ISSUE NO 3

MONDAY 13 OCTOBER 2008

BFBV NEWSLETTER
A Chain Is Only As Strong As Its Weakest Link.
Or Is It?
Hi,
Metaphors are
important and as you know
I use metaphors in class to
better illustrate some ideas.
Remember “Boiling Frogs,”
“Pavlovian Dogs,”
“Ostriches with Heads in
the Sand,” and “Burning
Bridges?”
When it comes to
chains, I like to use two
metaphors.
The first one is to do
with bias !om commitment &
Imagine that for an not invest. To judge that, you also consistency. Old habits die
investment operation to be need to know the outcome in this hard (its difficult to teach an
successful, four events must very low-likelihood scenario, old dog new tricks) and its
happen. Imagine further that you which must be weighted against better to develop good
know what are the chances of the outcome of the operation’s mental habits early in life.
each of those events happening. failure. “Chains of habit,” Mr.
You reckon that there is a Life is full of very unlikely-to- Buffett says beautifully, “are
95% chance of the occurrence of succeed operations, but ones with too light to be felt until they
each of the first three events. But huge potential payoffs in the are too heavy to be broken.”
the fourth event is not very likely event of success. So merely The second chain-
to happen. In fact, it is highly because the chance of success is metaphor I like is to do
unlikely and has a probability of low does not have to mean that with the theory of
only 5% of its occurrence. you turn down such opportunities. Probability.
How should you think about But you should think about I hope you enjoy
this investment operation? weak links — they are very reading about it...
Elementary probability important. In the above example,
theory, which you read in school, the weak link is the low-
probability fourth event. Which Thank you,
taught you that the chance of
achieving a success in this brings me to the title of this -Sanjay Bakshi
investment operation is very newsletter. “A chain is only as strong
small. Indeed there is only a as its weakest link” should, perhaps,
4.29% chance of success (0.95 x be re-stated as “A chain cannot be
0.95 x 0.95 x 0.05). Of course this stronger than its weakest link.”
does not mean that you should

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 ISSUE NO 3 MONDAY 13 OCTOBER 2008

The weak link metaphor is a makes the passengers very

very important one in the upset. Not only do they ask
investment business. Let me for compensation, they also
illustrate… decide to never fly that airline
Some businesses are what I again.
like to call as “accidents waiting to It has been estimated that
happen” because they have many given the airline industry’s cost
weak links. structure (very high, and largely
These weak links could arise uncontrollable, fixed costs as a
from a variety of sources. My percentage of revenues), and the
favorite example to explain this possibility of long strikes from
is the airline industry. Let’s just pilots, or flight stewards, or
think a bit about this industry. baggage-handling staff, or
We will expand the discussion ticketing staff etc, even the
of weak links after that. strongest airline (low-cost
operator, debt-free balance sheet
Here is one very etc.) will be brought down to
interesting fact: there are its knees if its planes can’t fly
more bankruptcies in the for just six weeks.
airline business worldwide,
than in any other business. There are other problems
Now I find that very with the airline business
fascinating and I want to which you can learn about
know why that happens. by reading Mr. Buffett’s
comments on USAIR in
Why is the airline business his letters from 1989 to
an accident waiting to happen? 1996.
What are the weak links in the
airline business? Let’s return to the
metaphor of weak links.
There are many and if any of When evaluating any
the weak links breaks, then the investment
business falls down to its knees. opportunity, I think it
And it happens again and again in makes sense to do
the airline business. some thinking about
So what are those weak links? the weak links in that
Strikes, Cost Structure, Commodity opportunity. While I
Product, Excessive Competition, and won’t bore you with a
Leverage. long list of possible weak
Let’s just focus on strikes. For an links, let me give you a few
airline to make money its planes examples.
must fly. For the planes to fly, a lot of One weak link is what I call
things must happen and if any one businesses which depend on
of those things don’t happen the the “kindness of strangers.”
planes won’t fly: You would need There are a few businesses
willing Pilots, willing flight which, by their very nature,
stewards, willing baggage-handling require for their survival
staff, willing ticketing staff, willing plenty of “kindness of
aircraft maintenance staff, willing strangers.”
air traffic controllers etc… If any I am, of course, referring to
of these guys (or girls) don’t “access to capital markets.”
show up, the planes can’t fly. What kinds of businesses
And if the planes can’t fly, it require frequent access to capital

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 ISSUE NO 3 MONDAY 13 OCTOBER 2008

markets? There are many but ones which come We discussed this idea when I introduced you
immediately to mind are investment banks which to confirmation bias — the human mind seeks
use huge amounts of leveraged capital, low-return confirmation for decisions it wants to take and
businesses with insufficient internal cash does not automatically look for information which
generation to fund their operations, high-growth could prove the decision wrong. So you have to
businesses which require huge amounts of kind of de-program yourself from what you’ve be
incremental capital to fund their growth, and programmed to do by evolution. So my suggestion
businesses which have embedded ponzi schemes in is to always ask that question because it will then
them — the “robbing Peter to pay Paul” type of force you to find the weak links you are not
businesses. programmed to be looking for.
As we move ahead in BFBV, you’ll see how easy After you’ve spotted the possible weak links,
it is for these businesses to be then what should you do? You should think about
brought down on their knees how important is the weak link
because capital markets have in the totality of the
shut their doors on their faces. situation. Coca-Cola is
You are already seeing what largely a one-product
investment banks are going company so it has a weak
through right now as an link, but that does not mean
example of weak links in a that you should not invest in
business which cannot the company.
refinance debt or raise As a deep value investor, you
equity capital for even short can do one very smart thing.
time periods. You can hunt for opportunities
Another weak link could in areas where the weak links
be over-dependence on a single customer. of businesses have already
Many auto-ancillary companies been exposed causing their
come in this category, as do stock prices to crash. While
many suppliers to big retail hunting in this field, you
giants like Wal-Mart. might find opportunities
Dependence on a single produced by an
product, is also a weak link. overreactive, semi-
What if someone built a better psychotic Mr. Market.
mousetrap leaving you exposed to Many banks, for example,
the risk of the going extinct? are now selling for far
High margins earned by less than their
companies in cyclical a industry are conservatively-estimated
also a weak link. Investors get over- liquidation value because the weak
optimistic about the prevalence of high margins link in banking is there for the whole world to see.
and value them based on the assumption that they I do not think that conservative banks will die —
are more-or-less permanent. Frequently this although I cannot rule it out. This means that I
assumption turns out to be wrong. Paying even must look at bank stocks a'er their stock prices
moderate multiples of near-term earnings and near- have fallen by 70% or more from their peaks,
term cash flow for stocks of companies because of possible over-reaction of Mr. Market
experiencing cyclical booms, represents a weak link over the weak links in the banking business model.
in the investment thinking in my view. So, in a sense, weak links could be your enemies
Its always a good idea to think about weak because they could destroy your business, or they
links in the idea before making an investment. How could be your friends, because they produce
should you do that? One trick is to ask this mouth-watering opportunities for thoughtful
question: “What three or four things can destroy this investors like you.
business?” Happy Hunting!

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