Continued on from part one.
In nature and in business, specialization is key.
Just as in an ecosystem, people who narrowly specialize can get terribly good at occupying some little niche. Just as animals flourish in niches, similarly, people who specialize in the business world – and get very good because they specialize – frequently find good economics that they wouldn't get any other way.
Advantages of scale are ungodly important.
And once we get into microeconomics, we get into the concept of advantages of scale. Now we're getting closer to investment analysis – because in terms of which businesses succeed and which businesses fail, advantages of scale are ungodly important.
For example, one great advantage of scale taught in all of the business schools of the world is cost reductions along the so-called experience curve. Just doing something complicated in more and more volume enables human beings, who are trying to improve and are motivated by the incentives of capitalism, to do it more and more efficiently.
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The very nature of things is that if you get a whole lot of volume through your joint, you get better at processing that volume. That's an enormous advantage. And it has a lot to do with which businesses succeed and fail.
There are also benefits to informational advantages of scale.
And your advantage of scale can be an informational advantage. If I go to some remote place, I may see Wrigley chewing gum alongside Glotz's chewing gum. Well, I know that Wrigley is a satisfactory product whereas I don't know anything about Glotz's. So if one is 40 cents and the other is 30 cents, am I going to take something I don't know and put it in my mouth – which is a pretty personal place, after all – for a lousy dime?
So, in effect, Wrigley, simply by being so well known, has advantages of scale – what you might call an informational advantage.
Which can translate into psychological advantages of scale.
Another advantage of scale comes from psychology. The psychologists use the term "social proof." We are all influenced – subconsciously and to some extent consciously – by what we see others do and approve. Therefore, if everybody's buying something, we think it's better. We don't like to be the one guy who's out of step.
The social proof phenomenon which comes right out of psychology gives huge advantages to scale – for example, with very wide distribution, which of course is hard to get. One advantage of Coca-Cola (NYSE:KO) is that it's available almost everywhere in the world.
But bigger isn’t always better, which is why it’s important to specialize.
For example, we – by which I mean Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) – are the largest shareholder in Capital Cities/ABC. And we had trade publications there that got murdered – where our competitors beat us. And the way they beat us was by going to a narrower specialization.
We'd have a travel magazine for business travel. So somebody would create one which was addressed solely at corporate travel departments. Like an ecosystem, you're getting a narrower and narrower specialization.
Well, they got much more efficient. They could tell more to the guys who ran corporate travel departments. Plus, they didn't have to waste the ink and paper mailing out stuff that corporate travel departments weren't interested in reading. It was a more efficient system. And they beat our brains out as we relied on our broader magazine.
Technology can help you, but you also need to be sure it won’t kill you.
The great lesson in microeconomics is to discriminate between when technology is going to help you and when it's going to kill you. And most people do not get this straight in their heads. But a fellow like Buffett does.
For example, when we were in the textile business, which is a terrible commodity business, we were making low-end textiles – which are a real commodity product. And one day, the people came to Warren and said, "They've invented a new loom that we think will do twice as much work as our old ones."
And Warren said, "Gee, I hope this doesn't work – because if it does, I'm going to close the mill." And he meant it; he knew that the huge productivity increases that would come from a better machine introduced into the production of a commodity product would all go to the benefit of the buyers of the textiles. Nothing was going to stick to our ribs as owners.
Is the stock market so efficient that people can't beat it? Well, the efficient market theory is obviously roughly right – meaning that markets are quite efficient and it's quite hard for anybody to beat the market by significant margins as a stock picker by just being intelligent and working in a disciplined way.
Indeed, the average result has to be the average result. By definition, everybody can't beat the market. As I always say, the iron rule of life is that only 20% of the people can be in the top fifth. That's just the way it is. So the answer is that it's partly efficient and partly inefficient.
Winners bet big when they have the odds – otherwise, never.
It's not given to human beings to have such talent that they can just know everything about everything all the time. But it is given to human beings who work hard at it – who look and sift the world for a mispriced bet – that they can occasionally find one.
And the wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, they don't. It's just that simple.
Only a handful of the best ideas are needed to generate stellar returns.
How many insights do you need? Well, I'd argue that you don't need many in a lifetime. If you look at Berkshire Hathaway and all of its accumulated billions, the top 10 insights account for most of it. And that's with a very brilliant man – Warren's a lot more able than I am and very disciplined – devoting his lifetime to it. I don't mean to say that he's only had 10 insights. I'm just saying that most of the money came from 10 insights.
So you can get very remarkable investment results if you think more like a winning parimutuel player. Just think of it as a heavy odds against game full of bullshit and craziness with an occasional mispriced something or other. And you're probably not going to be smart enough to find thousands in a lifetime. And when you get a few, you really load up. It's just that simple.
Disclosure: The author owns no stock mentioned.
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