Buffett, the well-written biography of Warren Buffett by Roger Lowenstein, offers an interesting biographical sketch with several insights into principled business and investing.  In this first reflection I am going to compare Warren Buffett's management philosophy with that of Charles Koch's.

While their businesses face a host of different incentives — Berkshire Hathaway a publicly owned company and Koch Industries privately held — their principled approach to business echoes many similarities.

Value Creation

Both Buffett and Koch approach business with an openness to change and with a focus on creating value, wherever they can find it.

"Buffett did not think of Berkshire necessarily as a textile company, but as a corporation whose capital ought to be deployed in the greenest possible pastures."  As Berkshire's textile business struggled, Buffett began directing it's profits into new sectors and opportunities.

Similarly, Koch, initially in the oil refining business, diversified his re-investments in the company into other more value-rich propositions — from commodities trading to fiber.  Koch Industries' vision does not focus on a particular industry, but on value creation:

"Apply Market-Based Management to identify and capture those opportunities for which our capabilities will create the greatest value and develop and implement strategies that will maximize this value long-term."

Measure Meaningful Things

To reach these lofty goals both Koch and Buffett rigorously look to align the incentives of their companies and employees with creating value for shareholders and society.

"I believe in establishing yardsticks prior to the act; retrospectively, almost anything can be made to look good in relation to something or other."  Buffett's basic theory of return on investment is to focus on "the return on equity capital — that is, the percentage profit on each dollar invested."  He strongly emphasized not wasting time on quarterly projections and other time-wasters.

Koch also frowns on needless paperwork and aims to measure profitability whenever it is practical, placing emphasis on value created by the economics means rather than by the political means.

Compliance

After a series of government investigations and media attacks in the 1980s 1990s, Koch restructured his company and added an entire division to focus on the public sector and compliance. This fueled a new stage of growth.

Buffett also sees the value in operating within the legal environment.  While he does his best to invest in companies with high standards and good management, from time to time he finds himself holding a bad apple. When unordinary situations have arisen, such as they did with the fraud at Salomon Brothers, Buffett felt it his duty as a long-term investor to help restore the company's long-term position as a financial leader.

As Lowenstein frames it: by the end of the ordeal, Buffett had been so compliant that if the regulators had punished him too severely, they would be encouraging less cooperation in the future from other corporations under similar investigations.

Focus on Good People and Long-term Relationships

Though perhaps the value that trumps all else is one of character. "[M]ost people, regardless of what they say, are looking for appreciation as much as they are for money," writes Lowenstein.

Buffett and Koch both seem to understand this and act accordingly as they search for new investment opportunities and new personnel.  Their investment decisions focus on long-term value.

Koch avoids operating as a public company as he believes their quarterly requirements to be adverse short-term incentives. Buffett refuses to offer dividends or divide his stock in order to attract long-term investors.  Koch upholds a rigorous hiring process and would place a higher value on someone with good character and adequate skills over someone with adequate character and high skills.  Buffett chooses to invest in companies whose management he trusts and believes will be running their company for a long time.

At a talk this Fall, Charles Koch mentioned that the book Why Wages Rise by F.A. Harper was an influential book in his career. Curious of the subject and the inspirations of such a successful man, I decided I best read it myself.

It was fascinating to see that the book did not begin with much framing and jumped right into the discussion with a focus on labor unions and the misperception that their demands lead to a rise in wages. This says a lot about who Harper was trying to communicate these ideas to and places the stage of development of the US economy at the time the book was written, in 1957.

Harper draws a nice analogy to explain why it can be harmful to simply raise workers wages without a commensurate increase in productivity:

During 1955, the average pay of an employee of GM was $5,011. Yet GM's profits for the year were $1,189,477,082 (or $3,751,477,082 before any ascertainable taxes) on a total business of $12,433,277,420. It can be seen at a glance that doubling the pay of this employee would be no more noticeable in the whole enterprise than would be the adding of another automobile to those owned in the State of Michigan.

Doubling the pay of all GM employees, however, would be quite a different story. It would eat up in one year more than the total value of the firm's real estate, plants, and equipment.

He continues to explain how productivity is the true source of real wage increases and how inflation can harm wages. He emphasizes the role a sound currency play when considering wages:

When you accept money in trade, you are proceeding on faith in it as a sort of implied contract. The implied contract is this: When you trade something for money as an intermediate step to getting what you eventually want in exchange, you are operating on the assumption that the money will serve your intent rather than thwart it.

Harper's broad approach to understanding the forces which influence wages is commendable. I truly enjoyed Harper's use of images throughout the book to complement his main points. Here are a few of my favorites:

The Business Cycle

The eloquence of this graph captures the fluctuation of the economy as a force that is always present rather than a cycle that fluctuates around some sort of equilibrium, as the business cycle is often depicted.

Buying Power

What I particularly like about this graph is how it labels the section in between the citizens buying power before taxes, and the citizens buying power after taxes. The section is labeled: The Cost of Being Governed. I find the language eye opening in a small way. Most of the costs that we have in our life we try to find a way to reduce. Increased productivity involves identifying better ways to do things and then changing our ways accordingly, freeing up more time to invest in other ways or for leisure in the process. By framing the data in such a way, it suggests that governance has a specific role in the economy and leaves the hope that: if we can improve the ways in which we currently govern our society, we can reduce our necessity of this governance, freeing up more time to invest in other ways or for leisure across the society. A very nice way to put it.

"Reality is far more vicious than Russian roulette. First, it delivers the fatal bullet rather infrequently, like a revolver that would have hundreds, even thousands, of chambers instead of six. After a few dozen tries, one forgets about the existence of a bullet, under numbing false sense of security," says Nassim Nicholas Taleb. He refers to this as the black swan problem.

Mistaking Luck For Skill

Fooled by Randomness is a book about mistaking luck for skill, a mistake Taleb sees most prevalent in journalism and the world of markets. At the root, "risk detection and risk-avoidance are not mediated in the 'thinking' part of the brain but largely in the emotional one." "The consequences are not trivial: It means that rational thinking has little, very little, to do with risk avoidance. Much of what rational thinking seems to do is rationalize one's actions by fitting some logic to them."

Yet, "[p]eople fail to learn that their emotional reactions to past experiences (positive or negative) were short-lived." "[T]hey continuously retain the bias of thinking that the purchase of an object will bring long-lasting, possibly permanent, happiness or that a setback will cause severe and prolonged distress (when in the past similar setbacks did not affect them for very long and the joy of the purchase was short-lived)."

He paraphrases a remark by Einstein: "[C]ommon sense is nothing but a collection of misperceptions acquired by the age eighteen."

Other Common Misperceptions

Taleb also redefines a common misperception of the word 'mistake': "A mistake is not something to be determined after the fact, but in the light of the information until that point."

This point ties succinctly with the concept of creative destruction which embraces the role of failure in development. Mistakes need not be avoided, but learned from. But, many environments are not conducive to such a framework. Many of these frameworks have been engrained in society and social relationships for years. Taleb explores why "bad traders have a short- and medium-term survival advantage over good traders," by tying the world of markets to naive evolutionary theories.

"[M]any amateurs believe that plants and animals reproduce on a one-way route toward perfection. Translating the idea to social terms, they believe that companies and organizations are, thanks to competition... irreversibly heading toward betterment." This is simply not true.

Taleb offers multiple reasons. I will follow each with a few of my own thoughts.

1. Organizations do not reproduce like living members of nature. Competition is never between buyers and sellers. It is always between buyers and buyers or sellers and sellers. While finding the perfect mate could fall in the same category as competition between businesses, reproduction is different in many ways. Perhaps a more valid metric to compare the social environment of organizations to reproduction would be one of accessibility. That is, to what level do companies, or mates, have the opportunity to enter or exit the marketplace?
2. Randomeness. Some mutations are for the better, others for the worse. "Negative mutations (Gould) are traits that survive in spite of being worse, from the reproductive fitness standpoint, than the ones they replaced." Again, this acquires a level of complexity when translated into social terms. While market trends may be surprising on their own, subsidies, labor protection laws, and a variety of other market distorting policies add another level of randomness to the mix, often allowing unprofitable enterprises (negative mutations) to survive.

In Taleb's mathematical verse: "Just as an animal could have survived because its sample path was lucky, the "best" operators in a given business can come from a subset of operators who survived because of over-fitness to a sample path--a sample path that was free of the evolutionary rare event." "[E]volution means fitness to one and only one time series, not the average of all possible environments."

The Dive Bar that is Journalism

Distinguishing between signal and noise is widespread, though, journalism receives the largest swath of Taleb's relentless skepticism: "[J]ournalism may be the greatest plague we face today -- as the world becomes more and more complicated and our minds are trained for more and more simplification."

This effect of this large-scale compression -- going from the particular to the general -- "is the reduction in the degree of detected randomness." Journalism, through induction, favors the palatable over the counter-intuitive. In sum: "[M]ost poetic sounding adages are plain wrong."

From journalism to winning streaks, "if someone performed better than the crowd in the past, there is a presumption of his ability to do better in the future." But this is a weak presumption. It depends on two factors: "The randomness content of his profession and the number of monkeys in operation."

While Taleb doesn't offer any advice on which particular profession to choose, he does offer a suggestion. Don't shoot for a profession where you only like the way people live at the top. Consider the lifestyle of the average person, there are many more of them.

Escaping Randomness (Kind of)

The idea of alternative histories across several disciplines all seem to converge on the same concept of risk and uncertainty: "certainty is something that is likely to take place across the highest number of different alternative histories; uncertainty concerns events that should take place in the lowest number of them." Taleb mentions examples in philosophy, physics and economics.

However certain this convergence may appear, one still has to stay alert. Profits and losses are never guaranteed. "The frequency or probability of [a] loss, in and by itself, is totally irrelevant; it needs to be judged in connection with the magnitude of the outcome."

For a while now I've shared common hopes to have the Economic Freedom data take new forms. The relationship between Economic Freedom and GDP per capita for example is not hard to imagine, however there is always something a bit more compelling about a nice visualization. Gapminder's Trendalyzer seemed to have established the perfect format ? it was just a matter of time before unique data sets could be plotted in a similar manner. Google has now made this possible, and with the release of their new spreadsheet gadgets I've taken the opportunity to dive into the Economic Freedom data, and add motion.

This first graph compares the Heritage Foundation and Wall Street Journal's Index of Economic Freedom country scores with GDP per capita in US dollars as reported from the United Nations Common Database the data from 2000?2005. Colors denote regions. Size denotes population.

This second graph uses the same data minus some of the clutter. I've selected to display just a few countries which I think are interesting to compare to one another: North Korea and South Korea, China and Hong Kong, Cuba and Spain, and Botswana and Zimbabwe.

A hat-tip to Google for making this powerful tool available at such an accessible level. Now, on with setting free all that interesting information housed in academic jargon, repelling visuals, and bullet-pointed presentations.