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Kyle Grieve (23:51)

back to the show. One great example covered in this book was a business called Atlantic Acceptance Corporation. Now, this was a Canadian business that specialized in automobile and home lending. So in 1964, it created a considerable amount of buzz because it was just simply a product of its time. It was a time when there was a cultural shift on Wall Street. So you had younger investors that began proliferating, taking over for some of the older generation, and they were tending to take a much more daring approach to investing compared to that prior generation. They resonated more with speculation and gambling over more boring and predictable routes of, you know, compounding your money slowly. So Atlantic was a product of its time. It basically ended up telling a story to its investors that didn't exist. But let's get into that. So Atlantic was led by the gentleman by the name of Campbell Morgan, a former accountant who also enjoyed the cheap thrills of a badly placed bet. So let's rewind to 1955, when Morgan realized that he could tap into public markets Wall street to raise money for his company. He signed on a number of investors, beginning with Lambert and Company, who supplied Atlantic with about $300,000. By 1959, the business appeared to be aging very, very well, and U.S. steel Fund decided to invest. The Ford foundation quickly followed suit. After that, it was quite easy for him to attract new investors, and money just began pouring into this Canadian domicile business on Wall Street. Now, ironically, one of Atlantic's investors was none other than Moody's, who specialized in assessing the credit quality of corporations, by the early 1960s, Atlantic was just crushing it. Sales in 1960 were 25 million. In 1961, it was 46 million. And by 1962 it was 81 million. By 1963, it over doubled to 176 million. So you were looking at just one of the cleanest examples I've ever seen of a business, basically compounding at 100% a year. But here's the thing. The business wasn't based on some sort of pie in the sky technological marvel. It was just a lending business. And lending businesses just don't grow like this for long periods of time. There has to be a reason. It was growing parabolically. And the reason, it turns out, was that it was making loans that its competitors just didn't want to make because they were just too risky. But Atlantic took them on, allowing them to capture more and more premium while just throwing caution to the wind. But here was what Morgan was really doing. So he was basically running a typical Ponzi scheme, relying on fraudulent accounting to just dupe investors. Atlantic would use new capital inflows it raised to make these new risky loans. But that risk was hidden from investors because Atlantic hired complicit accountants that were willing to commit fraud. And these loans obviously made their growth continue to look more and more impressive, which brought in more and more capital. So on their books, they actually overstated assets and they understated their allowance for bad debts. So in 1964, Atlantic published profits of $1.4 million. But in reality, they actually incurred a loss of 16.6 million. By 1965, investors were starting to wonder about their investment. Morgan, who was very fond of gambling, also owned, through Atlantic, a hotel with an attached casino in the Bahamas. This, predictably, did not turn out well either. Eventually, TD bank refused to honor 5 million in Atlantic checks for notes that had been matured. The same day, 41 different brokers received buy orders for Atlantic stock using checks from the same bank account. But the certification was actually fake. And oddly enough, this wasn't even done by Morgan, but by one of his unsavory associates. As a result, even more notes were called for a total of $25 million. But now the scheme was up, as Atlantic just didn't have the funds to pay. As a result, owners of his debt and equity were completely obliterated in bankruptcy proceedings. It was found that there is a paucity of credit information and as far as we were able to ascertain, no real financial control. There appears to be no reporting procedure for real estate machinery and other types of fixed asset loans. Apparently no appraisals were obtained and there was no evidence on file of the value of loan collateral. In sum, procedures considered necessary in the conduct of financial business were just missing. Now, this was a big moment in Canadian history as the repercussions from the Atlantic deal had systematic effects on the Canadian economy. The first two months after the default, the Central bank of Canada increased the money supply to avoid a credit panic. Foreign investment into Canada from the U.S. all but dried up as well as a result of Atlantic's Ponzi scheme. Now, even on his deathbed, Morgan would never admit that he was complicit in the fraud. After Morgan passed away, there was a commission that found he was very well aware of the fraud and he had acted in a highly, highly dishonest way. So here's a great quote from Brooks about Morgan and Atlantic. A smooth operator with a streak of a gambler. A company more interested in attracting investors than in making real profits. The resort to tricky accounting. The eager complicity of long established, supposedly conservative investing institutions. The desperation plunge into a gambling casino at the last minute. The need for a massive central bank action to localize a disaster. And finally, reform measures that were instituted too late. Now, the hard part about scams is that investors are supposed to be protected from them. But in reality, all we can really rely on is ourselves. And if well respected investment firms can be duped, what's stopping the retail investor from also being fooled? In Atlantic story, it seems odd that nobody would have caught on earlier. There's just plenty of insurance underwriters and lenders that had been operating for a very long time. And it's kind of hard to find out exactly what differentiated Atlantic from its competitors. This is the main lesson from the story. If a company is producing incredible results versus its peers and isn't really doing anything differently, you just have to ask yourself why that is. Either they have some sort of hidden moat, maybe that's not easily discovered, or they're taking part in some form of fraud that's deliberately hidden from investors. A more modern example is Luckin Coffee, a Chinese coffee shop. This business exploded from zero stores in 2017 to over 2,000 by the time it IPO just two years later. By 2021, they claimed to have over 4,500 stores. And just like Atlantic, they had exceptional growth. But it was kind of left unchecked. And I think that was probably some sort of a yellow flag. Now, in April of 2020, Luckin disclosed that over 300 million of its 2019 revenue had been completely fabricated. So executives had created fake transactions, fake sales, all with the aim of inflating revenue to meet their lofty growth expectations. They were eventually uncovered by a short seller report from Muddy waters back in 2020. While I'm a huge fan of growth businesses, it's very important to remember that growth is can become its own kind of self fulfilling prophecy. And when management owns things like options or warrants that gain in value, they're actually incentivized to continue growing the stock price. And unfortunately, if they do it in illegal ways, that's something that you have to try to pay very close attention to to try to avoid at all costs. Now I think with businesses that are growing fast, you must inject some degree of skepticism and you have to ask yourself if this growth is actually feasible. Are their margins realistic? When you go into their store, do they appear to be busier than their competitors? In the Muddy Waters short report on Luckin, they spent a lot of time, money and effort trying to figure out if Luckin was being truthful on its growth. KPI's Muddy Waters reportedly reviewed over 11,000 hours of video footage while hiring 92 full time and 1418 part time staff to run surveillance at stores. And what they found was simply that the growth numbers at Luckin was presented to investors just didn't align with reality. Their surveillance covered things like foot traffic, number of cups sold per store and the average order size. As a result of the research, they claimed that Luckin overinflated numbers of KPIs like number of items per store per day and net selling price per item. Now this is all great, but certainly it's a very hard task to do if you have limited resources and time. Now let's get back here to the inception of the Go Go year. So I already mentioned with the Atlantic example that there was this new breed of investors who were willing to take on certain risks that the previous generation may have just skipped. But there are other changes happening as well that are very easy to overlook. So in Boston, the vocation of managing money was one that was taken very seriously. The art of managing money was first by just managing a trust. And when you managed a trust historically, especially in Boston, it was to basically generate profit for the beneficiaries of that trust. But this notion began to change in the 1960s with the formation of the hedge fund. But let's first look here a little more closely at a gentleman named Edward Johnson. So Edward Johnson owned Fidelity, which probably many of you, all of you are going to be familiar with as it was there that Peter lynch would go on to post his legendary investing returns. But interestingly, when Edward Johnson assumed control of Fidelity, the organization refused to take a dime for it. They were the typical Bostonians who did not believe in profiting from their trustees. Now I wondered here for a sec, if Buffett was inspired by this when he was offered money for his Buffett partnerships, because I know he decided to skip it too, because he simply just didn't want to benefit or profit from his partners. But back to Edward Johnson. So Johnson wasn't the typical manager of a trustee who tended to be, you know, highly conservative. He was more interested in things like speculation. And his investing idol was a master speculator, Jesse Livermore. So here's what he wrote about the Fidelity we didn't feel that we were married to a stock when we bought it. You might say that we preferred to think of our relationship to it as a companionate marriage. But that doesn't go far enough either. Possibly now and again, we like to have a liaison or very occasionally a couple of nights together. Essentially, he was using relationship as a mental model for his holding periods. And he admitted that he wasn't really willing to have a long term relationship with his stocks. Now this is very vital because Edward Johnson would bring on the very highly talented Gerald Tsai, who also shared in the sentiment. Now, Jerry Tsai absolutely crushed it on Wall street in his early years. He was one of the first investor celebrities. He gained popularity simply with large amounts of success. But his success wasn't your, you know, uber long term Buffet type of success. His success was more based on short term high turnover that resonated with the average investor. And I would say that that probably still resonates with the average investor today. Now what Jerry Tsai was able to do was pick stocks that quickly appreciated in value. And his trading patterns of getting in and out of stocks relatively quickly was what just put him over the top. He was the epitome of get rich quick. One thing that Jerry mentioned when he spoke about his time with Edward Johnson was that Edward was willing to hand off a lot of responsibility to his key employees. So he called it handing them the rope, meaning they could either succeed or they would grievously injure themselves with the rope size rope would be known as a Fidelity Capital Fund. Now his strategy here was kind of simple. Make a few concentrated bets on more speculative businesses like Polaroid, Xerox and Linton Industries. But the parameters of entering the positions was also key to his strategy. Since he was making these concentrated bets, he'd require his brokers to buy shares in, you know, maybe 10,000 share increments. He basically did this intending to move the share price by 1 or 2% after his order was filled. And if he talked to the brokers and they couldn't make the share price move, then he just wouldn't use them. It was that simple. And since obviously Jerry was bringing a lot of business to these brokers, if one broker refused to do it, then he could go to the next one to find someone who could fulfill his parameters. Now next thing he would do when he had these companies was, as I've already discussed, he wasn't really a long term holder of business looking for these compounders. His turnover rate was apparently well over 100%. Meaning he was unlikely to hold a position for longer than a year. Now due to the fact that he was able to enter and exit large blocks of stock. The companies that he invested in also took note of his presence. So they wanted to be on the good side of this investor who wielded the ability to just move markets with their stock picking abilities. In mid-1962, Tsai had his first hiccup. The market crashed and his strategy of investing in high growth companies with concentrated positions was severely punished. But a rally ended the year increasing Fidelity Growth funds assets by 68% at the end of the year. So after this, the bull market was in full action and Jerry Tsai's strategy was highly successful. In 1965, the fund gained a 50% in net asset value on 120% turnover. But at the same time, Fidelity had come to a sort of crossroads. Its owner, Edward Johnson, was now 65 and he was set to retire. Since Cy had so much success of Fidelity, he figured that he was kind of a shoo in to take over leadership. But it was just not to be. Edward Johnson informed Jerry that his son would be the one who eventually would succeed him. This painful event caused Jerry Tsai to quit and just go out on his own. So he ended up selling his stock in fidelity for about $2.2 million. And he established the Manhattan fund. As with most success stories in investing, investors tend to, you know, time things all wrong. They invest in successful managers at the apex of their success and they ignore the unsuccessful ones at the apex of their weakness. And this is exactly, unfortunately what happened with Jerry Tsai. So he sold his shares of mutual funds for $10 each. He figured he might be able to raise somewhere in the region of $150 million. But once the funding had been complete, Tsai was actually handed a check for $247 million. Now at the standard 1% management fee. the time, Tsai's firm started with about 2 1/2 million dollars in revenue. But the problems that come with early success are quite simple. If you set unrealistic return expectations, you run a very high risk of redemptions if you fail to meet them. And as we know, 50% returns are just not feasible over a multi year timeframe size. Strategy worked incredibly well in bull markets. But take the bull market away and the entire strategy is no longer viable. Now, the first few years that he opened his fund were okay, but by 1968, his fund had taken an absolute beanie, declining in value by about 6.6% in placing 299th out of a possible 305 other mutual funds. Now, even with this poor performance, especially on a comparative basis, Manhattan Fund had actually grown by accumulating more and more AUM to over $500 million. When it became clear to Tsai that he was no longer able to generate outsized returns for his partners, he decided to sell the business. He alone made somewhere around $30 million in that sale in 1968, which equates to approximately $280 million in today's dollars. So clearly the original standard of not profiting from trust structure no longer existed, at least in Jerry's eyes. Now, what does Jerry Tsai's experience managing money teach us about investing? A hell of a lot. First, momentum can look like genius. I remember following a lot of funds in 2020, and pretty much all of the most successful ones own stocks that I had basically no interest in, and the reason being that they were obviously overpriced. These fund managers took a similar strategy to Tsai. They bought these businesses that were growing really fast, but they were all growing fast in a raging bull market. That strategy just works until the bull market reverses course, in which case we get pretty catastrophic results. So in the short term, this obviously results in high returns. These high returns attract more and more aum from new and existing investors. But then things inevitably go south. If you own a portfolio of businesses that are going to suffer from a massive multiple compression and earnings compression, once the economic environment no longer supports them, you're going to be in for a large amount of pain. Now, it's important to balance aggression with defensiveness. Yes, you can take advantage of the times to become somewhat imbalanced for short periods, but don't make the Mistake of going completely imbalanced to such an extent that you leave no space for any defensiveness. The second point here is that liquidity can disappear much faster than you expect. When you have a strategy that requires large volumes, then attracting competitors is not the best feature. When other intelligent investors saw what Cy was doing and that it was working, they would have piled into the exact same stocks that he was buying, which would make it harder and harder for him to make large concentrated bets while also paying a fairly reasonable price. And the other problem with liquidity is that it can be fatal when the market moves against you. When you have an ownership basis made largely of momentum investors when they leave, you're going to lose a lot of money if you don't have the conviction in the business to ride the correction. Now, since Tsai was looking to get in and out pretty quickly if he wasn't ahead of the selling, he exposed himself to a lot of downside risk. The third lesson here is that incentives shape behavior. When Jerry Tsai first started working at Fidelity, Edward Johnson was taking 20% of just the profits. He didn't even have a management fee. But the times were changing, and with larger staff sizes and an increased reliance on technology, management fees are being justified by a number of different funds. As a result, tsai took a 1% management fee. Now, when you have management fees, the incentive structure just really changes. The business makes money by simply gathering assets. The result of what happens to your investor's money matters a lot less. In Cy's case, he was able to continue to attract Aum despite the fact that he just wasn't creating that much value for the fund. The lesson here is for investors looking to invest in other managers. So I would highly recommend finding a manager who makes a lion's share of their money. When you are also making money and when you aren't making a reasonable return, or even if you're losing money, the manager should also feel the pain of that underperformance as well as Fourth, here is to just look at how performance chasing is in relation to where you are in the cycle. So Tsai's experience clearly illustrate the cyclicality of markets. You had strong performance, you had massive capital inflows, concentrated bets, then the market conditions changed and you had a rapid reversal. This is a cycle that constantly repeats in the market. Instead of eventually playing the victim to the cycle, try and position yourself best to deal with it. For instance, in the cycle above, if you see the first four attributes in the market, just simply don't partake. Yes, you'll probably miss out on some of the short term returns that other investors are making, but you'll also take a much smaller part in the rapid reversal that will take place at some point in the future. Now this doesn't mean selling everything and going to 100% cash. After all, we never know when a reversal will happen, but it might mean maybe taking some profits and adding to your cash position. If you're still working like me and regularly add cash to your brokerage account, it might mean taking a break on adding to new and existing positions and just allowing your cash to pile up and take advantage of a reversal whenever it happens. Now, one of Jerry Tsai's highly successful investments was a business called Litton Industries. Now, Litton was a new form of business that was exploding in popularity during the Go Go years. This business is now known as a conglomerate. Today we might loosely compare them to serial acquirers like Berkshire Hathaway, but the similarity mostly ends at the idea of buying more and more businesses. Berkshire buys wonderful businesses at sensible prices and holds them indefinitely. Most conglomerates of the Go Go years were exploiting financial engineering rather than building operating excellence. Now part of the reason the conglomerates were able to get a foothold into Wall street was due to several very early successes. For instance, in mid-1966, the New York Stock Exchange declined by over 20%. But one group of businesses had been shielded from this decline. So you had Ling Temco Vaught, which was up 70%, Citi investing was up 50%. Litton and Textron were each up 15%. So clearly there was a market for businesses that were following this conglomerate structure. So what exactly is a conglomerate? It's a business that diversifies through mergers and other lines of business. Now this is different from say a roll up that is buying businesses in one line of a business such as, you know, H Vac. A true conglomerate buys businesses in completely separate industries. Perhaps the business started selling machine tools. They systematically add businesses such as ice cream helicopters or eyeglass frames. Oddly enough, the word conglomerate was actually frowned upon by conglomerate operators in their early years. The CEO of Litton Industries thought conglomerate implied a large mess and instead used the term multi company industry when describing Litton. Textron felt similar, referring to itself as engaging in non related diversification. I find it kind of strange that all these great businesses that were conglomerates looked down upon the term. But that's the way it was. Let's take a quick break and hear from today's sponsors.

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Shopify and Vanta Sponsor (45:16)

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Kyle Grieve (47:25)

Alright, back to the show. Now there are three major forces that help build the rise of the conglomerate structure. The first was antitrust laws. With new laws enacted that made M and A within the industry more challenging, these businesses become targets for businesses that are lacking in synergies. A cable operator owned by a conglomerate just didn't have the same monopoly advantages if it were acquired by another cable operator that could pool additional resources and then leverage a larger customer base. The second was that there was a changing ideology by educational institutions. So Brooks writes, graduate business schools taught that management's ability was an absolute quality, not limited by the type of business being managed. This meant new managers were going into businesses not only to specialize in a single business line, but could also use their managerial skills in a more diverse way. Conglomerates were a great structure to test your absolute quality as a manager. And third, here was just rising evaluations. Since businesses had risen in price, it reduced the cost of equity for many businesses. If your business was now growing at a PE of 30 versus a previous PE of, let's say 15, it opened up the ability to, you know, acquire a much larger base of acquisitions that you just wouldn't want to have acquired if your shares were trading at a major discount. Now let's go over point three here in some detail because it's very vital to understand why the conglomerate structure at this time worked so well. So let's create a hypothetical case study to show why these deals worked and how they could easily fail. Let's say we have a business called Grastron which sells lawn equipment and turf services and has a pe of about 20 times. They want to diversify away from their core business and to do so, they start buying businesses that sell car parts. They find a business called Car Parts Inc. Which sells side and rear view mirrors. The sellers are willing to part with a business at a PE of just 5 as it's a low growth business with very steady earnings let's say car parts generates 10 million in profits. Grasstron is already doing about 50 million in profits. Now, Grasstron buys car parts for $50 million, using pure equity to purchase it. And this is because they understand the benefits of merger arbitrage. So once they add the earnings stream to Grasstron, they are now doing 60 million in profits. But the arbitrage comes in the difference in the PE ratios. Grasstron isn't just worth $50 million more, given its higher PE ratio, it's now worth $200 million more. But it only paid $50 million for that increase in value. Now, let's imagine that Grassron begins getting more and more excited about making deals. After all, they had a super successful deal with car parts, and maybe they had some other deals that were really successful. So they're very high on their ability to do M and A. They're so high on that ability that they begin making errors. They know that making acquisitions are very key, but they begin to lose discipline on their purchase price. Instead of creating shareholder value by exploiting arbitrage, they begin focusing on just building a larger and larger empire at the expense of their shareholders. They begin looking for large acquisitions. This time it's in chemical manufacturing. So Grassron now has $200 million in profits. One chemical business they find is also doing 200 million in profit. But the times in the markets aren't nearly as good as they once were. And Grasstron has been a victim. And its PE ratio has now dropped to 10 times. The chemical manufacturer that I was looking at trades at 15 times, Grassron just says, screw it. Let's get this deal over with, double our profits then. The market's gonna love it. Now, unlike the first deal, they're now paying 15 times for chem Core to double their profits. Once Chem Core is inside Grasstron, its earnings are now valued less than before. So this deal basically ends up actually destroying shareholder value rather than adding to it. They added $2 billion in value, but they actually paid $3 billion to do so. Now let's look at James Ling, who was one of the pioneers of this structure. James started an electrical Service Company in 1946 with about $2,000 of his own savings. He eventually scaled up to an annual revenue of about $1.5 million. In 1955, he went public at an evaluation of about a million dollars selling shares in a booth at the Texas State Fair. Now, going public was really a light bulb moment for Ling. He realized that he could generate cash in exchange for basically paper. And that paper was Equity. With his million dollars in cash, he used it to acquire a business called LM Electronics. Now, here's what Brooks said about Ling's strategy. In essence, though, they are all geared to the crucial discovery that Ling had made at the Texas Fair. That people like to buy stocks and that their overpayment for stocks can be capitalized by the issuer. To his advantage, his basic tool was leverage. Capitalizing on long term debt to increase current earnings, he built his business up substantially, then switched course. In 1964, his new initiative, called Project Redeployment reversed course. Instead of adding new businesses, he decided to spin out certain businesses from his conglomerate and sell them to the public. Essentially, Ling was taking advantage of the public's yearning to buy stocks by spinning out parts of his business to generate shareholder value. And it worked. He'd sell off 25% of a share in a business and 75% of was kept by Ling's company, now named Ling Temco Vaught. And doing so would make their 75% share worth a lot more than it had been worth weeks before. So in 1965, Ling Temco Vaught ranked number 204 on the Fortune Directory of largest US industrial businesses. But by 1969, it was ranked 14th. Net income before dilution, which would have been large, I would have assumed here, tripled in 1966 and went up 75% in 1967. Between 1965 and 1967, the stock price increased by 10x. Now, as with most bubbles, the newness of a new paradigm shift, in this case conglomerates, wears off over time. And what is usually left over is a bunch of angry bag holders kicking themselves for making the investment in the first place. While some conglomerates gave the illusion of infinite growth, most were pretty unable to make that a reality. Inventors believe that conglomerates had this diversification which projected their downside. And also that a lot of these conglomerates were run by superstar managers that were able to make acquisitions that basically guarantee growth. But unfortunately, they are in for a very rude awakening. As these businesses scaled, their biggest flaws began to be exposed. The businesses had become large and unwieldy, and it became nearly impossible for just one man to run the show without a significant amount of help and decentralization. In the case of Litton Industries, management had been so disconnected from its subsidiaries that it didn't actually even realize that there was a problem with them until it was too late. Several of Litton's divisions were in very serious trouble, and management discovered that they could actually not even contain the problem. This event caused investors to challenge the premise that the conglomerate was built on. If a superstar management couldn't control his subsidiaries, what was the value in diversification? Once Litton reported the quarter, its stock was crushed. Earnings came in at $0.21 per share, versus $0.63 for the same quarter in the previous year. Lytton lost about 18% of its price in one week, a month after earnings had gone down 50%. The drop in Litton dragged down all conglomerates with it, just as the rise in conglomerates allowed for them all to take advantage of that merger arbitrage. Now, my first big lesson from this chapter was that high stock prices can create the illusion of business skills. The conglomerate operators looked like geniuses because their strategies made shareholders money. But the actual success of their strategy came from areas that were outside of their control. And that was from the stock price itself. The high evaluations that euphoric market assigned to them allowed them to have a high evaluation, which gave them access to acquisition currency, which further fueled EPS growth, leading to an even higher prices. This is what Howard Marks likes to refer to as the virtuous cycle of rising multiples. Now the problem is, like all cycles, they eventually reverse. And if you were holding on during the reversal, then it becomes this vicious cycle as you must prepare to either back up the truck on weakness or just sell at a large loss. But even if the business is improving, there are other attributes that now have changed which will affect their acquisition strategy. If they no longer have a share price, then they can't continue acquiring businesses that would have made sense before. And when you have to reduce your acquisition pace, EPS growth is going to slow down considerably. And when this happens, you lose the faith of a lot of your investors, causing painful multiple compression. And this unfortunately, is exactly what happened to many conglomerates during this time. The second lesson is that financial engineering can masquerade itself as operational excellence. In the case of Litton, it was eventually proven out that the conglomerate simply just wasn't improving its acquisitions after they bought them. They were more focused on simply relabeling earning streams. Now, taking advantage of merger arbitrage works very well when you own businesses that will either maintain or organically grow its earnings power. When it weakens, you obviously expose yourself to a lot of potential risk. One business that I own, I think would be considered a modern form of conglomerate is a business called Teravest Industries. So in its early days, a large portion of its revenues came from kind of cyclical areas related to the oil and gas Industry now realizing that depending so much on the cyclical gas industry was too risky, they decided to kind of pivot because they wanted to make sure that their business was protected from cyclicality. So they ended up diversifying into other areas such as compressed gas vessels and H Vac equipment. Additionally, TerraVest does a really good job of creating value for subsidiaries. Once they're part of the TerraVest family, it's not unusual for post acquisition EBITDA multiples to drop to, you know, maybe two times a year after being acquired. So when you're actually creating value like the way I think Terabas is doing, then the financial engineering plays very well in your favor and you protect your downside. But if you're looking at a business that can create value strictly through financial engineering, then you must consider what happens if the business declines in earnings power. The third lesson here is in humility. The best modern conglomerates tend to run a pretty decentralized business model. This takes responsibility from upper management and it spreads it out across the company. Berkshire, Constellation Software and Lyftgo are great examples. If all the power was centralized and their leaders, there's probably no chance that these business would have had the success they had today. The early conglomerates had a lot of key man risk, but the modern equivalent have created business models and cultures where key man risk is a lot less impactful. The fourth lesson regards something you probably noticed that I love to speak about, which is incentives. The book doesn't divulge what the incentives were for the CEOs that were evaluated, but one thing they were most likely not incentivized on was long term metrics. When you're incentivized to outperform in the next year, then making endless acquisitions, empire building and dilution are actually highly encouraged. When you have to focus on things like capital efficiency, per share metrics or organic growth, your strategy has to obviously change. Instead of focusing on what you can do to increase profits this year, you're more focused on creating profits maybe three to five years from now. And there's a major difference in strategy between these two objectives. I prefer the long term strategy simply because it just doesn't incentivize nearly as much risk taking. Brooks had one incredible story that I have to share and I never knew this, but for a time during the Go Go years, Wall street was actually shut down from trading on each Wednesday. This is a pretty strange event, you know, to shut down trading during a raging bull market. But let's dive into why this happened. As the Go Go Years progressed, the market's euphoria continued to rise at a very rapid pace. But the technology stack back then was obviously a lot different than it is now. Back in those days, when you bought a stock, your broker had to do the back end paperwork on your behalf. Much of this was done manually. The broker's back office would be inundated with ever increasing paperwork, having to mail out share certificates based on each individual trade. Now, as euphoria rises, second order effects emerge. And one second order effect is that volume obviously goes up. More and more stocks are changing hands, which increases the burden on these back offices. And the people doing the back office weren't even the brokers. They had people who specialized in the back office and it was basically an entry level job. Now, as Wall street became more chaotic due to increasing volumes, the infrastructure needed to keep up with the growing demand from new entrants to the market just wasn't increasing at the same rate. They were very far behind in processing trades, and not just days behind, but actually months behind. As a result, the back office's work decreased substantially in quality. Share certificates that were supposed to be mailed out to their new owners were lost, misplaced or stolen. And it was so prevalent that it was given its own name. A fail. Now, a fail occurs when, on a normal settlement date for any stock trade, five days after the transaction itself, the seller's broker, for some reason does not physically deliver the actual sold stock certificates to the buyer's broker, or the buyer's broker, for some reason, fails to receive it. In January of 1968, the New York Stock Exchange allowed for a certain number of fails as just a regular part of business. So at the time it amounted to a billion dollars. As a result, the exchange cut trading hours and closed at 2pm to slow down the system, with the intention of allowing the back offices to catch up with their missed transactions. By April though, fails had actually reached 2.67 billion, May was 3.47 billion, and by June, it was just a touch under 4 billion. As a result, the exchange basically closed the New York Stock Exchange every single Wednesday. This was the first midweek closure since 1929. And the break actually didn't even work, as most brokers just took Wednesday off rather than doing the necessary work to catch up. What eventually fixed this problem was the market just turning bearish and because of that, volume dried up and so did the fails. Now, I'm not sure there are many modern lessons we can learn from this, but I found this story fascinating. Perhaps it's A lesson in understanding the complexity of seemingly simple things like back office paperwork. Even today, nearly 60 years later, we still have manual back office events. My wife, who works in an accounting firm, still manually enters data. Another lesson is a second order effect on the market. There are never any shortage of second order effects and unfortunately many of them remain completely hidden until it's too late. And this is a good reminder to ponder the unknowns that could be happening in the background during the next bull or bear market. Now the next story I want to discuss concerns mental models that I find crucial not only in investing, but in life. And that's incentives, particularly in conflicts of interest. Now, in the go go years with so many new investors coming to place their first trade, there wasn't a lot of education on how the brokerage industry inside Wall street really operated. Back then. Just like today, brokerage firms earned revenue through commissions and the fees were insanely high. Back then, the SEC continuously had to fight with brokerages just to get them to cut their fees. Now, bull markets are great for brokerages. This is why online brokerages today tend to be a pretty good place to invest if you believe that volume will continue to rise. I agree that that's probably the most likely scenario. But I don't think profiting from others needs to gamble on stocks is right for me. Now, in 1966, Francis Huntington was a clergyman at Trinity Church on Wall Street. The church is still there today as you walk uptown from Wall Street. Francis began having conversations with people like brokers, lawyers and bankers about what was just bugging them most about their jobs. One finding that Francis had was that brokers especially were much more open about divulging their deeper problems that they had in their own jobs. And most of the things that were bugging them about their job concerned being ridden with guilt and frustration. Now, one big question that Francis focused on with his brokers was where to draw the line between investment and speculation. The problem with the brokerage industry is that incentives are just misaligned. A broker who puts his needs above the customers can rake in large fees. But there's a good chance that he's also encouraging his customers to speculate and quickly move in and out of stocks because doing so fattens his wallet. Now, in one conversation, Francis had a broker tell him, if you really want to know what bugs me, it's the fact that I can take a client out of General Motors and put him in Chrysler when in my heart I feel that he probably shouldn't be in any motors at all. Now, this simple sentence tells you the fine line that brokers are walking. This broker felt that it was in his customer's best interest not to invest in an entire industry. But instead of admitting this to his customer, he basically just had to shuffle him from one automotive company to another just to make a living. Now we reach the apex of the Go go years. In 1970, the Dow started at around 800, already down 15% from the start of the year in 1969. By April, the Dow was at 750. A few days later, 728. President Nixon, when asked for a quote on the market this time, said that if he had any spare cash, he would be buying in the market as well. Now, Brooks here was clearly trying to draw a few parallels between the crash of the Go Go years and the Great Depression. So after Black Thursday of 1929, President Hoover said, and I quote, the fundamental business of the country is on a sound and prosperous basis. John D. Rockefeller told the press that he and his son had been buying stocks just to try and reduce the fear in the market as well. So by the end of May, the Dow had dropped to below 700. And this prompted the Fed to reduce margin requirement on stock purchases from 80% to 65% to try to get more liquidity back into the market. Investors Overseas Services, one of the largest mutual funds in the world, which operated as a fund of funds, was hit very hard. They lost about 75 million in value in bad investments and poor loans. It had sold at about $20 in late 1969 and was now selling for just $2. This would have been bad news for mutual fund investors. That would have obviously had far reaching consequences to other mutual funds. Then look at what happened to James Ling's Ling Temco vault. The business was now suffering from antitrust suits and had dangerously high levels of debt. They were now at a point where their cash flow just couldn't service their interest payments. The business model obviously once thrived on a high price that could be used as a currency to buy cheaper businesses. But now that the price had been punished from a peak of 170 to a depressing $16, that strategy was completely out of the window. Under pressure from the company's creditors, Ling stepped down as a chairman and CEO. Brooks writes. Thus, in hardly more than a week, the king of the conglomerates and the king of the mutual fund operators were both forced from their thrones. By the end of May, the Dow was now at 640. Doomsayers were now talking about a 500 point Dow. But by the end of 1970, the Dow was back up past 840. Now I'd like to finish this episode by speaking a little bit about Brooks comparison of the 1970 crash to the Great Depression. So from 1929 to the deepest low of the depression in 1932, the Dow dropped 90%. In the 1970s crash, it dropped 36%. So from the looks of it, it didn't look very comparable to me. The problem with comparing the Dow between both time periods is that the businesses inside of the dow in the 1970s wasn't a great representation of the best businesses in America as they had been in 1929. So Brooks decided to use a different yardstick. He looked at a proxy index that a financial consultant named Max Shapiro had discussed. This index consisted of many of America's greatest winners of that time, businesses that were, you know, in the portfolio of many average Americans. So the portfolio had 10 leading conglomerates including Linton, Lingtemco, Vaught, 10 computer companies such as IBM, Leaseco and Sperry Rand, and then 10 technology stocks including Polaroid, Xerox and Fairchild Camera. The average decline of these 30 companies from 1969 until 1970 was 81%. But I tend to disagree with some of Brooks's takes on comparing the two. For one thing, while this one index didn't fare so well, it seems a little like cherry picking data to fit your narrative. Of course the 30 most hyped up expensive stocks are going to get killed during a bear market. I'm sure if you looked at the 30 most expensive stocks trading during the dot com bubble after it popped, you could probably also create an index that would have suffered a very similar drawdown. Now Brooks goes on to talk about how the crash of 1970 affected a lot more people because more Americans were invested in stocks in the 1970 versus 1929. So in 1929 estimates were that about 4 to 5 million Americans own stocks and by 1970 that number swelled to just 31. On this point I think he was correct as the total percent of Americans owning stocks during the Great Depression was just 4% and in 1970 it was over 15%. Now that's all I have for you for today. Want to keep the conversation going? Then please follow me on Twitter Rational Mrks or connect with me on LinkedIn. Just search for Kyle Grief. I'm always open to feedback, so please feel free to share with me how I can make this podcast even better for you. Thanks for listening and see you next time.

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