#ContrarianProblems

I am generally a contrarian by nature.

To illustrate:

  • I am skeptical of home ownership as wealth creating endeavor.
  • I do not like reading “popular” books or seeing “popular” movies for the sake of being able to have conversations about them.
  • In my view at least 50% of the episodes of Game of Thrones are time-wasting filler.
  • I am generally not that into big events that draw crowds (sports victory parades, Coachella, Burning Man or Fyre Festival–but there are exceptions).

Perhaps unsurprisingly this permeates my investment philosophy. Things I like right now include a Russian natural gas company, a Brazilian aerospace company and sub-Saharan African bank holding company (I have a North African/Middle Eastern bank on my watch list, too, if the valuation ever comes down to earth). This is not a recipe for outperformance. It is not investment advice. It is just who I am as an investor.

Being a contrarian investor is great. You have good company in people like Seth Klarman and Howard Marks. On the other hand, being a contrarian in the investment business is not nearly so pleasant.

Contrarian ideas are often hard to sell and investment committees are engineered to arrive at consensus decisions. Consensus decisions are generally good for business. Consensus decisions will not deliver top quartile performance but they will not deliver bottom quartile performance, either. You can have a very nice business and never deliver top quartile performance. But woe betide you if you end up in the bottom quartile. It may well be the end of your business.

I sometimes hear about firms that designate “devil’s advocates” on committees. The devil’s advocate’s job is to argue against every single investment thesis. She is not allowed to argue in favor, or to moderate her argument. She is a dedicated short and everyone knows it in advance. This is a neat solution to the problem of encouraging a contrarian viewpoint in a high pressure group setting (contrarians can often grate on their fellow committee members). But does it make any difference?

What percent of ideas get blown up because of the devil’s advocate? Or is the whole thing just an exercise in box-checking dreamed up to please consultants? I suspect in most cases it’s the latter.

Edward Hess summarizes the issue quite nicely in an article titled “Why Is Innovation So Hard?”:

Most organizational environments won’t help us overcome our fear of failure and build our innovative thinking skills. That’s because most organizations exist to produce predictable, reliable, standardized results. In those environments, mistakes and failures are bad. That is a problem. To innovate, you must simultaneously tolerate mistakes and insist on operational excellence. Many businesses struggle with implementing that dual mentality.

Here we can learn from exemplar companies like IDEO, Pixar, Intuit INTU -1.84%, W.L. Gore & Associates, and Bridgewater Associates. In those organizations, mistakes and failures are redefined as “learning opportunities.” IDEO takes it even further, characterizing failure as good because it helps people develop the humility that is necessary for empathy—a critical skill in user-centric innovation.

But in many workplaces, people do not “feel safe enough to dare.” They don’t necessarily feel that they can speak with candor up and down the organization. Can you tell your boss the truth?  Innovation occurs best in an “idea meritocracy,” a culture where the best evidence-based ideas win. There can’t be two sets of rules—everyone’s ideas must be subject to the same rigorous scrutiny. As Ray Dalio, the founder of Bridgewater Associates, one of the largest hedge funds in the world, so bluntly said, “We all are dumb shits.” That’s why everyone at his company is engaged in a radically transparent “search for truth,” which involves candid feedback and a deliberate effort to “get above yourself,” to get past the emotional defenses that inhibit our thinking.

In other words, organizational incentives are skewed toward rewarding preservation of the status quo. If The Golden Rule is “He who hath the gold, maketh the rules,” surely immediate the corollary is “He who f***eth with The Golden Goose shall meet with a pointy reckoning.”

#ContrarianProblems.

Lethal Risk Management Failures: The Battle of The Narrows

For some reason people find risk management boring. I do not understand why. Some of the most influential and fascinating events in history were a direct result of poor risk management. The sinking of the Titanic; the near collapse of the global financial system in 2008; the Ford Pinto’s fuel system. One of the things I find fascinating about catastrophes is that they typically do not follow from a single point of failure—risk management failures are really systemic failures and are therefore worth considerable attention.

I am currently reading a book about the decline and fall of the Ottoman Empire (The Ottoman Endgame: War, Revolution And The Making Of The Modern Middle East (1908 -1923), by Sean McMeekin). The Ottoman Empire controlled Turkey, the Balkans and much of the Middle East and North Africa for several centuries. It entered the terminal phase of its decline (the exact reasons for this are still debated) in the late nineteenth century. The First World War ensured its demise.

Despite this unhappy end the Ottomans achieved some notable victories during the war: preventing the British and French navies from forcing the Dardanelles for one and thwarting the ANZAC landings at Gallipoli shortly thereafter for another. This post is concerned with the first of these military debacles, which I believe has something to teach us about systemic failures and risk management.

This post is structured like a Tarantino film. We will see the outcome first and then explore why things went down the way they did. The date is March 18, 1915. The place is the Dardanelles Narrows (below is a visual). Simply imagine a fleet of British and French warships steaming into the Narrows and you have got the idea.

Dardanelles_defences_1915
Image Source: Wikipedia

Now I will turn things over to McMeekin:

Just past noon de Robeck sent in the French squadron, commanded by Vice Admiral Guepratte, to see what they could do from shorter range. Guepratte obliged with his usual dash, sending the Gaulois, Charlemagne, Bouvet, and Suffren up the Straits, right into the teeth of the Narrows defenses. Now the guns were booming on both sides, with the channel all but choked in smoke and rocked with one detonation after another. At 1:20 p.m., the Bouvet came within range of the Hamidie battery, which rained down fire on the French ship. At 1:50 p.m., Hamidie scored two direct hits from a 355 mm Krupp gun, causing an immense explosion, with a “column of smoke shot up from her decks into the sky.” The Bouvet, listing to her side, then ran over a mine, capsized, and sank within minutes.

[…] Toward 4:00 p.m., the Irresistible had come in range of the deadly Krupp monster gun at Hamidie, which hit her fore bridge and set it on fire. At 4:09 p.m., de Robeck observed that the Irresistible “had a list to starboard”: she had raised a green flag, indicating a serious hit on that side. Though having passed out of range of Hamidie, the then drifted into range of the Rumeli Mecidiye Fort, which rained down shells on her. All the officers could do was evacuate wounded men onto the swift destroyer Wear, which pulled up alongside, and prepare for possible towing.

[…] At 4:11 p.m., the Inflexible, hitherto undamaged, ran over a mine and immediately began to list, down by the bows, in more serious trouble than the Irresistible. Inflexible, at least, was near enough the mouth to limp away from the battle: the Irresistible, having passed up the Asian shoreline into the teeth of enemy fire, was not. Trying to salvage something from the burning, de Robeck sent in HMS Ocean to tow his wounded battle cruiser – only for Ocean, too, to suffer a huge explosion at 6:05 p.m. — leaving both ships helpless under enemy fire at short range.

[…] Doubtless believing the rumors about panic in Constantinople […] Keyes and Churchill seem to have applied them to the shore batteries without thinking things through from the enemy’s perspective. The Turks and Germans, after all, had just witnessed three enemy battleships sink to the bottom under their Straights under their fire from shore; the crippling of the modern, near-dreadnought-class battle cruiser Inflexible; and the rout of the entire French squadron. Over six hundred men had perished on the Bouvet alone, with the British suffering another sixty casualties. By contrast, only three Germans had been killed and fourteen wounded, with Turkish losses scarcely higher, at twenty-six killed and fifty-two wounded—a reasonable price to pay for knocking out fully a third of the invading fleet (six out of eighteen ships).

Bouvet_sinking_March_18_1915.jpg
Image Source: Wikipedia

What Went Wrong

The root cause of this disaster was that allied military planners refused to accept that the Ottomans had the resources, wherewithal or ability to put up this kind of defense.

This was partly a result of poor intelligence. The British did not appreciate the extent to which German military advisors had improved the overall competency of the Turkish officers and soldiers defending the Straights. This is always a risk in war. Rarely does one have perfect information.

The bigger mistake — and one that should have been preventable — was that military planners did not want to believe the Ottomans were capable of such a defense:

Just as they had heard what they wanted to hear in the [Russian] grand duke’s (vague) request for a diversionary strike, so did British policymakers believe what they wanted to believe about the enemy’s dispositions–and fighting capacity […]

[I]n December, Captain Frank Larken, commanding HMS Doris, had subdued the minimal shore defenses of Alexandretta (Iskendurun) simply by showing up in port and getting the Ottoman vali to agree to dynamite two rail locomotives in lieu of bombardment, in a curious face-saving compromise.

The British certainly had experience with more robust Ottoman fighting spirit, during an earlier operation in Mesopotamia (modern day Iraq). McMeekin again:

Shatt-al-Arab was a British victory, to be sure: but it had been a bloody slog, requiring a month to secure a lightly fortified waterway that had been all but abandoned by the Ottomans since Enver was committed to his Caucasian and Suez offensives.

As I see it, British military planners failed to appreciate the risks associated with the Dardanelles operation because they had little incentive to appreciate them. They were engaged in a massive, unproductive slaughter in Western Europe and were eager to achieve tangible results somewhere else on the global battlefield. A direct strike at the Ottoman Empire would serve that purpose nicely. What’s more, because the French were touchy about British military action in certain other parts of the Middle East, options outside the Dardanelles were limited.

Warren Buffett coined the term “institutional imperative” to describe this type of inertia:

In business school, I was given no hint of the imperative’s existence and I did not intuitively understand it when I entered the business world. I thought then that decent, intelligent, and experienced managers would automatically make rational business decisions. But I learned over time that isn’t so. Instead, rationality frequently wilts when the institutional imperative comes into play.

For example: (1) As if governed by Newton’s First Law of Motion, an institution will resist any change in its current direction; (2) Just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds; (3) Any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops; and (4) The behavior of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated.

Institutional dynamics, not venality or stupidity, set businesses on these courses, which are too often misguided. After making some expensive mistakes because I ignored the power of the imperative, I have tried to organize and manage Berkshire in ways that minimize its influence.

So it was with the British in 1915.

Critically, there is no risk management process that can counteract the institutional imperative. As Buffett points out in his 1989 letter, “any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops.” No amount of fact-finding or analysis will help. Only prudent leadership can prevent systemic failures resulting from institutional inertia.