Warren Buffett’s biggest mistake and the psychology of decision making

When Warren Buffett speaks it appears as though an old sage is speaking. And yet he is so fond of talking about his fallibility. During his first India visit this week, he said in an interview with ET, “I have made plenty of mistakes. Over the last 60 years, sometimes I have misread the future. [And] that’s gonna happen to me again in the future”. Interestingly his biggest mistake didn’t happen because he misread the future. It happened because he got mad at the person on the other side and ended up buying instead of selling. How did that happen? And what were its implications for Buffett? Let's see in brief below.

Berkshire Hathaway (BH) was formed in 1954 in New Bedford, New England from the merger of two textile mills each of which traces its origin to 19^th century. By the time Buffett’s buddy Dan Cowin from Graham-circle suggested him the idea of buying BH, it was making losses for over a decade. However, BH was interesting to Buffett because it was selling cheap. According to its accountants it was worth $22 million as a business or $19.46 per share. And yet, you could buy a share for just $7.50. BH’s President Seabury Stanton knew this as well and whenever he would close a mill and sell its assets, he would issue a tender to buy-back shares. So Buffett devised a strategy to buy BH on a low tide and sell whenever Stanton issues a tender for stock purchase at some profit. The point is Buffett started buying BH not for keeping it forever but for selling it.

In his usual style, Buffett drove up to New Bedford one day to see the place for himself. When Buffett was reluctantly ushered into Stanton’s palatially furnished, ballroom-size office, he saw that there was no place anywhere near Stanton’s desk to sit. The seventy one year old six-feet two niches Stanton was used to summoning people to stand before him while he sat behind his desk. The two men seated themselves at the uncomfortable rectangular glass conference table in a corner and Stanton asked Buffett at which price would he sell when the next tender comes up. Buffett said, “I‘d sell at $11.50 a share if it’s in the reasonably near future”. However, when Buffett actually received the tender letter back in Omaha a few weeks later, Stanton had quoted $11 3/8. Buffett felt Stanton cheated him for 12.5 cents less per share. He got furious and decided he would buy a controlling stake of BH and fire Stanton. And that’s what he ended up doing.

Unfortunately, what Buffett got at the end of the heroic act was a lousy business. This is how Buffett remembers what happened next in his 2010 letter to shareholders, “The dumbest thing I could have done was to pursue “opportunities” to improve and expand the existing textile operation – so for years that’s exactly what I did. And then, in a final burst of brilliance, I went out and bought another textile company. Aaaaaaargh! Eventually I came to my senses, heading first into insurance and then into other industries.” No wonder when MBA students at University of Georgia asked him about his mistakes, he said, “Number one is Berkshire Hathaway”

Elephant-Rider model we looked at earlier tells us that our decisions are mostly governed by the Elephant side of our thinking. And the Elephant is emotional. And when emotion takes over, the tiny Rider which is the rational side of our thinking has no chance of influencing the decision. This Warren Buffett story illustrates how weak the Rider is even if you have the best Rider in the world.

Source: The Snowball, by Alice Shroeder (Chapter 27, Folly).

Image source: www.rationalwalk.com/?p=5052

Innovation pipeline: a popular lead indicator metric on innovation

It is no use hearing the fire alarm after the fire engulfs you. The real value of any metric system is in raising alerts so that you have time to take action. Innovation pipeline seems to be the most commonly used lead indicator metric by CEOs to track innovation in the company. In fact, GE CEO Jeff Immelt told his top leaders, “If you can do only one thing well, this is what I’d pick: Make sure this pipeline is always full”. What kind of strategic actions are taken by CEOs after reviewing the innovation pipeline? Let’s look at a few examples from 3M, GE, Biocon, HUL and Infosys.

Following story is narrated in 3M’s storybook “A century of innovation”: One Saturday morning in 1940 CEO McKnight analyzed the “birth rate” of 3M products. He ticked them off: Wetordry waterproof sandpaper in 1921, Scotch masking tape in 1925, Scotch transparent tape in 1930, Colorquartz roofing granules in 1933 and rubber cement in 1934. Then there was a six-year dry spell. Although Scotchlite reflective sheeting was created in 1937, the rewards of that new product had not yet been recognized. “While these dates are only approximate and are really predicated on when the product commenced to yield some profit, it indicates rather a long period of hunger . . . nothing appears to have been developed since the rubber cement birthday,” McKnight wrote Carlton. McKnight took an action the same day and 3M’s New Products Department was born. In a memo dated October 12, 1940, McKnight wrote, “3M is spending a substantial and an increasing amount on research every year. It’s time to create a department to cooperate with all interested parties in studying the commercial value of each research project upon which money is being spent.”

One of the initiatives that Jeff Immelt kicked off when he became CEO of GE in 2001 was “Imagination breakthrough”. It is a pipeline of ideas that could generate more than $100M in incremental revenues. Out of the 30 ideas that entered the pipeline in the first year, about 20 of them turned out to be good projects. Today the pipeline is managed by CMO Beth Comstock and has 100 plus ideas in the pipeline with everything from new stroke technologies that are offered to ambulances to solar or wind energy technologies. Immelt tracks about 30 of them every month.

I am sure Indian CEOs review their innovation pipeline as well. Biocon CEO Kiran Mazumdar-Shaw has mentioned in the annual meeting in 2007 that there is an “enviable research pipeline” and she mentions a few programs in the pipeline like oral insulin, an antibody for Rheumatoid Arthritis etc. In a Q&A session at India Knowledge @ Wharton HUL CEO Nitin Paranjpe mentions that “We have a robust innovation pipeline across categories.” Similarly, Sandeep Dadlani, Head, Retail, consumer goods and logistics at Infosys mentioned following in the analyst meet in July last year, “There is a significant innovation pipeline of new ideas, new solutions, new IP at Infosys which is being evaluated literally every month. Business plans are being reviewed and approved.”

If everybody tracks innovation pipeline, what is the differentiator? Is it about how some of those ideas are linked to customer’s anxieties and aspirations at a deeper level? Perhaps coming out of an immersive research like P&G does or a “dreaming session” with customers like Immelt does? Is it about a discipline of funding & protecting investments in the good ideas and parking the rest? Is it about ensuring the speed of experimentation and customer feedback cycle? I don’t know. Any thoughts?

Related post: How innovative are you? A simple innovation dashboard

Walchand Hirachad Doshi: A daredevil innovator

Each of the four businessmen in Gita Piramal’s “Business Legends” – Kasturbhai Lalbhai, Ghanshyamdas Birla, Walchand Hirachand Doshi and J R D Tata – is legendary in his own way. However, Walchand Hirachand appealed to me in a special way. If Jamsetji Tata and Mahatma Gandhi epitomized systematic innovation then Walchand Hirachand epitomized non-systematic innovation. If Warren Buffett was paranoid about wide margin of safety then Walchand thrived on narrow margin of safety. Why do I call Walchand, the man behind several pioneering works in India from Bhor Ghat railway tunnels between Mumbai and Pune to Hindustan Aeronautics Limited (HAL) in Bangalore, a non-systematic innovator and yet adore him so much? Let’s see in this article.

Walchand was born on 23 November 1882 in Sholapur, Maharashtra, to Raju and Hirachand Doshi, a devout Digambar Jain trader family. Walchand learnt the tricks of trade the hard way, losing money in the first two attempts – a speculative jowar trade and even more speculative cotton trade. His loss in the second attempt was even bigger than the first. Walchand had also concluded that banking was not for him as he considered collecting interest was ‘a woman’s job’.

A turning point came when Walchand was twenty-one years old and frustrated with life. This is when he met Laxmanrao Phatak, a thirty-something ex-railway Brahmin clerk. Both shared a love for Marathi literature, theatre and movies. By the time the two met, Phatak had gained a thorough knowledge of the way the wheels of railway affairs revolved, what strings to pull, how to manipulate the allotment of funds and turn it to advantage. In 1903, Phatak and Walchand joined hands and bid for a tender to lay seven mile narrow gauge track near Barsi. Walchand convinced his father and uncle to put in Rs. 80,000 and a partnership registered in October that year was to last fourteen years and take both their careers to new heights.

Walchand entered shipping accidentally. Mr. Watson, a senior Crompton executive, told him over lunch in a train journey to Bombay that a steamer which had been purchased by Maharaja of Scindia during the war was up for sale. Walchand was so fascinated by the idea of a shipping venture that on reaching Bombay he drove straight to the docks to inspect the ship. It was love at first sight. “Then and there I resolved to leave no stone unturned in order to buy SS Loyalty”, he would recall. Before the end of the day, Walchand had roped in friends to buy the ship for Rs. 25 lakh.

A series of surprises popped up as Loyalty commenced its first voyage from Bombay to London on 5^th April 1919. Walchand was told in Bombay that Loyalty’s repair cost would be Rs. 1 to 1.5 lakhs. In London he discovered them to be Rs. 7 lakh. Six weeks of stay extended to five months. Walchand utilized the time to study his primary competitor the then Microsoft of shipping – British India Steam Navigation Company (BI) and decided to buy a fleet of six medium-sized cargo steamers from Palace Shipping Company in Liverpool for a million pounds. After paying a deposit of £100,000, Walchand realized he had to first obtain a shipping controller’s sanction. Walchand launched an emotional propaganda at the backdrop of Jalianwala massacre and ended up buying the entire Palace Shipping company instead of just six steamers. After two more rounds to Europe it was clear that Loyalty wasn’t economical and was sold in February 1923 as scrap for Rs.1,35,250.

Scindia decided to focus on cargo in Bombay-Rangoon sector, an area monopolized by BI. As expected, BI slashed its freight on rice from Rs. 18 per ton to Rs. 6. This tactic had worked for several of the 102 Indian shipping companies that went into liquidation since 1860 including Jamsetji Tata’s company. To fulfill cargo requirements Scindia started subsidiaries to trade rice and coal. Bill Gates of BI, Lord Inchcape offered Rs. 25 for every share which was traded for Rs. 6 on Bombay Stock Exchange to buy Scindia. Walchand went to meet Inchcape in Delhi along with another Director Narottam Morarjee on 14^th March 1923. Inchcape said, “We look on the Scindia Company which has trespassed into our field as pirates. That’s what you are – pirates!” Walchand flung back, “Who are pirates? We or you?” and walked out of Inchacape’s office. The second meeting opened with Walchand proposing, “Scindia is not for sale, on the contrary we are prepared to buy BI. Name your price.” It was like a local chain in Bangalore like M K Ahmed proposing to buy Wal-Mart. What guts!

This is how Walchand describes himself, “I am a dreamer, oblivious to reality, creating friction where I should not, obstinate and opinionated, allowing no peace either to myself or others.” How many of us have an image of ourselves as rooted in reality as Walchand’s? And if we have how many of us have the guts to say it openly? Hats off to the daredevil!

Why does Edgar Schein say, “A culture of innovation doesn’t scale up”?

“DEC is dead, long live DEC” by Prof. Edgar Schein is a forty year saga of the rise and fall of an innovative organization – Digital Equipment Corporation (DEC) – seen primarily through a “culture” goggle. Founded in 1957 DEC grew to become the number two computer company in the US with $14 billion in sales at its peak in late 1980s and from there on waned over a decade and got sold to Compaq in 1997. Schein, an authority on corporate culture, draws 15 lessons towards the end of the book. According to him, the most powerful lesson is, “A culture of innovation doesn’t scale up”. What does Schein mean by “culture of innovation”? And why does he say it doesn’t scale up? Let’s explore these questions in this article.

To understand some of the tenets of DEC culture, let’s look at two stories from the book. The first episode occurs in 1967 when Schein participated in an Operations Committee offsite at a hotel on Cape Cod. The committee decided to review all the projects that were under way in the various parts of DEC. The presenter was Ted Johnson, who stood at the blackboard and wrote down the list of projects he knew to which others contributed. The list grew to some thirty fascinating projects. Schein’s curiosity began to be aroused as to how the group would now set priorities and make decisions about where to allocate resources and effort. CEO Ken Olson was very quiet and seemingly uninvolved. The group took a long look at the list and nodded approval and then went on to the next item on the agenda! In action was an underlying belief of internal competition and “Let the market decide”.

The second story unfolds in 1980 at the beginning of PC revolution. Ken Olson, an engineer at heart, is said to have described IBM PC as “a piece of junk” and so DEC was set out to produce a more elegant product. Operations Committee approved three PC projects, Professional, Rainbow and DECMATE. The market was not interested in a proprietary PC and hence rejected all three. Following the debacle the engineers at DEC wrote a proposal in 1984 for a PC clone. It was called DEC PC25 and 50 proposal. Compaq was just being founded. Ken killed the project – DEC is not a copycat. Underlying tenet was “DEC defines the product spec, neither market nor IBM”.

According to Schein the cultural elements at DEC that guaranteed a continuous stream of innovation were – the philosophy of empowering people, holding them responsible, depending open and truthful communication, forcing broad consensus and buy-in in decision making and ultimately trusting people at all levels to do the right thing – essentially operating like an extended large family. As organization grows, you have silos, turfs, lack of communication and it becomes almost impossible to get active buy-in (only on-paper agreement). This he feels makes it difficult for a large organization to innovate successfully. And hence Schein says, “A culture of innovation doesn’t scale up.”

If Schein’s claim were true, IBM (Rev: $100B), P&G ($80B), 3M ($23B) & Google ($23B) shouldn’t be innovative. A G Lafley’s claim that P&G built repeatable and scalable process of innovation should be false. Perhaps Schein doesn’t mean this to be a sweeping generalization. In fact, Shein does advocate the role of leaders as “change agents” in this article “Leadership and organizational culture”. However, it is not clear how many organizations are serious about developing change agents. For that matter, how many CEOs consider themselves as change agents?

(Note: As I was writing this article, I realized that Ken Olson died earlier this month at age 84. Hats off to the legend!)

Related article: Edgar Schein's fundamental laws of organizational change

3M’s innovation storybook: A time-travel experience through a culture-capsule

We have a natural bias to focus endlessly on the problems with our culture and in the process ignore what is working well already. What can we do? Perhaps 3M’s “A century of innovation” holds the key. This innovation storybook not only brings out the success stories like Spencer-Fry’s Post-It and Okie’s waterproof sandpaper but also learnings from some of the failures like Thermo-Fax copiers or magnetic audio-video recording. Here are the three things I liked about the book.

1. Stories behind the pithy wisdom: Like every organization 3M’s culture would carry a number of pithy sayings many of them still active in some form or the other e.g. “Patient money”, “15 percent rule”, “Look behind the smokestacks”. When KcKnight was appointed sales manager in 1911 he knew that 3M’s sandpaper product was no better than competition. But rather than just talking to the front-desk of the furniture manufacturers McKnight asked if he could step into the back shop to talk to the workers. The usual front office answer was, “What for?” McKnight’s reply was, “We are new that’s why we are anxious to learn what you need”. Luckily some “gatekeepers” let McKnight into the factory’s inner sanctum and men on the production line told him what they thought, including how sub-par some 3M products they had tried actually were. This information went back to the product team. This is how the practice of sales folks “Looking behind the smokestacks” and going right to factory floor was born.

2. Company’s defining moments: Every company has defining moments where its core beliefs get tested. Stories of such moments as to how the company responds during such moments are quite inspiring. One such story relates to “Three-M-ite cloth” which became 3M’s first profitable product, after 12 long years of wait since 3M was started in 1902. But the glory was short lived as their biggest competitor from New York, The Carborundum Company charged 3M with patent infringement and demanded that they stop making Three-M-ite cloth. 3M hired a tough Chicago lawyer, Paul Carpenter, decided to fight. Ultimately, Carpenter argued that Carborundum’s patent was invalid: his argument was so strong 3M prevailed. This incident educated the young company about the importance of patents, a philosophy that endures today.

3. Celebrating the heroes: In 1951, James Hendricks, a manager in Tape Research, a tall man with a professorial style, invited every technical person at 3M - 400 in all - to join a forum called “Technical Forum”. An organization in which participation was purely voluntary, its original goals were to foster idea sharing, discussion and inquiry among members of the 3M technical community, while educating technical employees. In 1971 the forum had its first female chair, Julianne Prager and the forum started its Visiting Technical Women program in St. Paul area schools during 1970s. Marlyce Paulson, coordinated Tech Forum activities from 1979 to 1992. Paulson says, “The forum pulled specialists like polymer chemists across the divisions to share what they know.” I like the way this storybook highlights the work of non-CXO people like Hendricks, Prager and Paulson.

I hope more organizations use storybook as a way of communicating its values and legacy to employees, customers and other stakeholders.

Applying the Elephant-Rider model to a failed innovation program

A large insurance company hired a new CEO who concluded that among the company’s main problems was a lack of innovation. He launched multiple programs to increase innovation including various campaigns to reward innovation (suggestion boxes, prizes for new ideas) yet received little response. Why? A number of employee focus groups were launched to analyze the problem. In reviewing the company’s history it was revealed that past success was based on a tightly structured system of figuring out the best solution to any given problem, documenting the solution, putting all of the solutions into large manuals organized by every conceivable kind of problem that could arise, and systematically rewarding employees for using the rules written out in the manuals.

Over the years, employees had learned that the road to success was to apply the rules. The number of manuals grew to cover every new situation that arose. Employees who did not like to work in this kind of rule-bound, structured environment were encouraged to leave the organization, leading to a workforce that was comfortable in the structured environment. Previous CEOs had glorified this system of working, and indeed it had been highly successful in building the company. It came to be taken for granted that the best way to work was to follow the rules in the manuals.

Given the situation it is not surprising that the program failed. But how could the CEO have done any better?

To understand the options, let’s first see a simple and useful model of how human brain works. According to this model the human brain has two independent systems or processes of thinking at work all the time. The first one is intuitive and emotional. It is the part that makes you duck when a ball is thrown at you unexpectedly or makes you nervous when your airplane hits turbulence. The second part is the one that plans, analyzes and looks into the future. It is the part that makes a new years resolution that you will go for a morning walk three times a week.

Chip and Dan Heath use an analogy for this model in their bestselling book Switch which I like. In this analogy the emotional side is like an Elephant and deliberating side is like a Rider. Perched atop the Elephant, the Rider holds the reins and seems to be the leader. But the Rider’s control is precarious because the Rider is so small compared to the Elephant. Anytime the six-ton Elephant and the Rider disagree about which direction to go, the Rider is going to lose. He is completely overmatched.

Elephant carries all the baggage from the past like the employees of this insurance company which are habituated to “following the rules”. Even if the Rider gets an idea, the Elephant would ask the question, “Where is the rule?” One option is to shape the path for the Elephant and make the new direction easy. In fact, Edgar Schein who narrates this story in “Corporate culture survival guide” suggests following: “Every month every department had to invent three new ways of doing things and write up a manual to that effect!!!” The Elephant may still feel like doing the old way and in a slightly different way. Behaviroral economist Richard Thaler calls this a “Nudge”.

The other option is based on the assumption that response to an initiative in any organization is never completely zero. There will be a few people in some corners who would have submitted ideas. We zoom in to those people and ask, “Why the hell is it working here?” Then we try to clone the situation in other places. This technique directs the Rider and is called “Follow the bright spots” and I wrote about it last year.

Image source: www.wpclipart.com

My theme for 2011: Robust intervention for systematic innovation

I had identified four themes for study last year. I pursued all of them – some with more seriousness others with less. This year I am down to only one theme which I call “Robust intervention for systematic innovation”. It means either I am more focused this year or getting older. I have mentioned what systematic innovation means earlier. But what does a “robust intervention” mean?

Bailout of banks, radiation therapy of a cancer patient or launch of an innovation program – each is an example of an intervention. An intervention is an act in order to bring about a change. I read the term “robust intervention” in an interview of Nobel Laureate Joseph Stiglitz in Economic Times. He said, “By that [robust intervention] I mean interventions that are simple enough that you don’t have to very fine tune to make them work, even if you have a bad president like President Bush.” Stiglitz says robust interventions work in spite of dysfunctional systems or flawed institutions. OK, so what is not a robust intervention? Here are a few I came across:

· An initiative in an organization where Economic Value Added (EVA) based scorecard was percolated from CEO all the way to the first level manager. The EVA number was not so easy to compute and was too abstract for many. The initiative was a disaster.

· Telling our son, “Don’t play games on the computer”

· An innovation program whose scope was defined by a set of “creativity” workshops covering as many people as possible. Everybody had good fun. Nothing happened after that.

What are the examples of robust interventions? Here are a few I have written about in this past:

· A G Lafley’s open innovation program at P&G. I wrote about it here and here.

· Jerry Sternin’s community program in Vietnam that reduced malnutrition.

· Dr. Kiran Bedi’s reform program at Tihar Jail

Now, here is what I would like to study further. What are the characteristics of a robust intervention? How do we go about carrying out such an intervention?

Here is my initial take on the characteristics of a robust intervention. I could be wrong here and your inputs will help.

1. Non-dependence on scarce resource: If an initiative depends upon “non-corrupt politician” or “good quality teachers” or “systems thinkers”, it is not a robust initiative. There are just so few of them around. Sugata Mitra’s idea of Self Organizing Learning Environments (SOLE) depends upon teachers not playing any role in teaching. Does it make it a better candidate for robust intervention? I don’t know.

2. Appealing to both the Rider and the Elephant: To borrow Dan & Chip Heath’s metaphor from their book Switch, the intervention should appeal to both the emotional Elephant part of our brain and the ever-analyzing Rider atop the Elephant. The EVA initiative mentioned above did not appeal even to the Rider let alone the Elephant. Telling our son to stop playing the computer game is certainly not appealing to his Elephant.

3. Margin of safety: There is a high chance that the initiative moves 4 steps forward and with some bad luck may move 2 steps backward. However, the initiative carries extremely low probability of moving 2 steps forward and 4 backward. How to create cushion against the Black swans?