Priceless: The Myth of Fair Value (and How to Take Advantage of It) Book Review

How much would you pay to rent a condo in downtown Toronto? How about the U.S. island of Saipan (a fun little island 7,800 miles from Washington D.C.)? You probably can only give a reasonable answer to at most one of these places, and even then you would probably answer it with a question like “In what neighborhood?”.

Like most, you would start looking at comparables. What is the going rate these days? According to BNN, the average monthly rent in Toronto is about $2,166, while googling around about Saipan finds places for $500. “Oh this must make sense from a supply and demand standpoint”. Maybe.. If you sat down and compared 4 or 5 condos in either one of these markets you could make a reasonable decision about which is the best value compared to the others.

But what about the fact that you’re starting at $2,166 or $500? As you will learn when you read Priceless: The Myth of Fair Value (and How to Take Advantage of It): , humans are q) very good at understanding relative value but are horrible about understanding absolute value, and 2) we can be easily misled about what “absolute’ value is.

“Put it this way, our ratio-based senses are eminently reasonable. There is an Achilles’ heel. The price of being so acutely sensitive to ratios and contrasts is a relative insensitivity to the absolute.”

As we talk about frequently on this blog, humans are terribly fallible, and we are particularly fallible to incentives and prices. Charlie Munger (Vice-Chairman of Berkshire Hathaway) even has this as his #1 Standard Cause of Human Misjudgement!

“Number 1: Under-recognition of the power of what psychologists call ‘reinforcement’ and economists call ‘incentives.’ Well you can say, “Everybody knows that.” Well I think I’ve been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I’ve underestimated it. And never a year passes but I get some surprise that pushes my limit a little farther.”

For the full story on Munger’s List see - http://www.canadianvalueinvestors.com/behavioural-finance/

When talking about investing, being as conscious as you can be of how prices work and can influence you and others is extremely important – both from understanding what a business is worth and understanding the actual business and its model.

The author William Poundstone has done a great job of putting together the foundations. It provides entertaining overview of the beginnings of Behavioral Economics, covering Ward Edwards, credited as one of the founders of behavioral decision theory, to Amos Tversky and Daniel Kahneman, the creators of the Prospect Theory. It also gives numerous case studies of how people as a whole can be consistently manipulated (and how even if you are aware of this you can still be susceptible).

For example, the book covers numerous examples of anchoring, such as the ID Number experiment by University of Virginia psychologist Timothy Wilson (“basic anchoring effect”).

“Wilson and company tried to find out how subtle a ‘background’ anchor could be. In one experiment, volunteers were given questionnaires with adhesive notes attached. Written on each sticker was a four-digit ‘ID Number” between 1928 and 1935. One group of participants was required simply to copy this number onto the questionnaire. They were then asked to estimate the number of physicians in the local phone book. The average estimate was 221 doctors.

The important thing here is that the ID code was just a number that happened to be there, not a meaningful part of the problem. Other groups were given slightly different instructions that caused them to pay a little more attention to the ID number. Some were told to note whether the ID number was written in red or blue ink (on the pretext that this would determine which page of the questionnaire to fill out). For these people the average answer was 343 doctors. A split second’s extra attention to the number has raised the estimate 55%. (All the ID numbers were big. As anchors they would have pulled the estimate up). Another group was asked to note whether the ID number was in the range of 1920 through 1940 (they all were)….This group [averaged] 527. One group was asked [first] whether the number of physicians…was greater or less than their ID number, and then give their estimate of the number of physicians. This group’s average was 755….

The researches later asked some participants whether they thought their judgements might have been influenced by the ID number of the adhesive sticker. The answer, overwhelmingly, was no.”

Another fun example is the Beer Problem posed to university students by Joel Huber and Christopher Puto, then a professor and grad at Duke University’s school of business.

“Joe Sixpack is reaching for a brew on the market shelf. There’s a premium beer that costs $2.60, and a bargain brand that’s only $1.80. The premium beer is “better”…rated at 70 out of 100 in quality, while the bargain brand is only 50. Which should Joe buy?….The students preferred the premium beer by a 2-to-1 margin….

Another group chose among three beers, the two above and a third with a rock-bottom price of $1.70 and a quality rating in the basement (40). Yet it affected what they did choose. The proportion of students choosing the original bargain beer rose to 47%, up from 33%. The existence of the super-cheap beer legitimized the bargain beer.

In another set of trials, the three choices were the original bargain and premium beers, and a super-premium beer. Like many upscale products, this was much more expensive ($3.40) and only a little better in quality (rated 75). 10% said they’d choose the super-premium beer. An astonishing 90% chose the premium beer. Now nobody wanted the bargain beer. It was like pulling the string on a marionette. Huber and Puto found they could make students want one beer or the other, just by adding a third choice that few or no one wanted.

There are numerous examples of every day life things that can be adjusted to change your decision. The book covers restaurant menus, strategies used by luxury goods companies like Prada, lawsuits, and even negotiation strategies. It also includes some techniques on how to avoid falling for these traps, like Antidotes for Anchoring where you force yourself to Consider the Opposite, or the Buddy System – techniques that can be applied to analyzing companies.

As we here focus (primarily) on understanding businesses, the real question always comes down to “how much is the business worth?” In turn, it’s worth doing everything you can to understand how humans think of prices.  

If you like this book it would also be worth checking out Misbehaving: The Making of Behavioral Economics by Richard Thaler.

Eric Ries - The Lean Startup - Talks at Google - Full Transcript

FULL TRANSCRIPT

Who saw 'The Social Network'? OK. Right. I feel like that's probably the best modern example

of the entrepreneurship story we're all used to.

  What do we do as entrepreneurs that actually makes a difference? We spend our time trying to figure out which customers to listen to and who to ignore, how to product-prioritize product features.

I mean you guys, how many product prioritization meetings do you go to? It's not exactly the stuff of movies. It's unbelievably boring.

And how do we hold people accountable? How do we measure to figure out if we're actually making progress or building something that nobody wants? See, watching somebody pretend like they don't have anxiety that their vision is wrong, is not very good for movies. But that's what most entrepreneurs do.

And so, we're gonna have to talk about stuff like management and accounting.

My goal, my mission in doing this whole Lean Startup thing has been to try to put the practice of entrepreneurship on a more rigorous footing. And so, I started out with a definition.

Here's mine: What is a startup? "A human institution designed to create something new under conditions of extreme uncertainty."

Click the button below for a link to the full transcript.

Book Review/Summary: Prime Movers of Globalization - The History and Impact of Diesel Engines and Gas Turbines, by Vaclav Smil

In Prime Movers of Globalization, Vaclav Smil writes about the origins of diesel engines and gas turbines, their crucial (and understated) role in the growth and maintenance of today's society, and a broad prediction on their continued role over the next few decades. Although diesel engines and gas turbines now dominate long-haul travel and shipping, Smil discusses the incredible advancements these two inventions went through before becoming viable options.

I have sometimes been in discussions with people who have complained about the lack of innovations in the internal combustion engine ("ICE"), arguing that it has essentially gone unchanged for the last ~140-150 years. No one is debating that the same type of reciprocating motion of pistons looks the same, and people from the late 1800s would still recognize it. But this understates the truly dramatic improvements in the first few decades of the ICE. One point Smil points out is the importance of mass-to-power (g/W). In the early 1870s, an ICE may have weighed 900 g/W. 20 years later, Daimler -Maybach made a gasoline-powered ICE with 45 g/W, and about 10-15 years after that, Daimler-Mercedes and Ford had cars with mid-single digit g/W. It took about 50 years after this, in the mid-1960s, before this stabilized at around 1 g/W. The same type of improvements were also made in gas turbines, and without these huge improvements, you can imagine the limitations on transportation means (1hp is about ~750 watts - good luck building a NASCAR car!).

Smil also tells some interesting stories which may be of use to some entrepreneurs. Rudolf Diesel initially wanted his engine to power small machines, even believing it could be used for sewing or ironing machines. Diesel had somewhat socialistic intentions - he wanted to produce an engine that small businesses could use, as opposed to large factories which he thought were the only ones that could afford larger and more efficient steam engines. As you can tell from your non-diesel-powered sewing machine, this prediction failed miserably (Tesla's electric machine took over due to high conversion efficiencies, no direct fuel requirements, low noise) but that does not subtract from the fact that well over 95% of large container ships are powered by descendants of Diesel's engine. It is a good thing that Smil also devoted a small part of the book on containerization, and the also-necessary innovations for global trade to take off in the mid-late 1900s (read The Box by Marc Levinson).  

Gas turbines originated when there became a need for very high-powered engines (with very low mass-to-power ratios) that could operate at top speed without straining the engine. Two engineers in the US and Germany, without knowing each other, had began working on such an engine at essentially the same time in the 1930s. Although these engines ended up being used near the end of World War II, they did not have any impact on the war's outcome.

So what are the impacts of these two engines? Ocean freight, which as stated above is powered almost exclusively by diesel engines, carries ~80% of all mass from exports, while planes carry ~35% of all value from exports. With the largest ship engines using up to 100W, and a 747's peak thrust at ~280MW, one only has to look up the power density of most renewable energy and batteries to understand exactly why society today absolutely requires fossil fuels.

However, Smil also talks about the negative environmental impacts of ship freight and air travel. The former may contribute to contamination of microbes/foreign species from tankers emptying the ballast water, while the latter (despite very low CO2 emissions) can have potent warming effects due to other GHG emissions left in the Earth's lower atmosphere.

I would have liked the book more if Smil discussed in detail some possible alternatives (albeit in the somewhat distant future) that can help displace these engines. However, Smil does provide a compelling case that, due to the very established energy infrastructure in place and the low mass-to-power ratios, among other factors, gas turbines and diesel engines are here to stay for now, and generally wrote an interesting book that can fit into anyone's history reading list. 

In