Sam Zell is the patron saint of contrarians and poet laureate of dumpster divers. He has one of the best track records of any real estate or distressed asset investor, and helped pioneer the use of REITs, NOLs, and other key strategies and structures. His excellent autobiography is a valuable lens from which to understand the last 50 years of economic history.
Although he built up his reputation in off the beaten path markets, his sense of macro timing is also surreal. He loaded up on multifamily properties at the bottom of the market in the 1970s. He sold out of a large portion of his holdings near the top of the market in 2007(although that story was a bit more nuanced than I realized prior to reading the book).
Here are my notes and highlights from the book:
A full throttle opportunist
This isn’t a dress rehearsal. I try to live full throttle. I believe I was put on this earth to make a difference, and to do that I have to test my limits. I look for ways to do that every day. After all, I think it was Confucius who said, “The definition of a schmuck is someone who’s reached his goals.” It’s up to me to keep moving the end zone, and go for greatness.
….At some point the guy I was sitting next to turned to me and asked, “So what do you do?” I replied, “I’m a professional opportunist.” And that has been my response to that question ever since.
Zell’s Jewish parents were on one of the last trains out of Poland, just hours before the Nazi’s bombed the train tracks and took over. Many of his ancestors perished in concentration camps. His parents reminded him of this, and it appears to have had a significant impact on his world view
Did you ever wonder how the Jews allowed the Nazis to come into Poland without taking action? I asked my father that when I was little, and I’ll never forget what he said. The Jewish community in Poland at the time was extraordinarily myopic—it had little idea what was going on in the world. And it cost most of them the ultimate price. In contrast, my father’s macro understanding of world events and the conviction to act saved the lives of my family. I apply the same strategy on a much less life-and-death scale. I rely on a macro perspective to identify opportunities and make better decisions, both in my investment activity and in leading my portfolio companies. I am always questioning, always calculating the implications of broader events. How will worldwide depressed currencies affect capital flows and world trade? Does it create opportunity for international expansion among multinational companies? What real estate needs will they have? How can we get a first-mover advantage into new markets? And on and on.
Avoiding the crowd
Zell was clearly unafraid of career risk. Several times in his career he safely sat out major bubbles, and pounced later when it all burst.
The industry has a long history of overbuilding when there’s easy money, without regard for who will occupy those spaces once they’re built. At the same time that construction cranes were dotting the horizon of every major city, the country was just starting to tip into a recession. Supply was going up and prospects for demand were not good. I was certain that we were headed toward a massive oversupply and a crash was coming. That’s when I just said, “Stop.” I was done. I stopped buying assets, started accumulating capital, and got ready for what I was sure would be the greatest buying opportunity of my career thus far. My thesis was that over the next five years, we would have the opportunity to make a fortune by acquiring distressed real estate. So I established a property management firm, First Property Management Company (FPM), to focus on distressed assets. Everyone thought I was nuts. After all, occupancies were still over 90 percent. Absorption was high. Companies were hiring. It was one of many times I would hear people tell me that I just didn’t understand.
I didn’t listen. I just stepped aside while the music was still playing. It was the biggest risk I had taken to date in my career. After all, I had a stable of investors by then. What would they think if I bowed out and the end didn’t come? That would mean I was forgoing a lot of upside for them. It was a true test of my conviction. But I had to follow the logic of supply and demand. Turns out I was right. Less than one year later, in 1974, the market crashed. Hard.
Overnight, we were buying assets at 50 cents on the dollar. At the time, financial institutions did not have to mark to market. In other words, they didn’t have to adjust the book value of their assets to the current market value those assets could actually sell for. If you were an insurance company, instead of marking to market, you could avoid taking a hit
By being contrarian, Zell avoided competition.
In 1980, Bob and I sat down and listed the reasons we didn’t like where the real estate market was headed. First, the key to our prior success had been an inefficient market. The real estate industry had always been fragmented, with valuations and projections that often varied widely. That started changing rapidly with the debut of Hewlett-Packard’s financial calculator. All of a sudden, any owner could hire an MBA with an HP-12C to run ten years of cash flows, none of which considered recessions or rent dips, and make an elaborate and sophisticated case for investment—and a bunch of eager investors would show up to check out the property.
That was not an arena we wanted to compete in. Second, up until then, lenders made long-term, fixed-rate, nonrecourse loans. But as a result of inflation in the 1970s, they got scared and switched to short-term, floating-rate loans. We believed the real money in real estate came from borrowing long-term, fixed-rate debt in an inflationary scenario that ultimately depreciated the value of the loan and increased the position of the borrower. Finally, we had always looked at the tax benefits of real estate as what you got for the lack of liquidity. All of a sudden, sellers were including a value for tax benefits in their asset pricing. So we said, “If we’ve been as successful in real estate as we have been, aren’t we really just good businessmen? And if we’re good businessmen, then why wouldn’t the same principles that apply to buying real estate apply to buying anything else?” We checked the boxes—supply and demand, barriers to entry, tax considerations—all of the criteria that governed our decisions in real estate, and didn’t see any differences. So we set a goal that we would diversify our investment portfolio to be 50 percent real estate and 50 percent non–real estate by 1990.
We narrowed our universe by targeting good asset-intensive companies with bad balance sheets, a thesis similar to real estate. We liked asset-intensive investments because if the world ended, there would be something to liquidate. The low-tech manufacturing and agricultural chemical industries were perfect fits for us—the former driven by Bob with his expertise in engineering and passion for anything mechanical.
I’ve spent my career trying to avoid its destructive consequences. Competition skews people’s assessments; as buyers get competitive, the demand for assets inflates pricing, often beyond reason. I jokingly tell people that competition is great—for you. Me, I’d rather have a natural monopoly, and if I can’t get that, I’ll take an oligopoly. Not long after we got involved with GAMI,
Micro Opportunities in Macro Events
As an investor, Zell has a unique way of combining macro insights with bottom up research.Several examples in the book highlight this. He was “all about seeing micro opportunities in macro events. For example:
In this case, the macro event was legislation similar to the impact of the Economic Recovery Tax Act of 1981 on NOLs. But I find implications for opportunity everywhere—in world events, economic news, and conversations. I’ve always been on the lookout for big-picture influencers and anomalies that will direct the course of industries and companies. But first-mover advantage requires conviction. While the rest of the radio industry was deliberating about what the telecom bill meant and how it would be implemented and whether it was a good change or a bad change, we moved and bought up
Zell’s abiliy to see the big picture gave him an edge in international investing. He was the first gringo in town buying real estate in a lot of the bigger emerging market stories of the past few decades:
This is our primary premise in international investing—the transformation of businesses into institutional platforms. We started in Mexico, then went to Brazil. Then to Colombia, India, and China. So far we’ve brought about thirty companies in fifteen countries along for the ride, with four IPOs. I’m drawn to emerging markets because of their built-in demand. I’ve always believed in buying into in-place demand rather than trying to create it. To me, international investing is largely a story of demography. Just look at population growth. Most of the developed countries (e.g., U.K., France, Japan, Spain, Italy) have aging populations and are ending each year with flat or negative population growth rates. For instance, we don’t spend much time looking at Western Europe. It’s Disneyland. It’s great for wine and castles and cheese, but there’s no growth there. Further, Europe has the largest population of pensioners in the world. The number of retirees who don’t work is close to double what we have in the U.S. and most of those European countries fund each year’s pensions from taxes. It begs the question, with a shrinking workforce where will that money come from? In contrast, most of the emerging markets (e.g., India, Mexico, Colombia, South Africa, Brazil) have younger populations and higher growth rates. And while growth rates across the board have fallen off a cliff opportunity there as well. In particular, we are drawn to Mexico. After the Fukushima nuclear disaster occurred in Japan in 2011, nearly every multinational executive I talked to was bemoaning the cost of delays and availabilities in exports coming out of Asia. I couldn’t help but think that companies would not want to get caught in that type of scenario again, so they would be looking for an alternative manufacturing option closer to home. The only logical place was Mexico. Also, Chinese labor costs were steadily rising and eroding the margin for U.S. companies to manufacture there. So we invested in a Mexican warehouse and logistics company to support what I believed to be a pretty good bet on future growth. Sure enough, within four years, Mexico was in a manufacturing boom with a double-digit increase in exports from Mexican factories. We continue to view opportunity on a global scale. I see international investing as a challenge of connecting multiple dots to reach a conclusion. My job has always been to identify the dots we should pay attention to as well as the incentives that will connect them—all to get maximum possible results
- One of Zell’s early breaks was buying massive amounts of apartments at the bottom of the market in the late 70s He outlined this thesis classic article : “The Grave Dancer”
- Sam Zell Looks Back
- A dozen things I’ve learned from Sam Zell
I was cleaning out some files and came across notes from Alibaba: The House that Jack Ma Built.
The Iron Triangle
According to this book, Ali Baba’s rise has been the result of a combination of three strengths : E-commerce, logistics and finance. The author refers to these as the “Iron Triangle”
E-commerce, logistics, finance.
Ali Bababa’s e-commerce sites offer an unparalleled variety of goods to consumers. Its logistics offering ensures those goods are delivered quickly and reliably. Finance subsidiary ensures that Alibaba can get paid via a process is easy and worry free.
One can’t help but notice that there are many companies that have one or two parts of the iron triangle, but few that have all three. Of course there were several unique characteristics of China that Jack Ma has profitably exploited. It will be interesting to see if he succeeds in bringing this model abroad to other emerging markets, and to developed markets.
China’s retail market is highly fragmented and inefficient.
“Key factor in success of e-commerce in China is the burden of real estate on traditional retailers. Land is expensive in China because it is a crucial source of income for the government. Land sales account for one-quarter of the government’s fiscal revenues. At the local government level they account for more than one-third. A prominent e-commerce executive summed it up “ because of the way our economy is structured, the government has a lot of resources. The Government decides the price of land…. The government relies too heavily on the taxes and fees associated with selling land. That almost destroyed the retail business in China, and pushed a lot of demand online. They deprived offline retailers of the opportunity to benefit from rising consumer demand- which they effectively channeled to e-commerce players. “
As a consequence, there has been far less investment in marketing, customer service, human resources or logistics in China’s traditional retail sector in the West. The result? China’s retail market is highly fragmented and inefficient. In the United States, the top 3 grocery chains account for 37% of all sales, In China they account for just 7 percent.
Despite all the shopping malls, offline retail penetration is quite low. In China there is six square feet of retail space per person, less than ¼ the amount in the US. Nature abhors a vacuum, and online retail filled in the gap left by inefficiencies.
“China’s e commerce market differs in important ways from the US and other western economies, the legacy of decades of state planning and important role played by state-owned enterprises. Alibaba has sought out and exploited inefficiencies these have creates, first in e-commerce, now in media and finance. “
Yiwu wholesale market was the template for first e-commerce operations. E commerce had started out with non-standardized products for mom and pop businesses.Lack of national supply chains removed barriers to entry that exist in west, making it possible for individuals to make a money.
Now China has greater e-commerce penetration than the US. Its always fascinating to see the leapfrogging phenomenon in action.
China post laughed at Jack Ma’s attempt to enter logistics.
Zhejiang, where Ali Baba is headquartered is now home to most of China’s largst curior companies: Shentong(STO Express), Tuantong (YTO Express), Zhongtong ZTO Express, Yunda. This small cluster, referred to as the “Tonglu Gang” delivers 50% of all packages
Note that Wells Fargo had its own parcel delivery service in California gold rush.
Having its own financial services arm, Alipay diffuses trust throughout e-commerce empire. The rise of the smartphone was huge for Ali Baba’s financial services segment. Many financial innovations happened in nearby Wenzhou.
Ali Baba exploited inefficiencies in the financial services market, just like it did with online retail. State owned banks paid little heed to needs of individuals and small businesses. Alibaba has access to entire trading history of business customers, much better position to assess credit risk than traditional banks.
Jack Ma’s story is quite inspiring for entrepreneurs.
In 1978, only 728 foreign tourists visit Hangzhou. Jack Ma went to the one hotel where foreigners went and read an English book, starting at 5 am. Every . Single. Day. He’d give free tours of West Lake to foreign tourists in exchange for English practice . He did this day for 9 years.
Long before Ali Baba, Jack Ma had an online directory business called China Pages. When he launched China Pages hardly any one in China had the internet.
Instead Jack came up with an alternative approach. First, he spread the word through friends and contact about what the Internet could do for their business. He then asked those interested to send him marketing materials to introduce their companies and products.
Then he mailed them to Seattle, had a company put them online. Then he printed out screenshots of websites and mailed them to friends.
People treated him like a con man, because he would get people to pay him $2,400(in RMB at the the then exchange rate), to design and host a website, even though the clientele couldn’t see the internet. That was a lot of money in China back then. He must have been a great salesman if he could get customers to pay that much for something they couldn’t see
Key lessons from Jack Ma’s early internet businesses
“It is difficult for an elephant to trample an ant to death as long as you can dodge well. “
More tech entrepreneurs began to emerge as China invested in telecom infrastructure. But internet bubble came and went. How did Jack Ma navigate this?
“ for Jack, the bursting of the bubble represented a great opportunity for Alibaba “ I made a call to our Hangzhou team and said “Have you heard the exciting news about the Nasdaq? … I’d like to have had a champagne on hand. This is healthy for the market, healthy for companies like us
He felt confident that now the IPO gate had closed, venture capital would stop funding Alibaba’s competitors. “In the next three months, more than sixty percent of the internet companies in China will close their doors, he said, adding that Alibaba had spent only $5 million of the $25 million it had raised. “ We haven’t touched our second round funding. “ We have lots of gasoline in our tank.”
Once the bubble burst, Alibaba started using the cash it had built up. Jack started hiring foreign talent and travelling around to tradeshows.
Tao Bao’s Iron Triangle Crushes E-Bay
Two key lessons from Ebay’s failure in China:
- Localize, Localize, Localize
- Its critical to have a faster product development cycle( this fits with John Boyd’s OODA Loop)
Ebay in China was led by foreigners and foreign educated with little knowledge of local amret. They tried to force feed American website standards.
Ebay’s arrogant disaster in China is a valuable business lesson. They continued to represent to investors that they were winning in China, but they lost disastrously. Alibaba had a faster product development cycle(ie OODA loop), and it adapted more quickly to local needs than eBay. eBay burned a lot of money. In the process, E Bay made everything look great on powerpoints and conference calls , but at odds with situation on ground.
Corporate headquarters demoralized local talent, (they ran a site called EachNet in China)
“This gap was reflected in the design of the two rivals’ websites. eBay moved quickly to align the EachNet site with its global site, revamping how products were categorized and altering the design and functionality of the website. This not not only confused customers, but also alienated a number of important merchants who saw their previously valuable China account names had been deleted. This invalidated their trading history and forced them to reapply for new names on an unfamiliar global platform. Worse still, the Chinese websites lacked a customer service telephone number. Ebay’s China site, modeled closely on eBay in the States looked foreign to local users, who found it “empty” when compared to local sites.
In website design, culture matters.
Taobao structured like local bazaar. Edge in e-commerce(see iron triangle above). Better understanding of country’s merchants. Let them do initial listings for free. Eachnet gave into short term shareholder pressure to charge for simply listing products online.
“Ebay just wouldn’t take Alibaba seriously, questioning the reliability of mounting data that showed Taobao was selling more goods than eBay in China. Taobao now had more listings, but eBay convinced itself that because these listings were free, they must be inferior. Jack vigorously rejected that thesis: “The survival and growth of Taobao are not because of the free service. 1Pao[the joint venture of Yahoo and Sina] is also free but it is nowhere close to Taobaol. Taobao is more eBay than eBay China [because] Taobao pays more attention to user experiences.”
Sensing it was over Alan Tien concluded, “Taobao’s product development cycle is much faster. Jack Ma’s right. We cannot fight on his terms.”
Jack Ma’s Iron Triangle had won.
Everybody has access to Bloomberg and Google. Every global macro investor closely follows macro data out of every country. To gain an an edge, one must look beyond headline numbers, and find underutilized datasets.
This applies when finding countries, industries, and individual companies in which to invest. Any time you want to combine top down and bottom up insights, you need to get creative with finding the right data.
Schumpeter and Perez
Joseph Schumpeter pointed out that aggregate figures “conceal more than they reveal”.
Relations between aggregates are
“entirely inadequate to teach us anything about the nature of the processes which shape their variations, aggregative theories of the business cycle must be inadequate too…”
In Technological Revolutions and Financial Capital, ( Carlota Perez emphasizes that new technological paradigms can only be analyzed by looking closely at inner workings of an economy. Within the same country, or industry some subsectors will grow at astonishingly high rates, while others decline. Perez’s framework is valuable to analyzing times of great technological change, which is basically anytime. Examples she uses include the first British Industrial Revolution( the age of Steam and Railways, the Age of steel, electricity, and heavy engineering, age of oil, automobile and mass production.
Top line numbers such as GDP or earnings could deceive an analyst, especially when looking at a new market.
Valuation and pricing
“People living through the period of paradigm transition experience real uncertainty as to the ‘right’ price of things(including that of stocks, of course).”
Extreme jumps in productivity change relative price structures in the economy. “The change in relative price structure is radical and centrifugal. Money buying electronics and telecommunications today does not have the same value as money buying furniture or automobiles.” Therefore, looking at inflation or deflation in aggregate is deceptive. Many years after Perez’ book, this now exacerbated by the Amazon effect. To some effect this may impact valuation in some industries.
Long term aggregate data, spanning multiple periods of technological change are senseless. This goes for GDP, corporate earnings etc. Yet disaggregated stats are rarely available(except during more stable phases), as Perez points out.
The internet has provided more opportunities to find disaggregated, unique, underutilized datasets. Often this means poking around on weird regulatory websites, and following up on footnotes to academic papers.
This process might be about to get a lot easier.
Google launched a new dataset search engine. I’m excited to see how its impact snowballs as more datasets are added. Although intended for journalists, it is likely to be a valuable tool for investors seeking differentiated alpha.
Of course that means today’s edge, will be tomorrow’s table stakes.
See also: The hard thing about finding easy things
King of Capital: The Remarkable Rise, Fall, and Rise Again of Steve Schwarzman and Blackstone discusses the early days of the leveraged buyouts(LBOs) and junk bonds from the vantage point of Blackstone’s founders.
In 1978, KKR did an LBO of an industrial pumps make (Houdaille Industries). There had been many small LBOS of private businesses, but no one had gone that big, done a public company. A young investment banker named Steve Schwartzman heard about the deal and realized he had to get his hands on that prospectus. “He sensed something new was afoot — a way to make fantastic profits and a new outlet for his talents, a new calling.
“I read that prospectus, looked at the capital structure, and realized the returns that could be achieved.” he recalled years later. “I said to myself, ‘This is a gold mine.’ It was like a Rosetta stone for how to do leveraged buyouts. “
Speculative Bridge Financing
It quickly became apparent how lucrative leveraged buyouts could be.
LBOs were financed with Junk Bonds. The process of issuing junk bonds was messy and cumbersome. It took most banks an extremely long time to issue bonds. Drexel was so adept at hawking junks, that companies and other banks in a deal would go forward on an LBO based solely on Drexel’s assurance that it was “highly confident” it could issue bonds. Other banks that couldn’t do that would offer short term financing, aka bridge loans, so a buyer could close a deal quickly, and then issue bonds later to repay bridge loans This alowed DLK, Merril Lynch, and First Boston to compete with Drexel in the LBO financing space.
But what if the bonds couldn’t issued? How would the bridge loan be paid for?
… bridge lending was risky for banks because they could end up stuck with inventories of large and wobbly loans if the market changed direction or the company stumbled between the time the deal was signed up and the marketing of the bonds. The peril was magnified because bridge loans bre high, junk bond-like interest rates, which ratcheted up to punishing levels if borrowers failed to retire the loans on schedule. The ratchets were meant to prod bridge borrowers to refinance quickly with junk, and up until the fall of 1989, every bridge loan issued by a major investment bank had been paid. But the ratchets began to work against the banks when the credit markets turned that fall. The rates shot so high that the borrowers couldn’t afford them, an the banks found themselves stuck with loans that were headed towards default.
In the late 80s/early 90s. several junk bond deals fell through with disastrous consequences. The $6.8 billion United airlines buyout turned out poorly. Several stores ended up going bankrupt due to a failed junk bond deal: Federated Department stores , the parent of Bloomingdale’s, Abraham & Strauss, Filene’s and Lazarus, etc. etc. First Boston nearly failed due to its exposure to junk bond deals. Blackstone mostly sidestepped the worst problems of the era, but fought hard to get refinancing in some cases, and had a couple deals jeopardized.
The Minsky view of junk bonds and LBOs
The collapse of the bridge financing market in the junk bond era illustrates a key idea in Hyman Minsky’s Financial Instability Hypothesis: the idea of three types of leverage.
How can one maximize mental performance? The Organized Mind- Thinking Straight in an Age of Information Overload by Daniel Levitin is a book that works towards an answer to this question. The book’s ideas on offloading things to external systems and organizational techniques are very similar to David Allen’s , Getting Things Done . However, The Organized Mind, provides much more historical and scientific background an context. Further, An Organized Mind avoids being overly prescriptive, and instead gives the reader ideas on how to best optimize for their own situation.
Some of my highlights on the key themes of the book:
Getting the mind into the right mode
One useful framework that the books develops is hte idea of the mind as functioning in different modes. An important component of high performance is the ability to use the right mode at the right time.
There are four components in the human attention system: the mind-wandering mode, the central executive mode, the attention filter, and the attention switch, which directs neural and metabolic resources among the mind-wandering, stay-on-task, or vigilance modes.
Remember that the mind-wandering mode and the central executive work in opposition and are mutually exclusive states; they’re like the little devil and angel standing on opposite shoulders, each trying to tempt you. While you’re working on one project, the mind-wandering devil starts thinking of all the other things going on in your life and tries to distract you. Such is the power of this task-negative network that those thoughts will churn around in your brain until you deal with them somehow. Writing them down gets them out of your head, clearing your brain of the clutter that is interfering with being able to focus on what you want to focus on. As Allen notes, “Your mind will remind you of all kinds of things when you can do.
The task-negative or mind-wandering mode is responsible for generating much useful information, but so much of it comes at the wrong time.
Creativity involves the skillful integration of this time-stopping daydreaming mode and the time-monitoring central executive mode.
Insights into how human memory works
The book delineates the nuances of human memory by comparing it to systems in the physical world.
Being able to access any memory regardless of where it is stored is what computer scientists call random access. DVDs and hard drives work this way; videotapes do not. You can jump to any spot in a movie on a DVD or hard drive by “pointing” at it. But to get to a particular point in a videotape, you need to go through every previous point first (sequential access). Our ability to randomly access our memory from multiple cues is especially powerful. Computer scientists call it relational memory. You may have heard of relational databases— that’s effectively what human memory is.
Having relational memory means that if I want to get you to think of a fire truck, I can induce the memory in many different ways. I might make the sound of a siren, or give you a verbal description (“ a large red truck with ladders on the side that typically responds to a certain kind of emergency”).
This feature can lead to either valuable insights or being overwhelmed, depending on how it is controlled:
If you are trying to retrieve a particular memory, the flood of activations can cause competition among different nodes, leaving you with a traffic jam of neural nodes trying to get through to consciousness, and you end up with nothing.
Categorization is key to mental functioning.
This ability to recognize diversity and organize it into categories is a biological reality that is absolutely essential to the organized human mind.”
Shift burdens to external systems
You might say categorizing and externalizing our memory enables us to balance the yin of our wandering thoughts with the yang of our focused execution.
A lot of time and money is wasted on unnecessary corporate meetings. Since the early days of Amazon , Jeff Bezos has taken a unique approach to meetings.
At a management offsite in the late 1990s, a team of well-intentioned junior executives stood up before top brass and gave a presentation on a problem indigenous to all large organizations: the difficulty of coordinating far-flung divisions. The junior executives recommended a variety of different techniques to foster cross group dialogue and afterward seemed proud of their own ingenuity. Then Jeff Bezos, his face red, and the blood vessel in his forehead pulsating, spoke up.
“I understand what you are saying, but you are completely wrong,” he said.
“Communication is a sign of dysfunction. It means people aren’t working together in a close, organic way. We should be trying to figure out a way for teams to communicate less with each other, not more.”
…At that meeting and in public speeches afterward, vowed to run Amazon with an emphasis on decentralization and independent decision-making. “A hierarchy isn’t responsive enough to change,” he said. “I’m still trying to get people to do occasionally what I ask. And if I was successful, maybe we wouldn’t have the right kind of company.
Bezos’s counter intuitive point was that coordination among employees wasted time, and that the people closest to problems were usually in the best position to solve them. That would come to represent something akin to the conventional wisdom in the high-tech industry over the next decade. The companies that embraced this philosophy, like Google, Amazon, and, later, Facebook, were in part drawing lessons from theories about lean and agile software development. In the seminal high-tech book The Mythical Man-Month, IBM veteran and computer science professor Frederick Brooks argued that adding manpower to complex software projects actually delayed progress. One reason was that the time and money spent on communication increased in proportion to the number of people on a project.
When you do have a meeting, make it useful
Of course, some meetings are necessary. There is value to cross-pollination of thoughts among intelligent people. Some processes do require explicit coordination and discussion. However, in practice, many hours are wasted on routine updates, grandstanding, and “thinking out loud”. To ensure meetings were productive Bezos required the person who leads a meeting to write detailed prose explaining their thoughts. The first half hour or so of every meeting would be silent reading time. This ensured everyone thought deeply and expressed complete thoughts cogently.
Meetings no longer started with someone standing up and commanding the floor as they had previously at Amazon and everywhere else throughout the corporate land. Instead, the narratives were passed out and everyone sat quietly reading the document for fifteen minutes—or longer. At the beginning, there was no page limit, an omission that Diego Piacentini recalled as “painful” and that led to several weeks of employees churning out papers as long as sixty pages. Quickly there was a supplemental decree: a six-page limit on narratives, with additional room for footnotes.
“History Repeats. The first time as a tragedy, the second time as a farce.”
– Karl Marx(1)
There are amusing parallels between the rise and fall of the real estate private partnership market in the 1980s, the pre financial crisis tenant in common(TIC) syndication market, and the post financial crisis non-traded REIT market driven by Nick Schorsch and his AR Global empire.
Each episode involved high fee investment products designed to fulfill investor desires for yield, tax efficiency and perceived stability, while creating disproportionate benefits for intermediaries. Each episode ended badly. And the cycle repeats, again and again.
First of all, the charts tell parallel stories:
Real Estate Limited Partnerships 1970-1991
TIC Equity raised 2001-2012:
Non-traded REIT Equity Raise 2000-2016:
Source: Stanger Report, author’s calculations based on SEC filings.
Note that the 2015-2016 dropoff would be much sharper if you excluded Blackstone’s REIT, which entered the wirehouse channel in late 2016, and accounted for 50% of total annual NT REIT sales within a few months. Sales to the independent broker dealer(IBD) channel, which Blackstone largely bypasses, were completely decimated, and the dropoff has accelerated in 2017. (2)
High fee products are sold, not bought. The commissions on illiquid real estate products have always been higher than other investments available to retail investors.
In Serpent on the Rock Eichenwald traces the original real estate partnership craze back to the May 1, 1975 abandonment of fixed commissions on sale of stocks and bonds. Yes it is viciously ironic that commissions were fixed before 1975. The financial services industry was apparently afraid of capitalist competition and all the wonderful creative destruction it brings. Once they lost large commissions on simple security trades, they went looking through more complex higher fee product.
After May Day:
No longer could brokerage firms subsidize their bloated through fat commissions on securities trades. Firms unable to adjust collapsed by the dozens. The industry had to either dramatically cut back expenses or find new products with higher commissions that could be pumped through the sales force. Suddenly tax shelters, which sold for higher commissions than stocks and bonds didn’t look so unappealing.
The impact of May Day has continued to drive down commissions decades later. This makes sense. After all, transactional costs should approach zero over the long run, because with computers the marginal cost of doing a trade in all but the most illiquid complex markets is effectively zero. Significant scale and technological investment is necessary to run a brokerage business focused on liquid markets.
Consequently, the current IBD ecosystem is highly dependent on non-traded REITs and other high fee direct private placement programs. This is complicated by the fact that IBDs payout a high proportion of commissions to the financial advisers(like 90% in many cases). Many financial advisers built their business on 1031 exchanges, non-traded REITs or other private placements. TICs typically charged 20-30% commissions. Commissions eat up a large portion of offering proceeds for non-traded REITs. Additionally, non-traded REIT sponsors pay out a due diligence kickback to broker dealer home offices. Many smaller IBDs depend on these kickbacks for survival.
Of course, the commissions were much more egregious the first time around. Old timers fondly remember 20%+ loads on product. up front sales loads have now declined to high single digits and low double digits. Inland has driven down commissions on 1031 exchange product. Plus state securities regulators put out NASAA guidelines to limit loads on registered products. Nonetheless in an age where interactive Brokers charges $1 per side on a trade regardless of size, and few modern brokerages charge more than $7 per trade, even high single digit sales loads on non-traded retail product are absurd.
In Backstage Wall Street Josh Brown outlines his “Iron law of product compensation”：
The higher the commission or selling concession a broker is paid to sell a product, the worse that product will be for his or her clients.
This was the thread that connects the 1980s private partnership craze, with the pre financial crisis TIC explosion and the post financial crisis non-traded REIT market.
Yield Pig Exploitation and the Illusion of Safety
Just like private partnerships in the 1970s and 1980s, brokers sold TICs and Non-traded REITs to unsophisticated yield hungry retirees as safe, stable investments.
Here is one description of the private partnership market:
Many of the public offerings were promoted as a way for the small investor to participate in real estate, widely believed to be an inflation hedge, offering greater return and moderate risk as compared to stocks. The ability for an individual of modest net worth or income to invest in securitized real estate was viewed as a real benefit of public syndications.
The limited partners were sold their investments on the assumption that real estate was a safe, growing investment. Often these investors were unsophisticated in investment matters, and were more often swayed by aggressive brokerage salesmanship. The importance of liquidity became apparent to the investors only after substantial investment had already occurred. Liquidity was never promised for limited partnership securities and the partnership structure itself was designed to constrain liquidity.
In Serpent on the Rock Eichenwald meticulously tracked the juxtaposition between sales materials promising safety and the ultimate collapse in values.Non-traded REITs and TICs are also sold as safe investments that do not have the volatility of the stock market. Of course the stability is an illusion, and investors are still highly dependent on the real estate performance.
Eichenwald describes due diligence at Prudentialduring the peak of the private partnership craze:
The due diligence team was not just overwhelmed from the number new deals they had to approve- they also had to keep tabs on the old deals that had already been sold. Darr had negotiated for Bache to be paid a monitoring fee from some tax shelters it sold in exchange for reviewing their financial performance. Supposedly, this was designed to make sure that the general partners managing the deals did things right and took care of their investors. It was a key selling point for Bache brokers: In sales pitches, they painted a picture of top Bache financiers in green eyeshades peering over the shoulders of the General partners, watching everything that was done, The image of financial professionals crunching numbers late into the night to make sure investors were protected was a persuasive marketing tool.
But asset monitoring paid only a small fraction of the fees that Bache received from selling new deals. So the job of keeping an eye on the performance of old shelters quickly became viewed as simply a headache. It was an obligation that slowed down the whole process of churning out deals., without enough juice from fees to make up for the effort. The monitoring assignment became a hot potato, passed from executive to subordinates, and from then on down the line.
Many similar scenes in the book are shockingly familiar to anyone who has worked in the alternative investments space.
In subsequent years, third party due diligence firms serving broker dealers helped drive improvements in deal quality, but there are still many serious gaps. Since IBDs depend on the revenue from commissions and due diligence kickbacks, they are under pressure to find product to approve. This bias leads to cognitive dissonance. As non fiduciary middlemen, they often sell things that they wouldn’t invest in themselves, especially with a full sales load.
In the wake of the bankruptcy of TIC Sponsor DBSI, and the collapse of several tax driven energy deals, Reuters investigated due diligence in the independent broker dealer space. It highlighted a too cozy relationship between sponsors and third party due diligence firms.
Perhaps of even greater concern is the disconnect between due diligence process and the needs of end investors.
Potentially alarming findings are often obscured in multiple pages of recondite language, with no definitive conclusions. “They’re these long-winded things that bury things that might be important inside boilerplate disclosures,” said Jennifer Johnson, a professor at Lewis & Clark Law School in Portland, Oregon, who has written extensively about the private-placement business.
Due diligence firms say their reports aren’t designed to be read or understood by investors. Rather, they are meant to help brokers decide whether to recommend private placements to their customers.
Same Same, But Different
Although the distorted incentives,exploitation of unsophisticated yield pigs,were almost identical in each of the three historical examples in this post, there are several key differences. Broker dealers primarily sold private partnerships in the 1980s as a way of reducing taxes. An investor can use a TIC structure as part of a 1031 exchange to delay taxes when selling a property. REITS are a unique IRS creation but the reason for investing in a REIT is mainly income(Excluding situations where someone exchanges via an UPREIT transaction)
The private partnership market collapsed because the tax reform act of 1986 destroyed their entire structure, and basically collapsed the national real estate market. (see: this FDIC report )
The TIC market collapsed when the financial crisis hit the entire real estate market, exposing the problematic underwriting of the TIC Sponsors. However, regulatory issues weren’t the main driver of the collapse. Like the private partnership craze in the 1980s, the modern Non-traded REIT market also collapsed due to regulatory change although the . Finra 15-02, which increased the transparency on client statements, made it harder for advisors to get away with charging the massive sales loads. The fiduciary standard required broker-dealers to act in the best interest of clients, also led many broker-dealers to suspend or slow down the sales of high commission products.
The farce of AR Global’s collapse
Although private partnerships and TIC sponsors generally overpaid for properties they purchased, the collapse of their structures happened during a time of across the board real estate declines in the US
In contrast, investors in post financial crisis vintage non-traded REITs have suffered, in spite of a buoyant real estate market. ARC Hospitality(Now Hospitality Investors Trust) offered shares at $25.00 a share from 2013-2015, and a client statement never would have shown a value below $22.00 until this summer. It revalued at $13.20. A PE fund recently offered $5.53 for the shares. Likewise ARC Healthcare Trust III sold shares $25.00, and recently marked its value down to $17.64, and is now subject to an affiliated transaction with no liquidity event in site.
Private partnerships and TICs were tragedies, AR Global was a farce.
To be continued….
(1) This is from The Eighteenth Brumaire of Louis Napolean.
The full translated quote is :Hegel remarks somewhere that all great world-historic facts and personages appear, so to speak, twice. He forgot to add: the first time as tragedy, the second time as farce.
(2) Wirehouses generally did not sell non-traded REITs until Blackstone entered the market in 2016 Anyone who carefully read The Serpent on the Rock will note how incredibly ironic it is that wirehouses have started to sell non-traded real estate securities again. More on his in a future post.
Smartcuts: How Hackers, Innovators, and Icons Accelerate Success is a book about the power of lateral thinking- solving problems through an indirect or creative approach. “Smartcuts” means sustainable success achieved through smart work. This is different than “shortcuts”, which are rapid, but short term gains. Ultimately the book outlines 9 key ideas, that lead up to the concept of “10x thinking”.
#1 Hacking the Ladder
Find sideways paths, like the warp pipes in Super Mario that allows someone to beat the game in seconds, not hours.
#2 Train with Masters
Find mentors, and/or study the greats. Shoe designer Dwayne Edwards stole discarded shoes so he could study and draw the designs. This helped him develop the ability to notice tiny design details in shoes.
#3 Rapid Feedback
Rapid feedback accelerates learning. This has been critical to a lot of companies that have a website as their main product. In this book, the example of Upworthy illustrates the point. Turn work into rapid scientific experiments, and depersonalized feedback.
Tools and technology that people can buid off of. a platform “amplifies the effort and teaches skills in the process of using it.“ Key example: development of Ruby on Rails as a programming language.
Platforms are how Twitter could build Twitter in mere days while running a separate company. And Platforms are why Finland made all its teachers get a Master’s degrees and its students learn with hands-on tools that made learning better.
#5 Catching waves
The world’s best surfers arrive at the beach hours before a competition and stare at the ocean. This is a valuable metaphor for a lot of things in business and life.
“Intuition is the result of nonconscious pattern recognition,” ….. However, research shows, that we can also see patterns just as well by deliberately looking for them. Deliberate pattern spotting can compensate for experience. “but often people don’t even try it”
Budgeted Experimentation helps business avoid being disrupted, by helping them harness waves on which younger competitors might otherwise used to ride past them. Its helped companies like Google, 3M, Flickr, Conde Nast, and NPR remain innovative even as peer companies plateaued. In contrast, companies that are too focused on defending their current business practice and to fearful to experiment often get overtaken.
Key example of what to avoid: Kodak
Key example: Che Guevera taking control of the radio, using it as a way of promoting Castro’s revolution to a much wider audience than otherwise possible.
Build up potential energy, and amplify unexpected opportunities.
The key feature of disruptively innovative products is cost savings(either time or money). But the key ingredient behind the scenes of every disruptive product is simplification.
Examples, email, USB Drives, Cars.(Henry Ford kept complexity under the hood).
Key example: Sherlock Holmes. He focused on what he needed to know, knowing how to figure out what he didn’t know, and forgetting about everything else.
#9 10x thinking
This quote from Astro Teller is key:
Its often easier to make something 10 times better than it is to make it 10 percent better…. In order to get really big improvements you usually have to start over in one or more ways. You have to break some of the basic assumptions and, of course, you can’t know ahead of time. Its by definition counter intuitive.
This means getting to first principles. 10x thinking forces you to come up with smartcuts.
10x thinking is probably now essential for survival in the modern economy.
Most innovation inside industries and companies today focuses on making faster horses, not automobiles.
This is why the innovator’s dilemma destroy’s so many companies. What replaces them is something better. Creative destruction is a beautiful thing.
Louis L’amour was an autodidact’s autodidact. John Wayne called him the most interesting man in the world. L’amour spent the first couple decades of his adulthood wandering across the country, and around the world, doing odd jobs, and obsessively reading whatever he could find. Only much later did he become a famous novelist. Education of a Wandering Man is a quasi-autobiography, in which he describes the trajectory of his life, and the evolution of his thinking in terms of the places he traveled and the books he read.
L’amour spent years as a hobo, hopping trains from town to town, working various jobs. In each town he would visit the local library.
Its important to note, that unlike a bum, a hobo is ready and willing to work.
To properly understand the situation in America before the Depression, one must realize there was great demand for seasonal labor, and much of this was supplied by men called hoboes.
Over the years the terms applied to wanderers have been confused until all meaning has been lost. To begin with, a bum was a local man who did not want to work. A tramp was a wanderer of the same kind, but a hobo was a wandering worker and essential to the nation’s economy.
…Many hoboes would start working the harvest in Texas, and follow the ripening grain north through Oklahoma, Kansas, and Nebraska into the Dakotas. During harvest season ,when the demand for farm labor was great, the freight trains permitted the hoboes to ride, as the railroads were to ship the harvested grain, and it was in their interest to see that labor was provided.”
He also worked on merchant ships, and traveled throughout Asia and most of the world. He would find books for free or cheap wherever he went, reading 100+ books per year. For example:
Byron’s Don Juan I read on an Arab dhow sailing north from Aden up the Red Sea to Port Tewfik on the Suez Canal. Boswell’s The Life of Samuel Johnson (Penguin Classics) I read while broke and on the beach in San Pedro. In Singapore, I came upon a copy of Annals and Antiquities of Rajasthan, Vol. 1 of 3: Or the Central and Western Rajput States of India (Classic Reprint) by James Tod.
Although he didn’t have real formal degrees, L’amour understood the value of books and knowledge:
Books are precious things, but more than that, they are the strong backbone of civilization. They are the thread upon which it all hangs, and they can save us when all else is lost.
…Knowledge is like money: To be of value it must circulate, and in circulating it can increase in quantity and hopefully, in value. “
He wrote 89 novels, and clearly a lot of ideas came from paying close attention when he travelled:
People are forever asking me where I get my ideas, but one has only to listen, to look, and to live with awareness. As I have said in several of my stories, all men look, but so few can see. It is all there, waiting for any passerby.”
… for a writer, everything is grist for the mill, and a writer cannot know too much. Sooner or later everything he does know will find its uses.
As with reading, L’amour never let the challenges of a transient lifestyle interfere with writing:
“I began my writing in ship’s fo’c’sles, bunkhouses, hotel rooms- wherever I could sit down with a pen and something to write on.”
L’amour also spent time boxing in various small towns, and coaching other fighters. I’ve seen reference online to a 51-8 professional record, although I wasn’t able to verify it.
In the later years of his life L’amour spent more time in his personal library. His deep knowledge of the world gave him perspective:
Surely, the citizens and the rulers of Babylon and Rome did not see themselves as a passing phase. Each in its time believed it was the end-all of the world’s progression. I have no such feeling. Each age is a day that is dying, each one a dream that is fading.
In Grinding It Out: The Making of McDonald’s Ray Kroc tells the story of how he built McDonalds into a behemoth. The key themes that run through it are his persistence and obsessive attention to detail. There are also some interesting strategic insights on how he views store operators differently than the typical franchise business, and how he selected real estate locations. If the book is too long, there is also a movie, and a country music song telling the same general story. The book is unique, however, since it provies a direct view into Ray Kroc’s thought process.
One of the basic decisions I made in this period affected the ehart of my franchise system and how it would develop. That was that the corporation was not going to get involved in being a supplier for its operators. My belef was that I had to help the individual operator succeed in every way I could. His success would insure my success. But I couldn’t do that and, at the same time, treat him a a customer.
There is a basic conflict in trying to treat a man as a partner on the one hand while selling him something at a profit on the other. Once you get into the supply business, you become more concerned about what you are making on sales to your franchisee than with how his sales are doing. The temptation coud become very strong to dilute the quality of what you are selling him in order to increase your profit. This would have a negative effect on your franchiesees business, and ultimately, of course, on yours. Many franchise systems came along after us and tried to be suppliers, and they got into severe business and financial difficulty. Our method enabled us to build a sophisticated system of purchasing that allows the operator to get his suplies at rock-bottom prices. As it turned out, my instinct helped us avoid some antitrust problems some other franchise operators got into.
On selecting locations for new stores:
Back in the days when we first got a company airplane, we used to spot good locations for McDonald’s stores by flying over a community and looking for schools and church steeples. After we got a general picture from the air, we’d follow up wit h a site survery. Now we use a helicopter, and its ideal. Scarceley a month goes by that I don’t get reports from whatever districts happen to be using our five copters on some new locations that we would never have discovered otherwise. We have a computer in Oak Brook tat is designed to make real estate surveys. But those printouts are of no use to me. After we find a promising location, I drive around it in a car, go to the corner saloon and into the neighborhood supermarket. I mingle with the people and observe their comings and goings. That twlls me what I need to know about how a McDonald’s store would do there.