Sunday, August 24, 2014

Good to Great: The Stockdale Paradox

After watching a video of Carlos Brito pounding the table on the book, Good to Great by Jim Collins, I had to reread it.  I read it years ago when it came out and thought it was a great book, but rereading it now, I enjoyed it even more.  That's because I've spent more time since then reading about businesses, annual reports, and watching companies succeed and fail over the years.  So I have many more reference points to relate all of this stuff to.

It is fun to read about Wells Fargo and how together they are, and it's nice to see that they have maintained their "greatness".  Unfortunately, Circuit City and Fannie Mae no longer exist, but most of the others have been doing well since then.  Collins did say that if these 'great' companies change, or don't continue their great ways, they will quickly fall back to mediocrity or worse.

By the way, here are the great companies in the book:
Circuit City
Fannie Mae
Philip Morris
Pitney Bowes
Wells Fargo
An interesting point is the contrast between this book and the Outsiders book.  Jim Collins even points out Teledyne and Henry Singleton as an example of a "genius with a thousand helpers"; a company that did well under a genius and then stumbled when the genius departed.

As an investor, either one is fine with me.  I don't mind investing with "geniuses" (that's what we do when we invest in Berkshire Hathaway and other companies not to mention some funds/hedge funds).  And I would love to invest in great companies too even if they are not dependent on a single genius.

Anyway, both are great books so there is no need to compare.  Each book looks at businesses from a different angle (one looks at great companies (and how they became so) and the other looks at great CEOs).

Stockdale Paradox
But the thing that really got me (again) is what Collins calls the Stockdale Paradox.  It is a well-known concept now; it is mentioned in survival books (like Mt. Everest survival stories) etc.

And the idea is really similar to what I wrote about in my recent post, Catmull's Mental Models.  

For those who don't know, Admiral James Stockdale was a POW during the Vietnam war; the highest ranked 'guest' in the Hanoi Hilton.   He was there for eight years and was tortured more than twenty times.

Many POWs didn't make it but Stockdale and some others did.

Collins asked Stockdale, "Who didn't make it out?"
"Oh, that's easy," he said.  "The Optimists."
Collins was confused as he thought Stockdale was an optimist as he had no doubt he would get out of his situation.

Stockdale clarified:
"The optimists.  Oh, they were the ones who said, 'We're going to be out by Christmas.'  And Christmas would come, and Christmas would go.  Then they'd say, 'We're going to be out by Easter.'  And Easter would come, and Easter would go.  And then Thanksgiving, and then it would be Christmas again.  And they died of a broken heart."
"This is a very important lesson.  You must never confuse faith that you will prevail in the end - which you can never afford to lose - with the discipline to confront the most brutal facts of your current reality, whatever they might be."
Collins defines the Stockdale Paradox as:
Retain faith that you will prevail in the end, reglardless of the difficulties.
                                                       AND at the same time
Confront the most brutal facts of your current reality, whatever they might be. 

Stockdale Paradox and Value Investing
And of course, I have to tie all of this to value investing.  This concept is very similar to the stuff that the Pixar people shared with Catmull in his book.  They all had mental models to help them get through the inevitable tough times in making movies.  And those models were really good models that would apply to value investing as value investing is not at all easy and have some rough periods.  Bear markets are inevitable, and even the best stocks will go down 50% every now and then (as we know, even Berkshire Hathaway stock does that too!).

And the Stockdale Paradox is a perfect model to deal with this.

Optimists and Perma-bulls
It's interesting how Stockdale puts it when he says that the "optimists" didn't make it.  This sort of reminds me of a perma-bull.

But first, we must define a perma-bull.  Is Warren Buffett a perma-bull?  He is always talking up the future of America, and he is always almost fully invested (he may build up cash every now and then).

Buffett is not a perma-bull in the sense that he is always bullish the stock market (because he is not).  He is more of a market agnostic.  Bull markets will happen, bear markets will happen, but nobody will really know when, so don't try to figure it out.  That's his stance, so it's not really perma-bullish at all.

Perma-bulls are people who always think the markets will go up.  You see this in wire-house investment strategists etc.

So I distinguish perma-bulls from market agnostics.

Optimistic Investors That Fail
So Buffett is a long term optimist, confident that the U.S. will do well over the longer term, just like Stockdale was confident he will get out of his situation.  But like Stockdale, Buffett just doesn't know when things will happen, just that things will work out over time.

Like Stockdale's colleagues that didn't make it, though, there are a lot of optimistic investors that don't make it.  For example, people who were excited about stocks in the late 1990's were optimistic that stocks will continue to earn 15-20%/year just as it had in the recent past.  This was sort of the "we'll be home by Christmas" optimism in Stockdale's story.  Maybe it doesn't seem so bad as the market hasn't done much since then, but most likely, these people piled in at the top and then puked out their positions in the following bear market (and most likely didn't get back in).

If you buy stocks and expect them to go up 10% every single year, you will be disappointed when it doesn't and will probably end up dumping stocks at the wrong time. If you don't think a bear market will come any time soon, then you will be disappointed when one does come and you will probably sell out at the worst possible moment.

Some became value investors after seeing the 1999/2000 internet bubble/crash.  And then they got hit in the financial crisis and swore off stocks altogether.  They were optimistic that they wouldn't lose money as they would stay away from bubble stocks.  When value stocks got hit hard in the crisis, they were disappointed and left.  This too, is sort of like the "we'll be home for Christmas" optimism.

Or how about optimists that believe that their stock will keep beating earnings estimates; once the streak of 'beats' ends, they get disappointed and dump their stock (regardless of whether it is a good long term investment).

Or optimists that believe their stock or fund will beat the market every single year, year in and year out.  A recent study showed that very few people can do that but I found it interesting because it is sort of irrelevant; you don't need to beat the market every single year in every single time period to beat the market.  Most good funds have periods of outperformance and periods of underperformance.  Insisting on outperformance at all times is what leads to trouble.

I can go on and on (and so can most of you).

Most of us who have been in the business have seen this sort of thing happen over and over.  And it's amazing because it perfectly fits the Stockdale Paradox model.

So let's take a look, again, at the Stockdale Paradox as defined in Collin's book:
Retain faith that you will prevail in the end, reglardless of the difficulties.
                                                       AND at the same time
Confront the most brutal facts of your current reality, whatever they might be. 

For retaining faith, we have to believe that whatever happens (recessions, near depressions) that we in this country (including the government) will (eventually) do the right thing.  In severe recessions, they will step in.  Corporations will cut costs and do what needs to be done to survive.   Just as we figured out how to make more food (after Malthus' prediction), whatever problem we face, we will figure it out.

We also have to retain faith that value investing does work over time.  As Joel Greenblatt says, no investment strategy or approach works all the time.  There will be times when value investing doesn't seem to work (and many value investors will abandon the idea).  If you buy something for less than it is actually worth, then over time you will make money.  We value investors can't lose that faith. 

The brutal facts that we have to confront are usually bear markets (in the whole market or just the stock or stocks we own).  The stock market will fluctuate.  No matter how much due diligence we do and how well we know a company, the stock price of that company will go down 50% or more at some point if you own it for the long haul.   That's just a fact that we have to face, and one that many people can't (and that's why they dump stocks at the wrong time!).  If that is not acceptable to us, then we simply shouldn't be investing in stocks.  

This is not fair to Admiral Stockdale, but think of bear markets as sort of the market torturing investors (losing money can't fairly be compared to physical torture).  This is what markets do.  If we hope that there won't be any more bear markets, or that we will be smart enough to get out before the next one, that is sort of like "home by Christmas" optimism and we would inevitably die of heartbreak.


  1. Brilliant thought. This,I believe is the core principle of value investing. One can learn all about companies,markets, valuation,etc. but without the understanding of and ability to cope with market vagaries, one cannot thrive as a value investor.

    1. Yes, you can be the smartest and know the most but if you can't deal with the market, you won't do well. I've seen that happen time and again. Some of the people you would think should be making the most money in the market don't at all for the above reasons; they are "home by Christmas" optimists.

      Warren Buffett is the Admiral Stockdale of the stock market; he made it (and continues to).

  2. Brilliant, kk.

    I haven't read Good to Great. But Stockdale's story reminds me Frankl's Man's Search for Meaning.

    Is there a link to Carlos Brito's video?

  3. Wow, great post! I read all of Jim Collins books, they're all great.

    This reminds me of a friend who bought JNJ shares for the "long-term". A month later, the stock price went nowhere and he hadn't received his quarterly dividend. He got frustrated and sold. Now he's considering buying those same shares again because they're higher from where he sold them. Everyone has a different perception of time I suppose.

  4. For a different perspective, I'd highly recommend "The Halo Effect".

    Tom L

    1. Thanks, that definitely looks interesting. It's great to look at counter-arguments.

    2. After reading "The Halo Effect" I realized that Jim Collins is a wonderful story teller. Many of the things that Collins points out are typically necessary but not sufficient conditions.

      Love your blog!

    3. Thanks. I'm going to have to push up this book in my reading queue. I can sort of guess where it will go and I sort of have those views about 'how to' books in general. But I came back to this one because of Carlos Brito. At least he seems to be doing something useful with it (even though he obviously does other things too).

    4. The Carlos Brito video was awesome. He is the man. Personally, I don't understand his fascination with Collins. I tried to read "Good to Great" again yesterday, but it just doesn't ring true after reading Halo Effect.

      Thank again for the great blog. Tom L

  5. Well I was unaware with the fact that the brutal facts that we have to confront are usually bear markets.

  6. Stockdale was a great man. That said, survivorship bias and small sample size are at play here. If you ask some of the other surviving POWs what the secret was, some might say it's daily prayers. Some may say it's unflinching hatred of the enemy. Others will say it's keeping a low profile.

    But check the cemetery. There are plenty of daily prayers, unflinching haters and low profilers there. And plenty of people who confronted reality while maintaining faith.

    I'm going to posit that luck plays a huge role in outcomes.

    1. That's a good point and unfortunately we can't prove or disprove a lot of things. But Stockdale lived through a lot and saw a lot and he had this to say, so I totally respect that. We can say the same with Buffett too. He keeps telling us what he did and how he did it; don't trade, don't buy crappy stocks, read a lot, focus on value, focus on moats, don't pay silly prices etc...

      And yet, we see a whole industry of people who say they do precisely that and still underperform the stock market.

      Does that make Buffett's advice worthless? To me, not at all.

      In a world where there are instant pundits, people who have done nothing and know nothing giving out a lot of advice (and making tons of money doing so), it's good to see that there are substantive, meaningful things said by people who have actually done something.

      And yes, even the advice of the greats won't guarantee success and if we have that attitude, then we can't learn from anybody at all...

      But you raise a fair point. If you can get something out of Stockdale's advice, that's great, and if you see no value in it that's fine too.

  7. Great blog, But i too think that there are many other 'brutal facts when it comes to our trading and investing outside of just bear markets. With shorting,inverse etfs and options, bear markets can be traded. I think u can apply the 'I'll be home by Christmas' as well just to daily decision making in trading, second guessing ourselves or thinking that This is the one that will make my career.That doesn't even work in baseball. You are only as good as your last homerun(good trade). That is a brutal fact.
    But again, great blog, Thnx!

  8. Hi kk,

    Any thoughts on the Gabelli Equity Trust (GAB) rights offering?


    1. Sorry, no. I don't follow GAB at all. If you like it and own it and don't mind owning more, why not subcribe? Or if it's sellable rights, you may be able to sell the rights instead of exercising it. Otherwise, it's abot how diluted you will be by not subscribing...

  9. One word: Brilliant.

  10. Everyone who thinks Jim Collins's books are good should read The Halo Effect - it basically debunks Good to Great and similar titles.

    1. I just finished it because someone else mentioned it above, and it is a good read with many good, valid points. I totally agree with most of what he says in the book. I tend not to like management books in general as I like to read more about the specific companies and people involved (business histories / bios / autobios etc.) as they dig deeper into each situation. When you try to find the common elements in each, you tend to lose a lot of information and then come up only with very general ideas.

      Having said that, this Halo Effect is something that is hard to get away from. Even if you go to lunch or dinner with very successful fund managers, CEO's, athletes, musicians or anything, you will have that effect; whatever they say will be sound more important or meaningful because of their success.

      But does that mean that you shouldn't go out and talk to or read about successful people and try to learn from them? I think not. I think it's great if you can read as much about them as possible, and yes, be aware that the same ideas can be seen as brilliant or catastrophic depending on who says it and what their track record is.

      This sort of thing happens all the time in the financial markets. Fund managers with good one year, five year or ten year track records get a lot of press etc...

      The first part of the Halo book talks about Cisco and it's a great example. But most people I was around only assumed Cisco was doing great because they were selling bullets in a world war (and nobody I know thought it would go on).

      I was thinking of making a post about the Halo Effect because it is an important idea to know about, even for investors.

      I would have concluded that these books are one reason why I tend to like focusing on people and not really the organization. I think there is more consistency in evaluation people than in evaluating firms. For example, I think the people featured in books like Market Wizards, Money Masters and other similar books (not to mention the Superinvestors of G&Dville) tend to continue to do well.

      Anyway, if I have more thoughts on the topic, I will turn this into a post because it is really interesting. And to me, it's not so simple as "Halo Effect" is good and "Good to Great" is bad, or anything like that...

  11. There seems to be much more to investing than I actually realized. After reading this I found that Investment is not as boring as I thought, it is actually fun if done with insight. No matter how optimistic one may be about investing, it all comes down to doing it the right way.


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