At the recommendation of a good friend, I picked up a copy of John Carreyrou’s book, "Bad Blood: Secrets and Lies in a Silicon Valley Startup." Once I started reading it, I just couldn’t put it down and finished reading the book in one go. It’s a fascinating account of the Theranos and Elizabeth Holmes story, filled with ambition, passion, vision, envy, jealousy, anger, power, lie, threats, self-denial and delusion.
I’ll leave out the details of the story as well as the most commonly cited lessons you can find from the voluminous amazon reviews. My focus today will be the thing that bothers me the most – how is it possible that Elizabeth Holmes fooled so many intelligent and powerful people? First, let’s take a look at the names of a few big shots behind Theranos’ supporters:
- Channing Robertson – associate dean of Stanford’s School of Engineering
- Donald Lucas – the venture capitalist who backed Larry Ellison.
- Larry Ellsion – founder of Oracle
- Bill Perry – former Secretary of Defense
- Henry Kissinger – former Secretary of State
- George Shultz – former Secretary of State
- James Mattis – former Secretary of Defense
- Rupert Murdoch – Media mogul.
Any established company would be honored to have any of these people on the board. It’s a miracle that Theranos, a start-up company, without any proven technology, got the support from so many big shots names.
I spent hours pondering why Elizabeth Holmes was so successful at conning so many successful political, academic and business celebrities. But as with most hard questions, there’s no easy and definitive answer. In this regard, I found some inspiration from a story recounted by Charlie Munger (Trades, Portfolio) during the 1990 Wesco meeting. Here is what Munger said:
“Ben Graham was first, second or third in every department at Columbia – whether it was physics, mathematics, music, or the classics. He spoke fluent Greek and Latin. He could write poetry in Latin. He was a kind of a polymath and a genius. Later in life, he came to one of the meetings that people who had learned from him and studied under him had held for some years. And he had a little test that he invented himself. And the average I.Q. of those at the meeting was certainly above 150.
"Graham gave this little true-false test. And all but one of these people – including the one speaking and Warren Buffett (Trades, Portfolio) – got less than half of the questions right, again, on a true-false test.
"What happened? The answer was that Graham was a very brilliant man. He had deliberately set out to trick us. And he was very good at it. The person who got the highest score actually knew the answers to three of the questions – and all the others he just guessed. And using that technique, he got a little better than half of them right."
Munger then spoke about what he thought Ben Graham was trying to teach them:
"Graham never explained what he was trying to teach us. But I think what he was trying to teach us is that it’s very hard to demonstrate good judgment and to get correct conclusions when somebody very intelligent is trying to mislead you. If you create a system with huge incentives in sales and put a lot of high I.Q. people into it and say you can’t eat unless you sell savings and loans a lot of complex strategies, then you are going to get a fair amount of bull from some very talented people. Maybe the average savings and loan executive is up to handling it, but all I can say is that Warren Buffett (Trades, Portfolio) and I weren’t when Ben Graham did it to us.
"Luckily, Ben Graham was quite exceptional, so we don’t meet many like that. Also, because we’re quite aware of our inadequacies – which are ample – we try and operate with what Warren calls ‘our circle of competency.’ And he and I regard that as a pretty small circle.
"A friend of mine when I was very young said, ‘Munger wouldn’t know the world was round if it didn’t help him in his business.’ We try and figure out what we know and what we don’t know. And we tend to stay within our circle."
What Munger said can be boiled down into two points:
- It’s very hard to demonstrate good judgment and to get correct conclusions when somebody very intelligent is trying to mislead you.
- You can more likely be misled if it’s outside your circle of competency.
Now I can see why Holmes was successful in deceiving the big shots. First of all, she was very intelligent herself, and she was deliberately trying to mislead the big shots. And secondly, the bit shots were operating outside of their circle of competency, with the exception of Channing Robertson perhaps. Of course there are other big, powerful, human psychological biases in play, such as commitment and consistency and deprival super-reaction. But by and large, I think Munger’s two points summarized it well.
This also made me appreciate more why meeting with management teams can be so dangerous, especially when meeting with the C-suites. When you don’t know the edge of your circle of competency and when the C-suites are trying to mislead you, chances are you’ll be just like the big shots who were fooled by Holmes and Sunny Balwani.
In the end, we have to circle back to the most important concepts in investing again – circle of competency. To quote Charlie Munger (Trades, Portfolio) again: “We’re quite aware of our inadequacies – which are ample – we try and operate with what Warren calls ‘our circle of competency.’ And he and I regard that as a pretty small circle. We try and figure out what we know and what we don’t know. And we tend to stay within our circle."