Tuesday, May 13, 2008

Leucadia National - Annual Meeting – May 13, 2008

IC = Ian Cumming
JS = Joe Steinberg

How do you protect against political risk in Argentina (referring to recent export taxes)?
IC: They’ve had a successful run in Argentina. A long time ago, we privatized the national insurance company, successfully got out before the dip. It’s never ending. It’s not politically correct, but the old joke is that Argentina is a country with wonderful natural resources, the problem is that it is full of Argentines. We don’t have a great answer, just pray. We paid a cheap enough price, think we will do just fine.

JS: There are two outcomes. The export taxes go away over time or it all blows up and the country slides off into the ocean.

Origins of Fortescue investment? How quickly will that ramp up? What do you think about China investing in Fortescue?
The deal came from Jeffries. We noodled on it, waited for awhile, then came back to look at it seriously. We worked on it for awhile. We have an old miner who works for us, guy used to run Kennecott Copper, we went over there and walked the site and took iron ore samples and it tested like they said it would. Andrew Forrest is a difficult guy, hyperactive, visionary, great at what we does. We laughed at our calculations when we did them, but we’re now at those numbers.

The ramp up will happen more quickly than we know. They get things done expeditiously over there.

We get the information on what China is going to do from the same place you do. We have no idea what they are going to do. Joe is on the Board and I am the alternate. We are going over to Shanghai in a bit to meet the iron ore poo-bahs over there.
Fortescue has been a very successful investment; a career maker.

(Question that I did not catch on whether Leucadia took additional shares in a rights offering of a company. Answer was yes).

Jeffries Investment:
IC: We have known them for a great long time and have partnered very successfully.
We entered because the stock was bedridden and moribund, below book value.

JS: No, it was at book value.

IC: At book value. They were not harmed by the tumult of the past year. They were hurt in Q1 by the markets going all haywire, but they didn’t make any really foolish investments. They have been cooperative with us as directors. We are trying to change how things are done over there. I am more optimistic about this than Joe.

You have made money in the past with Jeffries as a partner in deals, but do you want to own the company, given their practice of paying lots of the revenue out to employees?
IC: Both of us HATE dilution. HATE.

On real estate, last year you made the comment that you were “not yet seeing blood in the water”. Please comment on real estate.
JS: There has been a huge unwinding of leverage in single-family homes. We haven’t seen good opportunities yet. Most homebuilders have written down land to levels far from what they paid. All markdowns of this land are likely to continue. We don’t see how they can make money building homes on the land at these prices. We are looking.
Myrtle Beach – that is doing well, healthy project.
Panama City – we bought the old airport. The money is in escrow and won’t be paid for 3 years. We are planning a large development.
Real estate is strictly opportunistic for us. We don’t consider it a core line of business.
Homefed – it’s just cash and completed lots, and a program on the road to entitlement.

Americredit investment?
IC: It is an interesting company. Americredit is a leading provider of subprime auto loans. This country is one-story. You may not realize it in New York, but that is how it is. People need cars to go about their lives. Americredit was writing $7-8b per year, has shrunk that down a great deal. You can’t run the country without cars.
They have superb platform. We know about the business because we used to run a $700m subprime auto book of our own before the big banks came in and drove down pricing and we liquidated. We are working hard to get them forward. They just got an egregious loan from an international bank with an incredible rate. We are very comfortable with the investment even though a recession is coming.

JS: And it was cheap.

Succession plan?
IC: Both of us have been working on this. We have both signed up for 10 years, until we are 75, at which point we’ll sign up for another 10 years. We are working hard to develop strategies and people who we think can take over. We are trying to find people who think the same way we do about investing and risk. We have avoided all kinds of foolishness in the past 31 years, going back to the pre-Milken days.

JS: We may have a lump.

IC: Yes, a lump. We could buy a business that is producing $500m a year in profit, and then we are just doing the investing on the side.

JS: We could liquidate, not the first choice. (Cumming points finger as gun to head and pulls trigger).

IC: Oh right, we can’t liquidate, because of the tax loss.

Where do you look for good investments relating to fallout from subprime?
IC: From Wall Street to the top of Manhattan.

Pershing Square LP investment?
IC: Saw the opportunity, it hasn’t paid off. It is Bill’s black box. He is extremely smart, but impulsive sometimes.

Do you invest in it blindly?
IC: No, we don’t do anything blindly. We have made a lot of money with Bill over time.

Goober Drilling?
IC: I am an advocate of peaking oil. Oil products will go up over time and natural gas will follow. They are disjointed, but not completely. (Gave some numbers on supply/demand of rigs in U.S. over time). It’s amazing, now you can drill 10,000 feet down with a big pipe and then go a mile sideways. Read the CHK annual report if you want to get a sense of our view on natural gas. Aubrey Mcclendon is a wild man in his own right. With Goober, we bought 26 rigs that were paid off within confines of the 3 year fixed-price contracts we had. Of course, with these kinds of things everyone goes around happy as hell and then, boom, it falls off a cliff. We hope to avoid falling off the cliff.

Why the split between oil and natural gas price?
IC: Baffles me.

Medical investments
IC: Investing is like a bell curve. These investments are at one end. Friviolous things. With Sangart, the story is that 3 people have tried this and ended up killing people, and we haven’t killed anyone yet. Maybe we will make lots of money. The eye investment thing is small.

JS: It is a cute investment.

LNG plant?
IC: Most local stuff accomplished. We are 1 year from the FERC certification process. Then we will revisit. It scares me. If it really is peak oil, it should scare the hell out of everyone. If I was the head of a country with natural gas, I might decide to keep it for domestic industry instead of shipping it off to the U.S.
If it gets licensed and ready to go, it will have a high current market value and we might do a valet maneuver and get off stage.

JS: The only spending we have been doing is on forms. It is just an option. Things change a lot over 10 year periods. In 1995, when we bought the Cruces copper mine in Spain, it was just a long-term option on copper prices. Having options on things that could become valuable down the road is very good. We have lots of those imbedded in Leucadia right now.

Accounting for Fortescue royalty deal? Are you comfortable with the concentration risk?
IC: We have it on our books for $200m. They have it on theirs for $1.6b. The difference is due to accounting. How much is the royalty interest worth? Do the arithmetic. 100m tons of iron ore at 4% royalty at $100/ton. We have half our net worth in Australia. We continue to watch the value go up. They hit a “project completion” milestone after they have taken out 2m tons over a 4 week period.

JS: The way it works for us in terms of this showing up on our balance sheet is that it will turn into net income and go through that way. Eventually, we will get paid back the $100m it cost us.

Cresud (Argentine farming investing)?
We watch it carefully. Even if they mess with the taxes, nothing bad happens to the land.

FX risk in Argentina? How handle?
IC: We are not going to do anything.

JS: I think the Argentine peso is likely to appreciate vs. the USD.

Casino in Biloxi?
IC: It was rebuilt and opened and didn’t do as well as we had hoped. We changed management and things have been doing better.

Gasification plants?
IC: There are three plants in various stages. We are producing 40bcf of synthetic natural gas. They are in Mississippi & Louisiana. Basically, we are trying to create a riskless bond. Match 20 year contracts with long-term financing with the help of the state. We will eventually put in a big slug of equity and we will make rich returns on that.

Corn investment? Brazil sugar investment?
A year ago we were besieged with proposals to invest in corn ethanol. We look at it and thought the energy balance went the wrong way. It was stupid. We don’t just go down to Brazil and hang out a sugar investing shingle. That’s not how we invest.

Plans to produce synthetic natural gas at Lake Charles?
LUK energy guy: Natural gas is at $11.50 and would have to fall below $5 for the project to be uneconomical. We make the big profits on the sale of hydrogen and sulfuric acid. Everyone in the Gulf is switching to heavy sour crude and the pricing of petroleum coke is coming down, from $60 now to eventually $30, which helps us.

Dearth of opportunities?
IC: The competition hasn’t really gone away. Prices are heading down in the right direction, but people aren’t jumping out of windows yet.

JS: There is still a huge amount of hedge fund money. After the subprime and leveraged loans crises, you would have thought there would be better opportunities. It’s not like 1981, when we had no money. Interest rates are so low. There are lots of hedge funds. It’s horrible.

Deal to buy refinery from Valero?
IC: It’s over. Done.

STi prepaid cards business?
IC: Going well.

What do you think about iron ore and commodity prices being in a long-term bubble?
IC: We have noe idea.

Investments in LP interests of hedge funds?
IC: It was a mistake, not worth the time or trouble.

When will you pay dividends?
IC: We wait until the end of the year, see if we are still standing, then sit down with the board and decide. That’s how we have always done it.

What are EPS looking like for rest of the year?
IC: We struggle to create wealth. We don’t pay any attention to reported income results. There is a trend in accounting where you have to mark to market your investments or do a lot of complicated stuff that we don’t want to do, so we mark it to market. Things will be reported as more volatile as a result. Financial statements these days are almost meaningless. It is impossible to figure them out outside of those who practice.

How do you value Leucadia?
JS: Look at the investments, mark them to market, then the difference is the value you think Ian and I will add over time.

Do you think there will be opportunities in the Jeffries partnership that invests in high-yield debt?
IC: Oh yes.

Do you know of any smaller companies that are similar in how they are run to Leucadia?
IC: No. If you see them, shoot them. There is a paucity of deals, and we don’t need people looking in the same briar patch. That is not something I have spent much time thinking about.

Do you prefer to invest 100% in companies vs. taking equity positions?
IC: Yes. These were tactical investments where we thought stuff was very, very cheap. Unfortunately, due to Leucadia groupies who follow what we buy, they don’t usually stay cheap after we start buying.

Leucadia National – Annual Meeting – May 15, 2007

IC = Ian Cumming
JS = Joe Steinberg

IC: Not much to say, everything we wanted to say about the year we put in the annual report.
One thing to note, Fortescue (Australian iron-ore mining investment) book cost is now $711 million, a $500 million gain (I think he may have meant to say “market value is now $711 million). Inmet (mining company) book cost of $78 million now has a market value of $360 million, a $280 million gain.

Former head of Kennecott Copper (guy was sitting in crowd – Kennecott is an enormous mine right outside of Salt Lake City, where IC and JS are based) is our advisor. He has been helping us with the business of scraping the ground.

This is a record turnout. I wish I knew why – it makes me a little nervous (laughter).

Prospects for Sangart? (medical product development company that Leucadia has invested $85 million in)
JS – I know a guy named Bob Winslow, a scientist, worked for the U.S. Army. He is the most renowned blood expert in the U.S., one of the top scientists. I ran into him 5 or 6 years ago in San Diego when I was selling our condo units. He told me about this artificial blood he was developing. We declined to invest. We met the next year and decided to invest. The product is now in a Phase 3 test in Europe. Ian went to medical school, he should talk about it.

IC – The Phase 3 test had 900 patients who took 1 to 2 units in hip surgery and other orthopedic surgeries. During Phase 1 and 2, there were no adverse effects. We are hoping to slog along and eventually have a product. It’s actually a fortunate outcome of the tech bubble bursting – we were able to get a factory in San Diego with almost all the equipment we needed for 250k units of production for very cheaply. We don’t know the retail price, it will depend on what they finally put on the label – it will likely be anywhere from $200 - $500/unit. It could be a substantial business based out of that little factory.

JS – Like all venture capital, in for a dime, in for a dollar. The original investment was $5 million, and we are now up to $85 million. We own 85%. Maybe it will be a big zero, it’s high risk. I’m in love with it and drinking the Kool-Aid, or “taking the blood”. Winslow is a gifted scientist and a wonderful person.

IC – It is still two years away form commercial production. We will move along to do a Phase 3 trial in the U.S.

Fortescue – seemed like a dicey investment. Any indication of production and amount of royalties? (The Fortescue investment was for 26.4 million common shares, 9.9% of shares outstanding, and a 13 year, $100m note, where interest is 4% of revenue from iron ore production, net of government royalties).

JS: I am leaving tonight for Australia for a meeting on Monday and Tuesday. Building on the railroads and port is coming along, almost on schedule and on budget. There were 3 cyclones that cost $100 million AUD in repairs and caused a 1 month delay. Iron ore demand continues. India just put on a $7/ton export tax. Most of the iron ore in China is inland near the old steel mills. The new mills are on the coast and ready to take in seaboard iron ore. The current investment is planned to produce 45 million tons/year, which should be $1 billion revenue. We are studying an expansion to 120 million tons/year, which would cost $2 billion. We have expected the price of iron ore to level off, but we have been wrong so far. The conventional wisdom is that prices will rise when they are set in a few months. We have a good strategic relationship with Chinese steel mills, we hope to have a long-term relationship with them and to develop similar relationship in Taiwan and Korea. This is a development company with no revenue yet. Things could go wrong.

IC: The worry is that iron ore prices revert to the mean.

Jefferies High-Yield bond fund – area is frothy and spreads are tight. Expectations? (Leucadia has a JV with Jefferies where they invest in and broker high-yield bond spreads. They have historically earned 20% annually on the deal and just reupped the deal at a $600 million investment).

IC: The record of high-yield spread is up and down like a ping pong ball over time. Look at the paper and prices you see for assets. If you don’t predict that something will unwind in the next few years, you are crazy. The cycles are caused by human nature, you see the herd run back and forth like a bunch of lemmings. Jeffries is a great business. They issue the credit, watch them all blow up, run in and rescue them, and then issue new great. It’s a great business!

JS: If we held our breath waiting for the correction, we’d be dead. Jeffries is a liquidity business. It’s a pretty good business. We hope to make a decent return while waiting for a correction. We could lose money holding inventory when spreads widen 200 bps some day, but that will be a big opportunity for us.

Telco acquisition – STi (prepaid calling cards business). IDT has struggled in this business. What intrigues you? (I am not sure this is accurate – IDT’s prepaid calling segment has done very well – it has lost money on other side ventures).
IC: The spreads. It’s a very profitable business. There is a great irony in the lawsuit in this area, the pot calling the kettle black. Look at the plaintiff’s record.

JS: We have a high regard for the guy who runs it. We structured the deal in a way to protect Leucadia.

IC: We are very sensitive to accusations that will explode that customers in this business have been overcharged. We took great pains to go in and clean that up.

Sangart – why double down on investment?
IC: To simplify, in phase 3, we injected units into a few hundred skinny Swedes and they all survived. That’s not true of other companies who have tested similar products in the past. The way the science works is that the molecule that attaches to hemoglobin is very big. It causes more oxygen to get delivered to the capillaries than the normal molecule. We don’t know why. That is potentially very exciting and good for soldiers who are injured in the field. Getting doctors to change patterns is very hard. If it turns out that you can freeze-dry this stuff and reconstitute it with saline solution, the armies of the world will be all over it. This is high-risk stuff. There might be side effects that could turn up only after long periods of time, like Vioxx.

Update on gasification business? (Leucadia has expensed $15 million over the past few years looking at developing a gasification business to produce clean energy?)
IC: The technology is out there. We are looking for finance opportunities for the gasification process.

Can you comment on the carrying value on investments vs. the market value?

IC: No. Do the digging yourself.

Costs of mining copper?
JS: This was a tactical investment, not a strategic investment. We invest because there are specific opportunities. We bought this mine 9 years ago and expect to start production in March, 2008. Cost is 0.40 Euro cents/pound.

IC: This is a bet on copper prices, period. Prices were at $0.60/pound when we invested and are at $3.60/pound now. This is a lesson you should all pay attention to closely; it is better to be lucky than smart.

IC: Here is my take on it. Along came CNN, people around the world got television sets and everyone saw the U.S. and wanted some of it. The U.S. is financing the growth of China. They are building a vast infrastructure. It is hard to fathom unless you have been there. There is an arc of development from Korea to the ‘Stans. I was just in Vietnam. It is seething with development. They are the most capitalist Communists you can imagine. There is a major shift of wealth from the U.S. to Asia because the labor rates are so low. It is nothing magical. Vietnam with their latest “5 year plan” is planning on building a fast railway the length of the country, 900 miles or so, along with a 4 lane highway. This will cost a fortune.

JS: The way economists oversimplify it is by saying that the U.S. consumes 25% of everything and China is on its way to equal that. There is a change in the supply/demand curve. Also, there are long waves of growth in commodity prices if you look back several hundred years. They go up for long periods of time. We may be in the midst of that right now (this sounds very similar to Jim Rogers’ argument.) Of course, long trends from 200 years ago may not repeat. History has a way of doing that. I think we are in a long-term boom now due to the growth from China, India, Vietnam, and Korea.

IC: Ladies and gentlemen, you have just seen something I have not seen in 30 years, Joe is optimistic.

JS: No, I am not optimistic for us, I am optimistic for the Chinese.

10 years ago you were sitting up there with a Pepsi can on the lectern talking about how excited you were about Russia? (Laughs from board)
IC: That can of Pepsi cost us $60 million (argument between JS and IC over whether it cost $40million or $60 million).

JS: These investments are scary! We could lose all our money!

IC: The only thing dictators do well is make the trains run on time, because if they don’t, the engineers will kill them! Vietnam is still Communist. They call each other comrade.

Asset price bubble?
IC: (Referring to securitizations – he was talking about process of slicing and dicing securities) We don’t know how this works over a long period of time.

JS: We go to auctions all the time, we just hired a few new guys to do this. It is very frustrating. When we do win and are the most optimistic people in the room, it is because it is a cyclical business that can’t be leveraged or a screwy business with some quirk. It is difficult and discouraging.

IC: We have been in hundreds of meeting around the country where we tell someone what we are willing to pay and they look back blankly and say, “Private equity can pay more.” and we say, “Adieu.”

What do you two disagree on?
IC: Everything.

(Long question on Russia and Putin pursuing a “Dr. Evil” strategy.)
IC: You are more sophisticated than we are. No, we haven’t thought about that.

IC: That question is floating towards a more strategic bent, although I guess our mining operations are kind of like that. Nothing in Japan is yummy.

JS: We invested in copper because we thought copper at $0.60/pound was cheap. That was basically the cash cost to get it out of the ground and we had the chance to buy a lush 6.6% rich copper vein. A year ago, I went to Japan with Bud Scruggs and we were looking for stuff. I think that to work in Japan, you need to open an office and hire native Japanese who speak English. It is a long-term strategic commitment. Maybe it makes sense, but we aren’t going to do it. When we don’t control companies, we want to trust the people who are running them, and there is a vast difference between how we look at companies and how many of the Japanese do.

Coal gasification project?
IC: This is a massive project. It would take $1.5 billion. We have several projects on the way, although something adverse could happen. We have a $130 million tax credit for a project with Eastman Chemical in Longview, Texas.

Why do you split the stock, unlike Buffett?
IC: I don’t know, it felt good. We usually split it when it gets to around $60/share. We are acquaintances with Warren, but we disagree about a lot of stuff, including the length of annual meetings. Of course, he is way smarter than us and has a lot more money, so maybe you should side with him.

Opportunities in subprime?
JS: We have looked a lot. It is interesting, the losses are spread so widely, no one person is taking a lot of heat. The brokers were in the business of generating paper for Wall Street. There is nothing to buy. As soon as things calm down, the guys who started New Century will come back and start over. Every Tom, Dick, and Harry hedge fund is looking to buy paper when it is 5 points down.

Are you generally seeing a lot of opportunities?
IC: Yes, we are seeing a lot of interesting things. They tend to be more entrepreneurial and less buying companies. We’re busy.

JS: Ian is correct. Instead of buying something cheap, we have to go in and do something.

IC: The opportunities in telco and Goober (said with heavy Texas accent) Drilling – we had to go in and restructure the back office, bring Sarbox to the poor people of the West.

Net Operating Losses?
CFO: There are two buckets. $500 million of losses can offset any income. $4.6 billion can offset income from certain areas of the company, areas where conveniently we have almost all of our assets. (A few members of the board snickered.).

Is size yet an impediment to returns? Is there a limit to the size of deal you would do? Are you looking for elephants?
IC: We are looking for small elephants. We are looking for value. If we saw it somewhere, we would finance anything. We have got friends in the world who have a lot more money than us who would help us.

Housing bubble?
IC: We pay cash when we buy real estate. If things go bad, we shut it off and pull the plug. Southern California has slowed down, and I think it should have slowed down more. It think there will be a crisis when the price of homes falls and people are underwater on their mortgages. This is a mysterious place that we live in. It has a remarkable capacity to absorb everything from ridiculous presidents to ridiculous financial stuff.

JS: If you buy a beautiful piece of real estate with cash, you will tend to do well. The properties we have in Maine are very high end, and the hedge fund types buying those have not seen any slowdown. I am very surprised that in the lower-end stuff, builders are still willing to buy lots of land for 10% less than they were paying last year. There doesn’t seem to be any sign of blood in the water.

Jeffries high-yield bond relationship?
IC: We go out to dinner with Richie all the time and scream at each other and air out our differences. There is another guy there, Andrew Whittaker, who is great. We have a very long and good relationship with them.

Vineyards? (Big laugh from one of the board members)
IC: Our former controller, after getting $5 million in Leucadia equity, immediately quit and went out and bought a vineyard. He is doing very well. We hope to replicate Archery Summit up in Washington state. It is very valuable. It’s amazing, Duckworth (another vineyard) is for sale for $300 million, and they are earning $5 million. Asset price in Napa Valley are the Easthampton of the San Francisco set. They are tired of getting really pretty women and now they are buying vineyards. Archery Summit is on allocation also, which is good, and we are upping the basis (didn’t understand this fully, but I think the way it is structured the tax basis of the investment is rising over time).

IC: In closing, we are both optimistic about the future.

Tuesday, March 28, 2006

Visiting Warren Buffett

Notes from a Columbia Business School trip to Omaha, Nebraska on Friday, March, 24, 2006

8:30 – 10am - Visit Nebraska Furniture Mart w/Bob Batt, grandson of founder Rose Blumkin and senior executive
10am – 12pm - Q&A with Warren Buffett at Berkshire Hathway headquarters
12 – 2pm - Lunch at Gorat’s steakhouse w/Buffett
2 – 4pm - Visit Borsheim’s (jewelry store) w/ Susan Jacques, CEO

I recently had the good fortune of visiting Warren Buffett in Omaha with a group of roughly 130 Columbia MBA students and several professors. Most of the students were taking a Value Investing seminar with Bruce Greenwald, a professor in the Value Investing Program at Columbia. Joel Greenblatt and Eddie Ramsden, adjunct professors in the program, also came along. Special Thanks to Erin Bellissimo and Liz Koe from the Heilbrun Center for Graham and Dodd Investing for helping set up the trip.

Buffett has hosted a number of similar such visits over the past few years and will host several dozen this year. Many of the notes from other visits can be found online with a little digging. The visit was fantastic. Everyone we encountered from Berkshire was a class act.

Below are my general observations and my notes from the Q&A. This is not meant to be a complete transcript of what happened. In cases where Buffett covered a story that he has previously told, I tried to link to it. I tried more to capture the gist of what was said than the exact quote. What is below is taken from my scribblings and memory, and any factual errors or misrepresentations are my own.

General observations
Eddie Lampert, the hedge fund manager and current chairman of Sears Holdings, is a long time Buffett admirer. In his recent letters to his shareholders, Lampert has used the adjective commercial numerous times to describe the type of employee he is looking for. It’s a peculiar adjective, one that you don’t hear very often, and it well signals Buffett’s impact on Lampert.

The word “commercial” perfectly describes Warren Buffett and the soul of what he has built at Berkshire Hathaway. Buffett is shamelessly and unabashedly commercial. The man has spent most of the waking hours of his 75 year life obsessively reading about, learning about, and engaging in the game of business. During our visit, when he was not telling us about an off-the-wall deal from his past (like trying to buy a town in Ohio as a 21 year old in 1951) or some commercial genius he idolizes (Rose Blumkin), he was trying to sell us jewelry and mattresses, or mugging for the camera with his capitalist groupies. He clearly enjoyed every minute of it. Buffett is an exemplar and cheerleader of the capitalist ethic, and in this circle, at least, he is virtually a rock star. He is both the dean and the Elvis of American Business.

Buffett's commercial spirit extends to the entire Berkshire Hathaway family. Bob Batt, one of three executive officers at Nebraska Furniture Mart, and Susan Jacques, CEO of Borsheim’s, each took a few hours to show us around their respective stores. They both clearly knew their businesses cold, and they are obsessed with pleasing the boss. Bob Batt understands the furniture business better than almost anyone else on earth, from the design of the showroom floor to the export competitiveness of fifteen different developing countries. Susan Jacques could break down the competitive characteristics and financial details of her jewelry competitors to the nth degree. She chatted with me for fifteen minutes on the threat of the internet distribution players in the jewelry business, and was keenly aware of the threats she faced ten years out. Buffett didn’t find these people at Harvard Business School. When he made Jacques CEO of Borsheim’s, she was a 34 year old immigrant with no college degree. But he saw that she had the ambition, the passion, and the integrity, and he was smart enough to realize that is what matters.

This deeply rooted commercial DNA is an enormous competitive advantage for Berkshire Hathaway in each of its businesses. I would guarantee that those businesses outperform their competitors financially by a large margin. As Buffett has mentioned before, asking his managers about making money or controlling costs is like asking them about breathing; it’s not something for which they come up with a strategic plan, it’s a completely reflexive act. Nebraska Furniture Mart has 3 executives, 15 vice presidents, and 3,000 employees. Bureaucracy is non-existent. When asked about how they charge buyers for capital employed, Batt replied, “We know the business, so we don’t need to employ cost accounting systems. Plus, that would mean hiring cost accountants, and we don’t have the time or energy for that.”

It is Buffett’s peculiar genius that he is able to make the game sound so straightforward. Want to make money investing in businesses? Remember three things: Mr. Market, Margin of Safety, and make sure the business has a moat. The moat either comes from a low-cost position or from pricing power, the latter of which usually results from a strong brand. If you’re going in with a partner, make sure that they are a passionate and ambitious fanatic who has devoted their life to the business, and that they don’t lie, cheat, or steal. That’s about it. As Buffett puts it, you don’t need an eleventh commandment; it’s all spelled out in the first ten.

At the end of our lunch, I witnessed Joel Greenblatt meet Buffett. Greenblatt is in many ways the heir to Ben Graham’s legacy at Columbia, and it was fascinating seeing these two great investors, a generation apart, meet for the first time. Buffett told the surrounding students how lucky they were to have professors like Greenblatt and Greenwald at Columbia. Then he congratulated Greenblatt on his best-selling recent book, The Little Book That Beats The Market. “Terrific book,”, Buffett said. “Buying great businesses at cheap prices. Doesn’t it seem so simple?”

Buffett opened with the story of Rose Blumkin, one of his idols. Blumkin was a Russian Jewish immigrant who came to the US in 1919 speaking no English. She worked for 18 years saving money to bring the rest of her family over and accumulating the $500 she needed to start the Nebraska Furniture Mart in 1937. That was the entire sum of outside invested capital in the company. When she passed away at age 103 in the 1990’s, having never learned to read or write English, she was worth tens of millions of dollars and she presided over a business empire. Her heirs have carried on running the family business, and the Nebraska Furniture Mart had sales of roughly $700m in 2005.

Question 1: How do you determine your circle of competence?

He tries to buy businesses where he can see the future – where he has a very good idea of what the business will look like in 10 to 20 years. The business needs to have a wide and deep moat, and it needs to be selling for a reasonable price. You need to be prepared to move quickly when you find a good business, as the opportunities to buy them can be very fleeting.

Buffett told the story of Craig Ponzio, owner of Larson-Juhl, a picture-frame distributor. Ponzio started the business in 1982 and increased sales from $3m to $300m over an eighteen year period. Ponzio gave Buffett a phone call in 2000 to see about selling him the business. Buffett had never even considered the business before, but knew after about ten minutes of talking with Ponzio that it was a cinch.

Larson-Juhl has over relationships with over 18,000 framing outlets, and has distribution centers throughout the country. It fulfills 95% of its orders the next day. It would make no sense to try and compete with it – the investment would never pay off. Even if you did have hundreds of millions of dollars, it would be almost impossible to get the framing outlets to switch distributors. The business has an enormous moat.

Buffett also relayed the story of his recent BusinessWire purchase. The CEO read the November 2005 WSJ cover article on Buffett, called him upon, and they soon struck a deal. Business Wire and PRWire are essentially a duopoly in their business, and a price war wouldn’t make any sense and is unlikely.

Question 2: GEICO is one of Berkshire’s crown jewels. You know the auto insurance industry cold, and you have been extolling the virtues of the GEICO and Progressive business models for decades. Why haven’t you ever taken a stake in Progressive?

Essentially, "thumb-sucking". That is what his partner Charlie Munger calls it when they identify opportunities in their circle of competence and fail to pull the trigger. Buying one didn’t preclude buying the other. He immensely admires Peter Lewis, the longtime CEO of Progressive. He asks the question of CEO’s – if you had a silver bullet and could kill one of your competitors, who would it be? For GEICO, Buffett would his silver bullet, and all the rest of his ammo, shooting Progressive. Years ago [presumably in the early 1980’s], they were briefly looking at putting the two companies together. He joked that each CEO, Jack Byrne of GEICO and Peter Lewis, would each come to him and report that negotiations were moving along, only that each was under the impression that he was gong to be the CEO of the combined company.

Buffett told the story of his initial involvement with GEICO as a Columbia student. It was obvious to him in 1951 that GEICO would do very well for a very long time. Everyone hates buying car insurance, but they are forced to, and a good chunk of them will go with the low-cost provider.

Buffett mentioned that GEICO now has a slightly better position than Progressive [due to a lower cost structure, I believe], but that the two of them will be duking it out and both will gain share for a long time. When the internet hit, Progressive actually had an edge for awhile. Because they had no direct distribution up to that point, they were quicker to seize on the internet as their direct distribution channel. GEICO had been so successful with its direct mail and phone strategy that those institutional forces vested in the old systems prevented it from shifting to the internet nearly as quickly as it should have. Buffett eventually had to lock them in a room and tell them they couldn’t come out until they had a viable internet strategy.

Question 3: What do you read?

Everything. Annual reports, 10-K’s, 10-Q’s, biographies, history. When he’s in airplanes, he’ll read the instructions on the seat backs. Two books he recommended specifically are Poor Charlie’s Almanack and Personal History, Kate Graham’s bio. He rarely ever reads fiction, feels like it would be taking up time he could be reading about business. He reads five newspapers a day, and plays bridge twelve hours a week.

Playing bridge significantly improves his quality of life, and he noted that those twelve hours he spends on it come directly out of his reading time. He pays $120/year to play online and would easily pay a million dollars, but they can’t figure out how to get more money out of him. He finds that fascinating. When he goes out to speak at the Microsoft Summitt, he challenges all of those brilliant technical people with that – he loves bridge and would easily pay millions, yet they can’t get it out of him. He bets them he will come back the next year and the situation will not have changed. His bridge name is ‘tbone’ and Bill Gates’ is ‘chalengr’ [not sure if the spelling on that is correct, but the point was that Gates’ name was a misspelling of “challenger”. I did not catch the name of the online service he plays on, but presumably it is the largest one.]

Reading has made him rich over time. He told the story of going through 12,000 pages of Moody’s manuals in 1951. “It was absolutely a question of turning pages”. On page 1433, he found Western Insurance Securities. Its earnings per share were as follows: 1949 - $21.66, 1950 - $29.09. In 1951, the low-high share price was $3 - $13. He went to a broker and read the Best’s Insurance manuals, and talked to agents – it was a perfectly fine company with nothing wrong.

Ten pages later, on page 1443, he found National American Fire Insurance (“This book really got hot towards the end!”) NAFI was controlled by an Omaha guy, one of the richest men in the country, who owned many of the best run insurance companies in the country. He stashed the crown jewels of his insurance holdings in NAFI. In 1950, it earned $29.02. The share price was $27. Book value was $135.

Buffett found it fascinating that this company was located several blocks from the broker where he worked. His fellow brokers were bright, rational people whose job it was to buy cheap securities, and they refused to buy NAFI, instead investing in “blue chips”.

He then took out a copy of the 2005 Korean Stock Market guide. It was more of an almanac than a brokerage report. It was sent to him for free by a broker. “If it had been $10, I wouldn’t have paid for it.” Based on the recommendation of a friend who thought South Korean stocks were cheap, Buffett spent 5-6 hours leafing through the pages and put together a $100m portfolio of 20 or so companies. Daehan Flour sold 25% of the flour in South Korea, which had a large and stable economy. It’s earnings over the last few years: 12,870 won, 18,000 won, 22,830 won. It had over 100,000 won in securities. The stock price was 38,000 won. “You have to make money buying stocks like this at 2x earnings. Brokers aren’t going to tell you about Daehan Flour.” Reading is key. Poor Charlie’s Almanack is great – that book has all you really need to know about investing. The Intelligent Investor is still the best book on investing. It has the only three ideas you really need.

1) Chapter 8 – The Mister Market analogy. Make the stock market serve you. The C section of the WSJ is his business broker – it quotes him prices every day that you can take or leave, and there are no called strikes.
2) A stock is a piece of a business. Never forget that you are buying a business which has an underlying value based on how much cash goes in and out.
3) Chapter 20 – Margin of Safety. Make sure that you are buying a business for way less than you think it is conservatively worth.

Buffett told the story of how he ended up going to Columbia. It was August of 1950, he had graduated from University of Nebraska and was in the library in Omaha looking at different grad schools. He had applied to Harvard Business School that spring and been rejected. He had read the Intelligent Investor in college, and was surprised to find Ben Graham and David Dodd listed as Columbia professors. “I figured they were long since dead.” He wrote a letter to David Dodd and received back a wonderful acceptance letter from Dodd.

Question 4: Please share your thoughts on your position in Remy International and the auto parts industry in general.

“Boy, I thought airlines were tough." They took the position in Remy three years ago.

When your big customers are teetering on the brink of bankruptcy, it’s tough to get price increases. You can’t survive as a high-cost producer in this industry. You can’t pass through costs like you could in the old times. He is very sympathetic to Rick Wagoner and Bill Ford. It is fascinating to see how these companies ended up in this position. Back in the 1950’s and 1960’s, GM’s only worry was that it would have anti-trust problems for having over 50% share of the U.S. auto market. Workers wanted a piece, and it was easy for the executives to give pension and health care benefits, as those benefits did not show up on the income statement [as opposed to, say, wage increases, which flowed directly through the income statement.]

Accounting drove the decisions. If you were a 63 year old executive at GM who was retiring in two years, it made absolute sense to give in on those benefits, because there were no accounting consequences. You know his incentive. It was really nuts. They fight the idea of unrecorded costs all the time at Berkshire Hathaway. In insurance, it’s easy; people do it by not reserving properly.

He talked about his position as a board member at USAir. Their seat costs were 12 cents/mile, compared to 8 cents/mile at Southwest. USAir had a huge percentage of the routes at several main hubs, like Philadelphia (something like 70-80%), and charged high prices. You knew that those profits weren’t going to last, but it was several years out in the future and the board of USAir didn’t want to face reality.

Question 5: What investment lessons have you learned?

He keeps making mistakes. Predicting the future is hard, and it will keep being hard. As long as his mistakes are in his analysis, that’s okay. When you buy a stock, you need to be able to get out a yellow legal pad and write down, in one page why it is cheap. For example, “I am buying the Coca Cola company for $14b for x, y, and z reasons and I think it is worth far, far more than that.”

He bought Dexter [shoe company] in 1993 and paid in Berkshire stock “which was ungodly dumb”. It was earning $40m pretax at the time, but that didn’t last as it got hammered from lower-cost foreign competitors.

Petrochina had a $35b market cap when he purchased it. He could say for sure that he thought it was worth appreciably more. It had a similar profile to Exxon, with the advantage that it was committed to paying out 45% of its earnings to shareholders in cash. “You could tell by the way they wrote about it in the annual report that it was a serious commitment. They quoted the dividend payouts out to twelve decimal points.” Petrochina made $16b in 2005 and paid out $7b in dividends, and Buffett bought his stake in the whole thing at a $35b valuation. The reason that he bought internationally with Petrochina and in Korea was because they were so cheap.

This all assumes that things sometimes trade at the wrong price. The framework is simple. Mistakes come from misassessing an industry, sometimes getting management wrong. You are going to make mistakes when you are looking at the over 50 businesses [that he has bought]. Mistakes are okay when you have a margin of safety.

Question 6: If you graduated from business school now and wanted to do what you are doing now, what would be your approach?

He would do the same thing. While there is more competition now, there are more opportunities. He wouldn’t waste any time. He bought his first stock when he was eleven years old, and if anything, would start earlier. He had read every book on investing in the Omaha public library by age nine.

It’s terrifically important to understand history. The Long Term Capital Management blowup in 1998 was a repeat of Northern Pacific in 1903.

These kinds of opportunities keep coming up not because humans are dumb, but because humans are human.

Working with your own money is more fun. He told the story of trying to sell GEICO to his clients when he was a broker in the early 1950’s. People wouldn’t touch it, so he’d try and scrimp up extra money to buy an extra five shares whenever he could.

He finds the game fun and always has. If you like it, keep practicing. It’s hugely important to buy stocks on your own. By doing that, you learn in a way that you can’t from reading books. Temperament and emotions are hugely important, and you need to experience that first-hand.

You want to go work around smart people who you admire. Make sure that you are doing what you want to do with interesting people. He told the story of the HBS student who picked him up at the airport in Boston for a talk years ago. The guy was 30 years old. Buffett asked him what he was doing after school, and the guy replied that he was taking a consulting job “because it would make his resume look good”. At a certain point, you need to jump in the pool. “It’s like saving sex up for old age.”

Question 7: What current business leaders do you admire?

Graham is up there. There are lots. In terms of one person, Tom Murphy is the guy he would go with, in terms of blending business talents, people skills, and qualities as a human being. Here is a great interview transcript with Murphy from a few years back. Murphy was the longtime CEO of Capitol Cities, which bought ABC in the 1980s.]

Murphy is now 80 years old, but if Buffett had a business to run and could convince him to run it, Murphy would hit it out of the park.

Question 8: Comment on your change in investment style and recent dabbling in silver, currencies, etc.

He does what he understands. He has been buying junk bonds for 50 years, doing arbitrage since he was a teenager. The currency bet originally had a positive carry, although that is not true anymore. If he had to make a bet about the dollar declining over the next ten years, he would say the odds are pretty high.

Silver has an interesting history. [My notes are fuzzy here]. The government was involved for a long period of time. In the 1930’s, the government bought up large stocks at a fixed price. After World War II, there was a big demand increase, and a large imbalance built. There was a huge amount above ground, over 1 billion ounces. You could see the imbalances in the government’s published numbers. 400-500m ounces is mined each year. Production is largely a byproduct of other metals (copper, etc), so supply is relatively inelastic. When prices get high, larger amounts come on from reclamation (melting down existing silver items), but normally reclamation is a small percentage.

In the late fall of 2002, buying junk bonds was like shooting fish in a barrel. His friend Howard Marks of Oaktree Capital was buying many of the same positions (telecom and energy) at the same time. Marks had a chart showing a list of the bonds and their price in the fall of 2002 and then 12-18 months later. The YTM on the bonds went from 30-50% to under 7% in 12-18 months. [Buffett showed a copy of this slide at last year’s annual meeting. That kind of jump in YTM implies a 4-7x jump in price.] You don’t need to do that many times in your life to get rich.

It’s crazy what happens in markets occasionally. In 1998, after the LTCM blowup, the spreads in on-the-run and off-the run treasuries were 30 bps.

Another example is the Resolution Trust Corporation in the early 1990s. All of the Savings & Loans went broke. Hundreds of billions of dollars in real estate were dumped on the government. The government officials in charge had no incentive to keep the properties and/or maximize the value they received in return. In fact, every time they got rid of a property, their lives got easier. All of the commercial developers were broke, so their was no buying competition. Buffett went in on a deal for the Woolworth building in downtown Manhattan near NYU. The lease was at $4/square foot and the building was clearly worth a lot. The building would surely release at over $20/square foot. It was a bet on foot traffic around NYU. They put in $8m. They later took out a non-recourse $26m mortgage. “You couldn’t miss”. Buffett half-mentioned a commercial building in Phoenix. The building had a $100m mortgage – two years earlier you could have easily sold it for $100m. When things blew up, no one would touch it.

“You will see a half dozen fish-in-a-barrel opportunities in your investing lifetime, with the water drained and fish not flopping anymore. The key is to make sure you are ready to act quickly when they happen”. In 1998, he got the call about LTCM on a Sunday. “You can make lots of money when people call you at home on Sunday.”

Question 9: What are your thoughts on the newspaper industry?

The Buffalo News is going downhill. Buffett won’t sell it because he has promised not to sell any of his businesses unless a) they will permanently lose money, b) there are labor issues, or c) the manager lies or steals. He started writing 15 years ago about how the economics of newspapers were no longer bulletproof. Forty years ago, newspapers and network television stations were the best businesses around; that’s not as true today. He told the story of the newspaper in Council Bluffs, Iowa. Back then, the newspaper owned the only megaphone in town that it made sense for local businesses to advertise through. Now, there are alternatives with cable and the internet.

The Las Vegas Review Journal – the area has seen explosive growth in population in recent years and it has seen a 15% decline in circulation.

Buffett told the story of World Book (which Berkshire bought through Scott-Fetzer in 1983). In 1985, the World Book encyclopedia cost $600 and sold 300,000 copies. It weighed over a hundred pounds and took up over thirty books. Now, that’s freely available over the internet.

“You can argue that my decision not to sell businesses is not economically rational, and I would agree with you. It’s just how I prefer to do it. But maybe it is economically rational. Craig Ponzio (Larson-Juhl) wouldn’t have called if he knew I might sell his business. We bought five businesses last year, none at auction, (because of this policy).”

Question 10: Why do companies sell to Berkshire instead of remain as standalone companies?

Businesses sell to him because he is solving a problem for them. In family businesses, when you get a few generations out, the ownership splits many ways, and families want a way to monetize the asset without losing control of the business. He gave the example of his purchase in Ben Bridge Jewelers.

When he is selling Berkshire as a buyer, he gives the following none-too-subtle pitch. “You have been working your whole life building up your business. It is your masterpiece. Selling to Berkshire is like putting that museum in the Metropolitan Museum. You know it will stay exactly as you left it, and won’t be touched it all. Or you can sell it to a Private Equity shop, which is the equivalent to a porn shop. Thhey will gussy it up, put in on display, maybe retouch the breasts, likely flip it to another porn shop in a year. Metropolitan Museum or porn shop, the choice is yours.”

Question 11: Would you invest in a hedge fund?

Yes, if a 30 year old Charlie Munger or Sandy Gottesman or Bill Ruane was running it, and they had all their money and their families’ money in it and were sharing in the downside. He has no complaint with incentive pay for hedge funds, he just wants to make sure the person running it is as committed as his partners. When he came back to Omaha in 1956, seven people wanted him to run money. He started with $105,000. He would setup the Partnership with the same fee structure today. [He kept 25% of gains over a 6% hurdle rate. Buffett mentioned offhand something about Charlie Munger recently turning his money over to someone to manage, although I am not sure if I heard correctly.]

You can occasionally find small groups of bright people who can do well over time. These people will be distinguished much more by temperament than IQ. You want to make sure that these people treat your money like it is their’s.

Question 12: What would you pay for a solid company that is growing earnings at 8-10%/year?

Not many companies will do that. You see a lot of garbage about EBITDA. Depreciation is the worst kind of expense in that it is prepaid. He looks at EBIT/EV. He’ll generally pay 7x for a decent business. For insurance companies, he looks at float and the cost of float.

He was CEO of Salomon Brother “for nine months and four days, and if you think I wasn’t counting, you’re crazy.” He found it fascinating that these bankers would run around creating pitchbooks for companies they had never heard of three weeks prior which contained projections going out years. When he asked them how much Salomon would earn next week, they couldn’t answer.
“It’s a joke.” Projections and how the numbers are dressed are ridiculous. He told the story of buying Scott-Fetzer. First Boston had been trying to sell the thing for some time and had put together several pitchbooks. Buffett ended up contacting the CEO directly and negotiating the deal with him. At the closing, the First Boston guy came in and collected his $2m fee. The banker went up to Charlie Munger with a copy of the pitchbook and tried to push it on him. Munger replied, “I’ll pay you $2m not to have to read it.”

Question 13: What would you do about the trade deficit?

Buffett rehashed what he wrote in his 2003 Fortune article, Why I’m not buying the U.S. Dollar.

The more trade, the better. Exports are 10% of GDP. Ricardo’s assumptions hold, but they didn’t consider IOU’s. He proposes a market-based “trade certificate” system; when U.S. companies export goods, they receive a matching nominal value of “trade certificates” that they can then sell to anyone who wants to import.

When foreigners want to cash in their dollars by buying U.S. assets, like the recent CNOOC case (large oil company whose assets are mostly overseas), Congress goes ape. This is not a good policy. It is hypocritical, and not good for stable politics over time. Other thean WMD’s, this will be the big political and economic issue in not too many years. [Buffett seemed to be emphasizing the political issue over the economic issue.]

Sunday, March 19, 2006

Notes From China

From March 4-12, I went on an eight day trip to China. It was organized and run by Columbia Business School students – 35 people made the trip. The trip involved a number of company visits, usually two per day, mixed in with visits to the major tourist sites and some time spent walking around the cities.

I had never been to Asia before and I didn’t really have any expectations for the trip, other than from general reading. Below are my notes and observations.

Traveling to China
The flight from New York to Beijing takes roughly 13.5 hours and there is a 13 hour time zone difference (China has only one time zone – kind of odd.) The flight path heads from New York northwest across Canada, up along the coast of Alaska, crosses the Bering strait, and follows the coast of Siberia down to China. New York to Beijing is about 7,000 miles – a little more than a quarter the circumference of the Earth.

On a related note, Federal Express has one of its largest airport/warehouse facilities based in Anchorage, Alaska, rivaling in size that of its Memphis, Tennessee headquarters. Over 400 flights a month come through this facility. Why Alaska? It’s slightly counterintuitive, but Alaska is an excellent spot for a global shipping hub, especially as a way station between the US and Asia. Over 90% of the industrialized world lives within a 10 hour flight. You wouldn’t think it from looking at a map of the world, because a flat map distorts in a way that a globe does not. For instance, Europe is much closer to China than it appears on a map, because you fly over the North Pole.

Fortune magazine had an excellent article in late 2004 on the Fedex Anchorage hub:
Why Fedex is Flying High

Geographically, China is almost the exact same size as the United States. The official population is 1.3 billion, compared to 300 million in the US. I heard a few people on the trip mention that China’s official population estimates are hugely understated, including the representative we met from Goldman Sachs, and that the real figure is closer to 1.6 billion. I did not get the chance to ask why.

In terms of thinking about the country, one can split it into two groups: the rich coastal regions, home to most of the major cities and recent economic growth, and the incredibly poor rural interior.

While slightly outdated (2001), this table demonstrates the disparity. The GDP per capita (in PPP, or purchasing power parity, which means accounting for local prices) of Shanghai was over $16,000, and Beijing was over $10,000, compared to a national average of under $4,000.

A very brief historical review follows. I include events insofar as they are relevant to an understanding of modern China and/or fairly interesting.

China was an imperial dynasty for over 2,000 years, from roughly 221 BC until 1911, i.e. it was ruled by an emperor based in Beijing. China was relatively isolated for most of that period, until European colonial powers (led by Britain) forced China open to trade in the 1840’s and established a presence in the major cities: Hong Kong, Shanghai, etc. This presence lasted roughly a hundred years and left a deep scar on the Chinese psyche.

During the later half of the 19th century, the Chinese imperial dynasty began to rot, weighed down by the pressures of poor leadership, corruption, colonial aggression, and civil wars (including the Taiping Rebellion in the 1850’s, one of the bloodiest civil wars in the history of the world, led by a guy who fashioned himself to be the younger brother of Jesus Christ.)

In 1911, the empire fell and the Nationalist Party came to power. The Nationalists led for a period of three very turbulent decades up through the Second World War. The Japanese occupied large parts of China before and during the war, during which time occurred the still deeply resented “Rape of Nanking” in 1937, wherein the Japanese slaughtered several hundred thousand Chinese.

At end of World War II, the weakened Nationalists, led by Chang Kai-shek remained in power but faced fierce opposition from the Chinese Communist party, which was established in the early 1920’s in China and led by Mao Zedong. The Communists ultimately defeated the Nationalists, and the Nationalists retreated to the island of Taiwan (up to that point a part of China) which they declared the Republic of China (as opposed to the Communist’s “People’s Republic of China” or “PRC” or “Mainland China”)

Mao led China from 1948 until his death in 1976. Mao was, to put it kindly, absolutely nuts. Upon realization that the Chinese economy was falling behind that of the West, Mao launched an economic plan called the Great Leap Forward in 1958, with the idea that the Chinese economy would surpass that of the West within 15 years, mostly through the production of grain and steel. The latter would be smelted individually by people in their backyards.

The end result of this was that over 35 million people died of starvation in the following decade. Mao, at this point realizing that he was in trouble, clamped down severely, launching the Cultural Revolution in 1966 to purge society of any dissenters, “imperialistic intellectuals”, and “capitalist roaders”. This nonsense came to an end in 1976 when Mao died and Deng Xiaopeng, one of his lieutenants, came to power. Deng started a program of gradual economic liberalization that is still playing out to this day.

We spent the first three days of our trip in Beijing.

Beijing lies on a plain in northeastern China, about an hour from the water. Beijing has historically been the center of Chinese empire and is the nation’s capital. The “Forbidden City’ (or Imperial Palace) lies at the heart of the city, sitting directly across from Tianamen Square and the main government buildings. This main downtown area is enclosed by a ring-road, and there are two larger concentric ring-roads which lie outside of that one. Beijing is absolutely enormous, and I found it to be somewhat dull, kind of like Toldeo meets Washington D.C. (A good analogy to the U.S. is Beijing:Washington DC as Shanghai:New York. The largest city in China is actually Chongqing, in the interior, with a population of 32 million).

The amount of construction going on in downtown Beijing is unbelievable. Looking out the window of a skyscraper from downtown, I counted 19 construction cranes – the huge, skyscraper-building kind – and that was only looking out one side of the building. It seemed to me that a lot of the finished buildings were empty and had been so for awhile. The bankers that we met (including a rep. from the Goldman Sachs joint-venture in Beijing) swore that the overbuilding wasn’t a significant problem, but I find that somewhat hard to believe. (On a related note, I had heard before the statement that more commercial real estate was built in 2005 in Shanghai than exists in all of Manhattan. I no longer doubt this is true.)

Part of the build-up is in preparation for the 2008 Beijing Olympics. The Chinese are extremely proud of this event, and you see Olympic ads and posters everywhere.

The pollution in Beijing is unbelievably bad. Imagine the smog in LA multiplied by about 20.

Companies that we visited in Beijing:

Lenovo recently purchased IBM’s PC business. We toured the company’s headquarters, and its accompanying computer factory, which was pretty cool.

UFIDA is an enterprise software company that focuses on small and medium businesses. It had revenues of $125 in 2005, with net margins of roughly 20%. The company is listed in Hong Kong and the market cap is roughly $600m.

Note on Chinese stock market
There are two domestic stock markets, located in Shenzhen and Shanghai. Because of the Communist legacy (under which all companies were owned by the state), there is an old dual-class share system that is currently being reformed. The result of this is that most of the good companies in China have chosen to list either in Hong Kong (which prior to 1997 was “abroad”), New York or London. Thus, when you hear that “the Chinese stock market was down 30% last year”, this isn’t reflective of the larger performance of the Chinese economy as only second and third-tier companies are listed domestically. All of the blue-chips are listed overseas.

Goldman Sachs Gao Hua
This is Goldman Sachs Joint Venture in China. Its structure is interesting and illustrates the complexity of foreign investment and corporate involvement in China.

Foreign companies are only allowed to own up to 33% of Chinese securities firms.
Goldman Sachs owns 33% of Goldman Sachs Gao Hua. Gao Hua Securities owns the remaining 67%.

Gao Hua Securities in turn is 75% owned by Fang Fenglei, a Chinese investment banker, and 25% owned by Legend Holdings, the parent company of Lenovo. Goldman Sachs had a long relationship with Fang prior to the partnership in 2004, and they lent him 100% of the capital for his stake in Gao Hua. Goldman Sachs has an option to buy out the foreign 67% ownership of Gao Hua Securities for a nominal price if and when the 33% ownership restrictions are lifted. Thus, Goldman essentially controls the company as though it owned it entirely. Here are the details.

Morgan Stanley was the first investment bank in China in the 1990s and they went with a more traditional joint venture with CICC, a local Chinese Investment Bank. This turned out to be something of a disaster. The story is well told in a chapter of the book One Billion Customers by James McGregor (discussed below).

We spent the last four days in Shanghai, a city that completely blew me away. In terms of vibrancy, dynamism, and general cool-factor, Shanghai gives New York a run for its money – not in 10 years or 20 years, but right now.

This dynamism comes from a mix of the traditional Chinese architecture, the beautiful colonial Art Deco buildings, the ultra-modern skyscrapers, the futuristic transportation system (elevated highways and the only commercial mag-lev train in the world) and the relative greenness of the city. At night, the entire city is lit up in neon and you feel like you are on the set of Bladerunner. Infusing all of this is the raw capitalist energy of the people. I have often heard commented that the Chinese are inherently some of the most capitalist people on Earth, and I finally understood what that meant when I got to Shanghai.

Looking at history, the rebirth of Shanghai should come as no surprise. In the late 19th and early 20th century, Shanghai was the leading financial center in East Asia. Britain, France, the United States, and Japan each had a “concession” in the city – essentially a part of town owned and run by that government (hence the colonial architecture). The only reason Shanghai ever lost its first-city status was because of the rise of Communist Party in 1949 and the ensuing trade embargos. Hong Kong was the direct beneficiary of these events, and I heard several people mention on the trip that Hong Kong’s best days are now behind it.

One of my favorite movie scenes is the opening to “Indiana Jones and the Temple of Doom” which takes place under the dateline “Shanghai, 1935”. Basically, fast-forward the scene 70 years and that’s what the place feels like today.

Western companies are firmly established in both Beijing and Shanghai. You see KFC, Starbucks, and Mcdonald’s restaurants everywhere, with KFC in the lead in the fast-food race. Likewise, you see Chinese imitators of these brands everywhere you look, which are mostly hilarious.
My favorite was Chinese Colonel Sanders (Or should I say, “Colonel Tseng”?)

Fosun Group
The Fosun Group is an interesting example of a modern Chinese corporation

We met with the 36-year old Vice Chairman (one of the four original founders) and his translator, an alumnus of Notre Dame and the University of Chicago Business School who also served as VP of Investor Relations and as a senior executive in the real estate group.

Fosun was founded as a pharmaceutical company in 1992 by four newly minted graduates of Fudan University, one of the leading universities in China. The founders very smart and ambitious, were also very plugged-in politically, with one of them serving as Deputy to the 10th National People’s Congress and another as a senior official in the National Communist Youth Party.

These guys were obviously very sharp businessmen. The company did well in the pharmaceutical area in the early 1990’s and used the cash flow to expand into steel, real estate, and retail. Currently, it is a multi-billion dollar conglomerate, with several of its subsidiaries listed on overseas exchanges.

The Fosun founders and their peers, in their late 30’s, are the business titans of modern China. I find it interesting that the generation of people aged 40-60, the group who comprise the business leadership in most countries, is not at all active in China as a result of the Cultural Revolution. That generation spent their formative and education years in “re-education camps” and slaving away in the Communist bureaucracy. As a result, there is a tremendous vacuum that the younger generation has eagerly filled.

While there are a number of successful young corporate titans in the United States, they represent a fairly small percentage of corporate leadership. In China, my sense was that this proportion was, and will continue to be, far more skewed towards younger leadership.

Other companies that we visited in Shanghai:
Bank of China, HSBC, Shanghai Media Group

China is a fascinating place. Its transition to a capitalist economy has been extraordinarily rapid and its totalitarian government has greatly helped in that regard (things can move very quickly when there are no dissenting parties, at least none with any power.)

A good friend of mine from college lived in Beijing for a year in 1999. He compared China to the Borg from Star Trek. China is an immensely large and powerful force – it takes awhile to get its act together, but once it does, it moves swiftly and relentlessly. The Chinese government has decided that it wants to make its nation rich and powerful, and all of its decisions are made with that in mind. The political crackdowns take place because the government is obsessed with losing control and stability, which they fear would threaten economic development.

I have little idea how the whole thing will play out politically. My sense is that economic development is occurring so rapidly and people’s lives are getting better so quickly that there is not a huge pent-up sense of rage against the system, at least not enough that would force the system to crumble. It will be interesting to see how the internet censorship issue plays out. My guess is that China will follow the other Asian countries that have gone down the capitalist road before it, like Korea and Japan.

I also think it likely that China will crash hard economically at some point in the next few years. Expansion is happening so quickly and there is so little sound legal and financial infrastructure, let alone any kind of “credit culture” (in the past, when people wanted money – and if they had the right connections – the government gave it to them, regardless of financial return), and the concept of “return on capital” appears to be so completely ignored in many areas, that I don’t see how they can go without hitting a major speedbump or two.

Below are a list of relevant books and articles on China.

One Billion Customers by James McGregor
Published in late 2005 by a former WSJ reporter and president of Dow Jones China who has lived in China for over 15 years, this book contains a series of interesting stories on doing business in China. A quick and worthwhile read. The title is a tribute to an earlier, similar book published in 1937 by another American journalist/businessman, Carl Crow, who lived in Shanghai in the 1920’s and 1930’s:

400 Million Customers by Carl Crow

Operation Yao Ming by Brook Larmer
The story of the rise of Yao Ming, the 7’5” NBA superstar. Yao was very much the product of the totalitarian state – his parents were two of the tallest people in China, intentionally matched and encouraged to have children by the Chinese government.

While I have not read this, a friend who lives in Shanghai recommended it as having the best coverage of recent Chinese political history, far better than One Billion Customers.

River Town by Peter Hessler

Fantastic book. Hessler spent two years in the late 1990’s as a Peace Corps volunteer in Fulin, a central Chinese city on the Yangtze. Hessler is an extraordinarily talented writer, and the book is perceptive, touching, and hilarious. Hessler still lives in Beijing and files a story for the New Yorker magazine every few months.

The Search For Modern China by Jonathan Spence
Spence is a history professor at Yale University. This book is widely considered to be the best one volume history of China.

Inside the New China - Fortune – September 21, 2004
Fortune published this special China edition a year and a half ago, with a dozen pieces on various business and political topics. Excellent coverage of recent Chinese business developments.

Thursday, January 12, 2006

Notes From Silicon Valley

I recently went on a three day trip to Silicon Valley with a group of Columbia Business School students. There were about 25 students in total - first years, second years, and an assortment of executive MBAs. Over three days, we visited the following companies: Google, Yahoo, Ebay, Apple, HP, Intel, SAP and LinkedIn, in addition to attending a panel of VC's and a morning meeting with a few former Cisco execs who are now running a startup chipmaker. The trip visits generally comprised a brief intro to job/internship possibilities by an HR person, then about an hour of talks by various executives at the company, often Columbia alumni.

Below is my take on the trip. There is quite a bit of editorial commentary. Take it with a grain of salt. Also, I don't believe that I am betraying any statements that were made on an implied off-the-record basis, and if I do, I apologize.

Geography & Background

What is perhaps most fascinating about Silicon Valley is how pedestrian the location is. Geographically, Silicon Valley is basically the collection of towns along Highway 101, which runs from San Jose northwest to San Francisco. Palo Alto (home of Stanford) is roughly in the middle.

Highway 101 has about as much going on as the highway connecting Seattle and Tacoma - i.e., not a whole lot. It basically looks like any other highway connecting a series of office parks; only those office parks happen to be home to some of the most interesting companies in the world, whose collective market probably runs upwards of a trillion dollars. It speaks well of the dynamism of Silicon Valley, in particular, and the United States economy, in general, that Ebay, Yahoo, and Google didn't exist 11 years ago and now they are global giants worth hundreds of billions of dollars.

A terrific journalistic history is Silicon Boys and Their Valley of Dreams by Robert Kaplan. Although it was written in 1999 and does not cover recent events, it's a great read.

General Impressions
The companies seemed exactly like one would expect based on accounts from the general press, and each very much seemed to reflect the personality of its CEO/Founders. I was a bit surprised at the extent to which this was true. If a sparrow falls at Apple, Steve Jobs knows it. And not just from an operational standpoint, either. A minor example: after we met folks at Apple, we went to the Apple Store on the campus for ten minutes of shopping. It was around lunchtime, so someone arranged for a cart of sandwiches to be brought in. The head recruiting guy, who had been around Apple for awhile, saw this and asked for them to be moved outside and said, quote, "If Steve sees this food in here, I will be out of a job." I had the feeling that he was not really joking.

Silicon Valley as Racket
Silicon Valley is a money machine and in some ways resembles a gigantic racket. I say that mostly in admiration.

An example (and while I might have some of the details slightly wrong, the basic story holds):
We heard the two founders of a chipmaking company speak on a panel. Each of them had worked at Cisco for a number of years, one guy as the head of a department there. While they were at Cisco, they identified a technology that the company needed but was not going to develop itself. They left to form a startup, with backing from Cisco. They developed the technology, and eventually sold the company back to Cisco for a heapload of money (the acquisition was lead by the guy's former boss). Around and around we go; these guys were on their third company. A classmate on the trip had worked at Cisco for a number of years and told me this kind of thing happens all the time.

That makes sense to me from a rational business perspective, but the possibilities for subtle (or not-so-subtle) corruption seem large. For instance, what if the Cisco guy was on the board of the startup, and perhaps had a large slug of options in the company? While I am sure that Cisco and other companies have policies/rules against this, it all seems very cozy.

One of the great business juggernauts of all-time, the place is obviously full of legions of formidably smart people. Their stated modus operandi is "to throw a lot of stuff against the wall and see what sticks", and their culture is perfectly set up for this kind of "let a thousand flowers bloom" mentality. That being said, the very rapidity of its rise is going to cause some problems over the next few years.

Will Google collapse under its own weight?
It will be interesting to watch at Google is the ability of the organization to absorb its massive and rapid employee growth. The number of employees at year-end has done the following over the past five years: 284 to 682 to 1,628 to 3,021 to roughly 6,000 in 2005. That is a massive influx of people - how many companies have ever grown that quickly? The specifics of its business aside, this presents an immense organizational problem.

Bureaucracies aren't bureaucracies because they are full of bureaucratic people - bureaucracy is an emergent function of large organizations. This was readily apparent to me when we visited Intel and Hewlett Packard later in the trip. I am sure that both of those companies had cultures similar to Google when they started, but coordinating the actions of over 100,000 people (or even 10,000 people) is inherently a cumbersome process, especially without a mature infrastructure.

Google, as an organization, appears not to have come to grips with the fact that this is even an issue. One of the senior project managers who presented boasted of how Sergey and Larry had personally approved each of the 3,000 or so employees who were hired in the past year. When I went up to her afterwards to ask her about the possible bottlenecks in a Sergey & Larry, Inc, model, she replied, literally, "Well, they will work longer hours." She then went on about how Google was a "learning organization" that was able to rapidly grow and respond to problems. My impression is that the place is almost entirely run by Larry and Sergey - every single project is run across them.

This is not an inherently bad thing - just that Google is still very much in a honeymoon phase and is going to have some serious growing pains in the next few years. It is like the brilliant kid who graduates from Cal Tech at age 15. While the kid will do very well, at some point his lack experience and maturity is going to bite him in the ass, hard.

What are the issues caused by the stock going so high, so fast?
Another interesting thing to watch will be the secondary effects of the rocketship stock price growth. Google's market cap has gone so high so fast, and this will have an effect on recruiting hotshot engineers who want to get rich.

To illustrate:
Microsoft went public in 1986 with a market cap of roughly $700m. The stock price compounded fairly steadily (at roughly 60%/year) for the next 15 years, to a high of around $500b in 2000. (It is now at roughly $290b). That steady rise was a very good thing for its employees and for the general stability of its workforce, as those who joined at any point between 1980 and 1995 and stayed did very, very well. And because the stock continued to rise at a steady pace, there weren't enormous gaps between people who joined in, say, 1988 and 1992.

Google, on the other hand, went public at a $24b market cap and now is roughly at $130b. While this is very good for the early investors and employees, it's a very bad thing for recruiting current employees who want to get seriously rich. Google's market cap is not going to go up 20x from here. Most of the Google centi-millionaires have already been minted. While the company has a ton of money with which to compensate its employees and is currently the hot place to be for seriously talented software engineers (the lifeblood of the company), these types of people have others options whose financial lures will become greater over time. Of course, Google will acquire many of those startups, but it will face competition in doing so.

People tend to forget that Google is an advertising company
While it sometimes seems to get lost in the hullabaloo over the stock price, Google makes 99% of its money from advertising, (the business model was originally to license its search engine to other sites, something which it still does, although the money pales in comparison to the advertising revenue. It stumbled upon its current model out of desperation, as it was running out of money in 2001.) In looking at the new products, the fundamental question to ask is, "How will this help Google make more money from advertising?". Robert Cringeley, a seasoned and very tech-savvy Silicon Valley reporter, has written quite a bit about this and I highly recommend his weekly column. A neat feature and good grounding exercise for investors is that he has archives going back to 1997. Remember Prodigy? (Bonus points if you knew that it was originally a joint venture between IBM and Sears.)

Betting against Google would be insane
On the advertising sales side, Google has recently "verticalized" into twelve different areas and is hiring lots of ad salespeople to get out there and beat the bushes for business. One of the biggest barriers to Google's growth (and internet advertising in general) is not the technology, but convincing marketing people at various companies that they should switch their ad spend from television to the internet. This is inherently a slow process, as there is a great deal of inertia in the advertising industry, and the tens of thousands of people who work at ad agencies and ad production houses have, let's say, a vested interest in sticking around. This is very good news for Google, as it means there is plenty of room to still grow - internet advertising still accounts for only 5% of all advertising spend, roughly equal to Yellow Pages spending in 2005.

For all of the talk above about how Google is going to hit some speedbumps, it is sitting fat in the middle of a $220 billion marketplace that is massively inefficient and just starting to shift online, and it has built a better mousetrap. A much better mousetrap. Betting against this company would be insane.

Checking job postings is a good method of competitive intelligence.
On a related note, one executive on the trip mentioned that a good way to do competitive intelligence and figure out what a company is up to is to look at the job postings on a company's website. Simple, yet very effective.

Minor architectural comment
Google and Yahoo both have "zany" campuses - with outdoor volleyball and primary colors galore. They look more like Romper Rooms on steroids than corporate headquarters. From an architectural standpoint, I don't think these are going to age well. Ebay's HQ in San Jose, on the other hand, is a bit more understated and should stand the test of time. But maybe that's just my snooty East Coast bias talking.

The company seems like, well, a burgeoning, media conglomerate of the future, with its eye firmly focused on grabbing more and more user time and fees and advertising dollars. Good job, Terry Semel!

I like where Yahoo is going with the heavy incorporation of social networks/tagging (Flickr, Delicious...Youtube?). I think this will prove to be a very smart direction to head.

Ebay feels like a fairly mature place. Meg Whitman worked at Proctor & Gamble and as a strategic consultant prior to joining Ebay, and she has clearly hired people in that image. That is not meant as a knock. Ebay clearly understands network effects very well. For anyone wondering what the company is up to (like why they paid $2.6b for Skype), they put out a Powerpoint presentation after the Skype acquisition that pretty clearly explains their strategy.

It is intesting how dominant Skype is across the world - it is the VOIP leader in almost every country, and the United States is actually the market where it is least dominant, by a large margin. They go through it in the presentation, and personal anecdotal evidence from talking with international students at school confirms it.

Skype cellphone?
Thought: Say it's 2007 and WiMax is broadly deployed (roaming broadband internet access), or some equivalent. What is to stop Ebay from making a Skype-friendly cellphone? All else being equal, I would rather not pay Verizon $600 a year. Are there major technical hurdles that I am missing?

There was an engineer at the Ebay talk, a guy who used to work at Microsoft, who spoke to a few interesting topics.

Why hasn't Ebay entered Classifieds more aggressively?
I asked him why Ebay hadn't attacked the classified advertising space in the US more aggressively. After all, this space is right in Ebay's sweet spot, it has already made significant related acquisitions in Europe, and the U.S. landscape is still very fragmented. He said that the Craigslist acquisition had a lot to do with their holding back.

He indicated that Ebay had hoped it would be able to pull Craigslist into it fold, and had been frustrated that it had so strongly resisted this. And, given the relationship, Ebay had been somewhat wary of immediately launching a direct competitor, although this resistance was fading. This was surprising to me.

To review the history:
Ebay picked up a minority stake in Craigslist in mid 2004 (25% for $10m), purchasing it from an early employee who Craig had given stock to way back when it was still a garage project.

I have read a number of articles about Craig Newmark and I met him once, briefly, at a panel discussion. He strikes me as the absolute last person in the world who would ever sell out or change his ways for a financial carrot. If Craig wanted to be a billionaire, he could be one tomorrow, with or without Ebay. That Ebay would think it would be able to commercialize Craigslist in any way, without owning a controlling stake, strikes me as naive. And to the extent this move delayed their entrance into the marketplace by a few years (enough to give Google Base an opening), it was an absolutely terrible decision.

"Don't Be Evil", my ass
When I was talking with this engineer afterwards, the topic of net-neutrality came up, and he had an interesting theory. "Net-neutrality" is the idea that content carried over the internet pipes of service providers (the cable companies and telcos of the world) is all treated the same, i.e. Comcast cannot favor its own content over Ebay's. With the recent rise of video downloading and other pipe-intensive, the service providers are howling. The following is from a Business Week Nov. 7 interview of Ed Whitacre, CEO of ATT (formerly SBC):

BW: How concerned are you about Internet upstarts like Google (GOOG ), MSN, Vonage, and others?

Whitacre: How do you think they're going to get to customers? Through a broadband pipe. Cable companies have them. We have them. Now what they would like to do is use my pipes free, but I ain't going to let them do that because we have spent this capital and we have to have a return on it. So there's going to have to be some mechanism for these people who use these pipes to pay for the portion they're using. Why should they be allowed to use my pipes?

The Internet can't be free in that sense, because we and the cable companies have made an investment and for a Google or Yahoo! (YHOO ) or Vonage or anybody to expect to use these pipes [for] free is nuts! "

Pretty incendiary stuff. So Whitacre realizes that selling a commodity is a loser's game, that consumers would scream over variable pricing, and he wants a piece of the juicy content provider margins.

The mainstream media has latched on to this as Internet companies vs. Pipe owners.

However, the engineer had a different take, one that other people are speculating about as well.

He thought that Google would strike a deal with Verizon agreeing to pay the toll, and that after Google did this, the other major content providers would follow in suit. The theory behind this is that it would create an oligopoly for the content providers and effectively box-out the small, innovative (and poor) companies that could threaten their dominance because they couldn't afford the fees. Shrewd. Funny that Google didn't mention Adam Smith in their S-1, "People of the same trade seldom meet together even for merriment and diversion, but the conversation ends in a conspiracy against the public or some contrivance to raise prices." Hey, if you're going to try to take over the world, don't pull punches. You have to admire Bill Gates for at least being a straight-shooter.

Threats to the internet conglomerates will likely come from below.
When you think about the future threats to the large internet companies, it is much more likely to come from below - three software engineers in an office park in Palo Alto - than it is to come from entrenched "Old Media" companies. As long as Yahoo and Google can co-opt these threats either by buying them for $25m each or by blocking out access to important markets, they should do just fine. On a related note, it seems that Google paying $25m a year to lock up the most talented section of the Stanford Computer Science program would be a relatively cheap and effective insurance policy.

VC Panel
At one point, we attended a panel discussion of six VC's from assorted Silicon Valley firms. They were obviously very bright and talented people. A few things struck me.

Welcome to Herdsville, Population - Venture Capitalists
I was surprised as to how much herd behavior there obviously is in this community - similar to New York hedge funds, in many ways.

I have a theory that, in any given crowd, about 95% of people like to think of themselves as "independent thinkers", while about 5% actually are. The real independent thinkers are the ones who come up with and bet on ideas that are generally considered to be crazy at the time. Easy to say, hard to do - hence the 5%. What I find interesting is that when you ask the crowd, at the time, what they think about the crazy idea, it is generally dismissed not because the crowd has carefully analyzed the idea and come to a different conclusion - rather, the idea is dismissed out of hand as absurd. For instance, ask a "value investor" about Bill Miller's investments in Chinese Internet portals and see what kind of response you get. Forget about what you think about the investment – note how they respond.

On the topic of herd behavior/contrarian investing - one of the VC's mentioned a fund - Lake Street Partners - who go to corporations who are bailing out of their corporate VC investments and buy up those investments for something like 10 cents on the dollar and absolutely clean up.

Being a VC at Kleiner Perkins is like being an Admissions Officer at Harvard, only you own the upside.
Another thing I learned was how much the entire VC world was driven by social connections and signaling effects. This is obvious, I suppose, to anyone who works in that world, but I hadn't realized the extent to which it is true. If you are an entrepreneur with a great young company, the major reason to get funding from Kleiner Perkins is because that will signal to the world that you are a blue-chip prospect and give you access to decision makers at big companies, greatly enhancing your future likelihood of success. It doesn't have a lot to do with the sage wisdom of the VC's. (One guy mentioned that Kleiner Perkins 10th fund was in the red until the Google IPO. Think about the implications of that for second and third tier VC's.) Being a VC at Kleiner Perkins or Sequoia seems like being an admissions officer at Harvard, only instead of getting paid $40k a year, you get an equity stake of your admitted students' future earnings. Not a bad deal.

Why aren't more VC's targeting the advertising industry?
I was surprised that none of the VC's mentioned or were funding companies in the advertising space. Given the recent successes of Google and Yahoo and the structure of that industry, it would seem to be a good target for disruptive innovation. I asked one of the panelists about this after the talk and his response was, basically, "That's not really something that we understand very well." Fair enough.

We talked to an exec at LinkedIn, the social networking site for professionals. The guy was very sharp, and spoke more about the Valley culture and being a startup investor in general than about LinkedIn.

Quick notes on the company:
LinkedIn has about 4.5 million users and is adding about 50k new users a week. What is so valuable about LinkedIn is that the membership is largely drawn from the "best and the brightest". He showed one slide that showed that something like 65% of Google employees were members, 50% of Microsoft employees, etc.

Adsense has changed the game for content startups
He mentioned how Google Adsense had changed the game for many startups. Back in 2000, a startup would launch and spend $10m on big ads on television and AOL to try and get traffic. More often than not, that strategy failed, as the company did not get traction and it rapidly ran out of money. Trying to hire an ad sales team was difficult and expensive and was usually foregone.

Most startups today (at least those based on content), throw up Adsense on their sites and have a daily income stream which greatly slows the burn rate. His analogy: "It's hard to lose a football game when you are allowed to extend the clock." Adsense is a perpetual extending of the clock, and allows the company to keep experimenting until it hopefully catches lightning in a bottle.

It's nice to have friends in Silicon Valley
The exec was one of the angel investors in Youtube.com, the recent hot tagging video download site. How did he come across the investment? He was at a cocktail party in May, he ran into a few guys he knew and asked them what they were up to. They mentioned their cool new website. He gave them a $50k check on the spot. They insisted on taking him to a computer in some guy's bedroom in the house and showing it to him before taking his check, which he did.

If you ever talk to someone who is considering going to get an MBA at Stanford, and they complain about the tuition, tell them that story.

It's always a good idea to buy Hockey Stick Growth at a Reasonable Price
Related to this, the guy spoke about the different phases that startups go through. A few engineers get together, write the software, and unleash the product to the world. More often that not, it doesn't catch on, but sometimes it does and the user growth curve goes hockey stick. He mentioned that Mike Moritz (Sequoia VC, of Google and Yahoo fame) invests in these companies sight unseen, as they are indicative of a product that is catching on, and most products fail because they never really filled an unmet customer need. That strikes me as a very smart thing to do.

Startups hit a decision point at roughly the $50m mark
At that point, the entrepreneurs can usually sell the company for $25m - $100m to one of the bigger players. Youtube.com is at that point currently. It's a good deal for the entrepreneurs, as they make a nice little bundle in a short period of time, and they can go try and do the same thing again. Build, flip, repeat.

Or, the company can try and ride it through to relative maturity and, eventually, an IPO. The companies that make this decision risk failure, as when they don't catch on, they lose the early luster and end up being worth less than what they were worth in the early "heady" phase.

Evite is an example of such a failure. At its peak, the company apparently was offered $400m, which it turned down. It eventually sold to IAC for an enterprise value of $10m. Friendster is another example. It is apparently on the block right now for something south of $20m. The exec mentioned that thefacebook.com recently received an offer for something in the $500m-$600m range, and he thought they were crazy for turning it down.