bitcoin".
      I agree with you - big, fat, "don't know" - but the day Amazon and Alibaba start accepting Bitcoin, watch out.
      thanks again for your blogs

      Delete
  11. I meant business case studies on Davita and Harrah's, typo.

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  12. "I would just look at funds individually and if there is a good one, invest in that and otherwise don't."

    So if a stock don't go up, don't buy it?:)

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  13. Hello, I like your site. But I noticed you haven't posted in 2.5 months ( almost 3 months now). Have you decided to scrap posting here?

    ReplyDelete
    Replies
    1. Hi,

      Sorry, no. I have no intention of stoppng posting, but I got a little busy (kid's school stuff) and then the holidays came and I haven't even had much time to do much of anything, lol... So this was all unintentional; time flew by.

      I will post soon once things settle down!

      Thanks for dropping by.

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