The Future of Space, Part I: The Setup

The Future of Space, Part I: The Setup FutureBlind Podcast

Expansion of life across our solar system and beyond has been a dream of mine since childhood. Of course, this isn’t uncommon among other sci-fi enthusiasts, or anyone who grew up knowing we’ve sent humans to the Moon but haven’t sent them back in nearly 50 years.

Space is fascinating for many reasons. It’s a frontier in every sense: physically, technically, even socially. It’s at the bleeding edge of what humanity is capable of. “Looking to the stars” and “shooting for the moon” are common idioms because space has defined our limits for generations.

Now (finally!) the technical and business tailwinds are coming together to make it possible. The cost and ease of getting to space are about to improve by many orders of magnitude. This will drive the space industry to be one of the biggest sources of growth over the next 10-20 years.[1] It will make existing technologies cheaper and more ubiquitous, like allowing worldwide high-speed internet in even the most remote, rural areas. It will also open up a host of new possibilities previously only imagined in science fiction.

This is the first of a two-part essay on the upcoming future of the space industry. I’ve been closely following SpaceX’s progress in particular since their first launch of the Falcon 9 in 2010, so I’m excited to finally write about it.

Why now?

TLDR: SpaceX has pushed cost to orbit down by 10x, and will by another 10x in 5 years. Along with further commercialization and government funding, a threshold has been crossed.

The success of commercial launch services puts the space industry in the same place as the early days of railroads in the 1800s or commercial ocean shippers in the 1600s. The key here is early days as things are really just getting started.

The “why now?” can be reduced to one chart — the average cost to get 1 kilogram to orbit:

Data from https://aerospace.csis.org/data/space-launch-to-low-earth-orbit-how-much-does-it-cost/

In the next section I’ll go over the reasons why this makes such a big difference. But first, how did it happen? As should be evident by the chart, this is essentially the story of one company — SpaceX.

The driving ambition for Elon Musk when he founded SpaceX in 2002 was to drastically reduce the cost of escaping Earth’s gravity. Their “MVP” was the Falcon 1, a single-engine rocket that could launch small satellites. Falcon 1 only launched 5 times, with only the last 3 succeeding. Haven proven viability, SpaceX quickly moved onto production of the Falcon 9, a scaled up version with nine Merlin engines eventually capable of delivering over 22,000 kg to Low Earth Orbit (LEO). Here’s the price progression of each SpaceX rocket, starting from the base of what a conventional rocket costs:

From a conventional rocket price of $10k per kg to LEO, to a price of $60/kg for a Starship with 50 launches, over 100x lower. See the Google Sheet here to check my math.

Driving the first order-of-magnitude reduction in cost are the following:

  • Engineering from first principles. Designed and engineered from the ground up, famously using first principles to rethink standard industry practices. This led to seemingly trivial savings like using ethernet cables rather than serial cable bundles. But added up they make a huge difference.
  • Better incentives. Traditional government contracts were cost-plus. This incentivizes contractors to increase their costs both to make more profit and for more admin overhead to track expenses. With fixed-prices, companies are incentivized to drive costs down as much as possible.
  • Standardization of launch config. Rather than customized configurations for each launch and customer, SpaceX “productized” the Falcon 9, allowing for cheaper setups and repeated processes.
  • Reusability. Why is air travel cheaper than space travel? It’s obvious, right? Aircraft are reusable while rockets are destroyed after a single use. But not anymore, as anyone not living under a rock now knows that SpaceX can land and reuse the first stage(s) of their rockets.

And the next 10x reduction with Starship:

  • Bigger rocket. There are economies of size in rocketry: The bigger the rocket, the higher the payload-to-fuel ratio can be.
  • Full flow combustion cycle engine. This higher-complexity engine design makes it more efficient and capable of being reused many times with very little maintenance.
  • Lower-cost methane as fuel. Methane is cheaper than the previously used RP1 (rocket fuel), and SpaceX is planning on literally drilling for methane gas on their Texas property and synthesizing it on their converted oil rigs. (It can also be synthesized on Mars…)
  • Full reusability. 100% of Starship will be reusable, allowing dozens (or hundreds?) of uses for each stage and engine.
  • More launches. The more launches you can sell in a year, the less markup you need to charge to cover admin costs. Economies of scale and purchasing power are also achieved in raw materials and fuel production.
  • Refuel in orbit. Starship can park in orbit while it’s refueled by up to 8 other launches. This makes payload capacity to orbit the same as payload capacity to nearly anywhere in the solar system. Imagine what we can do with the ability to send over 100 tons to Moon, Mars or Europa.

Government funding, particularly from NASA, has been a key enabler. Without these contracts it would have been very difficult for SpaceX to fund R&D. And they’ll continue to play a key role for SpaceX and other commercial space providers. In recent years NASA has stepped up their commercial contracts significantly, and with further falling costs this is likely to continue. (See footnote [2] for a list of recent milestones.)

This moment for space companies is the equivalent of 1995 when the NSF dropped all restrictions on Internet commerce, which let private companies take over the backbone. The breaking of the dam that releases a tidal wave of activity.

The cost-driven industry flywheel

Expensive launches aren’t just costly in their own right — they lead to cost inflation of everything else. If it costs $100M to get a satellite to orbit, reducing the cost of development from $10M to $5M is only a 5% difference. So why not over-engineer, paying up for components and testing to ensure everything is perfect? Now if a launch costs $10M, there’s more incentive to cut costs. Even if there’s an issue, a second launch is much cheaper. Order-of-magnitude-lower launch costs will lead to similar decreases in payload costs.

From a Morgan Stanley report:

Currently, the cost to launch a satellite has declined to about $60 million, from $200 million, via reusable rockets, with a potential drop to as low as $5 million. And satellite mass production could decrease that cost from $500 million per satellite to $500,000.

More launches will lead to even cheaper costs, which will lead to cheaper payloads, which… see where I’m going here?

There are 4 distinct feedback loops here, all driving more launches. Not shown in this diagram are balancing (negative) loops involving things like launch failures or excessive regulations.

SpaceX has initially started the flywheel that got the industry to this inflection point.[3] But it won’t be the only one turning it. Ultimately to truly take advantage of space transportation we’ll be seeing many competing service providers, at all different levels of payload size and capability.

The flywheel is already turning and has led to a higher volume of launches:

https://en.wikipedia.org/wiki/Timeline_of_spaceflight

At some point in the near future we’ll be seeing a launch per day, with spaceports treated more like shipping ports: hubs of travel and commercial activity.

Current state of the industry

Before moving on to Part II, I want to quickly review the two main categories of payload currently being launched:

  1. Government research and exploration.
    1. International Space Station cargo. In the U.S. this encompasses missions for Commercial Resupply (sending equipment and supplies) and Commercial Crew (sending people).
    2. Other research and exploratory efforts. This includes missions like the recently landed Mars Perseverance rover, the James Webb Telescope set to launch after much delay later this year on an Ariane 5 rocket, and the Europa Clipper set to launch in 2024.
  2. Satellites. Communication and Imaging satellites account for a vast majority of the space industry. Exploratory missions get all the publicity, but they are currently very tiny. This will continue, especially with broadband internet constellations.

    The use of communication satellites in particular is already a ubiquitous part of everyday life: from GPS navigation[4] to phone calls, TV signals, internet, and more. Satellite imagery as well: what once was a tool for only the military and intelligence agencies of large governments is now used by anyone with a smartphone.

    Satellites come in a range of sizes, from tiny CubeSats the size of a shoebox launched 100s at a time; to huge geostationary satellites that take up the entire payload of a rocket.[5] Most of this hardware — particularly for the larger ones — requires costly, sophisticated engineering and infrastructure. The full stack can include satellite manufacturers, operators, suppliers, and ground equipment. As costs come down, so will satellite size and launch frequency.

What’s to come

I hope I’ve convinced you that getting to space is about to get a whole lot easier.

In Part II, I’ll talk about the progress we will potentially see in space in the upcoming 10 to 20 years: commercial space stations, tourism, manufacturing, mining, exploration and more.


Footnotes

  1. The same is true for biotech in the upcoming decades. Areas like AI and Crypto will play big roles as well, but they’re not the thing. They’re the “thing that gets us to the thing“.
  2. Here’s a timeline of a few milestones:
    • 2008-12 — Commercial Resupply Services (CRS) contract of $1.6B to SpaceX and $1.9B to Orbital Sciences to deliver supplies to ISS. This helps fund Falcon 9 development.
    • 2012-05 — SpaceX Dragon capsule launches “empty” to perform tests and dock with the ISS, the first commercial spacecraft ever to do so.
    • 2012-10 — SpaceX CRS-1 mission sends Dragon with supplies to ISS. Dragon is the only cargo vehicle at the time capable of returning supplies to Earth.
    • 2014-09 — NASA awards final Commercial Crew Program (CCP) contract to SpaceX ($2.6B) and Boeing ($4.2B) for the capability to send 4-5 astronauts to the ISS. First flights for both initially planned in 2017.
    • 2020-01 — NASA awards Axiom Space the first ever contract to build a commercial module for the ISS.
    • 2020-04 — NASA awards lunar lander contracts to Blue Origin, Dynetics, and SpaceX under the Artemis program. The goal is to land “the first woman and the next man” on the Moon by 2024.
    • 2020-05 — Commercial Crew Demo mission sends 2 astronauts to ISS. These are the first astronauts on a commercial mission, and the first from US soil since retirement of the Space Shuttle in 2011. 10 million people worldwide watched it live.
    • 2020-11 — Crew 1, the first operational flight, sends 4 astronauts to ISS. Due to delays and other issues, Boeing’s Starliner isn’t set to fly for another year.
    • 2020-12 — NASA awards Blue Origin a Launch Services contract to transport planetary, Earth observation, exploration and scientific satellites.
  3. Elon Musk is a master at many things, but one of the greatest is his ability to get massive, company- or industry-wide flywheels moving.
  4. Global Positioning System (GPS) was developed by the military in the 1960s but not made public until 1996. GPS is an extremely critical part of our current technical infrastructure. Every time you use your phone to navigate, order food, or track your run, it is pinging multiple GPS satellites to triangulate your exact location.
  5. Here’s a good visual size comparison of satellites:

Tech Stack Trees

Every product is built on and enabled by one or more technologies.

Understanding where a product fits on its higher-level tech stack is an important part of any long-term strategy or investment thesis.

The following is an exploration of tech stacks: what they are, how to model them, and what roles their components play. I also discuss what insights can be gained, such as potential opportunities to expand the business.

Stack Trees

Typically, a tech stack shows what infrastructure a technology is directly built on or requires. A SaaS startup for example could have a front- and back-end software stack with a cloud provider like AWS under it. The tech in focus is on top of the stack, with the supporting layers below it.

A tech stack tree is a higher-level version, branching both above and below the “layer” in focus. It shows both what the technology directly relies on and what relies on it. Stacks are fractal in nature, just like trees. An innovation spawns many others that use it, which further enable others, and so on.

A stack tree shows the relevant “slice” of the full dependency graph, going only a few nodes out. It looks something like this:

How to model a stack tree

Step 1: Determine the core tech. The first step is to decide what the actual technology in focus is. A technology in this case is a physical tool, process or system of other technologies that combine to do a job. It does not include businesses or social innovations. (A “business” is just a group of physical and social technologies united under a strategy — but we’re only concerned with the physical part here.[1])

Examples can range from the simple: hammers, glass, newspapers, or an assembly line process; to the more complex: CPUs, streaming video services, blockchains, smartphones, or nuclear reactors.

Step 2: Layers below. What are the primary technologies and processes needed to create and maintain the core tech? What does it need not only to function but to be sustainable? Clues can be found in:

  • Why now: What enabled the tech in the first place? Why wasn’t it widely used 20 or 50 years earlier?
  • Suppliers & major cost centers of businesses producing the tech. (Infrastructure, manufacturing tech, service networks…)
  • Supply chain & logistics: What gets the product/service to customers? (Transportation, shipping, internet…)
  • Distribution tech: What gets the customers to the product? (Retailers, advertising, search engines…)

Step 3: Layers above. What does the tech directly enable? It’s possible there are no layers here. Many well-known innovations don’t directly enable other tech, like Netflix.

  • What do other businesses use it for? Who is it a supplier to?
  • Is there anything in-between the technology and the ultimate end-user?
  • Is it a marketplace or multi-sided network that connects many groups of users?

Stack tree examples

Here’s a few examples of stack trees from the tech industry, although they can be drawn out for products any industry:

(The Amazon “Vampire Squid” is the best example I can think of traversing the stack, starting as an online marketplace and expanding outward in all directions: up, down, and sideways (I left out Prime, Music, Video, etc.).

What insights can be gained?

Companies are embedded in value networks because their products generally are embedded, or nested hierarchically, as components within other products and eventually within end systems of use. — Clayton Christensen

A tech stack tree is one way of looking at a company’s value network. This can lead to insights into where value flows, who captures it, and potential opportunities to expand the business.

What layers in the stack capture the most value?

Which technologies accrue most of the value depend on many things: how much value (productivity) created relative to alternatives, availability of potential substitutes, the size of the overall need, or other competitive advantages inherent to the business model.

One of the models Clayton Christensen uses makes sense to apply here: Where is the bottleneck in demand? In other words, where in the stack is the biggest difference between performance demanded and performance supplied? What needs to be better?

Nvidia is a good example here. They keep churning out GPUs with higher capabilities and the market keeps needing more. Supply hasn’t kept up with demand and that’s likely to continue for some time. This bottleneck (along with other factors ) allows the GPU layer to capture a lot of value.

Are there opportunities to expand into adjacent technologies?

Amazon (see stack above) is the prototypical example here. They started as an online marketplace with some fulfillment operations, and over time have expanded in all directions.

In more traditional business thinking, you consider expanding vertically into suppliers and customers or horizontally across industries. Traversing a tech stack is similar, but to me more focused on the true technological and needs-based relationships. Traditional business thinking would have never led to Amazon expanding into internet infrastructure via AWS.

Of course, expanding for the sake of it is never a good strategy. You have to ask:

  • Do our current products or processes give us an advantage here?
  • How much value does the layer capture? (Is it a bottleneck in demand?)
  • Are there existing barriers to entry, and if so, does our position in other stack layers help overcome them?
  • Does this improve the outcomes for our current customers?
  • Will expansion endanger our relationships with partners or customers?

Short case study: Food delivery apps

The core tech here is a mobile or desktop app where you can order food from many local restaurants and get it delivered within ~1 hour. DoorDash, UberEats, Postmates, etc.

Layers below: What are their major cost centers? Restaurants and delivery drivers. What enabled delivery apps? Primarily ubiquitous smartphones and access to GPS-based navigation. Restaurants also need to have some way to communicate, whether by phone or Wifi-based tablets, and be able to package food in proper take-out containers (plus potentially many others to manage operations).

Layers above: What needs delivery apps to run? Cloud kitchens, which operate large strategically located kitchens that can make food for many different branded “restaurants”. Recently a further layer was added with the concept of pop-up branded chains, which uses the cloud kitchen & delivery infrastructure.

What captures the value? In the stack above, smartphones capture far more value than any other tech — but they’re a platform with thousands of other use cases. In this case we just want to focus on value flow within the food delivery market. It may not be clear at first who captures more value: the delivery apps or the restaurants, given companies like DoorDash are losing so much money. But it’s clear that restaurants are not a bottleneck in demand — so it’s likely the apps that capture more value. And it seems their unit economics bear this out.

Opportunities for expansion? The clearest opportunity to expand within the tech stack is into cloud kitchens. This could potentially alienate some restaurant partners, but restaurants are so fragmented it shouldn’t matter. I think this has a lot of potential given: captive customers, synergies with delivery app, and lower costs with economies of scale and not having to operate normal restaurant ops.

Functions in the stack

How would you classify technologies in the stack? I think it’s most informative to categorize by what pattern (or archetype) they match in the greater ecosystem. These are functions that can exist in any industry or stack tree: Platforms, protocols, etc.

I’ll follow up with another post including examples of different tech functions and stack patterns.

To be continued…


Thanks to Leo Polovets and Jake Singer for helpful feedback on this post. Header photo from veeterzy on Unsplash.


Footnotes

  1. Physical technologies are “methods and designs for transforming matter, energy, and information from one state into another in pursuit of [goals]“. There are also social technologies (organizational processes, culture, values, incentive systems, memes, etc.) that evolve and build off of each other over time. (Definitions from The Origin of Wealth, by Eric Beinhocker.) ↩︎

1976 Buffett Letter About Geico

July 22nd, 1976

Mr. George D. Young,
National Indemnity Company,
3024 Harney Street,
Omaha, Nebraska. 68131.

Dear George:

Thanks very much for your memo of July 19th regarding GEICO which I believe summarizes well the problems attendant to the specific property treaty we are discussing, as well as the general problems associated with reinsurance of any type at GEICO. I still am willing to explore further the GEICO property treaty—if they subsequently decide that it fits their needs—and today committed to Jack Byrne that we would take a 1% quota share of their entire book. This increase from .8 of 1% was pursuant to his request in order to help him attain the 25% mark by the shareholders meeting tomorrow.

I consider the overall quota share to be an acceptable—but not exciting—piece of business. Under normal conditions we would take nothing like 1%, obviously, since that makes it by far the largest reinsurance treaty on our books, and involves substantial risks along with a limited prospect of profit. I also do not like the feature that provides for a credit to GEICO for interest earnings on funds held by us. In effect, we are making this contract number one in size for the reinsurance department, whereas the contractual terms make it less attractive than most of our other contracts.

However, I have three reasons for taking this unusually large portion of the quota share arrangement, and these same reasons also apply to my interest in the property treaty.

  1. I hope it is not a governing factor in any way, but I do have some sentimental reasons for wishing GEICO to survive. GEICO has enumerated all of the hard headed reasons, such as the State Financial Guaranty funds, etc. I just have pulled out of the bottom drawer of my desk a statement of my net worth at the end of 1951 when I was 21 years old. I showed net assets of $19,737, of which $13,125 was in GEICO stock. That was the year when I first started selling securities, and I told everyone who would listen to me that they should put every cent they could scrape together into GEICO. A number of friends and relatives did so, and enjoyed a significant change in their financial fortunes because of this. It provided the first big boost to my own small savings, as well as an even more important boost to my reputation in the Omaha investment community.

    During those early years, when I followed the company, the people involved couldn’t have been nicer. Leo Goodwin was running things then and was helpful. Even moreso was L. A. Davidson. He was personally encouraging and forthcoming with information regarding the business, which enabled me to develop a depth of conviction which I have felt few times since about any security.

  2. At that time I felt that GEICO possessed an extraordinary business advantage in a very large industry that was going to continue to grow. Since that time they never have lost that advantage—the ability to give the policyholder back in losses a greater percentage of the premium dollar than any other auto insurance company in the country, while still providing a profit to the company. I always have been attracted to the low cost operator in any business and, when you can find a combination of (i) an extremely large business, (ii) a more or less homogenous product, and (iii) a very large gap in operating costs between the low cost operator and all of the other companies in the industry, you have a really attractive investment situation. That situation prevailed twenty-five years ago when I first became interested in the company, and it still prevails.

    The company managed to nullify this advantage—and even more than nullify it—by inadequate recognition of loss costs through poor techniques of loss reserving. This led to improper pricing of product with the result that a product which *could* have been sold at a profit *was* sold at a loss.But the important point to note is that the company had not lost its position as a low cost operator; they merely had mismanaged their loss information which caused the product to be priced inadequately. I believe the advantages of a 13% acquisition cost ratio are as important as ever. I also believe that practically no other companies are going to achieve costs near that figure in the future. Therefore, GEICO, properly managed, should prosper if they can pull themselves back from the financial precipice.

    I like very much what Jack Byrne says about reducing policies in force. It seems to me that such an approach a rather than an obsession with growth is very likely to reconstruct the situation whereby they can give the policyholder an unusually high percentage of the dollar back in losses and still make good profits for themselves.

  3. The crucial factor, then, becomes whether they can get past their present financial difficulties. Much of the press –witness Time last week—assumes that they can’t. Until recently, I was unclear myself as to their possibilities in this regard. If they had been at all wishy-washy in obtaining rate increases or biting the bullet generally, I don’t think they would have made it. However, the size of the rate increases they have instituted, along with the underwriting results they have published for April and May, have convinced me that their combined ratio will come down to tolerable limits within a fairly short time.

    Even this would not have been enough if Mr. Wallach were inclined to put them into receivership because of the unwillingness of the industry to accept his 40% plan. When he did not move to do so after the June 23rd deadline, it convinced me that he was not going to act precipitously to terminate a business that fundamental economic logic still dictated had a bright future ahead of it. When he did not bow his back over the non-subscription to his 40% plan, I believe the company’s future became assured. I decided then to buy stock, which is the most tangible evidence I can give you as to my assessment of the Company’s chances for survival.

Therefore, George, I will take the responsibility for making the decision that GEICO survives as a business entity. You should make any underwriting judgments that you wish, with this as the premise—if I am wrong about their survival, it will be my fault and not yours. I do not want to go overboard because of sentiment, but I certainly want us to make every effort to come up with proposals that make business sense to us and are useful to them. I do not want mare of the overall quota share because I consider the terms too disadvantageous to the reinsurer, all things considered. But, if a property treaty can be put together with a prospect of gain that more than balances the risk of loss, let’s proceed.

Sincerely,

Warren E. Buffett

WEB/glk

Book Notes: Benjamin Graham

As with my other book notes, some passages are direct quotes and others are my own paraphrasing/summaries. Any footnotes or [brackets] are my personal comments.

The Intelligent Investor (1973) + Security Analysis (1934), by Benjamin Graham

Benjamin GrahamTo invest intelligently in securities one should be forearmed with an adequate knowledge of how the various types of bonds and stocks have actually behaved under varying conditions—some of which, at least, one is likely to meet again in one’s own experience.

An investment operation is one which, upon thorough analysis promises safety of principle and an adequate return. Operations not meeting these requirements are speculative. An investment operation is one that can be justified on both qualitative and quantitative grounds.

We speak of an investment operation rather than an issue or a purchase, for several reasons. An investment might be justified in a group of issues, which would not be sufficiently safe if made in any one of them singly. In our view it is also proper to consider as investment operations certain types of arbitrage and hedging commitments which involve the sale of one security against the purchase of another. The safety sought in investment is not absolute or complete; the word means, rather, protection against loss under all normal or reasonably likely conditions or variations. A safe stock is one which holds every prospect of being worth the price paid except under quite unlikely contingencies.

Outright speculation is neither illegal, immoral, nor (for most people) fattening to the pocketbook. There is intelligent speculation as there is intelligent investing. But there are many ways in which speculation may be unintelligent. Of these the foremost are: (1) speculating when you think you are investing; (2) speculating seriously instead of as a pastime, when you lack proper knowledge and skill for it; and (3) risking more money in speculation than you can afford to lose.

The defensive (or passive) investor will place his chief emphasis on the avoidance of serious mistakes or losses. His second aim will be freedom from effort, annoyance, and the need for making frequent decisions. The determining trait of the enterprising (or active, aggressive) investor is his willingness to devote time and care to the selection of securities that are both sound and more attractive than average.

Obvious prospects for physical growth in a business do not translate into obvious profits for investors. The future of security prices is never predictable.

In his endeavor to select the most promising stocks wither for the near term or the longer future, the investor faces obstacles of two kinds—the first stemming from human fallibility and the second from the nature of his competition. He may be wrong in his estimate of the future; or even if he is right, the current market price may already fully reflect what he is anticipating. In the area of near-term selectivity, the current year’s results of the company are generally common property on Wall Street; the next year’s results, to the extent they are predictable, are already being carefully considered. Hence the investor who selects issues chiefly on the basis of this year’s superior results, or on what he is told he may expect for next year, is likely to find that others have done the same thing for the same reason. To enjoy a reasonable chance for continued better than average results, the investor must follow policies which are (1) inherently sound and promising, and (2) not popular on Wall Street. Continue reading “Book Notes: Benjamin Graham”

Warren Buffett on Pensions (1975)

This is the full text letter from Warren Buffett to Katherine Graham discussing pensions, as released by Fortune. I find this easier to read on things like Instapaper than the PDF version.

PENSIONS

There are two aspects of the pension cost problem upon which management can have a significant impact: (1) maintaining rational control over pension plan promises to employees and (2) increasing investment returns on pension plan assets.

The Irreversible Nature of Pension Promises

To control promises rationally, it is necessary to understand the basic arithmetic and practical rules governing pension plans.

The first thing to recognize, with every pension benefit decision, is that you almost certainly are playing for keeps and won’t be able to reverse your decision subsequently if it produces subnormal profitability.

As a practical matter, it is next to impossible to decrease pension benefits in a large profitable company—or even a large marginal one. The plan may embody language unequivocally declaring the company’s right to terminate at any time and providing that contributions shall be solely at the option of the company. But the law has eroded much of the significance such “out” clauses were presumed to have, and operating practicalities render any residual rights to terminate moot.

So, rule number one regarding pension costs has to be to know what you are getting into before signing up. Look before you leap. There probably is more managerial ignorance on pension costs than any other cost item of remotely similar magnitude. And, as will become so expensively clear to citizens in future decades, there has been even greater electorate ignorance of governmental pension costs. Actuarial thinking simply is not intuitive to most minds. The lexicon is arcane, the numbers seem unreal, and making promises never quite triggers the visceral response evoked by writing a check.

In no other managerial area can such huge aggregate liabilities—which will be reflected in progressively increasing annual costs and cash requirements—be created so quickly and with so little immediate financial pain. Like pressroom labor practices, small errors will compound. Care and caution are in order. Continue reading “Warren Buffett on Pensions (1975)”

Why Buffett Didn’t Buy the Post

There have been many speculations about why Warren Buffett — a long time shareholder, admirer, and one-time delivery boy of the Washington Post — opted not to purchase the company. Berkshire Hathaway has over $35 billion in cash and they’ve been purchasing local papers recently, so passing on the Post is curious at first glance.

Followers of Buffett have pointed to the fact that he has a policy of not buying into money-losing businesses in a shrinking industry.

But I think the real reason is that Buffett believes the Post will be better off in the hands of Bezos. For the Post to stop losing money, it needs some serious changes — changes that would be difficult for Berkshire to provide. The company would be only a tiny part of the massive conglomerate, and there wouldn’t be a figurehead leader to guide the paper during such a turnaround.

Buffett admires and respects Jeff Bezos.* He also loves the Washington Post enough to look past his own desires so it can have a brighter future. Don Graham no doubt sought Buffett’s advice before making this decision, and I’d like to believe this is what he told him.

* It’s also worth noting that the admiration is mutual. One of the major aspects of Buffett’s success is his ability to realize talent in others. It’s easy to see that talent in someone who knows strategy, history, product, and capital allocation so well.

Dear Mrs. Graham

In 1973, the Washington Post Company couldn’t have been a more widely revered media company. The Watergate scandal, which Bob Woodward and Carl Bernstein begun reporting on in mid-1972, came to a spectacular end with President Nixon’s resignation in August 1974. But the reverence of the publication didn’t match the company’s popularity on Wall Street. The Post—along with many other stocks at that time—was trading at historic lows.

Below is the letter that Warren Buffett wrote to Katharine Graham in June 1973 after he had acquired over 5% of the stock. By the end of the year his stake had increased to 10%. The letter gives a lot of insight into how Buffett viewed the Post—not only as an investment, but as a business with noble purposes that brings out his sentimental side.

This purchase represents a sizable commit ment to us—and an explicitly quantified compliment to the Post as a business enterprise and to you as its chief executive. Writing a check separates conviction from conversation. I recognize that the Post is Graham-controlled and Graham-managed. And that suits me fine.

Some years back, a partnership which I managed made a significant investment in the stock of Walt Disney Productions. The stock was ridiculously cheap based upon earnings, asset values and capability of management. That alone was enough to make my pulse quicken (and pocketbook open), but there was also an important extra dimension to the investment. In its field, Disney simply was the finest—hands down. Anything that didn’t reflect his best efforts—anything that might leave the customer feeling short-changed—just wasn’t acceptable to Walt Disney. He melded energetic creativity with a discipline regarding profitability, and achieved something unique in entertainment.

I feel the same way about The Washington Post. The stock is dramatically undervalued relative to the intrinsic worth of its constituent properties, although that is true of many securities in today’s markets. But, the twin attraction to the undervaluation is an enterprise that has become synonymous for quality in communications. How much more satisfying it is going to be to watch an investment in the Post grow over the years than it would be to own stock in some garden variety company which, though cheap, had no sense of purpose.

I am additionally impressed by the sense of stewardship projected by your communications to fellow shareholders. They are factual, complete and interesting as you bring your established newspaper standards for integrity to the newer field of corporate reporting.

You may remember that I was in your office about two years ago with Charles Munger, discussing the New Yorker. At the time I mentioned to you that I had received my financial start delivering the Post while attending Woodrow Wilson High in the mid 1940’s. Although I delivered about 400 Posts per day, my record of loyalty is slightly tarnished in that I also had the Times-Herald route (much smaller—my customers were discriminating) in the Westchester. This was perhaps the first faint sign to keenly perceptive Washingtonians that the two organizations eventually would get together.

I should mention that Berkshire Hathaway has no radio or television properties, so that we will not be a complicating factor with the FCC. Our only communications property is the ownership of Sun Newspapers of Omaha, a group of financially (but not editorially) insignificant weekly newspapers in the metropolitan Omaha area. Last month our whole organization, seventy people counting printing, went into orbit when we won a Pulitzer for our reporting on Boys Town’s undisclosed wealth. Incidentally, Newsweek and Time used approximately equal space in covering the story last year, but Newsweek’s reporting job was far superior.

You can see that the Post has a rather fervent fan out in Omaha. I have hopes that, as funds become available, we will add to our holdings, at which time I will send along amended 13-D filings.

Cordially,
Warren E. Buffett

This letter was taken from Katharine Graham’s wonderful autobiography, Personal History.

Mental Model: Fitness Landscapes

UPDATE (September 2020): I wrote a more in-depth, detailed explanation of fitness landscapes and how they can be applied across disciplines. The original (shorter) version is still below but I’d recommend the latest one for a better understanding of the model.


Fitness Landscapes are used to visualize the relationship between genetic makeup (genotype) and evolutionary fitness (the ability to survive and reproduce). A fitness landscape is a vast landscape divided into a grid of billions of squares. Each square represents a genotype—some squares represent birds; some fish; some humans; with the majority being all the variations of genetic possibility that couldn’t survive in reality. Each square is very similar to its neighbors: two of the same species with a small variation, or two different but related species. The closer the squares, the more similar the genotype, and the further the squares, the more different. The fitness of each genotype is represented by its height on the landscape. Valleys represent low fitness, mountain peaks high fitness.

Fitness Landscape

Over time, species tend to move up the landscape to the nearest peak (A), where all future paths of variation lead downward. The peak that a genotype “settles” on is most likely to be a local optimum, which is not necessarily the highest peak in the landscape (a global optimum). This is because selection pushes fitness towards nearby peaks (what is called a basis of attraction), but lacks the foresight to select the highest peak.

To get to a higher peak, a species may have to reduce its fitness in the near term (C) as it slowly traverses across a valley in order to improve fitness in the long term. In order to make this shift, there has to be sufficient instability or challenge; otherwise, an organism will not opt to leave the intermediate peak and suffer the unknown prospects of the valley. If the valley is too low or the higher peak too far away, it may be unreachable as the low fitness hurdle can’t be overcome. (An example is the lack of wheeled animals, which although beneficial is inaccessible due to the valley of low fitness genotypes around it.)

Evolution usually moves in small steps, but occasionally it takes wild leaps—a single mutation might give a creature an extra pair of legs or another radically different feature. Most of the time these leaps result in much lower fitness (B), and therefore don’t last. But other times it allows the genotype to jump to a higher peak without the slow process of going down before going up.

Every landscape has different terrain that can be on a scale from flat to rugged. A rugged or coarse landscape has many local peaks and deep valleys, while a flat landscape has only very small hills (all genotypes have about the same success rates).

Landscapes don’t remain static—they shift over time due to either environmental changes or adjustments as organisms move across it. The movement can vary from being stable (relatively flat and slow to change) to roiling (likely rugged and changing quickly). Given the likelihood of ever-shifting landscapes, the evolutionary mix of small steps and occasional wild leaps is the best possible way to adapt to the environment.

Berkshire Hathaway Letters to Shareholders

Berkshire Letters CoverI’m excited to announce the release of a book I’ve been working on for about 6 months now, and first started in 2010.

It’s a compilation of every letter Warren Buffett wrote to the shareholders of Berkshire Hathaway. I first created it a few years ago for myself and friends. Last year I got Buffett’s endorsement — plus a few non-public letters — to publish the book for the benefit of fans and shareholders of Berkshire.

Here is the official page with all the details. There you can find a more detailed description, plus some sample pages and a chart detailing the performance of Berkshire’s insurance operations. (For any programmers out there, the chart was created with D3. You can check out the development version on GitHub.)

Features of the book:

  • Berkshire Hathaway annual shareholder letters from 1965 to 2012 (706 pages), including the 11 earliest letters not available on Berkshire’s website
  • Tabulated letter years so you can easily flip to the desired letter
  • Topics index
  • Company index
  • Person index
  • Charts of:
    • The growth in Berkshire’s book value and market price relative to benchmarks
    • Insurance float and performance
    • The operating businesses of Berkshire

The entire book is paginated, and has easy-to-flip-to labels for each letter’s year.

It is available for pre-order now. The first batch will be sold at the Berkshire Hathaway Annual Meeting on May 4 in the convention center. The rest of the copies will be available on Amazon on May 7.

Future projects

  • The obvious next step is to publish a digital version, easily readable on iPads or potentially Kindles. This is normally an easy transfer, but that’s not the case with this book due to the many tables that have to be converted. So no timeline on this but it will be forthcoming.
  • A book of letters to the partners of Buffett Partnership, Ltd., Buffett’s hedge fund he ran from 1957 to 1970. This will be a similar format to the Berkshire book, with indexes, page numbers, etc.

How to separate luck and skill

These are some of my notes from the book “The Success Equation” by Michael Mauboussin. This book was spotted on Warren Buffett’s desk in this tour of his office. There’s lots more interesting stuff in the book, but these notes in particular answer the question “How do you separate luck and skill?” We’ll start off with some definitions:

Luck is a chance occurrence that affects a person or a group (e.g., a sports team or a company). Luck can be good or bad. Furthermore, if it is reasonable to assume that another outcome was possible, then a certain amount of luck is involved. In this sense, luck is out of one’s control and unpredictable. Randomness and luck are related, but there is a useful distinction between the two. You can think of randomness as operating at the level of a system and luck operating at the level of the individual. Luck is a residual: it’s what is left over after you’ve subtracted skill from an outcome.

The definition of skill depends on how much luck there is in the activity. In activities allowing little luck, you acquire skill through practice of physical or cognitive tasks. In activities incorporating a large dose of luck, skill is best defined as a process of making decisions. Here, a good process will have a good outcome but only over time. Patience, persistence, and resilience are all elements of skill.

Separating luck and skill

Luck-Skill Continuum
At the heart of making this distinction lays the issue of feedback. On the skill side, feedback is clear and accurate, because there is a close relationship between cause and effect. Feedback on the luck side is often misleading because cause and effect are poorly correlated in the short run.

In most cases, characterizing what’s going on at the extremes is not too hard. As an example, you can’t predict the outcome of a specific fair coin toss or payoff from a slot machine. They are entirely dependent on chance. On the other hand, the fastest swimmer will almost always win the race. The outcome is determined by skill, with luck playing only a vanishingly small role.

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