Eleven years ago this month, the financial crisis of 2008 accelerated into high gear. Two of my favorite books about the crisis are All the Devils Are Here by Bethany McLean and Joe Nocera and Too Big To Fail by Andrew Ross Sorkin. The former provides great historical context of the companies involved, and the latter describes the high-stakes meetings and dramatic events that led up to the bankruptcy of Lehman Brothers. I recently watched an interview where the author talked to Warren Buffett about one of those meetings, and it got me thinking about one of the biggest risks in investing: allowing others to indirectly make your investment decisions for you.
Ken Lewis and Warren Buffett
In September 2008, Ken Lewis hired two different banks to provide him with a fairness opinion so that he could buy Merrill Lynch. Lewis badly wanted to buy Merrill. The banks he hired to value Merrill knew this. And those two banks dutifully performed their job, giving Lewis the value he needed to justify the acquisition. So, on the Sunday of the epic “Lehman weekend”, Bank of America decided to pay $50 billion for a company whose equity would have most likely been worthless just two or three days later.
Conversely, earlier in the summer, Buffett got a call from Dick Fuld late on a Friday evening. Fuld wanted Buffett to invest fresh capital into Lehman. This was before the crisis was in full force, but Lehman was starting to hemorrhage cash and was clearly struggling to survive. Buffett told Fuld he would think about it over the weekend. That same night, Buffett pulled out Lehman’s 10-k and began reading it, making notes in the margin. After a couple hours, he put the filing down and called Fuld back and told him he wasn’t interested. There was simply too much about Lehman’s books that he didn’t understand and couldn’t figure out, and so he found it too risky and quickly decided to pass. He came to this conclusion on his own after reading a document that was publicly available. He didn’t make calls to Berkshire CEO’s in the finance industry, he sent no analysts to talk to bankers on Wall Street, and he certainly didn’t read any third party research. He simply pulled up a filing that any one of us could have accessed, and decided to see if the company was worth investing in.
One guy outsourced his thinking, and one guy did the thinking for himself.
Ken Lewis certainly could have spent that Friday night studying Merrill’s books and forming his own conclusion on the company’s value and its risks, but I would bet that he never opened those filings that weekend. He made a lot of phone calls, and asked for a lot of opinions from smart people who he trusted, but my suspicion is he completely outsourced his thinking to others, whereas Buffett kept his thinking “in house”. The result is that Lewis paid $50 billion for a business that had risks he knew very little about, and the outcome was disastrous, to the point that Bank of America considered suing to break the deal when they found out what was inside the company they just bought. The destruction of value that Bank of America shareholders experienced might have been mitigated had Lewis just done his own thinking.
Theranos and the Outsourced Thinking that Permitted It
I recently read Bad Blood, which is an incredible story of the deception that occurred over many years at Theranos, the blood testing company that claimed to be able to run full blood tests using a tiny drop of blood from a finger prick rather than a conventional needle.
Theranos was engaged in fraud almost from the very beginning of their existence, and the fraud lasted for years by cheating on lab tests, reporting fake results, and lying to investors, employees and customers. The company raised nearly $1 billion of funding, a sum that evaporated by the time it was over. What is most incredible about this story is the company wasn’t just a typical scam, it was a high profile, widely-respected Silicon Valley company. It had a board of directors that included not one, but two former Secretaries of State, a four star general and Secretary of Defense, a legendary venture capitalist, and a former physician-turned US Senator, among others. Among the investors who put capital into Theranos were Carlos Slim, Robert Kraft, Larry Ellison, Rupert Murdoch, and the Walton family. Some of the most respected investors in the Bay Area, the most connected Stanford professors, and numerous high-profile hedge funds invested as well. How did so many of these smart, successful, connected people all fall for the fraud?
There is a famous socialogical experiment from the 1950’s where 75% of the participants denied completely obvious facts that were right in front of their eyes simply because they were told that the rest of their peers chose a different (incorrect) answer. There are many reasons for why the Theranos debacle occurred, but I think one of the main reasons the fraud became so big and lasted so long is that investors primarily relied on the opinions of others. The fact that so many other smart people had already given the company their stamp of approval led to a massive outsourcing of original thought. No real due diligence was performed by this A-list investor group. If they had, they would have likely discovered numerous warning signs (some investors that did do this original work passed on the investment, while a few became quite skeptical).
My observation is that independent thought is extremely rare, which makes it very valuable. On the other hand, outsourced thinking appears to be pervasive in the investment community, and because of how we’re wired, this dynamic is unlikely to change. Regardless of how convincing the facts are, we are just more comfortable if we can mold our opinion around the opinion of others.
Understanding this reality and being aware of our own human tendencies is probably a necessary condition to investment success in the long run.
John Huber is the founder of Saber Capital Management, LLC. Saber is the general partner and manager of an investment fund modeled after the original Buffett partnerships. Saber’s strategy is to make very carefully selected investments in undervalued stocks of great businesses.
John can be reached at john@sabercapitalmgt.com.