Mafia Insights Into Quality Investing: No Kidding!

In one of Gladwell’s latest articles entitled “The Crooked Ladder” he puts that old mafias were simply an attempt to be accepted by the society. Moreover, one of the biggest misconceptions in movies and also by us is that the really dangerous guys are those street drug dealers. Actually, those are not. As Gladwell puts it,

That’s why the crooked ladder worked as well as it did. The granddaughter could end up riding horses because the law—whether from indifference, incompetence, or corruption—left her gangster grandfather alone. The idea that, in the course of a few generations, the gangster can give way to an equestrian is perhaps the hardest part of the innovation argument to accept. We have become convinced of the opposite trajectory: the benign low-level drug dealer becomes the malignant distributor and then the brutal drug lord. The blanket policing imposed on 6th Street is justified by the idea that, left unchecked, Mike and Chuck will get worse. Their delinquency will metastasize. The crooked-ladder theorists looked at the Mafia’s evolution during the course of the twentieth century, however, and reached the opposite conclusion: that, over time, the criminal vocation was inevitably domesticated.

At the same time, one of the most insightful takeaways for me is that the real ‘bad guys’ were the ones who made illicit things at the society’s face. On top of that, they focused on niches and represented a really tiny slice of the cost structure of the entire value chain. With that, they had pricing power, outstanding returns on capital and no one bothered about them.

“James Jacobs, a New York University law professor who was involved in anti-Mafia efforts in New York during the nineteen-eighties, points out that the Mafia had every opportunity to take over the entire carting industry in the New York region—just as they could easily have monopolized any of the other industries in which they played a role. Instead, they stayed in the background, content to be the middlemen. At New York’s Fulton Fish Market, one of the largest such markets in the country, the Mob policed the cartel and controlled parking—a crucial amenity in a business where time is of the essence and prompt delivery of fresh fish translates to higher profits. What did they charge for a full day’s parking? Twelve dollars. And when the Mob-controlled cartel was finally rooted out, how much did fish prices decline at the Fulton Fish Market? Two per cent.

“This is one of the most interesting things about the Mafia,” Jacobs went on. “They did business and cooperated. They weren’t trying to smash everybody. They created these alliances and maintained these equilibriums. . . . You’d think that they would keep expanding their reach.

At the end of the day, isn’t that kind of business we are looking for? Companies that aren’t bothered by either suppliers or clients, that are really focused on a niche and don’t need to put a lot of capital to work while reap a disproportionate part of the profit pool?

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What Does Sense-making Can Teach Investors?

Sense-making is a qualitative, multi-disciplinary approach to make something sensible, i.e., how we structure the unknown as so to be able to act in it. In other words, it consists in constructing, filtering, framing, creating facticity and rendering the subjective into something more tangible. According to Karl Weick,

sense-making is about plausibility, pragmatism, coherence, reasonableness, creation, invention and instrumentality.

In this synthesis exercise in which accuracy is secondary, I found a couple parallels and antithesis to equity research, investing and managing an asset management firm.
On equity research and investing:
  • Sense-making is a synthesis exercise which usually benefits from mental models utilization to simplify complex and open-ended problems – it does not rely on extensive analysis and accuracy as enactment is needed in the learning process. This one is partially correct for investing in my point of view, since extensive analysis is a pre-requisite before synthetizing what the analyst has learned. A complete due diligence is required to mitigate risks, although it will never be complete due to the ever changing landscape and eternal unknown unknowns;
  • As I’ve just watched the True Detective TV series, I’ve learned from detectives this time (instead of Munger) that reading and studying different topics from a variety of sources helps us arm our brains with bits & bytes which can be combined later on our professional and personal lives. Although, we need previous knowledge and context to successfully use them “to consolidate bits and pieces into a compact, sensible pattern frequently requires that one look beyond those bits and pieces to understand what they might mean. Often, it is necessary to move outside a system in order to see the patterns within. (…) Of course, there is always more than one metaphor that can capture a situation, which means that any given metaphor is likely to be contested.”
  • And when we are unprepared, the man-with-a-hammer syndrome unleashes:  “operators who have specialized expertise do not see the big picture as crises develop and therefore miss key events.” We will try to frame the problem within our pre-existing models, unfortunately;
  • We are more likely to uncover unanticipated and potentially valuable viewpoints and information armed with open-ended questions. Moreover, in this way we avoid confirmation bias;
  • Marcel Proust helped me out in this one: “The real voyage of discovery consists not in seeking new landscapes but in having new eyes.” Again, it’s all about having perspective;
  • Sense-making benefits from past data (quant, social, etc.) in a given context to extrapolate necessary actions – just like investors learning from post mortem analysis/financial markets history to be better prepared for decision making;
  • Consequences are difficult to forecast in advance, though scenario planning could help out with this one;
  • Sense-making opposes scenario planning as “explanations that are developed retrospectively to justify committed actions are often stronger than beliefs developed under other, less involving, conditions.” This one is screaming for me since I live in Brazil and we are used to see growth embedded in 99% of potential investments here, thus we aren’t THAT creative imagining different scenarios. Unfortunately, we usually classify then as improbable as a preconception;
  • Learn not only what financial statements represent, but what is behind it: “e very sensitive to operations. Learn from those closest to the front line, to customer, and to new technologies.
On risk:
  • “Human errors are fundamentally caused by human variability, which cannon be designed anyway – so our function is to be risk mitigators which must be embedded in the capital allocator job description;
  • Compounding mistakes: “Small events are carried forward, cumulate with other events, and over time systematically construct an environment that is a rare combination of unexpected simultaneous failures.”
  • Constant learning, perspective and team complementarity as a knowledge growth vector and risk mitigator: “Capacity and response repertoire affect crisis perception, because people see those events they feel they have the capacity to do something about. As capacities change, so too do perceptions and actions. This relationship is one of the crucial leverage points to improve crisis management.” As investors, we should only act or react when we are prepared and comfortable with what we know and what we don’t know;
On governance:

  • “The dark side of commitment is that it produces blind spots” – This one I’ve learned from Malcolm Gladwell article in The New Yorker Magazine: do not engage in negotiation with fanatics, nor trust entrepreneurs living their dreams in listed companies. In other words, do not them live their dreams with your money;
  • “Turnover is as much a threat to capacity as is understaffing, but for a different reason. Institutional memory is an important component of crisis management”
  • “Perception, however, is never free of preconceptions, and when people perceive without institutional memories, they are likely to be influenced by salient distractions or by experience gained in settings that are irrelevant to present problems.”
  •  “In a globally competitive environment our reward structures are geared toward rewarding immediate action and hence we may be signaling that sense-making is not a valued activity.”
  • “Sense-making is inherently collective; it is not nearly as effective to be the lone leader at the top doing all the sense-making by yourself. It is far better to compare your views with those of others – blending, negotiating, and integrating, until some mutually acceptable version is achieved. Soliciting and valuing divergent views and analytic perspectives, and staying open to a wide variety of inputs, results in a greater ability to create large numbers of possible responses, thus facilitating resilient action.” – Sutcliffe & Vogus, 2003
At the end of the day, no single discipline or tenet will solve any problem alone, although sense-making might be useful when analyzing the past performance or story of a company in order to understand how things went out. It is like a mapmaking process. Sensemaking also uses mental models from previous experiences and disciplines. 

I do not agree though that it necessarily is a better exercise than scenario planning because it relies on past facts, as (i) facts are not as clean as they see, afterall someone made the fact up and you don’t know in what context and motivation and (ii) in a constant changing landscape it’s better to elucubrate about the future and try to foresee through group simulations what scenarios can come up.

References:

Enacted sensemaking in crisis situations – Karl Weick

Sensemaking in organizations – Karl Weick

How can David defeat Goliath? Gladwell Proposes an Answer

Malcolm Gladwell has just released his new book “David and Goliath: Underdogs, Misfits, and the Art of Battling Giants”. The book is all about winning asymmetrical wars, defeating giants, you name it. By using the “anchor & twist” strategy, making the unexpected move (pressing Goliath for example), using the advantage of being an outsider who doesn’t have anchored references or, simplifying, using the art of what I call “wise effort” one can win tough wars. For those who don’t have the time to read the entire book, below you can find an ’09 article published in the New Yorker by Malcolm himself on the same topic.