Wednesday April 15, 2015

Wednesday April 15, 2015

Here are some excerpts from Steve Jobs 2005 commencement address to Stanford University's graduating class:

"Remembering that I'll be dead soon is the most important tool I've ever encountered to help me make the big choices in life. Because almost everything -- all external expectations, all pride, all fear of embarrassment or failure -- these things just fall away in the face of death, leaving only what is truly important."

"Remembering that you are going to die is the best way I know to avoid the trap of thinking you have something to lose. You are already naked. There is no reason not to follow your heart."

"No one wants to die. Even people who want to go to heaven don't want to die to get there. And yet death is the destination we all share. No one has ever escaped it. And that is as it should be, because death is very likely the single best invention of life. It is life's change agent."

Three primary places to store capital

Over the years we have discussed a basic concept from time to time that continues to present itself in the marketplace. It is a market driven paradigm that has a great tendency to supersede secular and seasonal economic trends. It is based on the idea of investors constantly making comparisons.

In the end, excess income becomes capital. It tends to be generated continuously and it must be stored. In most instances it can be stored by investors using one of three primary vehicles. These vehicles are:

1.      interest bearing instruments

2.      income producing real estate

3.      shares of business

From time to time so-called alternate investment classes are suggested (commodities, Chinese ceramics, precious metals, fine art, etc.). However, the reality is that only the three primary vehicles listed above can produce cash, whereas non-cash producing investment vehicles rely on higher degree of speculation for capital appreciation.

It is very rare for us to ever find a period when all three primary capital storage areas are attracting strong net capital inflows at the same time. And it is very rare when all three areas suffer from net capital flight at the same time. Instead, it is normal for one or two of the primary areas to attract capital while the third suffers from capital outflows. And intermittently, there will be relatively short periods where there is a general state of equilibrium.

Predicting timing of a shift in capital flows OUT of one of these three areas is tricky.

With central banks all over the globe involved in unprecedented territory in terms easy monetary policy, traditional assumptions regarding interest bearing instruments are practically extinct.

Income producing real estate can hardly be described as a generic or homogeneous group of assets (location, location, location). Real estate valuations are also affected by supply, demand, financing costs, and the availability of financing.

The key remains the same for successful equity investing (selection, selection, selection) based on ever-changing variables.

Understanding Real Estate Investment Trusts (REIT's)

A REIT, or Real Estate Investment Trust, is a company that owns or finances income-producing real estate. Modeled after mutual funds, REITs provide investors of all types regular income streams, diversification and long-term capital appreciation.

REITs typically pay out 90% of their taxable income as dividends to shareholders. In turn, shareholders pay the income taxes on those dividends.

REITs allow anyone to invest in portfolios of large-scale properties the same way they invest in other industries – through the purchase of stock. In the same way shareholders benefit by owning stocks in other corporations, the stockholders of a REIT earn a share of the income produced through real estate investment – without actually having to go out and buy or finance property.

Most REITs are traded on major stock exchanges, but there are also public non-listed and private REITs. 

The two main types of REITs are Equity REITs and Mortgage REITs. 

Equity REITs generate income through the collection of rent on, and from sales of, the properties they own for the long-term. 

Mortgage REITs invest in mortgages or mortgage securities tied to commercial and/or residential properties.

Today, REITs are tied to almost all aspects of the economy, including apartments, hospitals, hotels, industrial facilities, infrastructure, nursing homes, offices, shopping malls, storage centers, student housing, and timberlands. 

REIT-owned properties are located in every state and support one million U.S. jobs annually.

U.S. REITs have become a model for REITs around the world, and now more than 30 countries around the world have adopted REIT legislation.

To qualify as a REIT a company must:

1.      Invest at least 75 percent of its total assets in real estate

2.      Derive at least 75 percent of its gross income from rents from real property, interest on      mortgages financing real property or from sales of real estate

3.      Pay at least 90 percent of its taxable income in the form of shareholder dividends each year

4.      Be an entity that is taxable as a corporation

5.      Be managed by a board of directors or trustees

6.      Have a minimum of 100 shareholders

7.      Have no more than 50 percent of its shares held by five or fewer individuals

REITs offer investors a number of benefits, including:

1.      Diversification:  Over the long term, Equity REIT returns have shown little correlation to the returns of the broader stock market.

2.      Dividends: Stock exchange-listed REITs have provided a consistent income stream to investors.

3.      Liquidity: Stock exchange-listed REIT shares can be easily bought and sold.

4.      Performance: Over most long-term horizons, stock exchange-listed REIT returns outperformed the S&P 500, Dow Jones Industrials and NASDAQ Composite.

5.      Transparency: Stock exchange-listed REITs operate under the same rules as other public companies for securities regulatory and financial reporting purposes.

Congress created REITs in 1960 to make investments in large-scale, income-producing real estate accessible to average investors through the purchase of equity. In the same way shareholders benefit by owning stocks of other corporations, the stockholders of a REIT earn a pro-rata share of the economic benefits that are derived from the production of income through real estate ownership.

To qualify as a REIT, a company must comply with certain provisions within the Internal Revenue Code.

Equity REITs mostly own and operate income-producing real estate, such as shopping centers, health care facilities, apartments, warehouses, office buildings and hotels.

Mortgage REITs mostly lend money directly to real estate owners and operators or extend credit indirectly through the acquisition of loans or mortgage-backed securities.

Most REITs specialize in one property type only, such as shopping malls, timberlands, data centers, self-storage facilities etc.

Some REITs invest throughout the country or, in some cases, throughout the world. Others specialize in one region or even a single metropolitan area.

The Internal Revenue Service reports that there are about 1,100 U.S. REITs that have filed tax returns.

As of Dec. 31, 2014, there were 216 REITs in the U.S. registered with the SEC that trade on one of the major stock exchanges—the majority on the NYSE. These REITs have a combined equity market capitalization of $907 billion. The total global market capitalization of REITS is well over a trillion dollars.

The majority of REITs trade on major stock exchanges. Investors may invest in a publicly traded REIT by purchasing shares through a securities dealer. As with other publicly traded securities, investors may purchase common stock, preferred stock or debt securities.

REIT investors also can buy shares in a REIT mutual fund or exchange-traded fund. There are many to choose from.

REITs are total return investments. They typically provide high dividends plus the potential for moderate, long-term capital appreciation. Additionally, REITs offer liquidity, portfolio diversification and usually strong corporate governance than private structures.

Growth in REIT earnings typically comes from several sources, including higher revenues, lower costs, and new business opportunities.

The REIT industry uses net income as defined under Generally Accepted Accounting Principles (GAAP) as the primary operating performance measure.

IMPORTANT - The REIT industry uses funds from operations (FFO) as a supplemental measure of a REIT's operating performance. NAREIT defines FFO as net income (computed in accordance with GAAP) excluding gains or losses from sales of most property and depreciation of real estate.

For REITs, dividend distributions for tax purposes are allocated to ordinary income, capital gains and return of capital, each of which may be taxed at a different rate.

Stock exchange-listed REITs file with the Securities and Exchange Commission (SEC). Shares of their stock trade on national stock exchanges.

PNLRs file with the SEC. Shares of their stock do not trade on national stock exchanges.

Private REITs do not file with the SEC. Shares of their stock do not trade on national stock exchanges.

A total of 31 countries currently have REITs. The majority of REIT laws around the world mirror the U.S. approach to REIT-based real estate investment.

One problem for REIT's is there can be difficulty of raising capital without dilution. Minus depreciation, these companies must pay out 90% of their net income, meaning there are significant restrictions on retaining earnings for new projects. REIT's are forced to issue equity (dilution) or go to the debt markets for funding growth.

Forecasting the variables in Valuation Models

The required rate of return

Risk free rate of return

Dividends in the future

Payout ratios in the future

Cash flows in the future

Management's capital allocation proficiency

Capital allocation opportunities

Changing cost of capital

Future capital spending needs

Competitive conditions

Great by Choice

by Jim Collins

Chapter 1: Thriving in Uncertainty

The nine-year research project behind this book started in 2002 around a simple question: Why do some companies thrive in uncertainty, even chaos, and others do not? When buffeted by tumultuous events, when hit by big, fast-moving forces that we can neither predict nor control, what distinguishes those who perform exceptionally well from those who underperform or worse?

The research method rests upon having a comparison set. The critical question is not “What did great companies share in common?” The critical question is “What did great companies share in common that distinguished them from their direct comparisons?”

Comparisons are companies that were in the same industry with the same or very similar opportunities during the same era as the 10X companies, yet they did not produce great performance.

10Xers (“ten-EX-ers”) - companies that didn’t merely get by or just become successful. They truly thrived. Every 10X beat its industry index by at least 10 times.

10X cases in this study:

 Amgen, Biomet, Intel, Microsoft, Progressive Insurance, Southwest Airlines, Stryker 

Research conducted shattered the following FIVE deeply entrenched myths:

1Successful leaders in a turbulent world are bold, risk-seeking visionaries

2Innovation distinguishes 10X companies in a fast-moving and uncertain world

3A threat-filled world favors the speedy; you are either the quick or the dead

4Radical change on the outside requires radical change on the inside

5Great enterprises with 10X success have a lot more good luck

Chapter 2: 10Xers

On one hand, 10Xers understand that they face continuous uncertainty and that they cannot control, and cannot accurately predict significant aspects of the world around them. On the other hand, 10Xers reject the idea that forces outside their control or chance events will determine their results; they accept full responsibility for their own fate.

10Xers then bring this idea to life by a triad of core behaviors:

1.       fanatic discipline

2.       empirical creativity

3.       productive paranoia

Animating these three core behaviors is a central motivating force: Level 5 ambition.

These behavioral traits, correlate with achieving 10X results in chaotic and uncertain environments. Fanatic discipline keep 10X enterprises on track, empirical creativity keeps them vibrant, productive paranoia keeps them alive, and Level 5 ambition provides inspired motivation.

Fanatical Discipline

 •  Discipline, in essence, is consistency of action – consistency with values, consistency with long-term goals, consistency with performance standards, consistency of method, consistency over time.

 •  10Xers are utterly relentless, monomaniacal even, unbending in their focus on their quests. They don’t overreact to events, succumb to the herd, or leap for alluring – but irrelevant – opportunities.

Empirical Creativity

 •  Empirical means relying upon direct observation, conducting practical experiments and/or engaging directly with evidence rather than relying on opinion, whim, conventional wisdom, authority or untested ideas.

 •  Having an empirical foundation enables 10Xers to make bold, creative moves and bound their risk.

 •  10Xers had a much deeper empirical foundation for their decision and action with gave them well-founded confidence and bounded their risk.

Productive Paranoia

 •  10Xers differ from their less successful comparisons in how they maintain hyper-vigilance in good times as well as bad. Even in calm, clear, positive conditions, 10Xers constantly consider the possibility that events could turn against them at any moment. Indeed, they believe that conditions will – absolutely with 100 percent certainty – turn against them without warning, at some unpredictable point in time, at some highly inconvenient. And they’d better prepared.

Level 5 ambition

 •  10Xers channel their ego and intensity into something larger and more enduring than themselves. They’re ambitious, to be sure, but for a purpose beyond themselves, be it building a great company, changing the world or achieving some object that’s ultimately not about them.

 •  10Xers share Level 5 leaders’ most important trait: they’re incredibly ambitious, but their ambition is first and foremost for the cause, for the company, for the work, not themselves.

Chapter 3: 20 Mile March

The 20 Mile March was a distinguishing factor, to an overwhelming degree, between 10X companies and the comparison companies in the research. A good 20 Mile March has the following seven characteristics:

1.       Clear performance markers.

2.       Self-imposed constraints.

3.       Appropriate to the specific enterprise.

4.       Largely within the company’s control to achieve.

5.       A proper time frame – long enough to manage, yet short enough to have teeth.

6.       Imposed by the company upon itself.

7.       Achieved with high consistency.

Unexpected findings

20 Mile Marchers have an edge in volatile environments; the more turbulent the world, the more you need to be a 20 Mile Marcher.

There is an inverse correlation between pursuit of maximum growth and 10X success. Comparison – company leaders often pressed for maximum growth in robust times, thereby exposing their enterprises to calamity in an unexpected downturn. 

10X winners left growth on the table, always assuming that something bad lurked just around the corner, thereby ensuring they wouldn’t be caught overextended.

Chapter 4: Fire Bullets...........Then Cannonballs

A “fire bullets, then cannonballs” approach better explains the success of 10X companies than big-leap innovations and predictive genius.

A bullet is a low-cost, low-risk, and low-distraction test or experiment. 10Xers use bullets to empirically validate what will actually work. Based on that empirical validation, they then concentrate their resources to fire a cannonball, enabling large returns from concentrated bets.

The 10X cases fired a significant number of bullets that never hit anything. They didn’t know ahead of time which bullets would hit or be successful.

Unexpected findings

The 10X winners were not always more innovative that the comparison cases.  In some matched pairs, the 10X cases proved to be less innovative than their comparison cases.

10Xers appear to have no better ability to predict impending changes and events than the comparisons. They aren’t visionary geniuses; they’re empiricists.

The combination of creativity and discipline, translated into the ability to scale innovation with great consistency, better explains some of the greatest success stories – from Intel to Southwest Airlines, from Amgen’s early years to Apple’s resurgence under Steve Jobs – than the mythology of big-hit, single step breakthroughs.

Chapter 5: Leading Above the Death Line

This chapter explores three key dimensions of productive paranoia:

1. Build cash reserves and buffers – oxygen canisters – to prepare for unexpected events and back luck before they happen

2. Bound risk – death line risk (no oxygen), asymmetric risk (big downside low upside), and uncontrollable risk – and manage time-based risk

3. Zoom out, then zoom in, remaining hyper-vigilant to sense changing conditions and respond effectively

10Xers understand they cannot reliably and consistently predict future events, so they prepare obsessively – ahead of time, all the time – for what they cannot possibly predict. They assume that a series of bad events can wallop them in quick succession, unexpectedly at any time.

It’s what you do before the storm hits – the decisions and disciplines and buffers and shock absorbers already in place – that matters most in determining whether your enterprise pulls ahead, falls behind or dies when the storm hits.

10xers are extremely prudent in how they approach and manage risk, paying special attention to three categories of risk:

 • Death Line Risk (which can kill or severely damage the enterprise)

 • Asymmetric Risk (in which the downside dwarfs the upside)

 • Uncontrollable risk (which cannon be controlled or managed)

Rapid change does not call for abandoning disciplined thought and disciplined action. Rather it calls for upping the intensity to zoom out for fast yet rigorous decision making and zoom in for fast yet superb execution.

Unexpected findings

The 10Xers cases took less risk than the comparison cases yet produced vastly superior results.

Contrary to the image of brazen, self-confident, risk-taking entrepreneurs who see only upside potential, 10X leaders exercise productive paranoia, obsessing about what can go wrong. They ask questions like: what is the worst case scenario? What are the consequences of the worst case scenario? What if? What if? What if?

The 10X cases didn’t have a greater bias for speed than the comparison companies. Taking the time available before the risk profile changes, whether short or long, to make a rigorous and deliberate decision produces a better outcome than rushing a decision.

Chapter 6: SMaC

SMaC stands for Specific, Methodical, and Consistent. The more uncertain, fast-changing and unforgiving your environment, the more SMaC you need to be.

A SMaC recipe is a set of durable operating practices that create a repeatable and consistent success formula; it is clear and concrete, enabling the entire enterprise to unify and organize its efforts, giving clear guidance regarding what to do and what not to do.

A SMaC recipe reflects empirical validation and insight about what actually works and why. Howard Putnam’s 10 points at Southwest perfectly illustrates the point.

Developing a SMaC recipe, adhering to it, and amending it (rarely) when conditions merit correlate with 10X success. This requires the three 10X behaviors: empirical creativity (for developing and evolving it) fanatic discipline (for sticking to it) and productive paranoia (for sensing necessary change)

Unexpected findings

It is possible to develop specific concrete practices that can endure for decades – SMaC practices.

Far more difficult than implementing change if figuring out what works, understanding why it works, grasping when to change and knowing when not to.

Chapter 7: Return on Luck

We defined a luck event as one that meets three tests:

1. Some significant aspect of the event occur. Yet 10X cases were largely or entirely independent of actions of the key factors in the enterprise.

2. The event has a potentially significant consequence (good or bad).

3.  The event has some element of unpredictability.

Luck happens a lot, both good and back luck. Every company in our research experienced significant luck event in our era of analysis. Yet the 10X cases were not generally luckier than the comparison cases.

The leadership concepts in this book: fanatic discipline, empirical creativity, productive paranoia, Level 5 ambition. 20 mile march, fire bullets, then cannonballs, leading above the death line and SMaC – all contribute directly to earning a great ROL.

10Xers credit good luck as a contributor to their successes, despite the undeniable fact that others also experienced good luck, but they never blame bad luck for setbacks or failures.

Unexpected findings

Some of the comparison companies had extraordinarily good luck, better luck even than the 10X winners, yet failed because they squandered it.

ROL might be an even more important concept than return on assets (ROA), return on equity, return on sales (ROS) or return on investment.

Who Luck – the luck of finding the right mentor, partner, teammate, leader, friend – is one of the most important types of luck. The best way to find a current of good luck is to swim with great people, and to build deep and enduring relationships with people for whom you’d risk your life and who’d risk their lives for you.

IMPORTANT QUOTE FROM THE AUTHOR Jim Collins - "We sense a dangerous disease infecting our modern culture and eroding hope: an increasingly prevalent view that greatness owes more to circumstance, even luck, than to action and discipline—that what happens to us matters more than what we do. In games of chance, like a lottery or roulette, this view seems plausible. But taken as an entire philosophy, applied more broadly to human endeavor, it’s a deeply debilitating life perspective, one that we can’t imagine wanting to teach young people."