If there’s one fantasy I see repeated in both public and private equity markets, it’s the idea that companies can grow without reinvestment.

Pull up any company model from a sell-side analyst or PE shop, and you’ll see projected sales and EBITDA go up while capex and net working capital growth is flat, if not declining. I see it in almost every model. Somehow, these companies are expected to undergo a magical transition that will accelerate incremental returns on invested capital and negate the requirement for reinvestment to grow in line with sales.

It’s easy to make these assumptions. It’s an entirely different matter for a company to deliver them. They rarely do.

This doesn’t mean the company isn’t a worthwhile investment or won’t make money. But it does mean a few things.

First, investors rarely understand the business. They have a trader mentality, only worried about fast growth because fast growth sells well in the short run. The cost and investment need to fund that future growth, however, is usually neglected with the hope someone pays a nice premium before the lack of reinvestment becomes apparent.

Second, it’s a way to dress up the company and solve for the valuation that you want. Nothing drives cash flow higher than not reinvesting in the business, at least for a while. Higher cash flow means higher valuation. That is, of course, if those cash flows are sustainable, which they are not. If you underinvest today, you’ll have to make it up in the future. Most of the PE industry is built on others not realizing this fact.

The world is obsessed with optimization. There’s nothing wrong with improvement, efficiency, and effectiveness. But many times, optimization goes to far. As with anything, there’s a point where the costs of optimization exceed the benefits.

For example, corporations optimize their capital structure with substantial debt, but end up in bankruptcy when a recession hits. Investors optimize their portfolios through leverage and mean-variance analysis, but forget the inherent flaws embedded in the data and assumptions. Even individuals who optimize their health end up wasting time and money chasing useless biomarkers and other hacks.

At some point, optimization breaks down. Optimization often relies on the assumption of near perfect knowledge of the future. That’s why those optimized companies go bankrupt. They planned on one future but got another. Optimization is fragile. It’s great if the world unfolds just as you expected. It’s awful in every other scenario.

Since we don’t know the future, robustness, not optimization, should be the goal.

On February 12, 2009, Colgan Air Flight 3407 crashed in New York, killing all 49 on board and one person on the ground. In an effort to improve airline safety, Congress passed the Airline Safety Act of 2010. One of the requirements required pilots to accumulate 1500 flight hours before becoming a first officer.

Seems reasonable, right?

Paul Craig, author of The Killing Zone: How and Why Pilots Die, explains the unintended consequences of that law:

This is why the Airline Safety Act of 2010 is a bad law. The law ignores the fact that quality flight training is better than quantity alone… The law requires pilots to have accumulated 1500 flight hours and hold the airline transport pilot certificate before they can become eligible for hire as a first officer on a Part 121 air carrier. It sounds reasonable that an airline pilot should have an airline pilots license, but here's the problem: the pilots are required to acquire 1500 flight hours before they can move into this career field, then two things will happen. First, pilots will go back to “boring holes in the sky.” This is the phrase used for building a flight time in the fastest and cheapest way possible. That means find the most inexpensive (read slowest and least well equipped) airplanes… Second, if a pilot has to pay for this flight time on his or her own, then the temptation will be strong to cheat. There will be a few pilots interviewing for those first officer positions with falsified records.

As stated previously, the research indicates that it is not how much flight time you have but what you did during that time that makes a difference… Military pilots flew supersonic jets in combat over Iraq and Afghanistan with approximately 400 total flight hours. Those pilots had structured, targeted advanced training, and nobody doubts that they aren't the best in the world. None need to wait to acquire 1500 hours to fly in combat.

The promise of change is exciting, but the execution of change is painful.

It’s not just a lack of willpower or toughness, which are the usual culprits we blame when failing to change. Biology is where we should start…

Anders Ericsson, author of Peak: Secrets From the New Science of Expertise, explains the resistance of change:

The human body has a preference for stability…The technical term for this is “homeostasis,” which simply refers to the tendency of a system to act in a way that maintains its own stability…So to keep the changes happening, you have to keep upping the ante: run farther, run faster, run uphill. If you don’t keep pushing and pushing and pushing some more, the body will settle into homeostasis, albeit at a different level than before, and you will stop improving. This explains the importance of staying just outside your comfort zone: you need to continually push to keep the body’s compensatory changes coming…

Because the work of change is uncomfortable, the promise of change becomes intoxicating: we get to imagine all the benefits of the expected change without any work or investment. It’s all a fantasy at this point. And one we hope comes true. But hope isn’t a strategy, and eventually it becomes a handicap.

In 2015, Pete Carroll, then head coach of the Seattle Seahawks, was vilified for an awful play call. This wasn’t any ordinary call. It was a call made with 26 seconds left in Superbowl XLIX, with the Seahawks down by four. The Seahawks had the ball on New England’s one yard line.

Annie Duke, in her book Thinking in Bets: Making Smarter Decisions When You Don’t Have All the Facts, describes what happened next:

Everybody expected Seahawks coach Pete Carroll to call for a handoff to running back Marshawn Lynch. Why wouldn’t you expect that call? It was a short-yardage situation and Lynch was one of the best running backs in the NFL…Instead, Carroll called for quarterback Russell Wilson to pass. New England intercepted the ball, winning the Super Bowl moments later.

The headlines the next day were brutal:

• USA Today: “What on Earth Was Seattle Thinking with Worst Play Call in NFL History?” 

• Washington Post: “‘Worst Play-Call in Super Bowl History’ Will Forever Alter Perception of Seahawks, Patriots” 

• FoxSports.com: “Dumbest Call in Super Bowl History Could Be Beginning of the End for Seattle Seahawks”

• Seattle Times: “Seahawks Lost Because of the Worst Call in Super Bowl History” 

• The New Yorker: “A Coach’s Terrible Super Bowl Mistake”

To the average person, the headlines delivered poetic justice for such a dreadful play call.

But to a select few, the criticism was flawed, if not wholly unwarranted.

There’s a lot that comes with a big title. More pay, more responsibility, more control, and more recognition.

But there’s one thing that doesn’t come with a title: the ability to call yourself a leader.

Titles don’t make you a leader. Your people do.

Leadership can’t be decreed, no matter how much power comes alongside a fancy title. While titles are awarded from above, respect is earned from below. It’s colleagues under the boss that will decide when leadership is earned. It’s never given on day one.  

Noted Silicon Valley coach Bill Campbell, in the book Trillion Dollar Coach, explains:

If you’re a great manager, your people will make you a leader. They acclaim that, not you…You need to project humility, a selflessness, that projects that you care about the company and about people.

One test of organizational health is how often titles or positions are used to justify decisions. As in, “I’m the boss and I’m telling you what to do.” Or, “I’m the highest ranking official in the room so it’s my call.”

Underperforming organizations rely on titles, rather than discussion, to make decisions.

A structure without redundancy is called fracture critical, meaning that a single broken component can collapse the entire structure.

Fracture critical extends beyond engineering to describe many firms in the finance industry:

• Hedge Funds: Excess leverage on top of bad trades

• Banks: Illiquid long-term assets funded by fleeting short-term deposits

• Funds: Illiquid assets with daily redemptions

• Allocators: Overcommitment to illiquid/opaque strategies

• Managers: Reliance on the one-person, “star” investor model

• Firms: One person holding together critical IT, treasury, or operational functions

We know the names of firms that suddenly blew up: SVB, LTCM, Sowood, Amaranth, etc. Why do firms choose this model when the lessons are evident?

Because it’s optimal in the short-term. It’s optimal when you believe you know what the future will hold. It’s optimal when you surround yourself with very talented people that have only experienced success. It’s optimal when the press and investors reward you for excessive risk taking in an up market. Operating in a fracture-critical environment is seductive because disaster never seems close.

No investor desires underperformance. Not the managers delivering it and not the investors receiving it.

You can’t get away from it. You can’t solve it. You can’t eliminate it. It’s not a flaw in the system. It is the system.

In 2019, Warren Buffett underperformed the S&P 500 by 20.5%! In 2020, he followed that with a 16.0% underperformance. Despite his tremendous track record, Buffett still underperforms at times.

So if Buffett hasn’t figured out how to eliminate underperformance, what in the hell makes you think your manager can?

I hear this every time I’m at a conference: allocators demand that an underperforming manager “fix” their underperformance.

“What are you doing to address the underperformance,” they proclaim to the manager. As if the manager just needs to find the one bad formula in excel that’s screwing everything up. As if the manager just needs to resolve to work harder by putting in 16-hour days instead of 14-hour days. As if the manager just needs to find a new formula or crystal ball that will magically crank out winning stocks.  

At the end of every argument or debate, the “winning” side has a choice. Accept their win with humility and graciousness. Or go in for the kill shot by humiliating their opponent.

We’ve all been in heated disagreements where emotions ran high and we said something we soon regretted. Even though we may have “won” the argument, we still felt the need for some instant retribution by humiliating the other side. The immediate desire is overwhelming during a conflict.

But be careful how you proceed after victory. While it may feel good to humiliate the other side when they are at their weakest, you may create an enemy for life.

FBI Hostage Negotiator Gary Noesner, author of Stalling for Time: My Life as an FBI Hostage Negotiator, describes how General Grant handled his victory of General Lee at the end of the Civil War:

No one…wants to be humiliated. I was always moved by General Grant’s gesture to General Lee in allowing the Confederate leader to keep his sword during the surrender at Appomattox that ended the Civil War. That small but symbolic act cost Grant nothing, yet gained so much by allowing the venerated Lee to maintain his dignity and positively influence his loyal followers. Many of the individuals we deal with are hardly venerated warriors, but they are repeat offenders. If we treat them poorly when they surrender, they may not be so willing to cooperate with us the next time they’re in a jam.

Purposeful urgency is a powerful indicator of organizational health. But don’t ask about it. Instead, observe it. Organizations will say anything that sounds good. But look at how people behave, and you’ll uncover the truth.

Behavior can’t be bullshitted. In the short run when people are being observed, people will work extra hard, show up early, stay late, and appear to move with a sense of purpose. But it’s not real and it won’t last. As soon as people stop watching, they’ll revert to their normal, sluggish state.

Urgency reveals the underlying energy and excitement of a culture. Is there an underlying force propelling people to do great work? Because if you see people moving fast, it’s because they want to.

Managing by mandate and decree can force compliance, but not purpose. It’s superficial. Progress occurs at a glacial pace, as people appear to move fast at everything but what’s valuable.  

Let’s discuss the wrong kind of urgency: It’s not running around in a manic, anxiety-fueled state. It’s not overreacting to every setback. It’s not putting out fires. It’s not packing your day with meetings. It’s not working 16 hours a day. It’s not activity for activity’s sake.

Nullius In Verba. Translation: Take Nobody’s Word for It. Pretty good advice for life, and even better advice for investing.  

The investing world is full of people that say many things. And many get paid specifically to tell you certain things that may or may not be true, accurate, or a complete representation of reality.

CEOs, investment managers, salespeople, consultants, and regulators all tell you a story, but rarely give you the whole fact pattern.

So take no one’s word for it:

• Do your own homework

• Read the footnotes

• Call references

• Recalculate the numbers

• Evidence, not confidence

• Written language, not spoken promises

• Source documents, not summaries

It’s almost always a classic appeal to authority fallacy. Trust me, because of my company/my background/my title/my school/etc.

If you ask people how to become successful, the default answer is to “get better.” It certainly makes sense, but there’s another way:

Find weaker games.

In his paper, Alpha and the Paradox of Skill, Michael Mauboussin shares the experience of Jim Rutt, former CEO of Network Solutions and the Santa Fe Institute.

Mauboussin explains:

He [Jim Rutt] mentioned that he played a lot of poker when he was young, became pretty good at it, and made some money. Rutt assumed that the best way to ensure continued success was to improve his skill, so he worked diligently at honing his game by learning the probabilities of each hand and studying other players for clues about the strength of their positions. At that point, an uncle pulled him aside and doled out some advice. “Jim, I wouldn’t spend my time getting better,” he advised, “I’d spend my time finding weak games.”

Great ideas don’t matter. It’s great ideas, actually shared, that matter.

Many people have great ideas. But because they hold back, they can’t be debated, discussed, or implemented.

Some people hesitate because of social anxiety. But most people hold back due to cultural expectations: those who get to speak are the “senior” people. People with the most experience. People who have “paid their dues.”

What an outdated, awful way to find the best ideas.

In her book, Rebel Talent: Why It Pays to Break the Rules at Work and in Life, Francesca Gino tells the story of Mellody Hobson, president of Ariel Investments:

I received precious and unforgettable advice on my first day at work from Ariel’s founder and CEO John W. Rogers Jr. He said to me, “You are going to be in rooms with people who make a lot of money and have big titles. But it does not mean your ideas are not as good or even better. I want to hear your ideas. It is incumbent on you to speak up.”

Every investment manager, since the beginning of time, promotes the success of their winners while deliberately distracting investors from the losers.

I get why they do it. They want to look good. It makes perfect sense. I’d probably do the same if I were in their shoes. Just highlight the good stuff and hope no one notices the bad stuff.

At the risk of sounding naïve, I wish managers would own their mistakes and talk to us about problem investments. Don’t bury it on page 107 of the annual report. Don’t conceal it in the appendix.

Emphasizing how great your realized investments were? That’s fine. But acknowledge the mistakes with the same amount of detail and description.

Be up front and explain what happened. Talk to us about the mistakes, what you learned, and what, if anything, will change going forward.

We see the overall return data. We know by cherry-picking a handful of winners there’s likely an equal number of losers dragging the fund down. Don’t pretend like it doesn’t exist.

Organizations struggle to hire talent, mostly from self-inflicted mistakes. Talent sourcing is relegated as an afterthought, a second-tier priority at best. It’s an unwelcome distraction when there’s so much other work to do. At no point do companies treat talent recruitment as a strategic skill.

It’s done by gut, intuition, and feel. In other words, it’s mostly made up.

How well does your company hire talent? Struggling to attract great people?

Fortunately, Tyler Cowen has several insights on how to change the hiring process. Tyler is an economics professor at George Washington University. He’s as close to a renaissance thinker as I’ve come across. He’s the founder of the popular blog Marginal Revolution. He hosts an exceptional podcast, Conversations with Tyler. He’s the author of several books (I count 13).

One of those books is Talent: How to Identify Energizers, Creatives, and Winners Around the World.

Below are 12 ideas from Tyler to change how you hire talent…

The CIO role is the pinnacle for most institutional investors. The prestige, the pay, and the ability to lead a team is a big draw.

However, the challenges of leading an investment team are rarely discussed. Your success or failure as a CIO isn’t determined by the glamorous parts. It’s determined by all the organizational and team issues you’ll inherit as you step into your new role.

As if investing alone isn’t hard enough, it becomes a nightmare when you join an organization that is completely different than what you were “sold” during the recruiting process.

What is not being addressed with clarity and honesty?

How can I separate the sales pitch from reality?

What’s being hidden from me?

No one is going to offer you the ugly truths. You must ask for it. And keep asking until you get it.

While the CIO role is the desired endgame for many investors, the question is, are you sure you want it?

Remember, you don’t get to just choose the exciting aspects of the job.

You must take the good and the bad. And often the negatives will dominate the positives.

So how do you know what you are walking into?

Here’s what I’d be asking:

Sam Zell passed away earlier this year but left no shortage of wisdom and one-liners.

Sam shared many lessons in his book, Am I Being Too Subtle? Straight Talk From a Business Rebel.

But you won’t find any lessons on cap rates or property types.

Instead, they are foundational ideas on being a good investor, a good leader, and a good person.

Below, I’ve shared 12 of the best lessons you should take away.

If you are really good at what you do, you have the freedom to be who you really are

One of the biggest raps about me is that I’ve been known to use profanity. Sure, sometimes my real estate colleagues will make over/under bets on whether or when I’ll drop the f-bomb onstage at a conference. I simply don’t buy into many of the made-up rules of social convention. I think people often get distracted by these superficialities. For example, I’ve been wearing jeans to work since the 1960s, long before it was acceptable. And to this day, I’m usually the only one at a business conference or on CNBC’s Squawk Box set in jeans. The bottom line is if you’re really good at what you do, you have the freedom to be who you really are.

Bob and I originated the unique culture at EGI that became our company trademark. We abandoned all pretense and established a casual-dress office policy—which, believe me, was unheard of in the rigid world of finance in the 1970s. We invented business casual. Our thinking was that if you dress funny and you’re great at what you do, you’re eccentric. But if you dress funny and you’re just okay at what you do, you’re a schmuck. We were determined to show everyone that we could excel without conforming.