Charlie Munger is Dangerously Wrong: The Value Investing Crisis (Mental Models Memo, May 2019)

Value investing is in a crisis.  Proof:

    1. WJacob Taylor's "The Rebel Allocator" is an irredeemably awful book that doesn't provide much useful nuance on capital allocation.arren Buffett fanfiction exists.  It is objectively terrible both intellectually and stylistically.  And yet,

    2. It has been generally glowingly reviewed by value investors.  Even Charlie Munger himself called the author and told him to make it into a movie.

    3. This epitomizes a pretty big problem in the value investing community – groupthink.  We should all care about it, because it’s damaging – to both our quality of thought, and to our portfolio performance.

We are better than this, y’all.  So let’s start acting like it.

Let’s start with a handful of disclaimers, since this is 2019 and we’re apparently supposed to do that now.

  1. This is possibly the most controversial thing I’m ever going to post on this website.  If the value investing community and any of its “gurus” are extremely personally meaningful to you, and you are easily offended, please stop reading.  Also, there are PG-13 sexual references throughout, though nothing more obscene than anything Buffett’s said fifty times.

  2. Notwithstanding the above, this is probably mostly (and perhaps only) of interest to people who are interested in value investing.  If you’re just interested in the mental models, and you don’t have a background in value investing, then this may be less relevant to you.  You’re welcome to read it; I just can’t guarantee it will be interesting or worth your time!

  3. In this post, I am essentially ripping to shreds the irredeemably awful book The Rebel Allocator by Jacob Taylor.   I am referring to him by his first name because it’s more human and less distancing and makes it harder to be mean.  You can Ctrl+F for “Circle Up” with no quotes if you want to skip the below context on my thought process in writing this.

    Jacob is an investor and had good intentions.  The Kindle version of the book is currently priced at $1.99; he’s clearly more interested in education than profit.  And it’s clear that, notwithstanding the quality of the result, Jacob put a lot of time and thought into the book. My own early (thankfully unpublished) works of fiction were probably worse than The Rebel Allocator.  So, I know what it would be like to be in his shoes reading this.  


    Writing is a learnable skill and I’m sure that if he worked on it, Jacob could craft a phenomenal novel in the future on the same topic (capital allocation.) This, unfortunately, is just not that novel.  It’s not even close.  It’s not just out of the ballpark; it’s out of the universe.

    As such – unlike I would with a full-time, day-job author – I emailed Jacob to inform him that I intended to post a really harsh/critical review and asked if it was okay with him.  I told him if I didn’t hear back on the email, I wouldn’t post it.  The easy way out would have been for him to simply never answer the email.

    Much to Jacob’s credit, he did answer the email, providing me with explicit permission to post a negative review (though he of course hadn’t seen what I had written.) 

    The hardest step as a writer is being open to feedback. Writing is very personal and my writing has only gotten as good as it is because I accepted that I wasn’t very good to begin with, and have consistently worked on it over the course of the last decade.

    Hopefully to my credit, I have to the extent possible tried to do the Covey/Carnegie thing and be as nice as I can.  There is a fine line between criticism and meanness, and the Internet makes it shockingly easy to say things you would never say to someone’s face.  I don’t like trolls – period.  And I don’t want to be one.

    I may despise the book (intensely) for being such a poor representation of our collective intellectual caliber, but I have no animosity towards its author.  Jacob has young kids, and he wrote this book for them, and while I don’t know him or his firm very well, all that I can see suggests that he’s a good guy.

    While writing this, I’ve tried to keep in mind how I would feel if I were one of Jacob’s kids all grown up, reading what they would undoubtedly feel like is unfairly harsh criticism of someone who is probably very nice and smart and had the best intentions writing this.  It’s definitely taken the edge off and, hopefully, eliminated unnecessary animosity and rancor. 

    All my criticism here is of Jacob’s book, not Jacob the person. I wish Jacob all the best both as a person and as an investor. 

    And what I really have a problem with isn’t even Jacob’s book – it’s the fawning reception of it among value investors who should be smart enough to know better.  If this book had gotten the reviews it deserved, I wouldn’t be writing this.  But, well, look:

Circle Up For Intellectual Fapital!

I am here today to address one of the glaring problems in the value investing community: the fact that a great deal of it feels like a circle jerk – a mutual admiration society where conformity and irrationality and laziness of thought are just as prevalent as they are in any other group of people, including non-value investors, like (shudder) quants or momos or day traders or anyone else who participates in the market.  

Most value investors, to me, seem like conformists.  They just conform to a slightly different paradigm than everyone else.  Indeed, as the Goth Kids in South Park told Stan: if you wanna be a nonconformist, all you have to do is dress like us, talk like us, and listen to the same music as we do. 

Really, who’s the nonconformist in this picture?

Well,

If you wanna fit in with value investors, all you have to do is quote Buffett a lot. No real independence of thought required. Click To Tweet

I thought this tweet was pretty great.  (I’m too much of a Luddite to figure out how to embed it in WordPress.)

Many of my (very smart) friends go to Berkshire for various reasons (networking, catching up with friends, etc), and I’m not saying they shouldn’t.  In fact, my third-party marketer goes every year and has a great time. So I’m not saying people shouldn’t go. If you enjoy going, please do!  Enjoy the weekend. 

But the point remains valid; can you really call yourself a contrarian or an original thinker if you let someone else do all your thinking for you?

I’m not sure why I’ve never been good at this conformist stuff; my excuse is that homeschoolers are famously bad at forming circles.  (Really, try it – grab a group of homeschool kids who aced the geometry questions on the SAT, and ask them to make a circle. The results will violate several laws of physics.)

Let’s All Be Contrarian… Together

Even as a professional value investor who literally does value investing for a living, I’ve always felt like a bit of an outsider to the value investing community.  My impression at this point is that much of value investing is a religion like any other, where the pronouncement of gurus on the mount (Buffett, Marks, whoever) substitute for independent thinking.  

Jacob himself called Berkshire a “religion” on his Twitter:

Many people think that by collecting these “gems” of “wisdom” from the “gurus,” they are developing intellectual capital.  

They are not.  

They are instead, to borrow a term Jacob coined in The Rebel Allocator, developing intellectual “fapital.”  (I’m bastardizing his term, to be clear; sadly, despite all the dirty jokes in the book, he did not intend the neologism the way I am using it.)  

To paraphrase that old saw about procrastination: standing in a circle quoting Buffett ad nauseam feels good while you’re doing it, but it doesn’t really lead anywhere.  At the end of the day, you’re just screwing yourself.

It is okay to do this in private every once in a while.  It is not okay to do it in public all of the time.

There are many reasons for this. I will address several of them.

The “Rebel” Allocator… Who Walks Like Buffett, Talks Like Buffett, and Does Everything Else 100% Exactly Like Warren Buffett.  Wow, Such A Rebel

What finally crystallized my views on this topic (after years of mulling and privately discussing it with friends and fellow investors) is the broadly positive reception, among the value investing community, to the recently (self-)published book, The Rebel Allocator, by Jacob Taylor, a professional investor from California.  It is a terrible book; this much will become obvious as you read on.  Yet, to reiterate, everyone loves it; it in fact has one of the best star-ratings I’ve ever seen on Amazon:

If you don’t want to read this section, you don’t have to.  But it’s useful context.  It’s just overview on the plot and style of The Rebel Allocator, covering the bad writing and the fact that the key character is a Buffett clone.  If you want to just assume the book sucks and skip to the punchline (i.e. the rampant errors in the book’s presentation of capital allocation), Ctrl+F for “For A Master Capital Allocator” with no quotes.

If you are not familiar with The Rebel Allocator, it is where I got the word “fapital” from (p 211), except that I have changed the meaning of “fapital.”  Originally, fapital was, sadly, a neologism coined with all seriousness and intent.  As Mr. X explains:

“The word is fapital, which is a portmanteau of financial and capital.  Financial, capital… fapital.  Fapital represents the ownership claim to real capital and productive capacity.  I would put money, stocks, bonds, deeds, things like that in the fapital bucket.”

Taylor, Jacob. The Rebel Allocator (p. 211). 5GQ. Kindle Edition.

I, um.  Well.  See.  Look, I am a value investor, and I love getting things at a discount.  But there is no discount large enough to incentivize me to purchase stocks and bonds that you have been storing in your, err, “fapital bucket.”  Old socks are one thing, but a whole bucket? Mr. X, you have problems.  Biohazard-level problems.

The word “fapital” made my very serious, very mature best friend die of laughter when I texted him a photograph of the page.  He later asked, when I informed him that the book’s co-protagonist was dead, if the proximate cause of mortality was “fapital murder.”  As Archer would say… phrasing.

Fapital is just one of the many reasons that self-publishing is rarely a good idea.  Fapital is merely the tip of the iceberg in terms of why The Rebel Allocator should have seen a professional editor before being published.

The unintentional masturbation reference is useful, however; it sort of epitomizes the value investing world’s response to the book.

Why?  This book is more or less intellectual porn for value investors.  It is essentially Warren Buffett fanfiction. And badly written fanfiction at that.

The plot is predictable and profoundly unengaging.  Grammar mistakes are so frequent and severe that they become distracting; commas are frequently used where they shouldn’t be (in place of semicolons), but not used where they should be (to break up long, run-on sentences). The “romance” scenes are, somehow, worse than those of Twilight.  

Many of Duluth Trading's most famous and popular advertisement crack viewers up with demonstrations of "plumber's butt."

The jokes and asides, rather than being amusing, are cringe-worthy.  I have never laughed less at the word “butt.” Butts as a concept are funny.  Butt-related humor helped build a $500 million apparel brand (see right.)

Conversely, TRA managed to ruin butts for me for at least, like, a week.  I may never be able to look at butts the same way.

Worst of all, the protagonist, “Nick,” is both extremely unlikable and unbelievably internally inconsistent, alternating between being this incredibly stupid and vapid person who can’t make heads or tails of basic concepts in his business classes, to someone who, eureka-style, immediately intuits high-level business concepts like network effects with only the slightest nudge from Mr. X.  

The plot of TRA: a young wannabe socialist sort-of journalist, Nick, plans to write a hatchet piece on a billionaire named Mr. X.  Instead, Mr. X slowly teaches him the virtues of capitalism through extensive 1×1 tutoring on the finer points of capital allocation.

The first major problem with the book is that it is mostly derivative.  Mr. X is more or less a carbon copy of Warren Buffett – he has the same car (a late-model Cadillac that he drives himself), eats the same food (hamburgers), and makes the same kinds of dirty jokes (except Mr. X’s aren’t funny.)

Mr. X lives in a modest house in a flyover Corn Belt town (like Buffett), works in a modest office (like Buffett), is a technophobe who can’t tell an app from a Snap (like Buffett), and perhaps worst of all, Mr. X is sometimes called the “Wizard of Wichita” (cough, Oracle of Omaha, cough.)  

There is one part of Mr. X that is not like Buffett – he (spoiler alert) many years ago watched his ten-year-old son die of a horrible disease.  This, of course, would be a gut-wrenching plot twist… if not for the fact that Charlie Munger had the same thing happen to him.  So this was not actually a surprise; earlier foreshadowing totally gave it away.  Yawn.

Not to worry, though – we’re not out of Buffett comparisons yet.  Mr. X alienated his wife because he focused too much on business (this is the biggest single thing I remember from Snowball – Buffett was a great investor, but a failure as a husband and father.)  Mr. X has a favorite steakhouse that he sends people to (except unlike Gorat’s, apparently it’s actually good). And Mr. X starts every lesson by sending Nick one or two quotes from Charlie Munger and Warren Buffett.

Oh, and the cherry on top: Jacob acknowledges in the epilogue / endnotes of the book that many of Mr. X’s stories, anecdotes, or quotes are often directly lifted from Munger and Buffett.  To wit, in Jacob’s own words:

I’ve been lucky to enough to catch the Warren and Charlie Show in person for more than a dozen years during the Berkshire weekend in Omaha.  Both of their fingerprints are all over this book; it simply doesn’t exist without them. I avoided direct attributions to keep from breaking the flow of the story, but Mr. X’s most sage quotes are often directly cribbed from Warren and Charlie.  They deserve all the credit.

Taylor, Jacob. The Rebel Allocator (p. 255). 5GQ. Kindle Edition.

So, all in all, Mr. X is basically a lookalike mouthpiece for pearls of Buffett wisdom.  If Buffett was the litigious type, the “this is fiction” disclaimer that Jacob leads the book with would almost certainly not stand up in court.

It is particularly ironic that Jacob also leads the book with a copyright disclaimer, when the book is largely Buffett’s likeness saying Buffett’s words (with a sad excuse for a plot whose only purpose is to further the Buffettisms.)

One to N Is Okay – This Isn’t One to N

Now, look – all the Buffett quotes would be okay if packaged well, because there are generally two ways to add value: zero to one, and one to N.  In the context of books, zero to one means coming up with new or original insights that you can’t find somewhere else.

One to N means taking existing insight and repackaging it in a new format that is helpful.  Most books have a mix of both, but oftentimes the author is mostly conveying research, lessons, etc from other people, but packaged in a helpful way: 1 to N.

Much of Poor Ash’s Almanack itself could, in fact, be considered 1 to N (with, like most good books, a modest amount of zero to one mixed in.)

This 1-to-N type of value creation is what Jacob was, presumably, trying to do.  You could compare this effort to Peter Bevelin’s All I Want To Know Is Where I’m Going To Die So I’ll Never Go There.  Bevelin’s book is literally just organized Buffett and Munger quotes, although he dispenses with the fiction that he’s writing a work of fiction.  He just straight up tells you it’s a book of Buffett quotes.

But Bevelin manages to arrange them and categorize them in such a way that the material is impactful; reading his book provides lots of thought-provoking lessons in a compact format that you would otherwise have to read dozens of letters to accomplish.  I thoroughly enjoyed the book. The book was very useful.

Jacob’s book does not do that.  It was not enjoyable. It was not useful.  As a novel, it literally has no redeeming features.  Business novels can be great books even if they’re not great novels – I still have very fond memories of The Goal (goal review + notes), for example.  The Goal is not a literary masterpiece, but is still a very engaging business book.  

However, there is a threshold of basic grammar, consistent/likable characterization, and engagingness of plot that any novel must surpass.  The Goal meets all three counts, with exceptions so occasional that they’re amusing (like when we learn Alex’s father died many years prior because he was too lost in thought worrying about stuff to notice the bus that was about to hit him). The Rebel Allocator fails all three counts, with exceptions so frequent that they’re annoying.

The sad part is that most of these issues were fixable – there’s nothing wrong with the concept of the book – but how hard would it have been to proofread, catch the internal consistency issues, and come up with a somewhat less transparent plot than “Buffett lookalike imparts wisdom upon young acolyte?” 

The Goal was cool because it put you inside an actual operating business, and even though (like all novels) it was unrealistic in many ways, it was at least believable / engaging, and you learned about things through the characters’ experiences, not just through some pseudo-fictitious guru talking at you. 

To this end, I think The Rebel Allocator would’ve been much more interesting if the novel was instead set decades ago, focusing on Mr. X actually going through the process of building Cootie Burger, allowing him (and the reader) to learn some of these lessons in real-time through actual experiences, rather than him simply telling Nick about it years later. 

Rand, of course, does something similar with Fountainhead and Atlas Shrugged; despite the occasional speeches on capitalism, there is at least a plot that is interesting and engaging, that illustrates the idea through actions and characterization rather than just through transparent 1×1 tutoring sessions.

The first rule of fiction is show, not tell – the Goal does a great job of this.  The Rebel Allocator does not.

As it stands, the parts of the book that are Jacob’s – not Buffett’s – are generally anywhere from mediocre (at best) to atrocious (at worst).  The only truly original, non-Buffett-derived part of the book is a bizarre, non-sequitur chapter right before the end about experts vs. models, which has no pretext, no context, no corroboration, and fails to take into account any sort of nuance on the topic.  

Several of our clients who have expertise in Big Data type stuff would undoubtedly disagree with many of the conclusions (we’ve talked about this kind of stuff.)  Jacob is free to hold the view that he does, and I would’ve been okay with him exploring it in the book… if the whole book had developed this thread, instead of simply repeating Buffett quotes for 200 pages and then sticking this unrelated thing in at the end with no warning.

For A Master Capital Allocator, Mr. X Is Pretty Bad At His Job

As far as the Buffett stuff, capital allocation is concretized mostly through the lens of one business – “Cootie Burger,” a burger franchisor, which Mr. X dropped out of college to run when his father passed away.  He subsequently grew it into a business worth billions.  

Here’s a major problem: the portrayal of Cootie Burger’s business model and strategy is wildly inconsistent, not to mention inaccurate.  If you’re going to write about capital allocation and you’re going to explain it mostly through the lens of a single business, I think you kind of have a duty to at least get the fundamentals of that business right – and Jacob, sadly, does not.

Let’s start here: in one chapter (pages 121 – 122), Mr. X says that Cootie Burger’s superior ROIC (20%+) is because they franchise rather than own real estate.  Per Mr. X, real estate returns suck (he pegs them at ~3% long term) and Cootie Burger doesn’t have any particular skill at investing in real estate, so they outsource it to others instead of doing it in-house. 

Such that I’m not misrepresenting what Jacob actually writes, and for the benefit of those who haven’t read the book, here is an excerpt of the relevant section.  Emphasis mine.  Focus on how Mr. X here drives home that they don’t like owning real estate, and real estate ownership is not a core competence:

For a long time, we kept everything in-house by building and running our own restaurants.  As you can imagine, it takes quite a bit of money to buy a promising piece of land. Then we had to use more money to put up a structure and add all of the restaurant equipment.  

We were decent at developing these real estate projects that would turn into good sites for restaurants. It required a lot of money to grow, which kept us expanding slowly. We ended up with a lot of capital tied up in real estate.  And the long run return on real estate is closer to three percent.

[…]

“Well, if most of your capital was tied up in real estate earning around three percent, how do you get up to twenty percent?” I asked.

“Bingo!” [said Mr. X.]  “I asked myself the same question: how can we get better returns on our capital? … discovery. We weren’t the best at the real estate side of value creation.  We shined when it came to sourcing quality ingredients, crafting an enjoyable customer experience, and strict attention to detail in operations. We were simply better at logistics than real estate.  Remember, it’s a fool’s errand to believe that you can be good at everything

The franchisee, whom we carefully screen, has responsibility for the real estate side of the business.  They get help from us on the operations and get to use the Cootie name and systems. In exchange, we get a percentage of their restaurant’s revenue.  Cootie makes more money with less invested capital through franchising. Our invested capital goes into designing better systems and building our brand–not buying more real estate.  That’s how our returns on invested capital are around twenty percent and not three percent.

Taylor, Jacob. The Rebel Allocator (pp 120 – 122). 5GQ. Kindle Edition.

Ok, fine, whatever.  Sounds good to me.

Except that’s not actually how franchising works on several levels, as few restaurants actually own their land whether or not they franchise or self-operate – most restaurant operators, franchisees or not, lease their land, so ROIC on real estate is not a factor on the business model, it’s more an issue of whether the fixed cost of rent meshes with the four-wall economics – but never mind that for now.   See Endnote 1 for a brief but thorough primer on restaurant economics, distilled from my hundreds of pages of research on publicly traded restaurant concepts.

More pressingly, two chapters later (page 140, 143), Mr. X says that they’ve made tons of money investing in distressed real estate by buying it when it’s cheap and sitting on it for many years (sometimes more than 10), and that’s how they have an advantage over competitors.  Again, so as not to misrepresent Jacob’s words, here is the exact discussion:

My taxi driver gave me a skeptical look when I gave him the address where I was to meet Mr. X.  I understood why when we arrived at the empty lot in a rundown part of town…

“Hi, Mr. X,” I said.

Welcome to the future site of a Cootie Burger restaurant,” he said with a surprising energy.

… “When an area is particularly rough, we’re able to acquire properties for very low prices.  The buildings and services like water and electricity are often still in decent shape…

Here’s the hard part of the strategy,” he said.  “We have to wait. And wait. And wait. In some cases, it’s taken over ten years of just sitting on the property doing nothing but paying property taxes.  When most CEOs are measured by the quarter, it’s very difficult to be that patient. The wheels of progress turn imperceptibly slowly.

But eventually a rough neighborhood gets cleaned up.  We then have a location in a hot area, and we paid a favorable price for the real estate. Now we have a material advantage over our competitors for a long stretch.

Taylor, Jacob. The Rebel Allocator (pp 137 – 140). 5GQ. Kindle Edition.

Nick, of course, laps it up.  I’ve never previously been tempted to use the word “sheeple,” but Nick is pretty sheeple.

Me, on the other hand, I’m actually paying attention to you, Mr. X.  Do you lack distinctive skill or have tremendous skill in real estate investing?  Do you handle the real estate purchases by identifying, purchasing, and sitting on land for ten years, or is that – as you said two chapters ago – the responsibility of your franchisee?

Seriously: do you not want capital tied up in real estate because returns suck and it’s not your core competence (you’re better at the brand stuff, and it’s a fool’s errand to believe you can do everything), or do you want your capital tied up in real estate for sometimes “over ten years of just sitting on the property doing nothing but paying property taxes?”

Either’s fine; I don’t actually care what Cootie Burger’s frickin’ business model is – I just care that it’s internally consistent.  Just pick one or the other, so that there isn’t a giant continuity error.

There are perfectly easy ways to resolve the contradiction – for example, Jacob could’ve simply added a page where Mr. X clarifies that, like many real-world franchisors, Cootie Burger likes to operate some portion of its own restaurants and franchise the rest, so they buy distressed real estate for their own future operating restaurants.  

Owning the land underneath, while unusual, is a strategy some employ – Cracker Barrel owns about two-thirds of their locations, and Texas Roadhouse owns about a third of theirs.  Conversely, Chipotle, Cheesecake Factory, Fogo de Chao, Dave & Buster’s, Fiesta Restaurant Group, The Habit, and most other restaurant concepts that I’ve looked at lease substantially all of their locations. 

So it’s worth noting that the book’s whole discussion of real estate is a total red herring; real estate ownership or not really has nothing to do with being an operator or a franchisor of restaurants. See Endnote 1.

Again, this is a resolvable paradox that just wasn’t resolved.  Mr. X could simply state that they are good at buying distressed real estate, but don’t want to own it when it’s priced at fair value, so they buy it cheap and do sale-leasebacks when the returns potential isn’t there.

Jacob’s a finance guy; there are many transactional ways out of this mess… but Mr. X, sadly, leaves the reader thinking that Cootie Burger both hates and loves investing in real estate, and both has a lot of it and none of it on the balance sheet at any given time, and that both of these diametrically opposed approaches are why they sustain superior ROIC and have a competitive advantage.

Magic Math:
3 = 20(X) + (1 – X)(Y), where Y > 3 and 0 < X < 1

The presentation of franchisee-franchisor economics is also profoundly inaccurate and irrational; no real-world franchisees would operate or open Cootie Burger locations under the framework put forth by Mr. X.  Mr. X tries to solve this problem with hand-wavy magic math such that 3% tranches out to two buckets, one of of 20%+ and one of more than 3%, but math is not magic; you cannot tranche out an implied (terrible) single-digit four-wall ROIC on new boxes so that both parties get acceptable returns.  

This is literally eighth-grade algebra.  See Endnote 1 for a fuller discussion – the quick summary is that you would not find enough franchisees to invest at single-digit rates of return to build a billion-dollar business.  Just not gonna happen. You probably need at least teens, if not twenties, four-wall cash-on-cash returns to make it worth franchisees’ while. 

Franchising is only an option for businesses with good four-wall economics to begin with; it does not magically transform bad four-wall economics into good four-wall economics.   Nobody would invest in creating a franchise at a 3% return when you can get 2%+ on savings accounts and the 10-year is at 2.6%.  That makes absolutely no sense whatsoever. 

Cootie Burger’s economics have to be better than this at the four-wall level; either Jacob didn’t understand this, or very poorly communicated what the actual returns of the restaurants are, because in my reading, it sounds like 3% or close to that number.  Really, any single-digit four-wall ROIC would be wildly insufficient for a franchise model, as I discuss in Endnote 1.

Readers are likely to be left with a mistaken impression that you can somehow tranche bad assets into good with financial engineering – wave the magic franchise wand and bad economics for one turn into good economics for two. 

Many people will remember that this was, essentially, the mistaken premise that lead to a little something called the global financial crisis of 2008 – 2009.

The “Rebel Allocator” Can’t See A Great Deal In Front Of His Nose

It gets worse.  Moving beyond operations, Mr. X claims to buy back shares at a price that is fair to both sellers and buyers – he goes so far as to claim he feels it’s his “moral obligation” to do so on page 188:

One of your responsibilities as the CEO of a publicly traded company is to make sure partners who need liquidity are able to get it.  You don’t know what’s going on in their lives and why they might need cash.  Maybe they have a sick relative they’re taking care of. 

Or maybe they have a charity project that desperately needs funding.  I believe you have a moral obligation to make sure they aren’t taken advantage of when they sell.  Does that make sense?”

Taylor, Jacob. The Rebel Allocator (p. 188). 5GQ. Kindle Edition.

Yes, Mr. X – that makes sense, and I agree.

But then it gets ridiculous: here’s the price he ends up thinking is “not taking advantage of” the sellers:

“We have a policy at Cootie Burger,” he said.  “We will make our best effort to provide liquidity to any partner who needs to get out.  At a minimum, we’ll give them dollar-for-dollar what the accountants say the net worth of the company is.  We think the partners should benefit from the business doing well, not by taking advantage of each other through opportunistic buying and selling.”

Our policy is to do corporate share buybacks any time the company’s stock price approaches that accounting net worth number, also known as book value.  We’ll put in buy bids at book value should the stock trade down to that level.  We buy back a partner’s shares and make sure those who really need the cash can access it without being harmed.

Taylor, Jacob. The Rebel Allocator (pp. 188-189). 5GQ. Kindle Edition.

Without being harmed?  Without being harmed?!?!??!?!  Oh come on Mr. X, I would be cracking up if you weren’t dead serious.  You’re a billionaire who made his money through capital allocation, and you are not seeing the problem here?

Many smart readers will have picked up on it by now.  If not, here, let me walk you through it.  We previously were told that Cootie had a 20%+ ROIC; here’s the exact wording:

I gave him some time to recover before I asked, “What is Cootie’s ROIC?”

“Sorry, this damn cough,” he apologized.  “For Cootie?  Last year it was twenty-one percent.”

Taylor, Jacob. The Rebel Allocator (p. 113). 5GQ. Kindle Edition.

Book value, in context of 20%+ ROIC, is an utterly nonsensical “fair value” estimate – again, by rough napkin math, that’s about ~5x earnings for a franchisor with a clean balance sheet and a strong growth profile.

If you don’t understand how I’m getting this – with low or no debt, ROE should be basically equal to ROIC, so if Cootie’s ROIC is 20%+, then its ROE should also be 20%+, and thus earnings should be 20%+ of book value, and book value is thus 5x or less of a year’s earnings.  Mr. X never discusses this, but it is basic algebra based on data points provided in The Rebel Allocator.

Using a ROE-BV model (really simple middle-school math, see Damodaran here), if a company does 20%+ ROEs and has decent growth prospects whether organically or inorganically (say 3-4%), then shares should trade at a teens-plus earnings multiple, or 2.5x book (2.5 times what Mr. X thinks is apparently a fair value.) 

A ~10x earnings multiple (~2x book value) would be fair if the business weren’t growing.  A lower multiple would be fair if it was actively contracting.  But we know that it’s growing; not contracting.  As such, fair value is at least 2x book value, so Mr. X is breaking his “moral obligation.”

If Mr. X had the real-world capital allocation savvy that he’s supposed to, then a mid to high teens earnings multiple, if not higher, would be a far more likely fair value… FV could easily be in the 3 – 4x book range, depending how much capital Cootie can deploy accretively.

We could also look at this from a relative valuation perspective – not my preferred approach, but at least something that lets us know if we’re remotely in the right ballpark.  Here is MCD’s earnings multiple over the past 15 years, according to my research tool Sentieo:

I have no idea if the data is correct, but essentially the floor multiple for McDonald’s (a well-run burger franchisor and thus a comparable business to Cootie Burger) is ~15x P/E, and that’s in, uh, MARCH 2009. 

For those who are less comfortable converting between book and earnings multiples, here is a chart of MCD’s price to book value from 2002 through 2014 – as you can see, the low point was 2.4x book:

Of course, I’m not super familiar with McDonald’s and there could be bogeys in the data that make it somewhat inaccurate.  But at least directionally, it demonstrates just how badly off The Rebel Allocator’s commentary on valuation is.

In a functional market environment, this sort of business clearly trades for (and is worth) several multiples more than ~5x earnings or ~1x book value.  It is exceedingly unlikely that a company like this, with a leader with the supposed reputation of Mr. X, would ever trade down to this level.

On top of this, MCD seems, per Sentieo, to have always had a bit of leverage:

It’s not clear how much leverage Cootie runs with exactly, but it sounds like very little or even net cash, per Mr. X’s comments in a place or two.  So maybe it deserves an even higher multiple than MCD.  As such, whether you wanted to use relative or absolute valuation, you would end up with a price that is nowhere close to ~5x earnings (book value) for fair value. 

Based on my understanding of the franchisor business model, it should really have a higher “true” ROIC on its core business (basically infinite, as you are not putting up any capital.)  So book value is probably not even relevant – you would end up with a price that is probably mid to high teens P/E, if not somewhere in the twenties. 

There is no universe in which Cootie Burger is worth ~5x earnings; again, through the worst financial crisis since the Great Depression, it looks like its best public peer traded for ~15x earnings.  If Mr. X truly feels a “moral obligation” to provide liquidity to selling shareholders who need it, then he should be supporting the stock at well over twice the price he puts bids in at, because there is no conceivable way that fair value is not at least 2.5x book value.

This is inexcusable – a book written by a professional investor should not make this sort of egregious error.  But I can forgive Jacob for making the error, because writing a book is hard, and he has a day job, and he didn’t have a professional editor to catch these sort of things.

What I can’t forgive are the dozens, hundreds even, of value investors who lapped this book up without noticing these sort of straightforward mathematical black holes and business model continuity errors.  Many of us are paid to speak to management teams and analyze their responses – or, at the very least, to analyze their actions over time.

If a real-life corporate executive talked and acted like Mr. X, would you think he was a stellar capital allocator?  Because I don’t – and if you read the book and missed this, what are you missing when you evaluate companies on behalf of your clients?

Making mistakes is OK.  I’ve made some.  Big ones.  I just decided today that initially purchasing one of my sizable positions was a mistake.  But my track record demonstrates that such mistakes are the occasional exception, not the usual norm.  This is how it should be for a value investor.  So how is it that the majority of value investors reviewing this are glossing over these profoundly obvious mistakes?

Either Extend Buffett, Or Leave Him Alone

There are many other issues beyond the discussion of Cootie Burger: Mr. X and Nick’s allegations that ROIC tells you ecosystem value do not make any sense to me; I strongly disagree with them (and I say this as someone who made similar points in my Atlas Shrugged essay years ago – but I only had a few pages to work with).  Buffett himself would likely disagree here; I certainly don’t share all of Buffett’s views, but I think he’s directionally correct on this one.  See Endnote 2 for some tangible examples of businesses – Valeant, Herbalife, etc – where high ROIC was or is correlated with destroying rather than creating ecosystem-wide value.

Mr. X’s discussion of pricing and differentiation also appears to leave out really important nuances and the issue of dose-dependency; price elasticity of demand is a well-understood and well-accepted concept, but Mr. X disregards it in favor of a far less helpful black-and-white, all-or-none model… again, for brevity, I omit this here.  See Endnote 3.

If this were a short story or brief essay, it would be OK to sacrifice such important nuances for the sake of brevity.  But Jacob had 248 pages, many of which were wasted (such as the first 26, on backstory, and literally all of the pages on Nick’s relationship with Stephanie, his job at Big Rock, etc, which are all 100% completely pointless, as their only function is to serve as “filler” between Mr. X’s lessons).  

The book would not have been worse off had the fat been cut, and replaced with useful stuff.

So excluding one useful straw model of Price, Value, Cost – which in fairness to Jacob, I thought was really very good and, at least at first, similar to the discussion on value creation / value capture from Peter Thiel that I love  – the book is essentially a predictable regurgitation of Buffett ideology in a manner that is less educational, and less entertaining, than simply reading the compilation of Buffett’s essays, or William Thorndike’s “The Outsiders.” Those – not TRA – are what you should read if you want to learn about capital allocation in an easy-to-understand format.

Or you could just go read conference call transcripts from current, real-life master capital allocators like AerCap’s Aengus Kelly. 

Kelly (pictured at right) is a real world “rebel allocator” who zigs where others zag; rather than having a huge (and potentially risky) order book like some peers, AerCap has spent much of the past 5 years repurchasing its own fleet at a meaningful discount to its fair value. 

There are plenty of great capital allocators out their, but Aengus Kelly puts on a clinic with every quarterly CC.

If you go read them, you will notice that in contrast to the fictional Mr. X, real-world Aengus Kelly’s communication of message and strategy are extremely consistent – over multiple years.

That’s not to say it can’t change in the face of new evidence or circumstances, but Aercap knows what its business model is, and executes it well, with thoughtful capital allocation, and that has allowed it to prosper over time. 

Reading merely five or six AER CCs would teach you more about good real-world capital allocation than the entirety of The Rebel Allocator.  (Disclosure: long AER.)

Unfortunately, from my perspective, The Rebel Allocator leaves readers with impressions that are incomplete, or in some cases demonstrably inaccurate.

Why’s Charlie Perpetuating the Cult?

So, at this point, it’s clear that the book is awful.  Yet Charlie Munger thinks it should be made into a movie, and all the reviews I’ve seen from other people I have heard of in the value investing community have been positive. 

Charlie shouldn’t have done that; he is dangerously wrong to suggest that more people should be exposed to this book. Charlie, and everyone else who has positively reviewed this book, should be capable of seeing this for what it is: the emperor has no clothes.  

It’s not really Jacob’s book that is the problem here; it is a book, it exists, that is fine.  The book sucks. But there are plenty of books that suck. I myself have written many, many books that suck (it’s just that none of them are published.)

I wouldn’t pick on Jacob if his book hadn’t already gotten great press; Jacob is not the problem.  Jacob’s book is not even the problem.  Writing books is hard. Jacob tried.  He failed. Edison tried and failed a lot, too, before changing the world.  Like Edison, Jacob can and should try again, and he will succeed at some point, if he wants it enough.

The problem, in my mind, is the people who are uncritically reading and accepting the book and giving it glowing reviews because it perpetuates the value investor circle jerk.  This book is praising Warren Buffett.  This book validates what I already believe (confirmation bias).  Therefore, this is a good book. I will leave this book a glowing review.

No.  Stop.  It’s a terrible book, and everyone can clearly see that if they just keep their eyes open.  If this was a presentation for Cootie Burger at a college stock-pitch competition, I might rank it dead last because the presenter (Mr. X) fails to understand basic tenets of finance, and apparently doesn’t even know what his own business model is.

The problem is that we live in a world of value investing where readers will call Jacob’s book the finest raiments of all time, rather than the Emperor’s birthday suit.  If Jacob were my very best friend in the world, I would have found an excuse not to endorse his book; I wouldn’t want my name anywhere near it.

As a complete stranger, there is no way I want people reading it – particularly not people outside the value investing community.  Many of my friends take value investing seriously because of me.  If I handed them this book, they wouldn’t.  They’d think what we do is a joke. 

It is difficult to take seriously anyone who seriously coins the word “fapital” as a business term, or anyone who apparently simultaneously follows diametrically opposed business strategies. 

I guess Mr. X lives up to his name the Wizard of Wichita – we ain’t in Kansas anymore.  Don’t look in the corner, okay?  Keep your eyes on the song and dance and pay no attention to the details.

Mr. X, to me, reads like one of those many public CEOs who talk the talk like Buffett in their pretty shareholder letters, but don’t walk the walk like Buffett.  I won’t name names, but many of them, too, have cult followings among value investors – even though they’re obviously wearing the Emperor’s clothes.

Anyone who analyzes businesses for a living, or even for fun, should have spotted the above-described continuity error with Cootie’s business model.  Anyone who calls themself a value investor should immediately notice that book value is an absurdly nonsensical valuation for a 20%+ ROIC business, certainly nowhere close to a “fair” or “intrinsic” value.  

Anyone who’s analyzed a business should understand the price elasticity of demand, which Mr. X apparently doesn’t.

Yet because Mr. X says it, and Mr. X is an obvious Buffett proxy veiled only by the Emperor’s fine new garments, I guess it goes, even though there are multiple instances of him saying one thing one place, and the completely opposite thing in another place.  Value investors will accept anything if you spoon-feed it to them in the form of a quote from a “guru.” 

This is the point I’m trying to make here.  Guru worship is bad.  Charlie Munger has talked, extensively, about why cults are bad.  Cialdini has talked about cults.  Cults muck up your brain.  Yet value investors still think it’s OK to be cult-y if the cult is named value investing.  Even if the cult leader (in this case, Mr. X), says something that makes absolutely zero sense, many value investors will simply accept it uncritically.

Just for fun, here’s one more internal contradiction. On pages 90 – 91, Mr. X shows his scorn for accountants by (rightly) pointing out that amortization is a completely stupid and fake “expense” on the P&L. Nick says he kinda feels sorry for accountants; Mr. X tells him not to because accountants bring the scorn on themselves.  (Mr. X here notes that public companies don’t have to amortize goodwill, but I would note that they do still have to amortize acquired intangibles – basically the same phenomenon, just under a different name.) 

So Mr. X thinks much of GAAP accounting is flawed.  Fine.  I agree with Mr. X here.

But then on page 189, Mr. X relies on that book value calculated by that same flawed GAAP accounting for the purpose of share repurchases.  To wit, here’s a shorter version of the earlier buybacks quote:

“We will make our best effort to provide liquidity to any partner who needs to get out.  At a minimum, we’ll give them dollar-for-dollar what the accountants say the net worth of the company is….

Our policy is to do corporate share buybacks any time the company’s stock price approaches that accounting net worth number, also known as book value.  We’ll put in buy bids at book value

Taylor, Jacob. The Rebel Allocator (pp. 188-189). 5GQ. Kindle Edition.

Mr. X has made it clear elsewhere that Cootie does M&A, and that intangibles amortization required by GAAP is a dumb fake expense.

I would point out that whether it comes from goodwill or other acquired intangibles is irrelevant, and all public companies I know of that do M&A end up with fake non-cash amortization expenses on their P&L.  For example, well-known real-world capital allocation paragon Danaher has tons of intangibles amortization running through their P&L – currently to the tune of hundreds of millions a dollars a quarter of completely fake expenses running through the GAAP P&L and depleting GAAP book value – 

So Cootie Burger would have this same issue – yet Mr. X is okay using the book value depleted by that dumb fake amortization as the ultimate arbiter of intrinsic value. 

How is this at all internally consistent???  First you scorn accountants, then you rely on their fake math to decide the price at which to buy back shares?

If a real-life corporate executive explained their business and capital allocation policy to me the way Mr. X does, I’d give them an F.  Maybe a D-minus at best. He either can’t explain his business model or doesn’t know what it is.

Real business books of the same length by real entrepreneurs provide far more consistent, thoughtful explanations.  Real-world founder-led companies tend to have a consistent and compelling vision and a specific set of operating principles.  

I’ve read dozens of entrepreneur stories; the vast majority share that clarity of vision.  It is thus intolerable that Mr. X, who we’re supposed to view as a paragon of sage capital allocation wisdom, is either incompetent or incapable of clear communication.

“Charlie Says” – OK, So What?

One of the most interesting and original questions I’ve ever received from a reader was the following email:

“16) Oh, I have a postscript: in the words of My Chemical Romance, “I’m just a boy, not a hero.”  And I mean that; I’ve learned over time not to put investors on pedestals, because…

This is an interesting reply by you on twitter  as I experienced the same. Looking back, the investors/role models whom I admired are not as impressive as I thought they were. This certainly reminded me of the humanity in all investors alike.

As a big follower of Munger yourself, what do you think are the weakness/blindspots that Charlie has as an investor?

This kid gets it.  He was referencing a “tweetstorm” I posted in reply to an aspiring investor calling me his idol – I appreciated the thought of someone thinking I’m great, but I didn’t like the decision process.  I think idolatry is dangerous. I’d rather people admire what I’ve done, but pursue the intellectual process I used to get there, rather than trying to emulate the investment process (which likely has flaws, and likely isn’t adapted to other people as well as it’s adapted to me.)

And so it is with value investing “gurus.”  When you’re starting out, it makes all the sense in the world to learn from Munger, Buffett, Marks, etc.  They are smart people with great track records. Using probabilistic thinking, the base rate of the probability of their highly educated view on any given topic (within their circle of competence) being accurate is far higher than the uneducated view of a novice.  

And so it makes absolute sense to start by assuming that everything Buffett / Munger / etc says is true, and drinking it all up. You should use their viewpoints as your priors in a qualitative Bayesian reasoning model.

But everyone is not disposed to know everything all the time.  Munger is very, very smart and very, very wise, but he’s still human, and – like all humans – he makes mistakes.  For example, despite making decisions very rarely and waiting for “cinches,” Munger swung – and missed – on POSCO.  Buffett’s IBM mishap, similarly, is well-known.

Outside of actual investments, I think Munger is wrong on holding cash, and wrong on the merits of 25/6 (anyone who understands behavioral economics understands that it’s a terrible way to run a business where emotional stability is valuable.) 

Just today, I saw a discussion of Charlie Munger’s windowless architectural designs for dorm rooms – which, from personal experience, I think is a terrible idea.  I lived in a quasi-windowless room in college for a semester and hated every minute of it.  Windows are good for mental health.

Similarly, I discussed last fall why Howard Marks’s new book isn’t wisdom – it’s lunacy.  Yet many investors drank that one up, too.

This is not to say that most of Buffett / Munger/ Marks’s investing decisions, like most of their ideas, aren’t correct.  Most of them, in fact, are correct. But here’s the gosh-darn problem: the paradox of absolute vs. relative skill, as discussed by Michael Mauboussin in The Success Equation (TSE review + notes).

College football players who are drafted in the 7th round today are probably more talented and better-trained athletes than some of those drafted in the 1st or 2nd round of the NFL draft decades ago.  Yet even these superstar athletes – by any normal definition of the word – have a slim chance of making the NFL.

Mauboussin eloquently conveys that as the level of absolute skill increases, the level of relative skill often decreases.  Think about it this way: many of the “nuggets” about investment strategy that people like to quote from Munger and Buffett date back to an era when if you wanted to read a company’s annual report, you had to literally send off in the mail for it.  If you wanted to compare data year on year, or to major competitors, you had to manually transcribe it (or have someone do it for you).

Today, every professional investor – and every college student – has access to data-research tools that allow them to slice, dice, and extract qualitative or quantitative data points from not only company filings, but also conference call transcripts, alternative data sources, etc.  

Not only has the time to process information per individual been compressed, but the sheer number of people in the industry has exploded – when Buffett started, everyone who was a “value investor” could probably be assembled in an average airport Hilton.  

Now, the number of people willing to spend time and money to merely travel to see Buffett from a distance is… enormous… and that doesn’t count all the people like me who are in the community, but aren’t going to show up in Omaha.

The world has changed over time; just as the traits needed by The Greatest Generation during wartime didn’t make them super well adapted to peacetime, so too the “wisdom” of value investors in a pre-computer era doesn’t necessarily cleanly translate to the world of 5G (or whatever comes next.)  

Trait adaptivity is a real phenomenon that is extremely easy to understand – heck, Mr. X himself even briefly references it in The Rebel Allocator – and yet within the value investing community, few people want to act like it is true.  Most people want to take the comforting, easy, lazy path of simply trying to formulaically apply certain rules without thinking about whether or not those rules make sense.  

This is understandable – it provides a sense of social connection; it fosters a warm fuzzy tribalism, etc.  But at the end of the day, we may all be friends, but we’re also competitors – and how do you expect to out-compete everyone doing the exact same thing that they are?  Do you really think that there isn’t anyone in the investing world who doesn’t know and apply the same 20 Buffett / Munger quotes that everyone always rehashes?

This isn’t to say there’s not still a lot of wisdom out there.  Much of my investment approach is profoundly unoriginal.  One to N is still a fine approach as long as you find new N.  Don’t try to be everything to all people; find your sweet spots and stick to them.  Don’t pay prices for assets that assume everything will work out forever. All geometric series that include a zero multiply to zero, so avoid things that can zero you via path-dependency.  I did not invent any of that stuff.

But in other respects, I blaze my own trail.  It is not important what these aspects are; to the point of this post, I don’t think anyone should try to copy me.

The point is that there is an unfortunate tendency for splinter groups of contrarians to become insular propagations of a fixed mission that no longer makes sense.  One of the things I loved about Ayn Rand’s books, particularly The Fountainhead, was the sense of independence – thinking for yourself in a world that doesn’t want you to, a la Emerson’s Self-Reliance (which Jacob mentions, in The Rebel Allocator.)

Yet at an Atlas Shrugged dinner, I was disappointed to see/hear that altogether too many of the people in attendance were not independent thinkers.  They treated Ayn Rand’s works the same way that my devout Christian friends treated the Bible: the ultimate truth, to be repeated and substituted for independent thought, with no allowance for questions or further development.

Well, Ayn Rand is clearly wrong about many things – she didn’t understand behavioral economics, or basic human emotion.  She got some stuff right, which is interesting and valuable, and a lot of stuff wrong, which is not.  Independent thinkers should recognize that and work on fixing the stuff that’s wrong.  Instead, they were content to accept it part and parcel.

If You Really Want To Be Like Buffett, Grow Past Buffett

Here’s the deal, y’all: Buffett and Munger didn’t get to where they are by doing what everyone else was doing when they started.  Buffett did not treat Graham like a guru; he treated him like a stepping stone. He learned from Graham, then improved on Graham, to the point that Graham became irrelevant.

That is what most of the successful investors I know do with Buffett / Munger – everyone starts there, for the Bayesian reasons I explored previously, but that’s not where they end up.   Buffett / Munger eventually become irrelevant, because we’ve internalized the aspects that work for us, and they are ours now; we’ve added other stuff on the top and on the sides.  Standing around quoting Buffett all day doesn’t do us any favors.

Everyone has a unique set of skills, interests, and constraints that shape their investment style.  There are an infinite number of ways to succeed; I’ve seen businesses succeed with centralization as well as decentralization, organic growth focus as well as M&A focus, etc.  

But the first step to achieving such success is engaging in independent thought – without it, you don’t have much of a chance.  This is why, in The Goal – the classic business novel that The Rebel Allocator tried, and failed, to live up to – the mentor, Jonah, never just gives Alex the answers.  He never expects Alex to merely parrot back his thoughts.

Instead, he leads Alex to discover them on his own, then lets Alex run free with them.  Too many in the value investing community would have you stick 100% to the Buffett/Munger model; merely deigning to point out that one of our deities like Howard Marks might, occasionally, be wrong is grounds for heresy.

So, if you’re a value investor and you want to achieve the kind of returns that someone really good achieves, stop trying to be like that person, and start trying to think like that person.

To be a real “rebel” allocator, you should, y’know, put the rebel into it.

Endnote 1: Restaurant Industry Economics Primer

This delves deeper into the issue of restaurant economics and why the presentation thereof in The Rebel Allocator is absurd.  If you’re not interested, feel free to skip.

Some readers may be aware that Askeladden Capital was a shareholder of publicly-traded restaurant Fogo de Chao (FOGO) on two separate occasions prior to its buyout by Rhone Capital.  We’ve also researched many other publicly-traded restaurants, and have hundreds of pages of total research on the restaurant sector conducted since Askeladden’s inception in 2016.  One such piece of research, on Dave and Buster’s (PLAY), can be found here.

From all of that research, here is a brief primer of restaurant economics.  We’ll start at the unit level.

It costs money to build a new restaurant – you have to put up the building, get the tables and chairs and kitchen equipment, etc.  Depending on the size and type of the restaurant, this can typically cost anywhere from the low 7 figures (for smaller boxes like QSRs) to the mid to high 7 figures (for a big sit-down box like FOGO.)

Now, once the restaurant is in operation, it generates revenue by selling food and beverages to consumers.  Easy enough.  Of course, the food and beverage isn’t free; depending on the restaurant, the direct cost of goods sold is usually in excess of 30% of revenues.  Again depending on the concept, labor is another big line item that usually runs 30%+.

Finally, at the box level, the company also has to pay for basic occupancy costs (rent, utilities, etc) and miscellaneous other expenditures.  These are usually 10%+.

So, all in all, a typical restaurant concept with good “four-wall” economics will achieve at least a high teens to 20%+ “four-wall” EBITDA margin, which usually equates to a similar teens-to-twenties “cash on cash return” (i.e., four-wall EBITDA divided by cash capex, net of tenant improvement allowances from the landlord, straightlined rent adjustments, etc.) 

For clarity, the term “four wall” implies that we’re only talking about costs and capital expenditures that occur within a restaurant’s four walls – if the costs or expenditures occur elsewhere (like at corporate headquarters), they are not counted in this particular analysis.  So in the restaurant industry (or retail, or any other business that operates by opening “boxes” used to sell their product), four-wall economics are the unit economics of individual boxes (or all the boxes as a sum), without concern for corporate overhead.

But wait.  We’ve missed a really important component here – so far, we’ve only been talking about “four-wall” economics.  The box doesn’t operate in a vacuum; there is a corporate office that has to source the ingredients, market the brand, etc.  There are also area / district managers who may not spend all their time at one location, but are responsible for making sure all restaurants in a given area are performing well.  Although it varies how this is assigned to four-wall vs. corporate, you can usually count on 5 – 10% corporate G&A drag (if not more).

We’re not done yet!  We’ve also, so far, not yet factored in the fact that there is more ongoing capex – while modest, you will need to do maintenance every once in a while, and most restaurants tend to need/want remodels every 7-10 years or so (if lots of new restaurants have been built nearby, yours starts to look old both inside and out.)  Additionally, there is corporate-wide IT capex – you obviously need a point-of-sale system, probably some demand planning stuff, etc.

So a real calculation of restaurant ROIC would subtract all those corporate costs, as well as adding excluded expenses like “pre-opening costs” (time to train, get the restaurant ready before it begins serving customers.)

The ultimate conclusion here is that the vast majorities of companies that quote “X%” cash-on-cash returns are lying; if the quoted cash-on-cash returns are twenties, real cash on cash returns the way I calculate them are usually low double digits. 

It is a hard business model; returns are usually OK if you get them right, and terrible if you get them wrong (bad siting decision, etc.)  While good public restaurant concepts can achieve double-digit EBITDA margins, many independently owned restaurants have terrible margins – apparently the net profit margin of restaurants in San Francisco is a miserly 3%.

Now, we move to franchising.  So far, we’ve only talked about operator economics, i.e. if I wanted to build one restaurant – or a chain of 100 – using my own capital and my own operations, the above discussion would apply.

However, as discussed in The Rebel Allocator, a less capital-intensive alternative to building and operating boxes is to simply get someone else to build and operate them for you.  You take care of the branding and give the franchisee a strict playbook to follow.  In theory, it’s a win-win for both parties – the brand gets to expand faster with less capital, and has less fixed cost risk (higher quality / more stable revenue), while the franchisee gets to build a restaurant that has the support and brand power of a larger concept.

However, it bears noting here that franchising is not a magic wand you can wave to turn coal into diamonds; bad economics do not magically transform into good economics.  If a given box generates $500K of “true” cash flow (after all corporate expenses, etc), and costs $2MM to build, then someone still has to pay that $2MM, and that $500K has to be divided somehow.

Think of it a bit like a pie.  You can eat it yourself, or you can share it with a friend.  But the act of choosing to share the pie (i.e. your restaurant) with someone else doesn’t magically make the pie cheaper, or make the pie bigger.  There is still only so much pie to go around, and it still costs the same amount to buy.  

In the real world, there are many ways for franchises to work – sometimes they buy ingredients (at a markup) from the franchisor, sometimes they pay fees and royalties, sometimes they do both.  Domino’s Pizza is an example of “both” – in the most recent 10-K (February 2019), you find this explanation:

Domino’s generates revenues and earnings by charging royalties and fees to our franchisees. Royalties are ongoing percent-of-sales fees for use of the Domino’s® brand marks. The Company also generates revenues and earnings by selling food, equipment and supplies to franchisees primarily in the U.S. and Canada, and by operating a number of our own stores.

Franchisees profit by selling pizza and other complementary items to their local customers. In our international markets, we generally grant geographical rights to the Domino’s Pizza® brand to master franchisees.

These master franchisees are charged with developing their geographical area, and they may profit by sub-franchising and selling food and equipment to those sub-franchisees, as well as by running pizza stores. Everyone in the system can benefit, including the end consumer, who can purchase Domino’s menu items for themselves and their family conveniently and economically.

In other cases – seemingly, per, Mr. X, Cootie Burger’s – the franchisor just takes a set amount of the revenue as their fee, and often also requires advertising contributions too.  For example, Diversified Restaurant Holdings – ironically named, because it is a franchisee of only one concept (Buffalo Wild Wings) – notes in its recent April 2019 10-K that it has to pay over 8% of its restaurant revenues to Buffalo Wild Wings as fees and advertising support:

Franchise Related

The Company is required to pay BWW royalties (5.0% of net sales) and advertising fund contributions (3.00% – 3.15% of net sales). In addition, the Company is required to contribute an additional 0.25% – 0.5% of regional net sales related to advertising cooperatives for certain metropolitan markets for the term of the individual franchise agreements.

So you can start to see why being a franchisee would make no sense if the ROIC on the boxes was terrible.  The franchisee is putting up all or most of the capital to build a box; if the returns on the box are bad to begin with for the brand owner, they’ll probably be even worse for the franchisee, because the owner is skimming a high single digit percentage of revenues off the top – which makes the box even riskier because although the cost is variable, it’s never going away, and there’s no way to trim it.

To drive the point home, if four-wall EBITDA margins for the operator would be 20%, then four-wall margins for the franchisee would be 12% or less.  For simplicity, let’s assume that four-wall ROIC is also 20% for the operator – in which case four-wall ROIC for the franchisee would be 12% as well (because the brand owner skims 8% of revenues off the top without contributing any capital.)  So if you started with a single-digit ROIC for the box, no amount of cheap financing could make it worth the franchisee’s while to put up the capital to open the box.

This is why the presentation of franchising in The Rebel Allocator is so horrible – Mr. X makes it sound like the returns would be bad if Cootie Burger built its own boxes, but somehow that problem magically disappears when franchisees build the boxes.  No.   If Cootie has bad economics to begin with (for the operator), then franchising would make those economics even worse for the franchisee.

The reason that not everyone can just follow the Zero Capital Franchise Path to Infinite Success isn’t that nobody in the restaurant industry has ever thought of franchising.  The reason is that, you know, the franchisee generally isn’t going to put up lots of capital to earn very low returns.  Franchisees are not some “dumb money” source of infinite capital.

Companies that can successfully franchise for the long-term usually have great four-walls even if they choose to operate their own boxes.  If the four-wall returns on Cootie Burger locations (for the franchisee) are as bad as the book makes them out to be, i.e. probably single digit, there’s no way that Cootie Burger would be a sustainable business over time, even as a franchisor.  Restaurants with bad economics don’t magically franchise their way to success; they go bankrupt – see Joe’s Crab Shack, Macaroni Grill, etc etc etc. 

In the real world, Cootie Burger might well have franchised to grow faster and have a higher-quality business – but returns on their boxes would’ve had to be pretty damn good in the first place.

Finally, on the real estate red herring.  As I mentioned, you can lease from landlords without franchising.  Franchisees, too, can lease from landlords.  Here is an example from the Buffalo Wild Wings 10-K filed in February 2017: while BWLD, at the time, had a roughly even split of 621 company-operated locations and 602 franchised locations, they didn’t own any land for their company locations; instead, they leased all of it:

As of December 25, 2016, we owned and operated 631 company-owned restaurants. We either lease the land and building for our sites or utilize ground leases. The majority of our existing leases are for 10 or 15-year terms and generally include options to extend the terms. 

We typically lease our restaurant facilities under “triple net” leases that require us to pay minimum rent, real estate taxes, common area maintenance and insurance costs and, in some instances, percentage rent based on sales in excess of specified amounts. Most of our leases include “exclusive use” provisions prohibiting our landlords from leasing space to other restaurants that fall within certain specified criteria. 

Similarly, the BWLD franchisee – Diversified Restaurant Holdings (SAUC) – notes in its 10-K that it, too, leases all of its locations rather than owning the land:

ITEM 2.        PROPERTIES

Our main office is located at 27680 Franklin Road, Southfield, Michigan 48034 and our telephone number is (833) 374-7282. Our main office has approximately 5,340 square feet of office space. We occupy this facility under a lease that ends June 30, 2019.

As of December 30, 2018, we operated 64 Company-owned restaurants, all of which are leased properties. Typically, our operating leases contain renewal options under which we may extend the renewal lease terms for periods of five to 10 years. Most of our leases include “exclusive use” provisions prohibiting our landlords from leasing space to other restaurants that fall within certain specified criteria and incorporate incremental increases based on time passage and payment of certain occupancy-related expenses.

We own all of the equipment, furnishings, and fixtures in our restaurants. The Company also owns a significant amount of leasehold improvements in the leased facilities.

As you can see, neither BWLD nor SAUC “own real estate” in any meaningful sense of the word. 

So ultimately, the whole entire Cootie Burger discussion is just really sad and disappointing, because in a book about capital allocation, you would expect at least a quasi-realistic overview of how the business’s economics actually work.  The Rebel Allocator comes nowhere close.

Endnote 2: ROIC and Ecosystem Value

On pages 117 – 118, Mr. X states that:

“Positive… ROIC… is a huge deal when you look at the entire capitalistic ecosystem… isn’t it amazing how when you look at it through this lens, capitalism puts everyone on the same team?  Capital allocation done well is good for everyone at different levels. We don’t celebrate it enough.”

And on the next page, Nick interprets this as:

“Higher returns on capital mean more value is being created.  Not just for the business or investors, but for the whole ecosystem.”

Um, no, not exactly.  I’m as big a fan of capitalism as there is, but this is an overly idealistic and simplistic view of the world, without any of the attempted proof in, say, Ayn Rand’s work.  Admittedly I made a similar point in my Atlas Shrugged essay years ago, but I was still basically a kid and I only had a few pages to work with – Taylor had a lot more room for nuance and a lot more business experience than I had.

A better framing for this is Peter Thiel’s X | Y disaggregation bit on value created and value captured.  You can create tremendous value without capturing much / any of it – think about the future value created (in purely financial terms) by a wonerful mentor or teacher or parent. 

Conversely, you can capture value without creating more by simply taking more of the pie.  Two ways to boost ROIC are to increase price to value, or in excess thereof, or to beat down costs with a hammer.  Both of those are good for ROIC and good for shareholders, but bad for some other constituency (customers or employees).

For the first case (pricing in excess of value), take a business like Valeant in its heyday – or Herbalife, or any other MLM, or timeshare, or similar business model that basically scams consumers into paying far more for something than it’s actually worth.  Herbalife has a ROIC that has ranged from a low of 30% to a high of 80%:

Very few rational observers would suggest that HLF’s high ROIC correlates to lots of value created for the world.  Most rational observers would suggest that HLF is destroying value for the world, and simply taking other people’s money while giving them something less valuable in return.

For those who aren’t familiar with Herbalife or what a multi-level marketing company is, here is an explanation from the Federal Trade Commission of just how Herbalife achieved those juicy ROICs:

Multi-level marketer Herbalife will pay $200 million back to people who were taken in by what the FTC alleges were misleading moneymaking claims. But when it comes to protecting consumers, that may not be the most important part of the just-announced settlement. What could matter more than $200 million? An order that requires Herbalife to restructure its business from top to bottom – and to start complying with the law.

Advertising in English and Spanish, Herbalife pitched its business opportunity as a way for people to quit their jobs and make the big bucks. Other ads promoted Herbalife as a means for already hard-working people to provide a little more for their families: “When we worked in factories our earnings could only pay for basic needs, but now we can take our 12 grandkids on vacations.”

But don’t start packing the kids’ bags because according to the FTC, it’s virtually impossible to make money selling Herbalife products. As explained in the complaint, our analysis shows that half of Herbalife “Sales Leaders” earned on average less than $5 a month from product sales. For folks who invested the most to build an actual retail business – a brick-and-mortar store that Herbalife called a Nutrition Club – the majority made nothing or even lost money. 

Which brings us to the inconvenient little secret about Herbalife that the FTC’s complaint alleges: The small number of distributors who actually made money made it not by selling products to people who wanted the company’s powders, pills, and potions, but rather by recruiting others to serve as distributors – and encouraging them to buy Herbalife products.

The lawsuit alleges that Herbalife deceived consumers into believing they could earn substantial income from the business opportunity or big money from the retail sale of the company’s products. In addition, the complaint charges that one of the fundamental principles of Herbalife’s business model – incentivizing distributors to buy products and to recruit others to join and buy products so they could advance in the company’s marketing program, rather than in response to actual consumer demand – is an unfair practice in violation of the FTC Act.

Indeed, for some businesses, superb ROICs are achieved by screwing over customers who either had no choice (Valeant raising the prices on lifesaving drugs), or were bamboozled into making a bad decision (the MLMs / timeshares.)  

Shareholders of these companies defend them; the defenses are transparent for what they are – excuses.  It is clearly not better for the world that Valeant bought a drug that used to cost $100 and increased the price by orders of magnitude.  No value for the world was created by them taking a drug that cost $100, raising the price to $10,000, then using the new profits to buy another drug and do that as well.   

Obviously you do great things to your ROIC if you increase the price of a drug by a couple orders of magnitude.  But which company is really helping the world more – Valeant with a high ROIC, or a traditional R&D-driven pharmaceutical company with a lower ROIC?

Similarly, with MLMs, it is clearly not better for the world that working-class or middle-class people are sold hopium – a promise of a better future and an independent business “opportunity” – in exchange for forking over piles of cash that enrich the CEOs and shareholders of scummy MLM business models.  It is just better for the shareholders; it is not better for everyone else.  The FTC would certainly take issue with the notion that the world is better off because Herbalife made a great ROIC.  Try telling that to the people who invested their savings into Herbalife products that simply piled up in their garage, spare room, or storage unit.

It would be better for the world if former-Valeant, and all MLMs, had far lower ROICs; the high ROIC of those businesses, by itself, does not tell you that they are doing good for the world.  I’ll let you work out the second example (costs) on your own.

So, subject to certain constraints, then yes, better ROICs are better for everyone.  But there are many ways to achieve a better ROIC, some of which benefit the world, and some of which do not.  Thus, no, Nick – a positive or negative ROIC does not tell you “all that.” Even as an investor, ROIC alone does not tell you much; oftentimes businesses have great ROICs until suddenly they don’t – or vice versa.

Endnote 3: Price Elasticity of Demand

Mr. X, on page 84, states:

“If you wanted to, could you raise prices and not lose customers?  If you can answer yes, you probably have a differentiated product. If the answer is no, you’re in a commodity business.  It’s that simple.”

No, Mr. X, not at all.  It is not nearly that simple.

This is an overly black-and-white view of the world that doesn’t reflect business reality; Taylor, as a professional investor himself, should be aware of the dose-dependency here.  

There are total commodities (oil, lumber, etc), where you have no pricing power at all.  And there are products of the sort Mr. X references (say, the only lifesaving drug on the market for a dire medical condition), where there is essentially no price elasticity of demand (see: Valeant example.)

But there’s a whole lot of in between that’s important.  Cootie Burger, as described in the book, seems to have a somewhat differentiated experience – no pink slime, friendly cashiers, clean bathrooms, etc.  And they earn some pricing power from that; if I still ate hamburgers, which I mostly don’t, I might be willing to pay a dollar or two more for Cootie Burgers than I would for competitors’ burgers.

But it’s not infinite, right?  You can’t talk about “raising prices without losing customers” without putting some numbers to it.  Pricing power is not an all or nothing proposition.  Cootie Burger can’t just charge me or you $100 for a burger and expect not to lose customers.  

There is elasticity of demand; this is econ 101. If they raised their prices a buck for a meal, they might have somewhat fewer customers, but they wouldn’t all go away – it’s not a true commodity.  

I am Groot!

Similarly, you could probably price tickets for Avengers: Endgame 20% higher than tickets for normal movies, and the average viewer wouldn’t really care too much; you’d probably not lose many viewers (at least for the first few weeks).

But if you priced Avengers: Endgame at $200 per ticket, then um yeah, you’d lose a lot of viewers. Avengers: Endgame provides a differentiated experience (if you’re an MCU fan, you can’t just go watch any other movie and have equal satisfaction), but that differentiation can only command so much of a price premium.

So these pages fail to take nonlinearity into account; see Jordan Ellenberg’s How Not To Be Wrong (HNW review + notes) – specifically the “how Swedish is too Swedish” section – to elucidate this point, i.e. that which way you go depends where you start from.  Taylor / Mr. X should have acknowledged this; pricing power / the price elasticity of demand depends heavily on where P is in relation to V (using Mr. X’s straws.)  If the business has already aggressively priced, it doesn’t matter that it’s differentiated.