FMEA to Risk!! Learning from Operational Excellence

I enjoy investing!! I enjoy as it allows you to apply frameworks from a diverse set of fields.

One of my favorite source of these models is Operational Excellence (OE) and the reason why I like these is that they force you to list and quantify all assumptions in a systematic manner. Also they are fairly simple to execute.

A new process! A new launch!! As soon as on OE practitioner hears this they would do this. They will try to identify break points. They will quantify impact of these breaks. And finally and the end of doing this in a systematic manner they would be able to see what are the biggest risks you need to worry about.

The blogpost discusses one of the common tools for this called FMEA.( Failure Model Effects Analysis)

Any FMEA analysis has following inputs.

1.     Failures across Processes

2.     Modes/Reasons of Failure

3.     Effect of Failure

a.    Impact of Failure (10 being catastrophic and 1 being negligible)- This will require you think business in terms of systems with one part of business impacting other with lag

b.    Probability of occurrence (10 being highest and 1 being lowest). You can use Baynesian thinking here to put probability basis a baseline and then change if things change.

c.     Detection Number: Your ability to detect this failure (10 being worst ability and 1 being best)

4.     Net Score

Now simply multiply for each risk the probability and impact to get to a net score. Higher Score means Higher Risk.

Example: Let’s look at Aashiana Housing. Any stock you own is a business which has multiple processes running. Using FMEA we want to identify failure modes associated with each of these processes. Here I have listed few business failure modes for Aashiana Housing

And now you can see the big failure modes you need to track. Example I had ignored the risk of softening of demand. I had assumed that the probability of slowdown is low and company should be able to handle it. But if I had understood the impact and my limited ability to detect this I would have been more prudent in understating this failure mode.

However, this analysis is not a static analysis. In OE world you keep reviewing the process and refreshing the risks. Similarly, you need to keep revisiting the probabilities, impacts and ability to detect on regular basis and if required adjust them to new information.

PS- The probability, impact are my assessment of these. The detection ability is my ability to detect in advance this failure reason with limited information.

Learning from Book: Zero to One by Peter Thiel. Part-2

This is a followup post on the earlier post on Learning from Book: Zero to One by Peter Thiel. Part-1

1. Preface
2. The Challenge of Future
3. Party like its 1999
4. All happy companies are different
5. The Ideology of competition
6. The last mover advantage
7. You are not a lottery ticket
8. Follow the money
   1. Unequal distribution often are described by exponential laws or famously Power Law. These means for VC's invest in companies who can return as much as entire value of fund. This eliminates most companies. For investors these a good mental model. think of companies that can give great returns over long periods. Something like what Ian Cassel recommends.
   2. For most people Power law is hard to understand, as it doesn't reflect our day to day experiences. We are used to standard deviation curves and worse our minds are tuned to straight line thinking.
   3. The beauty with any law or principle is the way it extends to other dimensions. Think on career perspective. We should evaluate a career with a belief that what we do now can be valuable for decades. That itself can eliminate a lot of poor choices. Personally for me a large part of my career i wasn't part of creating something valuable. 
   4. From all perspectives investment, career, company think if what you are doing is going to be valuable in future. Of course biases can cloud your thoughts and hence the need to have multiple mental models.
9. Secrets
   1. Due to enormous progress in last century and wide availability of information we have false sense of belief that there are very few secrets left to uncover. The reduction in geographical secrets further aggravates this. The age old biases of going against a known belief to find a secret and the complacency associated with it make it worse.
   2. For investors we can look at disasters if we find that company has stopped believing in secrets and solving them. Reading AR's from this perspective will be quite interesting. Solving these riddles leads to a natural moat. But as said often for solving that one riddle you need to try multiple riddles. Hence, the need of R&D in any company and investments in it.
   3. Great companies can be built by solving secrets which are right in open.Facebook, Airbnb, Uber are few examples.
   4. They solve for two questions
      1. What secrets is nature not telling you?
      2. What secrets are people not telling you?
      3. This lens is an incredibly powerful mental model to evaluate business, careers. What secrets are you or the company you are investing in helping solve?
10. Foundations
    1. Thiels Law: A startup messed at foundation cannot be fixed. This can be extended to investors when companies go change in management or new successor comes along and tries to change foundation.
    2. Check how well the founders know each other. This is one of the reasons why Family businesses in India succeed as they know each other and can easily align to a goal
    3. To evaluate the foundation of company check 3 things
       1. Ownership: Who legally owns the companies equity?
       2. Possession: Who runs the company on day to day basis
       3. Control: Who formally governs companies affairs?
    4. Overlay this with incentives at each level. If they are not aligned things can get messy.
    5. A company remains great till it creates new things thus remaining ahead on value curve. The day creation stops, companies start to end.
11. The Mechanics of Mafia
    1. Every company is a culture. Thus it makes sense that when we understand that. When we speak to employees about scuttlebutt that is also something we should check. How is the culture on creativity? how easy is decision making etc
    2. From a professional perspective since time is your most valuable asset (refer letter of Seneca) its odd to spend time with people with whom you don't envision long term future. 
    3. The same analogy extends to hiring. What kind of people you want to hire? Do they fit in your culture of value creation? What is needed is while people can be different they need to be like minded devoted to companies mission
12. If you build it, will they come
    1. Distribution or Sales of a product is as critical as design of Product. If you have a great product but not there is no effective distribution channel you still will end up with Poor business. That is why often distribution itself becomes a great moat. Superior Sales and Distribution by itself create a monopoly even with no product differentiation. But the converse is not true.
    2. For distribution design we need to think of two dimensions
       1. Customer Acquisition cost through a distribution channel
       2. Customer life Value (CLV) or Profits earned from customer through this. 
       3. Acquisition Cost should be less than CLV. Now think of advertising and distribution costs incurred by companies.
    3. Often for mid sized companies for increasing sales, distribution is the bottleneck. Mid sized business need to balance the cost of reaching customers and effort of personal sales.
    4. Marketing and Advertising works for companies who have low priced product with mass appeal but can't do viral marketing. Therefore, mostly new tech companies hardly advertising. They rather focus on building the network
    5. Advertising can also work when customer acquisition cost and CLV make every distribution channel uneconomical. Probably that is why Amazon needs to spend on advertising in India.
    6. Power law of distribution-If business can get even one distribution channel to work, we are into great business. That is why FMCG's are usually great business. Their offline distribution is very strong.
    7. Look around, if you don't see a salesperson you are :)
13. Man and Machine
    1. Technology is not substitution its complementary to humans. 
    2. Tech is one of the tools for better future
14. Seeing Green
    1. Every business needs to answer these 7 questions. Great checklist for investing
       1. 1. The engineering question- Can you create breakthrough tech, instead of marginal improvements
          2. The timing question- Is this the right time to start your business? Is this the right time to be in this business? Probably the question with most biases involved.
          3. The Monopoly Question- Are we starting with a big share of small market? Data driven answer
          4. The People Question-Do we have right team? Again can have huge biases
          5. The Distribution question-Do you have a way to not just create but deliver it also?
          6. The Durability Question-Will your market position be defensible in 10 or 20 years into future? Will be influenced by Optimism bias
          7. The Secret Question- Have you identified a unique opportunity that other's don't see? Try to answer this with data and not hypothesis
15. The Founders Paradox
    1. The best founders usually have inverted fat tails. They can high frequency of charismatic moments and Sullen jerkiness. They can be paper (stock) rich and cash poor. They can attract both fame and infamy. Almost as Charlie Munger says they are Intelligent Fanatics. Lesson for investors is to accept the negative sides. Lesson for a person joining a startup is to be ready for a bumpy ride and think if you fit the inverted curve.
    2. The greatest danger for a founder is to become certain of his myth. And an equally damning danger for every business is to lose all sense of myth and mistake disenchantment as wisdom.

                   

Learning from Book: Zero to One by Peter Thiel. Part-1

I recently had a chance to read the book "Zero to One" by Peter Thiel. While the book appears to be on building successful startups, it has a lot of wisdom on looking at business, evaluating them and how to look at your career.

In the first part of this post I have tried to cover learning from the first 7 chapters of the book. The key points are given as per each chapter basis my limited understanding.

1. Preface
   1. Every moment in business happens once. That is why great business are built by finding value at unexpected places. These business solve problem using first principles and deriving learnings from multiple points.
2. The Challenge of Future
   1. To build great things in future you have to find or do things which lead to vertical progress and technology is for that. Extrapolating it to people you want to find people who can answer question " what important truth very few people agree with you". Difficult to answer since it means probably it will be an unpopular answer ( Brilliant thinking is rare, but courage is in even shorter supply that genius). Similar when u look at product u might need to think unpopular. Being Popular means u copy and break the concept of every moment in biz happens once. Example, copying Facebook or google will be incremental not vertical 0 to 1 growth.
   2. Deriving from above a startup is the largest group of people you can convince to build a different future. We can use this in investing to evaluate next big idea stock idea.
   3. The above paras kind of summarize why 0 to 1 is so difficult. It is about finding unpopular truth, then finding people for it and then probably tech to solve it.
3. Party like its 1999
   1. Learn from past. First step in good decision making is to think what we know about past. These are the 4 lessons learnt from dot-com bubble, but probably applicable for any business. Also, important for investors to evaluate management on these dimensions.
      1. Make incremental advances--> Grand visions often don't work or attract competition. make incremental steps, conquer one battle at a time.
         1. Stay lean and flexible--> Paramount in today's age as planning seldom works these days. ( Mike Tyson: Your plan is good, till you get punched in face). Also beware of arrogance arising out of plans. Example, remember the CAPEX's gone bad basis those perfect XL sheet plans
      2. Improve on competition--> Don't try to second guess customer. Look at an existing customer, find the poor solution, then improve it and monopolize it
      3. Focus on product, not sales--> though i don't completely agree as it should be balanced, but focus on product. After all that is what ur core solution is.
   2. Our default assumption is that contrarian means going against the crowd. Being contrarian is not to oppose crowd but to think for yourself.
4. All happy companies are different
   1. All happy companies are different in the sense they create monopolies which by definition can't be same as other.They solve unique problems. The trick is that due to business environment they will seldom say or portray they are monopolies. Example google says its revenue is ad sales which is a tiny portion of overall ad industry. Yet it has solved a unique problem. It has built a VALUABLE business which nobody is building or cant build. In investments this is what is separating wheat from chaff. Also links with the mental model that in traditional low value industries few companies create monopolies. 
   2. On other hand most companies who are run of mill will say they are different from competition and have a unique positioning. 
   3. Good example: Airlines. All biggies claimed they were unique and different, but it was south-west which created a monopoly.
5. The Ideology of competition
   1. Competition for the sake of it is futile. The less we compete the more we gain. That is what game theory proved. Example, Pepsi and Coke. Instead of fighting wars now they play the price game in tandem. Both price products at same cost and raise prices at same cost. . Shakespearean thought on war that all combatants are similar and often in war forget about why they are fighting cause there is nothing to fight about. In business happens often. Google and Microsoft fought OS/Browser wars and Apple came and changed the landscape itself. 
   2. Unfortunately our education system makes us think that beating competition is the only way out.Similarly, inside organizations people keep fighting for advancement without realizing that they are not on 0 to 1 path.
   3. As an investor we need to look at companies whose promoters think fighting competition is the most destructive activity. They either partner competition (refer Sun Tzu) or find a niche where people can partner them not compete with them
6. The last mover advantage
   1. A very counter intuitive thinking. First mover means you create a monopoly but it can be transient. Its a matter of time that someone comes and attacks you. The other inverted approach is move last in a specific market where needs are visible and then enjoy years of monopoly profit. From an investor perspective it often means that company might lose or may not be profitable initially, but can be immensely profitable later. And as investors that is what we should care about. Cashflows of future long out not the very near ones. Links to the bias of being attracted to whats nearby
   2. Once a company is last mover it needs to create a moat to keep generating profit. Links to Buffet on moat definition. This can be done using Proprietary Tech, Network Effect, Economies of Scale, Branding. Very similar thought process shared by Pat Dorsey.
   3. Bringing it together, to build a monopoly start with small specific segment. Don't disrupt and avoid competition at all costs. "If your company can be summed by its opposition to already existing firms then it can't be new and probably not a monopoly. So,monopolize this small segment and then move ahead. This movement ahead can be unpredictable but you need so scale in slightly broader markets where your tools of monopoly ( tech, network effect etc) still work
7. You are not a lottery ticket
   1. Again counter intuitive and contradicting to earlier idea of staying lean. He says that we are now overestimating role of luck. We use it as an excuse to defer definite planning. The thought process works if the company has managed to find the segment it wants to monopolize. It can then make small plans and not grandiose ones which we often hear.
   2. Investment thought, " A Business with a good definite plan will always be underrated in a world where future is seen as random". Powerful idea.
   3. Key I think is balance between appreciating role of luck and planning.

The Worst Bet You Can Make

The realization of this bet came to me when i met a friend of mine over at lunch. So here it goes.

You work in an a great company and have  had a healthy career. The ultimate success metric for you is becoming the CEO/Head of the company. 

For this you spend a lot of time probably much more that others do. In this path sometimes you miss out on things you want to do. Miss out thinking what is your passion. 

And as your skill enhances, as you grow higher you get more confident of achieving this goal. 

Now lets for a moment lets step aside and look at this goal mathematically.

• Approx number of companies you would want to be CEO/Head=  5000
• Approx number of people who are employed in all these= 50 lacs
• Approx number of people who you think have similar capabilities as you (5%) = 2.5 lacs
• Chance of you becoming a CEO= 0.2% ( 5000/2.5 lacs)

If you are a poker player or investor considering the odds how much time and money will you put on this bet? To my mind playing this bet is one of the worst bets you will undertake.

IMHO, don't play this bet. Do things that you enjoy. Enhance your skills. Enjoy the process and don't be obsessed over winning this losing bet.

And if you want to play this bet, then loads of luck from my side, cause that is what you will need in loads.

cheers.

PS- Apologies for not declaring upfront that this is not an investment blog :)

The "WHY" Mental Model

I was thinking  of  writing on this topic after after I saw this lecture on TED by Simon Sinek and then read his book. 

The trigger came after reading this paragraph in Kiran's superb blog 

1) Owner’s View: Look at every business from the owner’s standpoint. What motivates the owner? What are 1 or 2 key factors that the owner  understands that bring value to the business? How will the owner react in adverse conditions? That’s absolutely critical to value the business. .

So here goes my rant :) 

The Traditional way of evaluating a business has this flow:-

• What's of the business/Evaluation of outcomes- To quote Simon Sinek all business know what they are doing. They know are selling cars, homes, pipes, IT services etc etc. These "what's" are evaluated using metrics like Revenue, Profits, Growth Rates etc
• How's of the business/ Levers of business - We then try to evaluate the levers of business like the domains in which business competes, which products sell where, what are their weaknesses, Moats etc etc. These " how's" are evaluated using metrics like Return on capital, Return on Assets, cash flow etc.
• By this time our investment decisions is almost made and we typically look for confirming evidence. Very rarely will we go to the next step of 
• Why's of the business/ Purpose of business- This is the domain where things become grey and fuzzy. This is where we need to think of words like Trust, Loyalty, Vision etc. There are no metrics to evaluate these. Think of a stock in your portfolio and ask can you measure the trust or loyalty generated by it. Its a tricky one to answer. And therefore most of the times this is ignored.

To summarize, we start with what are the outcomes of business, then try to identify how they are achieved and then pretty much stop.

The new way of thinking prescribed by Simon Sinek is to invert this process:

• Start with the "WHY"- Try to identify the purpose of existence of a company. Great enduring businesses know this crystal clear and all their actions are defined basis that. Few examples
• Apple- The founders gene was to rebel and almost all their products reflect that
• Coke- All along the single message they have tried to convey is Coke stands for happiness. Look at any campaign, product , communication and its always has this philosophy
• Google- Do no evil. Again every single google product tries to do this. Every communication to their hiring page reflects this

From a business perspective this defines the way it creates space in its customers mind.                   We ( can say for most of us) trust Google, We ( can't say for most in India) love every apple               product.

Their "WHY's" have resonated with their customers to create an unflinching loyalty.     

I realized while reading few Buffet letter that how rarely does he comment on metrics related               to How and What of business. Most of the times he comments on "Why" and things associated           with it like Trust, Loyalty, Belief etc

• The "How" is next- This is where we start to look at how business is trying to achieve the why. Spends on moats, technology, asset turns, RoE etc etc
• The "What" is last- This is where we evaluate if the How's are working. 

For me this has been a great mental model to use. Now I try to find the "WHY" of business using

• Mission/Vision Statements
• AR Commentary on these statements, if any
• Promoter interviews
• Scuttlebutt to see how these are translated at ground level for companies

Earlier I would ignore these portions. Now, I read them and try to see if its just  jargon or does the business actually try to follow it. If its jargon then for me that becomes almost like a no-go criterion.  

In some cases these statements will be so obfuscated that you just can't figure out the WHY. To me that is also a no-go.

As of now with my limited experience I see the clarity of "WHY" beautifully displayed in few businesses which i own.

Look forward to more suggestions on finding the "WHY" :)

cheers,

Saurabh

PS- The stocks mentioned above are held by me. This is not a recommendation to buy or sell any stock.

Sometimes let some money go down the drain

As markets rise and hopefully all the portfolio's maybe its a good time to start hedging your portfolio.

In ideal situation i would like protect all my gains by buying rights to sell shares in my portfolio at a designated price.

Unfortunately, none of my stocks are in the F&O category. This leaves with only one option of buying rights to sell NIFTY at a certain price and assume it to act as proxy to my shares.

How do we buy right to sell NIFTY  at a price we like? For that we need to enter the maligned territory of derivatives :)

To do this we will take assistance of what is known as PUT option.  Essentially, a put option gives you a right to sell at a pre-determined price. But, for getting this right you need to buy it  by paying a price. ( Known as premium).

To summarize you need to buy a PUT option to get rights to sell a stock/nifty at a pre-determined price.

Let me try and explain this through an example:-

1) Portfolio Size= INR 30 lacs
2) Portfolio composition= Mid-Caps/Small Caps who don't have options enabled for them by exchanges
3) Assume that a bad event happens ( 3rd Front coming to power). In such an even i can assume that my portfolio to go down by around 20% quickly.  Beyond that i actually might start buying my existing ideas :)
So the money @ risk is around INR 6 lacs
4) To hedge assume that NIFTY will fall from present levels falls by 20% (6800 to 5440). Basis this lets check what is the Price  (Premium) i need to pay if i want to buy rights to sell NIFTY at say price of 5500.  That price is around Rs. 10. By paying this I get to buy 1 lot of nifty ( 1 lot=50 NIFTY). So by paying Rs.10*50= Rs. 500 i get to buy rights to sell 50 NIFTY @ price of 5500.
5) Now if NIFTY falls....2 things will happen

• The price you paid of Rs. 10 will increase as more and more people will try to hedge these options. 
• In case the NIFTY falls below 5500 to say 5400, by exercising your right to sell you make Rs.100*50= Rs. 5000/-

In most cases the increase in put prices will take care of your potential loss on portfolio.

6) Coming back to the above example since the loss you can incur is Rs. 6 lacs. to hedge this you would need to buy around 120 lots.
7) This means that by outlaying Rs. 10*120*50= Rs. 60000 you are able to hedge the portfolio.

Though, this sounds very simple it is sometimes difficult to implement as there are no gains in this. You simply are allowing this money to go down the drain if NIFTY doesn't fall :)

Your broker will never recommend this, as it eliminates chances of trading, which is detrimental to your broker.

Regards,
PS- Disc.have bought put options.

The last mail

Its been a while since I posted something on my blog. Apologies for this since i moved jobs ( from banking to eCommerce) and have been quite caught up in getting a hang of my new work.

On my last day in my previous organization I had written the following good bye mail:
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Hi,

 

This is probably my last email from this mail I’d, so let me begin by wishing all of you very best for future (I know bonuses are round the corner :))

 

As I write this I am filled with mixed emotions. On one hand is the heady exhilaration of starting something new (have found a benefactor who is funding me to start a bee farm in Cyprus) whereas on other is the sad realization of parting with an experience which I have really cherished.

 

And the reason I feel sad is not because I am leaving an organization, but probably because I will be leaving some fantastic people with whom to quote from Mad Men “Had Swell of a Time”. In ways known and unknown to them, they helped me grow not only as a professional but also made me grow as an individual. Office where we spend substantial amount of our lives should be a place to forge friendships and discuss things beyond work and I have been lucky to form some great friendships. It was during one of these discussions that these folks inspired me to look at greener pastures (and not only in terms of currency!!!).

 

Lastly, would like to thank my seniors, my team (who unfortunately have declined to join me :( ) and my colleagues for making this journey at YBL a fun-filled and enriching one.

 

I can be reached on xxxx@gmail.com or on my twitter handle @saurshan or you can comment on my ramblings at my blog www.constantseeker00.blogspot.com

 

Saurabh

PS- Cyprus is bankrupt; I have no benefactor and I don’t think I can ever be a farmer. Ouch Damn these Bees!!

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The reason why i mention it here is to capture the reactions which i got after the email and the learning fn our behavior, apart from making all of you aware of my fantastic sense of humor :)

Reaction 1: What the hell, who quits a job to start a bee farm ?- Obviously these folks didn't read the mail and fell for the first line. This is reminiscent of how often we behave in investing. Few good lines, few good comments often push us to take an investing decision.

Reaction 2: How did you get a benefactor? How did you sell your idea- Again a trap in which we often fall, trying to answer the wrong questions. When we look at a stock the first question we try to answer often is what is the return i will make, rather than questioning the underlying business.

Reaction 3: That is a great and funny email :). That is what investing should be for all of us, if its not fun, looks like a burden, and you can't laugh on your mistakes go buy an Index Fund.

Hope all of you enjoyed reading this and hopefully i will be more regular in my posts now.

Cheers,
saurabh