Thursday, December 24, 2009

Margin of Safety: My most favorite insight of 2009

2009 was a year of severe economic depression. It is no surprise that I began to appreciate a concept called Margin of safety a lot more during 2009. What is Margin of Safety? And who was its father? Let’s explore these questions in this article.

Warren Buffett’s guru Benjamin Graham introduced the concept of “margin of safety” (MOS) in a seminal book “Security Analysis” published three quarters of a century ago (in 1934) in the middle of Great depression. Warren (who himself was born during great depression in 1930) explains MOS as follows: Our best ideas haven’t done better than others’ best ideas, but we’ve lost less. We’ve never gone two steps forward and then one back – may be just a fraction of a step back. Well, this last line, never going two steps forward and then one back, sums up what margin of safety means.

Most of us learn about MOS (or lack of MOS) early in our childhood when we play the game of snakes-and-ladders. We know that even if you have climbed several ladders and reached the 92nd position, the snake on 94th position can bring you back all the way down to 4th position. Perhaps Tiger Woods never played snakes-and-ladders when he was a kid. Perhaps he did but he climbed so many ladders in the past two decades without hitting a snake that he forgot that he is actually playing snakes-and-ladders.

Nassim Taleb calls the snake, especially the long snakes, “Negative black swan” in his bestselling book Black Swan and we saw earlier that being aware of the possibility of snake ahead is extremely important in innovation. We saw how Thomas Edison lost a decade worth of work in no time due to hitting upon a snake.

Incidentally, Benjamin Graham, like Tiger Woods, was also popular among girls. But he was wise enough not to create a brand out of his character. You and I may not consider anything wrong with having many girlfriends. Unfortunately, you and I don’t count that much when it comes to being a brand ambassador. Society counts and more importantly media counts.

Have you climbed too many ladders in the recent past? Then you better take a stock of the snakes ahead. And best is to avoid games with potentially long snakes. As Buffett’s partner Charlie Munger says, “Tell me where I am going to die, so I don’t go there.” And what if I can’t avoid “going there” like Tiger Woods? Then use Taleb’s suggestion and – Try to reduce snake-slide through redundancy, more insurance, more cash and less leverage.

Have a great 2010!

Tuesday, December 15, 2009

Thomas Edison and the patent paradox

With 1093 patents to his credit Edison has been an undisputed king of the patent world. At least a third of these patents have been related to incandescent lamps, generation and distribution of electricity. So one would expect that the electricity related patents might have been Edison’s greatest assets. Now, contrast this understanding with a remark from his biography Edison his life and inventions - Edison confesses that he has never made a cent out of his patents in electric light and power—in fact, that they have been an expense to him, and thus a free gift to the world. It is like Sachin Tendulkar saying all those centuries didn’t help India win. Is there some kind of paradox here? After all, aren’t patents supposed to create temporary monopolies? And if you have a few hundred, shouldn’t you be in a good position to beat competition? Then why didn’t Edison make any money in electricity business? Let’s explore the paradox which we call “patent paradox” in this article.

Now let’s start with the cynical proverb referred in Edison’s biography – A patent is merely a title to a lawsuit. How much money did Edison and his companies put in patent litigation? Upwards of two million dollars involving over two hundred lawsuits. That’s a lot of money, lawsuits and energy! The filament patent (part of light bulb) was the star attraction for legal battles resulting in over six thousand pages of legal record. So there was a lot of waste of paper too! The biography says - Every conceivable phase of ingenuity that could be devised by technical experts was exercised in the attempt to show that Edison had accomplished nothing new. Edison won but at a huge cost. Edison wasn’t dumb. So why did he go after patents? Let’s do a quick summary on what and why of patenting from patent FAQ at World Intellectual Property Organization.

What does a patent do?

It provides an exclusive right to the inventor without whose consent the invention can’t be commercially made, used, distributed or sold.

Why are patents necessary?

Patents provide incentives to individuals by offering them recognition for their creativity and material reward for their marketable inventions. These incentives encourage innovation, which assures that the quality of human life is continuously enhanced.

Nobody can deny the benefits patents offer to society. But how about the patent holder? Is everything hunky-dory for the patent holder?

Well, not really. Richard Tedlow, a business history professor at Harvard, points out three perils associated with patents in his book Giants of Enterprise. First, as we saw earlier they generate lawsuits. Second, a patent is a public document tipping off the rest of the industry to the company’s direction. Third, if a patent can be “invented around,” the information may cost the company dearly.

In technology based innovations, patents are essential. However, they are certainly not sufficient in keeping competitors at bay. As Peter Drucker pointed out a quarter of a century ago in his book Innovation and EntrepreneurshipBright ideas are the riskiest and least successful source of innovative opportunities. The casualty rate is enormous. No more than one out of every hundred patents for an innovation earns enough to pay back development costs and patent fees. A far smaller proportion, perhaps as low as one in five hundred, makes any money above its out-of-pocket costs.

What should systematic innovators do then? We will look at how one contemporary of Edison successfully resolved the patent paradox in the next article.

Monday, December 14, 2009

Edison’s Folly and understanding the exposure to negative black swan

What is the worst nightmare of an innovator? We may think it is a fear that the innovation may not take off. But we are wrong. The worst nightmare of an innovator is blowing up big time. Losing not only the investment made towards the innovation but much more. Falling so hard that you don’t get up again, ever. Hence, guarding against a possible “blow-up” is a critical piece of systematic innovation.

Before understanding how to guard against a potential blow-up, let’s understand a “blow-up” through a story commonly known as Edison’s Folly (given step-wise below).

1. By 1887, Edison had grown increasing bored with his electricity business as the business model was proven, competition intensified and legal battles became a norm. Edison developed interest in ore separation process as he saw the high price he had to pay for high-grade steel while building big electric generators and dynamos.

2. Edison starts experiments and files for 5 patents in 1887 improving the process of making high-grade iron ore from low-grade ore. He also writes his ideas in a magazine Iron Age. Mining experts dismiss the idea. A follow-up editorial labels the concept “Edison’s Folly”. Edison founds Edison Ore-Milling Company.

3. In 1889 he finds right kind of deposits on a mountaintop in the rural village of Ogdensburg on the northwest corner of New Jersey. He finds an investor Walter Mallory from Chicago and also puts in more than million dollars of his own money. He told his stockholders that “the sixteen thousand acres of land [at Ogdensburg] will supply the world with all of its ore requirements for seventeen years and the U.S. for seventy years!” Edison & Mallory purchase the land with stockholder approval.

4. Operation begins by fall of 1891. The mill and its machinery simply weren’t up to the task. The crushing rollers were not heavy or strong enough and often broke loose, endangering workers. Ore dust penetrated everything. The bulky steel conveyor system constantly jammed. In the following years nine workers were killed and many more seriously injured by loose, catapulting machinery.

5. Edison sells his electricity business to form GE and gets 12,000 shares. Sells the shares and puts most of the money into ore-milling business.

6. Plat shuts down due to depression in 1893. Edison goes back to his lab and during the idle time files more patents. By 1895 he is back at Ogdensburg armed with $250,000 and a box of new patents, drawings, and blueprints.

7. By 1898 the machinery starts to run dependably at last. A thousand tons of ore a day were being shipped out; if this volume could be continued and ore prices remained stable, the first operating profits might be just around the corner.

8. By 1899 the process matures further and Edison is able to offer a high-grade ore at $4.75/ton as against $7/ton of competition.

9. In 1898, two brothers had stumbled onto the great Mesabi Range in the northern Minnesota wilderness, hundreds of square miles of purest iron ore in the world. It needed only to be scooped from the ground and sent directly to the furnaces. By 1899 Mesabi starts delivering high-grade ore at $2.75/ton.

10. Edison finally closes the shop in 1900.

Nassim Taleb refers to the event such as “finding of high-grade ore in Mesabi” a negative black-swan. You can lose a decade worth of work in no time. We saw earlier that humans are very poor at predicting black swans. Question is – Was Edison aware of the exposure he had to a negative black swan? We don’t know. But I believe it is important for innovators to understand this exposure.

Warren Buffett when asked “What are the fundamental qualities of your successor?” has said, “I hope he is aware that 25 x 23 x 17 x 20 x … x 0 = 0; you had better be aware of introducing a zero in a series. In other words, we need someone genetically programmed to recognize and avoid serious risks.” Question is – is this quality, like Buffett says, really part of your genes? or can it be learned?

Related article: Pre-mortem: Tell me where I’m going to die, so I don’t go there.

William Denny and world’s first and pioneering idea management system

We looked at the evolution of a 50+ years old idea management system at Toyota. We also looked at benchmark data from idea management systems in India for the last few years. We observed that this benchmark data suggests that these suggestion systems are geared towards efficiency improvement only. Has efficiency improvement the only objective of idea management systems in the past? What were some of the oldest idea management systems like? What were the rules? What were the rewards? Let’s explore these questions with an example of a pioneering system introduced by William Denny of Scotland in his shipyard in 1880.

In Corporate Creativity, Alan Robinson and Sam Stern trace the history of idea management systems. About William Denny and his system, they write:

In 1864, at the age of sixteen, William Denny began a five-year apprenticeship in his father’s shipyard in Dumbarton, Scotland. He worked in the yard for twelve hours each day and upon returning home, studied for two more. In this way, he not only learned about shipbuilding but came to know well the workforce and the working conditions in the company.

On his twenty-first birthday, Denny was made a partner in the firm, and he soon set about overhauling the shipyard’s management practices, a project that would occupy him for twelve years. The systems he devised were described in a set of rules, a copy of which was distributed to every employee in the shipyard. These comprehensive rules were divided into five categories, one of which was “Rules for the awards committee to guide them in rewarding the workmen for inventions and improvements”.

This system was started in 1880 and quickly proved to be a success. To run it, he set up a two-people awards committee consisting of a member of engineering department and one person from outside the company, who also acted as a chairman. The rules were as follows:

An employee (exclusive of head foremen, officials of Awards Committee, and heads of departments) may claim an award from the committee on the following grounds:

1. That he has either invented or introduced a new machine or hand tool into their works

2. That he has improved any existing machine or hand tool

3. That he has applied any existing machine or hand tool to a new class of work

4. That he has discovered or introduced any new method of carrying on or arranging work

5. That he has invented or introduced any appliance for the prevention of accidents

6. That he has suggested some means by which waste of material may be avoiced

7. Or generally, that he has made any change by which work is rendered either superior in quality or more economical in cost.

Cash award from £2 to £15 were paid for each accepted idea, according to the committee’s estimate of its worth. If an idea was patentable, the rules stated that the company would give the inventor £15 and pay all expenses necessary to obtain a patent in inventor’s name. Other than the stipulation that the company should have free use of the idea, the inventor was free to pursue any other opportunities that might result from his patent. In 1884, a further incentive was added: award money would be doubled for any employee submitting five or more ideas.

By 1887, more than 600 ideas had been received, 196 of which had been accepted and award monies of £933 had been paid out. The company also built world’s first commercial ship model experiment tank in 1882. Dumbarton has a museum showcasing this tank and hosting exhibitions such as “Denny: innovation and experimentation”.

Sunday, December 13, 2009

Idea communication: The Edison way

In a previous article we looked at Thomas Edison’s method of innovation. As Edison’s innovation factory churned out incremental and radical innovations, Edison had to communicate his ideas to various stakeholders like the technicians in the factory, investors, patent officers, journalists and of course, potential users. What kind of methods did Edison employ in communicating his ideas? Let’s take a look in this article.

· Sketches: Henry Ford writes in Edison as I know him - If there is anything to be made or an experiment is to be conducted in a certain way, he draws a diagram in such clear, quick fashion that no further explanation is necessary. The speed with which Mr. Edison does all this is remarkable. He sketched the model of his first phonograph in less than five minutes.

· Analogies: We saw how Edison pursued the analogy of subdividing electric light so that it can be used like gas in small units (eventually turned out to be independent bulbs). Note that the analogy was not restricted to technical features alone. Edison established price points for electricity distribution based gas system comparison. On another occasion, Edison wondered, “Can we do to eye, what phonograph did to the ears?” (the innovation he worked on was motion picture camera).

· Use-cases: Edison invented phonograph in 1877. He articulated 10 possible uses of the phonograph in North American Review in 1878. They were: (1) Letter writing / dictation (2) Audio books (speaking to blind) (3) Teaching of elocution (4) Reproduction of music (5) Family record – sayings from members of family (6) Music boxes / toys (7) Clocks announcing going home, going for meals (8) Preservation of language (9) Education (10) Connection with telephone. Note that Edison suspended phonograph for almost 8 years in 1978 to focus on electricity.

· Prototypes: Demonstrating his prototypes was Edison’s pet method of attracting investments and publicity. Here is how he narrates his experience with Phonograph sometime in 1877 - That morning I took it over to New York and walked into the office of the Scientific American, went up to Mr. Beach's desk, and said I had something to show him. He asked what it was. I told him I had a machine that would record and reproduce the human voice. I opened the package, set up the machine and recited, 'Mary had a little lamb,' etc. Then I reproduced it so that it could be heard all over the room. They kept me at it until the crowd got so great Mr. Beach was afraid the floor would collapse; and we were compelled to stop. The papers next morning contained columns. (source: Edison his life and inventions)

Sunday, December 6, 2009

Idea management systems in India: Benchmark data from INSSAN

We looked at how idea management evolved at Toyota over 40 years from 1951 to 1989 cumulatively generating 20 million ideas. A natural question that comes to mind is: what is the industry benchmark?

I recently became a member of a 20 year old organization called Indian National Suggestion Scheme Association (INSSAN for short). This is a not-for-profit organization promoting and benchmarking employee suggestion schemes in the Indian industry. INSSAN bulletin for October 2008 – March 2009 (vol 20) gives the two tables shown above and below. This is the cumulative data for 18 organizations which shared their annual data on creative ideas coming from employees with INSSAN.

A few observations

· Scope of innovation: Impact of these suggestions is measured in “cost savings”. This is an important aspect of innovation. However, this means that the ideas entered in these systems are restricted to process improvements and not related to other 3 types of innovations (product, customer experience and business model). Perhaps these organizations use another mechanism for tracking these different types of ideas.

· Capacity of idea generation: On an average, number of ideas per person per year has improved from 3 in 2005 to 6 in 2008. For TVS Motors, this number is at 66 i.e. little over 1 idea per week per employee.

· Award per accepted suggestion at HAL, Bangalore is 80 times the average (HAL: Rs.7608, avg: Rs.93). Saving achieved per accepted suggestion is extremely high at HAL, Bangalore (Rs. 2.6 Crore) compared to average of Rs. 24,176. We don’t know whether this means that the standard of suggestions is very high at HAL or a few killer suggestions came this year.

· Idea acceptance rate: In case of, No of suggestions accepted out of number of suggestions received, a number of organizations (Maruti Suzuki, HAL, Godfrey Philips India, BEL) are at 100%. This is good as far as employee morale concerned. However, when the scope of innovation includes all types of innovations, this should look more like a funnel. For example, ex-CEO of P&G A G Lafley says in Game-Changer that for every 100 ideas that are received, 1 reaches the market. However, for every 2 ideas that reach the market, 1 succeeds. AG feels that the batting average (final success rate) shouldn’t exceed 70%. If it does, it would imply that employees are not taking enough risks. And that’s not good for innovation productivity.