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.

Continue reading “How to separate luck and skill”

Instacart: analysis of a startup

InstacartInstacart is a seed-stage startup that delivers groceries and other basic items in a very short timeframe. They are the “ with a 1 hour delivery.” At the moment their current market is only San Francisco and the Silicon Valley area. Customers can place either a 3-hour order ($3.99) or a 1-hour order ($14.99).  Orders are routed to shoppers who work for Instacart, who then pick up the items at a local store and deliver them within the timeframe.

In October they raised $2.3 million from Canaan Partners and Khosla Ventures. Below is a  a very brief analysis if I were considering a potential investment in Instacart.

Quick analysis

So basically Instacart uses software (algorithms & data analysis on the back-end, with good UI design on the front-end) to connect “deliverers” in need of cash with “buyers” who need quick delivery of basic items.

Opportunity: arbitraging the demand for instant satisfaction and convenience, using software + crowdsourcing. This will be disrupting convenience stores on the low-end, and potentially grocery stores in the future. It is taking advantage of the trends in mobile computing, data analysis, and e-commerce (willingness to trust online vendors).

Potential moatsbrand habit developed through repeated purchases. Learning curve — should remain ahead of competition on the learning curve because of technology (software) advantage. This is a business where it pays to have lots of data on: customer habits, traffic, prices, store traffic, etc. It is a virtuous circle: the learning curve reinforces customer experience, which improves the brand. These advantages are all geographically local, so it will be best to roll out to new cities as quickly as possible once the kinks are worked out.

Management: with only doing minimal due diligence with public information on the founders, I didn’t see any red flags. Apoorva Mehta has worked on the Amazon supply chain, so he has some experience in the business. All founders on the surface seem to be very talented. What am I looking for? Amar Bhide found that the most important traits for the founders of a typical startup are the dichotomies of: (1) seeking uncertainty while being risk averse; and (2) persevering while being adaptable.

What could go wrong: (1) other cities are not as receptive to the concept; (2) Amazon or other grocery company catches on and preempts their growth in new cities.

Investment edge: structural (not very many participants at this early stage) and psychological (grocery delivery has failed many times in the past, sometimes spectacularly — Webvan — investors are turned off by the concept because of these past failures).

Final note

This seems like a company with a good future ahead of it. That usually makes it a good investment, especially at this stage. I’m not sure what the valuation of the company is at the moment. But for a startup at this stage, the precise valuation you invest at isn’t usually as important as how well the company does (within limits, of course — refer to the internet bubble).

Disclosure: I have no ownership in Instacart.


Crunchbase: Instacart
Mobile first, desktop second…
I Trusted a Total Stranger to Buy My Groceries…
Instacart Bags $2.3M To Become Amazon of Groceries
How Instacart Hacked YC

Groupon Revisited

I never purchased shares in Groupon as it was obviously overvalued at first, and as the price fell I became more skeptical of the ability of anyone to predict future cash flows with any margin of safety.

The accounting troubles were unfortunate — I think this was a result of bad internal controls combined with extremely aggressive private market owners pushing to sell out to the public at high prices.

As I mentioned in my first post about Groupon’s competitive advantages, I still think it is very possible to have barriers to entry in this business, and to maintain high market share. People who claimed that the market was too commoditized turned out to be wrong in the end: so far, Groupon and LivingSocial have roughly maintained their market shares.

WSJ: “Groupon’s Growth Slows”:

Groupon has faced a series of hiccups since going public, including financial revisions and questions from regulators, as well as concerns that consumers are tiring of the daily discounted offers that it provides from merchants.

I think the last reason was the real downfall — not competitive pressure. I admitted the concept was faddish in my first post but clearly overestimated the sustainability of the online “group coupon” model in terms of popularity (Groupon, LivingSocial, Travelzoo, etc.).

I think it was originally a great idea — and it will continue to be a good product for certain businesses and consumers. But the incredible growth of the idea was short-lived. It turned out the be the “Peak of Inflated Expectations” in the Gartner Hype Cycle:

The idea itself became a fad among consumers (myself included) and as time went on people became either bored or sick of the idea. Small businesses that used the service also found out quickly that issuing a mass amount of hugely discounted coupons isn’t right for every type of business. It works for some, but not all.

At a price of $2.82, current enterprise value is around $750 million or $1.3 billion if you include the float from merchants payable. Will this price turn out to be cheap in hindsight? I still think it’s too hard to tell. But it very well might be if Groupon can right-size its business and reach the “Plateau of Productivity”. There is a certain level of volume that makes sense for this model, they just need to find it without losing too much money along the way.

Found Quotes 2

If you want to build a ship, don’t drum up the men to gather wood, divide the work and give orders. Instead, teach them to yearn for the vast and endless sea… — Antoine de Saint Exupery

The little dissatisfaction which every artist feels at the completion of a work forms the germ of a new work. — Berthold Auerbach

Whatever few awards are presented for risk control, they’re never given out in good times. The reason is that risk is covert, invisible. Risk–the possibility of loss–is not observable. — Howard Marks

Actually, all education is self-education. A teacher is only a guide, to point out the way, and no school, no matter how excellent, can give you education. What you receive is like the outlines in a child’s coloring book. You must fill in the colors yourself. — Louis L’Amour

I like nonsense, it wakes up the brain cells. Fantasy is a necessary ingredient in living, It’s a way of looking at life through the wrong end of a telescope. Which is what I do, And that enables you to laugh at life’s realities. — Dr. Seuss

There is no terror in the bang, only in the anticipation of it. — Alfred Hitchcock

It is much harder to become independent if you are wealthy than to become wealthy if you are independent. — Nassim Taleb

Nothing is original. Steal from anywhere that resonates with inspiration or fuels your imagination …  Authenticity is invaluable; originality is non-existent. And don’t bother concealing your thievery — celebrate it if you feel like it. — Jim Jarmusch (via Kirby Ferguson @ TED)

My favorite books on business, management, investing and design

Out of the many books I’ve read in different subjects, below is a list of some of my favorites with some brief commentary for some of them. There are a few other “Mental Model” categories (psychology, history, economics, ecology, etc.) that I left out — hopefull they’ll be the subject of another post.

Business theory

  • The Origin and Evolution of New Businesses, Amar Bhide — extensive study of startups of all kinds, how they grow, what makes them successful (this is not a “help” book it is mainly observational)
  • Innovation & Entrepreneurship, Peter Drucker — how companies should systematically innovate — lots of good startup/innovation strategies (it’s not random)
  • The Innovator’s Dilemma, Clayton Christensen — every businessperson or investor needs to read this (and the one below) — every industry’s value chain is disrupted at some point
  • The Innovator’s Solution, Clayton Christensen — expands on “Dilemma” with better explanations and examples — I think the “jobs to be done” concept is one of the most important in business
  • Competition Demystified, Greenwald + Kahn — how businesses capture value by building a moat, and what strategies to use if you have or don’t have one
  • The Halo Effect, Phil Rosonzweig — the anti-business-book — but still has great insights on how businesses work and how best to run them
  • Built to Last, Jim Collins — read this with The Halo Effect in mind — lots of good advice & stories (I like this much better than “Good to Great”)
  • The Strategy Paradox, Michael Raynor — dense at times but a great theory on why strategy is so hard
  • Hidden Champions, Hermann Simon

Continue reading “My favorite books on business, management, investing and design”

Charlie Munger on business education

From Charlie Munger at the 2011 Berkshire Hathaway meeting:

Costco of course is a business that became the best in the world in its category. And it did it with an extreme meritocracy, and an extreme ethical duty—self-imposed to take all its cost advantages as fast as it could accumulate them and pass them on to the customers. And of course they’ve created ferocious customer loyalty. It’s been a wonderful business to watch—and of course strange things happen when you do that and when you do that long enough. Costco has one store in Korea that will do over $400 million in sales this year. These are figures that can’t exist in retail, but of course they do. So that’s an example of somebody having the right managerial system, the right personnel solution, the right ethics, the right diligence, etcetera, etcetera.  And that is quite rare. If once or twice in your lifetime you’re associated with such a business you’re a very lucky person.

The more normal business is a business like, say, General Motors, which became the most successful business of its kind in the world and wiped out its common shareholders… what, last year? That is a very interesting story—and if I were teaching business school I would have Value-Line-type figures that took me through the entire history of General Motors and I would try to relate the changes in the graph and data to what happened in the business. To some extent, they faced a really difficult problem—heavily unionized business, combined with great success, and very tough competitors that came up from Asia and elsewhere in Europe. That is a real problem which of course… to prevent wealth from killing people—your success turning into a disadvantage—is a big problem in business.

And so there are all these wonderful lessons in those graphs. I don’t know why people don’t do it. The graphs don’t even exist that I would use to teach. I can’t imagine anybody being dumb enough not to have the kind of graphs I yearn for. [Laughter] But so far as I know there’s no business school in the country that’s yearning for these graphs. Partly the reason they don’t want it is if you taught a history of business this way, you’d be trampling on the territories of all the professors and sub-disciplines—you’d be stealing some of their best cases. And in bureaucracies, even academic bureaucracies, people protect their own turf. And of course a lot of that happened at General Motors. [Applause]

I really think the world… that’s the way it should be taught. Harvard Business School once taught it much that way—and they stopped. And I’d like to make a case study as to why they stopped. [Laughter] I think I can successfully guess. It’s that the course of history of business trampled on the territory of barons of other disciplines like the baron of marketing, the baron of finance, the baron of whatever.

IBM is an interesting case. There’s just one after another that are just utterly fascinating. I don’t think they’re properly taught at all because nobody wants to do the full sweep.

Tech trends shaping the future

Here are some of the questions I ask when thinking about what trends will shape the business and technology worlds in the years to come:

  • What is becoming cheaper/more abundant/ubiquitous?
  • What is improving productivity across many industries?
  • Does an innovation seem like an inevitable step in the progression of technology?
  • What happens when everyone uses it?

So with that said, what are some of the technology trends that have been, and will be shaping the business landscape? Here are five that I came up with:

  1. Bandwidth and ubiquity of internet access
    1. Software as a Service (Netflix, CRM, Google Docs)
    2. Hardware/Infrastructure as a Service (AWS, Dropbox, Heroku)
  2. Mobile computing
  3. Answer engines / modularized search (Quora, Wolframm Alpha, Wikipedia)
  4. Abundance of simple manufacturing
    1. 3D printing: allows consumers to solve jobs as they arise + democratizes rapid prototyping
    2. Simple electronic programming (Arduino)
  5. Open-source platforms/frameworks (GitHub, Thingiverse, jQuery, Ruby on Rails, other smaller plugins and building blocks)
  6. Distributed funding (Kickstarter, Gittip)

If you can think of any others please comment.

JCPenney: A Transformation


This is a selection from my Q2 letter to the partners of Braewick Holdings. Braewick currently has a position in JCPenney (JCP).

We first purchased shares in JCPenney for $27½ in 2011. But as the difficult transformation has progressed, just as short-term optimism drove the price above $40, short-term worries have knocked the share price down below $22. This gave us the welcome opportunity to increase our ownership at bargain prices.

Worries stem from the inevitable bumpy road to fundamentally changing the business. The first quarter saw sales declines of 20%, and I wouldn’t be surprised if Q2 wasn’t pretty either. But despite what the market believes, the turnaround at JCP is on track.

The first step of the transformation is to decide who your customer base is, and in tandem, what products and services you want to sell them. JCP wants to sell brand-name, fashionable merchandise at affordable prices (similar to Ron Johnson’s previous employer, Target). The second step is to create a unique and outstanding experience within the stores to give customers something they can’t find anywhere else.

The problem with step one is that the desired customer base is different than the current customer base (although there is large overlap). Even with a crystal ball that told management the exact changes needed to attract the new customer base, the “customer replacement” wouldn’t occur on a 1-for-1 basis. It is inevitable that unwanted customers would leave quickly and new customers would take longer to attract.

Let’s take a (very) extreme example: say the management of RadioShack decides the business they’re in is going nowhere and will continually lose economic profit in the future. After some research, they decide the best business to be in is motorcycle repair for hardcore bikers. Imagine a parking lot full of Harleys and a store full of leather-wearing biker gangs. These two customer bases are very different, with little overlap. It would be difficult to engineer a “slow” transition. Now, even if they are correct about the potential of this new business, once they make the change sales will fall off a cliff. Old customers would hate it, and it would take some time for new customers to find out about it. I’m stretching the example a bit, but you get the point.

The following table compares retail statistics in 2011 for JCP and two competitors:


Rent is estimated based on proportion of stores owned vs. leased. The figures in this table make things look dismal for JCPenney… but therein lays the opportunity. Management has stated their intention to lower expenses by $900 million, or $8 a square foot. JCP and Kohl’s both have the same number of employees per same-sized store, so it seems possible to lower overhead by at least $5 a square foot without getting rid of associates and impacting customer experience. Reduced advertising is another possibility with the new pricing strategy.

But the biggest potential future gains come from sales increases. With the operating leverage inherent in the business, a 10% increase in 2011 sales translates into cash earnings over seven times the current amount.

BreitBurn Energy Update

This is a selection from my Q2 letter to the partners of Braewick Holdings. Braewick currently has a position in BreitBurn Energy (BBEP). I posted about our first investment in BreitBurn two years ago.

BreitBurn is essentially a physical oil and gas hedge fund. They invest in properties that have proven reserves, and receive a return on that investment through extracting and selling the oil & gas at market rates. Like a hedge fund, they limit market risk by purchasing various hedges on future prices. Unlike most hedge funds, they have direct involvement in the operations of each of their holdings. Excess returns are achieved through the following methods:

  1. Opportunistic reserve purchases (low price-to-value, or “value investing”)
  2. Good hedging strategy (market timing + exploiting contango in futures prices)
  3. Operational efficiency (keeping costs low and extracting extra reserves)

Units of BreitBurn are currently yielding about 11%, and I believe this yield is safe for multiple years out. In other words, I believe that through a combination of the above methods, value per unit will increase at least 11% per annum.

Here’s their most recent presentation.

Oil pump

Found Quotes

If everything you do needs to work on a three-year time horizon, then you’re competing against a lot of people. But if you’re willing to invest on a seven-year time horizon, you’re now competing against a fraction of those people… Just by lengthening the time horizon, you can engage in endeavors that you could never otherwise pursue. — Jeff Bezos

A mistake is an event, the full benefit of which has not yet been turned to your advantage. — Ed Land, Polaroid

Do not imagine that you have to know everything before you can do anything. My own best work was done when I was most ignorant. — Freeman Dyson

Those who dream by night in the dusty recesses of their minds awake to find that all was vanity; But the dreamers of day are dangerous men, That they may act their dreams with open eyes to make it possible. — T. E. Lawrence

Experience tends to confirm a long-held notion that being prepared, on a few occasions in a lifetime, to act promptly in scale, in doing some simple and logical thing, will often dramatically improve the financial results of that lifetime. A few major opportunities, clearly recognizable as such, will usually come to one who continuously searches and waits, with a curious mind that loves diagnosis involving multiple variables. And then all that is required is a willingness to bet heavily when the odds are extremely favorable, using resources available as a result of prudence and patience in the past. — Charlie Munger

The world’s biggest problem is that not enough people are working on the world’s biggest problems. — Max Marmer, Student of Life, January, 2011