In lieu of a broader blog post this month, I’m sharing a link to a documentary film recently released on YouTube entitled “Tune Out the Noise.” It was featured in the Wall Street Journal this past weekend and tells the story of Dimensional Fund Advisors (DFA), a pioneering investment firm born out of exhaustive academic research at the University of Chicago. That graduate school of business, now known as the Booth School, is named for David Booth, a generous contributor to the university and a co-founder with Rex Sinquefield of DFA.
This 86-minute documentary, directed by the masterful Errol Morris, frames the practical application of decades of study by multiple Nobel Prize laureates around the triumph of passive investing over active investing. If you’re not familiar with the difference between index investors (passive) and stock pickers (active), or the alleged controversies surrounding the comparison, this film will provide an entertaining primer to one of Wall Street’s greatest battles for the hearts and minds of ordinary people putting their money to work for the long-term, particularly into retirement. I won’t spoil the punchline, but you won’t have to wait for the end of the movie to understand its thesis.
The DFA leadership team sponsored the production and made it available free of charge because they want to broaden the public’s perspective on the mathematics underlying equity markets, generation after generation. I have been a massive fan of DFA almost since its inception. Whether or not you agree with the firm’s approach to investing, I believe you owe it to yourself to better understand what they set out to do, how it has played out, and how many believers have been fortunate enough to benefit from so many serious, critical thinkers who set out to change their corner of the world and pulled it off in spectacular fashion.
I hope you enjoy the show as much as I did, and come to respect this brilliant group of financial leaders as much as I do.
The failure of Silicon Valley Bank is enormously troubling. Call it an isolated circumstance all you want, but it has further stressed our nation’s dialogue. An echo of other bank failures has followed SVB down the drain. Long lines of anxious customers waiting outside banks are never something we want to see. This was unnecessary. This was bad form.
As dependability in our institutions continues to fray, I worry increasingly about where we’re headed. As divided as we are in this nation, can we withstand a true crisis of faith in our banking system? What understandable assurances are in evidence that wider contagion is not possible, that limits can be maintained on the ramifications of remarkably poor judgment?
Where does resilience meet its match and cause us to lose faith in the basics of our grand experiment in economic expansion?
Our economy works on a number of elusive factors in concert with tangible reporting. One of those is faith. If we lose faith in our banking system, the notion of ongoing growth and innovation at scale seems to go out the window. The economic miracle we have created together freezes solid and then melts into the ordinary.
Ample credit fuels dreams. Intelligently borrowed capital brings to market hopeful new companies and bolsters the expansion of existing businesses. Financial institutions, mostly banks, have to lend money for ideas to become enterprises.
Lending money as its own business only works if there is leverage in lending. We understand the rules of engagement: a bank keeps some cash on reserve and lends more than it has at any given time. This works fine as long as there are no unaddressable runs on banks.
Should redemptions exceed liquidity, banks are forced to liquidate assets at any price to return cash to depositors. Trust in the banking system and the FDIC is required of depositors to prevent runs from melting down banks. Trust is a reflection of faith. Lose all faith, lose all trust, we all lose.
Here’s ground zero: If we lose faith that banks can get our money for us whenever we ask for it, deposits cease. If there are no deposits, there can be no lending. That’s the endgame you are teasing when you fail to do your job and cautiously manage risk. Kill deposits, kill lending — that’s a death spiral in the making.
Faith is increasingly becoming a conflicted proposition. Reckless financial engineers test us every decade. The savings and loan crisis. Long-Term Capital Management. Sub-prime mortgages. Washington Mutual. Collateralized debt obligations. Lehman Brothers. One day the combined impact of these attacks on faith may succeed in fully undermining the little faith we have left.
Then the thinning ice cracks for good.
Don’t tell me this time it’s about rising interest rates that weakened your balance sheet. You’re smarter than that. You know history. You knew interest rates had to rise. Nearly free money is never forever. You’ve been making loans as long as you’ve existed. You understand liquidity. You understand it so well that you spend millions lobbying against the very regulations you need to stay in business.
There are no excuses. You take bonuses for being clever. When you’re too clever, the damage has the potential to become systemic. When faith in the system evaporates, apologies are meaningless.
A brand is a promise. When a bank’s brand fails that promise, the entire concept of for-profit banking is soiled. We are only human. Serial violations of trust reveal fragile faults in what we’re repeatedly told is a robust system. We can only experience so many failures before trust is gone.
If we come to believe that U.S. Treasuries are the only safe place to park our money, what happens to commercial lending? If commercial lending retreats, how do the entrepreneurial efforts of the next hundred years replicate the last hundred years?
Do we really want to depend on government to keep righting the wrongs of irresponsible, conniving executives? Government’s role is to referee where self-regulation has proven farcical. Regulate, yes. Adjudicate, yes. Underwrite exponential losses, unsustainable.
If government must guarantee every deposit regardless of the amount in order to maintain faith in those deposits, how can bank executives ever be trusted to take risk seriously?
There’s a lot at stake, more than many of us may yet realize. We’re shell-shocked, but we’re supposed to maintain faith. Each day it’s harder. Each day we put our own historical investment paradigm at risk.
In simplest terms: Please stop putting our nation’s future at risk and punting your unnecessary failures to manufacture compensation you haven’t earned and don’t deserve.
Seek to restore our faith. You need deposits. We need loans. Keep our money safe to put it to work properly. We’ll pay our installments. That’s the contract. It’s a virtuous circle. We all have to abide by the rules, not wait to get caught if enough oversight is available.
Please make the rules work to all our advantage and believe in something more than your own benefit. Prosperity hangs in the balance. You’re toying with breaking everything. Let’s look to another hundred years of wise lending and liquidity to continue investing in positive outcomes we can’t even yet imagine.
You may have heard recently that Amazon is pulling back a bit on hiring and warehouse space. With all their vast resources in strategic planning, the executive team there overshot on leasing square feet their forecasts no longer support. I suspect they will manage through this just fine in the long run with little impact on earnings, but it is a powerful reminder of how difficult it is to predict future business both when you’re in an up-market and a down one.
We all get this wrong now and again. It’s normal and usually navigable. The problems come when balancing present challenges heavily compromises a company’s future, or betting only on the future sours a company’s current performance to the point where no one cares about the future.
I am often humbled by the nagging paradox of making tough business decisions every day at the relentless pace of 24x7x365. Running a company in response to everyday circumstances in the present will always be difficult, Running a company for an opaque future will always be daunting.
We have to do both well to accomplish our current goals and set the table for the next generation of growth prospects. Favor either the present or the future too heavily and the question becomes whether you want to lose now or later. While that’s not an option any leader wants to consider, if we don’t see the delicacy in how one affects the other, our intentions can be undermined by our outcomes.
We often hear about the pressures of being a public company, how corporate leaders make choices to focus on quarterly earnings from which they financially benefit immediately over building strong companies for the long haul. I do think this happens at some companies where short-term stock performance can dramatically impact executive compensation. Too often those companies fall prey to what Clayton Christensen famously has called The Innovator’s Dilemmaand allow their long-established norms of success to be fully disrupted by more nimble competitors.
There’s a more ironic take on this notion, where equity markets sometimes forgive emerging companies for failing to produce earnings at all in the near term in the hope that someday they will have gained so much market share that they will prove invincible. This all-or-nothing strategy has paid off handsomely for companies like Amazon that didn’t produce earnings for years, reinvested heavily in their growth, and today reap the benefits of that bet. Sadly, this example has been exploited by too many newly public companies that don’t even consider near-term profitability a goal, allowing lazy business models to overshadow unfounded optimism that someday their customers will reward them with enviable positions.
A company that bets only on the future, never becomes economically successful, and runs out of cash can be train-wrecked just as decisively as a once successful company that fails to address The Innovator’s Dilemma. If the executives steering either of those failures happen to be selling shares along the way to a company’s demise, a feast of lawyers will follow.
Inflation and rising interest rates make the cost of doing business higher for everyone. We painstakingly decide how much of these costs we pass along to customers and how much we absorb. The benefit of preserving current operating margins is always tempting, but the rewards of long-term customer loyalty and lifetime value speak for themselves. How do we decipher the balance between current and future financial results? Data will often shine a light on the path, but there are no conclusive textbooks with clear answers to these calculations.
It truly is hard to run a company both for today and tomorrow. We have to consider the staff sizes we need, the leases we’ll require, the stability of our supply chains, price elasticity, and the promise of our brands. We also carefully must watch cash flow, our balance sheets, compensation, incentives, technology advancements, and investments in future product cycles. What works today may or may not work tomorrow. It is seldom that what works perfectly in one set of conditions works just as well in another.
There are no perfect answers, but the fluidity of making a decision now for its short and long-term impact usually weighs heavily on those who wrestle with the impossible crystal ball.
Covid-19 has been a good reminder of how difficult and daunting decisions can be. We were all blind during Covid and it was easy to misread fluctuating data. No leader had substantial experience with stay-at-home working conditions. No one knew how long the pandemic would last, how it would impact supply and demand, or how it would impact investor sentiment. If that wasn’t enough of a challenge, most of what we thought going into Covid proved to be wrong, and most of our assumptions about how employees, customers, and investors would behave post-Covid have been equally wrong.
If you want to be humbled, try making decisions that address the unknown with this level of frequency. You’ll likely realize you’re wrong more than you’re right, but the less tangible skill we develop is how to rethink and react quickly when we discover we are wrong. That’s why the rewards for creating a company that is “built to last” are immense, but the odds of lasting fifty years are long.
When it comes time to decide short or long, know you have to do both, and do your best you to keep dialogue and debate flowing among diverse opinions. The decisions we make have an impact we might be able to see today, but unless you know someone who has a gift the world has never seen, we are almost always speculating on the impact a year or more from today. Sometimes it’s decades before we find out if we were right or wrong.
We choose to sign up for the difficult and the daunting. The longer I do this, the more humbling it is.
Think you’ve got leverage? You might. Now think hard about whether you want to exert it.
The success of a business reveals itself over long periods of time. The same is true of a career, even more so.
At any given time, circumstances may go your way. Cheesy television shows that gloss over the true workings of business may suggest this is the time to seize control of a weakened opponent, play the hard angle of opportunism, lower the boom on the boomless.
Certainly that’s one way to play the game.
You’re a property owner and the market is tight. You can play hardball with potential tenants. Maybe that works and they sign the lease without much choice.
Are you 100% sure that’s a great idea?
You’re a well-educated graduate entering the job market where positions that capitalize on your skillset are abundant. You are offered a very fair salary at an employer where you can grow, learn, and evolve your talent. You ask for 50% more. Maybe they say yes because they have a job that needs to be done right now.
Are you 100% sure that’s a great idea?
You’re a broker of commodity supplies suddenly in demand for construction or renovation. Longtime customers ask for your support in quickly completing a needed project without breaking the budget. You tell them you’d like to help, but new customers are willing to pay three to four times what you’ve been paying for the same materials you have stockpiled in inventory. Maybe you get the new asking price from your original customer and your margin soars.
Are you 100% sure that’s a great idea?
Here’s my take: You’re blowing it.
In all three of the above examples, the true price of hammering home your isolated moment of glory far exceeds the devil’s bargain you might be invoking.
You are sacrificing the establishment of trust.
You are shredding the notion of loyalty.
You are establishing a set of ground rules where the nanosecond leverage shifts, you are going to get swatted with a mirror version of the upper hand you thought was so nifty.
Think I’m wrong? Think business is just a cycle of gamesmanship where everyone longs for effective application of the upper hand? If that’s you, I am sure you are confident in your convictions. Relish the spoils of your conquest, but do us both a favor: Seek others who are like you and leave the rest of us to apply a much longer view.
Deals are short. They come and go. Want to win every single dispute, argument, and arcane point of negotiation? Try to build a brand, reputation, or legacy on that.
One day you will lose the upper hand because no one has it forever. When that day comes, you will get what you get. You put it in motion, you own it.
Am I suggesting that you should rollover and take less than you are due in any meaningful negotiation simply to be nice? No, that’s not the takeaway. Always figure out what you need, convince yourself through the other side’s eyes that your position is reasonable, and then fight for it with cordial determination. At the same time, consider the possibility that the few pennies you may choose to leave on the table today might be a stealth investment in a future windfall you can’t yet see, but might have the foresight to envision.
Being clever is seldom obvious. There are too many other clever people always around you. Being consistent in your values with an obsession for integrity is way more valuable and easier to benchmark.
Wise investors know that equities trade in cycles over decades with an upward trajectory. Timing the market is a fool’s game. You play long. Same with customers, same with brands, same with careers.
Seriously, why?
Because in the next down cycle, you are going to need help. You are going to need to pick up the phone and humble yourself. The question is, will someone answer?
I often say that one of the few good things about getting older is that you’ve accumulated the experience to navigate events with a framework for predicting a myriad of outcomes. Challenges are both temporal and lasting. Knowing the difference provides you with context for better decision-making.
As I also often say, the great tragedy of too many careers is that the learning you wish you had in your earlier years doesn’t come until much too late, and then you’re out of time.
Get ahead of the pack. This won’t be the last boom. A bust is coming. No one knows when, only that it absolutely will happen.
Then another boom and another bust. Rinse and repeat. Those are variables. The constant is you.
Play the long game. Build your network with reciprocal give-and-take. Be the kind of person in business people want to call all the time, not just when either one of you has a temporary advantage. The inspired upper hand is less about brute force, more about wisdom.
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