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This episode was recorded on March 22, 2017.
David Gardner: And welcome back to Rule Breaker Investing. I’m delighted that you’re joining with me this week.
Let me mention ahead of this week’s episode that we have mailbag next week and I’ll make a last minute invitation for you. If you have a question for me or a thought to share, we are taping mailbag early this week because I’m going to be away on spring break next week.
But if you hear this — if you’re a first-day listener of this podcast on a weekly basis and you want to drop us a quick note before I tape mailbag this Thursday — more than happy to accept it. If you don’t, by the way, I’ll mention we probably already have more mailbag entries than we even need, but I’ll just put it out there. If you feel moved so to do, and you want to be on this week’s mailbag, drop us a note and that’s just RBI@Fool.com by email.
So my name is David Gardner. I’m delighted to have you with me and I’m focused this week on one of my favorite magazine articles of the last decade. In fact I was looking at … you can read it online and I would almost insist that if you enjoy this week’s podcast that you read in full Malcolm Gladwell’s May 11, 2009 article entitled, “How David Beats Goliath.”
And if you feel inspired after having heard this podcast and read that article, I would encourage you to go on and purchase Malcolm’s book because, sure enough, as he’s sometimes wont to do, the extract in The New Yorker became a book (I believe it’s by the same title) and it has some great principles in it.
Now when I first read “How David Beats Goliath,” (which I think was that very month [of] May 2009), the subtitle “When Underdogs Break the Rules,” you can imagine that I loved this article. And what I love about the article I’ll be sharing this week.
But what I love about the article is it’s one of those things where you read something and intuitively you’ve been doing that thing over the course of time. Intuitively you roll that way, but a talented thinker and writer like Gladwell helps you understand and articulate what you’ve been doing in some new ways.
So what I love is that in a sense Malcolm Gladwell, in this article, has the lyrics to the music that you and I (if you’ve been a rule breaker) that you and I had been playing for a decade or more beforehand, but all of a sudden he gives you the lyrics and you get it. So my aim this week is to convey a few of the principles that I learned from this article, “How David Beats Goliath,” in order to help you be more self-conscious and assertive in understanding about the strange, magic brew of rule breaking.
And because Gladwell is at heart, I think, a business writer, I think you’re going to appreciate the business lessons and, of course, investing lessons that we can extract (just a few of them this week) from “How David Beats Goliath.”
I guess the best way to start in this week is just to do a little bit of storytelling that is done in the article, so I’ll be summarizing a few of the stories from Gladwell’s article, and then I’ll be highlighting the key points and takeaways for you and for me.
So the article begins — “How David Beats Goliath” — begins with a story of a girls basketball team, specifically one coached by a Silicon Valley entrepreneur. So if you’re thinking Silicon Valley and basketball (these two things don’t mix), well that’s probably a good place to be starting because this was a girls team. The girls were often from families that wouldn’t have played much basketball at all.
Think of Silicon Valley programmers. And the coach of the team (a talented public company CEO, himself) had never played basketball. His name is Vivek Ranadivé and he was, at the time, the CEO of TIBCO Software company that ended up being a Motley Fool Stock Advisor pick, partly in reaction to my love of what he does in this story.
So Vivek Ranadivé was puzzled by the sport of basketball. Again, as somebody who had never played it before having grown up in India, he was most familiar with the sport of soccer or futbol. And so as his experience of that sport had taught him over the years, what people were doing in American basketball made no sense to him in this regard: In soccer, when you’re playing defense, you challenge every pass all the way down the soccer pitch. That’s just how soccer works.
But when Ranadivé was contemplating coaching his daughter’s basketball team — when he watched basketball — it made no sense to him that all the way down the court for the most part, as girls or boys dribbled, the defense didn’t really challenge that at all. In fact, if a basketball court is 94 feet long (which I believe is the length of a basketball court), Ranadivé said, “Why do they only seem to defend the last 24 feet? It’s like they give up three-quarters of the basketball court without any challenge at all.”
So again, with a foreign eye … in fact his daughter, who’s quoted in Gladwell’s article, says, “It was really random … I mean, my father had never played basketball before.” With a foreign eye, he saw something different. A different way to approach the game and coach the girls. Which in fact he did, and a team that didn’t even have somebody who could hit a long-range shot ends up playing for the national championship some months later based on the way that Ranadivé was coaching the girls.
So as you’d expect, it’s a great story. I hope you’ll enjoy it. In fact I insist that you read “How David Beats Goliath.” As I mentioned earlier, it’s right there on The New Yorker site. It’s free online. So Google it. But I’m not going to cover all of this story or any story this week because it’s so well told, as usual, by Gladwell himself.
But the key takeaway for this was that the coach was teaching the girls a completely [untraditional], disruptive approach to the game of basketball because the way that things had been done, were being done, struck him as very conventional and he saw something different.
And just to lay a little bit more track, there, basically he had his girls press. Those who know basketball will understand a full-court press. If you don’t know the game of basketball, he had his girls challenge every single pass or dribble made all the way down the court, covering the whole court with defense instead of just the last quarter of it.
And, as you might imagine, if you’ve ever had somebody heckle you trying to inbound the ball in basketball; if you’re facing a frenetic defender or five frenetic defenders in the frontcourt as you just try to inbound the ball to start the next possession, it can be very disconcerting; heck, whether you’re a 12-year-old girl or a 50-year-old (what I am) guy.
So what he taught the girls was to challenge everything, and what started to happen was this: Other teams couldn’t inbound the ball effectively, or after a few dribbles would cough the ball up and his girls would take the ball away. Again, he didn’t have anybody on his team who could hit a long-range shot, but when you’d steal the ball on the inbounds, you’re already right in front of the basket that you need to score on, and so they would just flip the ball up and get two points.
And his teams would start going up 12-0, 16-0, this sort of thing. As you might imagine this was disconcerting to the opponents — not just the girls, but their parents. A lot of complaints about the way that Ranadivé was coaching his team. People saying things like, “You’re not really coaching basketball skills.” Or, “It’s not fair.” This kind of a thinking as his team goes up 25-0, and wins its own league, and then starts to compete for a national championship.
So again, from somebody who had never played basketball before, I want you to start thinking. To foreshadow a later lesson, think about never having invested before and how that might be an advantage for you and for me. We’ll talk about that later. But that’s what was happening. Fresh eyes from a foreigner changing the way to play a game and getting outstanding results. So that’s a little bit of the story of Vivek Ranadivé and his girls national-championship-aspirant basketball team playing the game in a different way. “How David Beats Goliath.”
I have three more stories I want to share with you, then we’re going to go with our takeaway points.
The next story I want to share isn’t so much a story as a fact. So Gladwell, in the article, “How David Beats Goliath,” quotes a guy named (I’m going to try to do my best with this name) Ivan Arreguín-Toft.
So this is somebody who’d put together a database looking at all military encounters of the last couple of hundred years. And what Arreguín-Toft discovers is that when a force dramatically outnumbers the enemy (and that’s measured as 10 times or more), it only won 71.5% of the time.
Now I think that would surprise most of us, because you’d think if you’re outnumbering your opponent, 10-plus to 1, you should win every time. But surprisingly, 28.5% of the time, the underdog was winning.
But, Arreguín-Toft went on to discover if you filter that data (all military encounters for the past couple of hundred years in this database), if you filter the data for when the underdogs knew that they were underdogs, acknowledged their clear weakness, and adopted an unconventional strategy, all of a sudden that win rate of 28.5% goes over 50%. In fact, it goes to 63.6% when the force that is outnumbered 10-plus to 1 wins more than half the time when they acknowledge their weakness and adopt an unconventional strategy.
Story number three. We’re going to go back to this Redwood City girls basketball team to make a separate point. And I already mentioned to you that a lot of the girls were not raised in families that understood or played much basketball. They did not have traditional basketball skills. I mentioned to you they didn’t even have a girl who could hit a 3-point shot, but by pressing (by playing that frenetic defense), the key lesson and takeaway, here, is it hid their weaknesses.
It’s a little bit connected to the previous point I just made, which is when an underdog understands that it is an underdog and makes a specific effort to hide its weaknesses (to make its weaknesses not count), great things can happen. So that’s exactly what happened for the Redwood City Basketball team and, as I am shortly going to try to convey to you, I think you’re going to benefit from that in business and in investing, as well. So that’s story number three.
And finally story number four from the article. Gladwell documents the 1981 Traveller Trillion Credit Squadron tournament. This is a military war game. The trillion credits — if you imagine you’re given a fantasy trillion dollars — and over the course of a weekend of computer simulations (you competing against others), you’re using your imaginary trillion to purchase a fleet of ships that you’re going to send to battle against my fleet, or her fleet, over the course of a weekend — that’s the “Trillion Credit Squadron” part of this tournament.
And a guy named Doug Lenat develops his own artificial intelligence program in advance of the 1981 competition. It’s called Eurisko — E-U-R-I-S-K-O. And as Gladwell tells it, what Lenat’s program taught him about how to play the upcoming tournament … he was an outsider. He was not, himself, in the Navy or the military. He was a gamer. Probably a software programmer. He was somebody developing AI. To think about how to play this game had him adopting an unconventional strategy.
So what Lenat decided through Eurisko, his AI, was that the most efficient way to build a naval fleet was not to have what everybody else was doing that weekend in the tournament, which is to have a balanced fleet. Everybody else probably spending on that trillion some billions on big ships. Some millions on small ships as they each have to spend their same fantasy trillion.
But what Doug Lenat does is he ends up purchasing basically all PT boats — small, highly offensive ships that will go down on a single hit. He spends all of his trillion credits, just about, on just PT boats and has this massive fleet of tiny, little ships that looked silly as he began the competition that weekend.
People who said, “I’m from the military. What are you doing?” And by the third or fourth match, as he sinks his opponent again, people stopped laughing and started looking. And as it turns out, Doug Lenat won the 1981 Traveller Trillion Credit Squadron tournament with his Eurisko-based strategy of little ships.
The reason it worked is because they packed an oversized offensive punch and if they went down, it wasn’t that big a loss to lose one of your PT boats from your massive fleet. And so with very little defense and an amazing offense, Doug Lenat won the tournament. And in fact the next year they changed the rules on Lenat a little bit. By the way, Lenat of Stanford University. If we have any Cardinal grads or fans, this was a Stanford-engineered strategy.
But they changed the rules on Lenat so that his previous strategy where all of those PT boats, by the way, were just kind of sitting there — they didn’t even move. They just sat there and shot. All of a sudden the new rules for the tourney in 1982 required that you have some what was called “fleet agility.” So going back to work with his AI program, what Eurisko did, Lenat is quoted as saying, “was say that if any of our ships got damaged, it would sink itself — and that would raise fleet agility back up again” — in an acceptable way to the simulation game. And sure enough, Lenat won in 1982 again.
To double underline that again, an unconventional strategy adopted by an outsider that wins in a shocking way. Doing, in fact, what David had done to Goliath centuries before. So the heart of what’s happening, here, are unconventional strategies being practiced by outsiders. But I want to triple underline three takeaway points this week.
So what can we investors learn as we think about the takeaway points from “How David Beats Goliath?” I have three of them for you this week.
The first one is the key point made earlier that Ranadivé had never played basketball before. And I want you to think about never having invested in the stock market before. That’s true of many, many people. And just like you’d think you shouldn’t be coaching a team when you’ve never played the game, yourself; you’d also tend to think conventionally you shouldn’t be investing (managing a portfolio, a team of stocks) if you’ve never invested before. But surely, all of us who do pick stocks — all of us who are investors — started from a point where we had never done it before, and fresh eyes are a great asset.
I know I’ve quoted to you before (in fact it’s one of those quotes that wasn’t actually said by the person who said it). It’s Marcel Proust’s great unquote. It’s still a great line, even if he didn’t exactly write it (not even in the French): “The only real voyage of discovery consists not in seeking new landscapes, but in having new eyes.” Fresh eyes.
In fact, Gladwell writes: “Not knowing the conventions of the game turned out to be an advantage.” And I think that is so true of us as stock market investors. I think a lot of us are either intimidated (because we don’t feel like we have the learning) — the school book learnin’ — to start investing, or we figure, “I’m just lil old me, and I guess I’m competing against mutual funds, and big institutions, and people on CNBC who are talking about the markets all the time, so how could I do so well in that kind of arena?”
And the answer is you can do wonderfully well. In fact, if you’re somebody without formal training in finance, then join the party, because your Foolish host, every week, is somebody who himself was “just an English major.” Somebody who loved the humanities. Somebody who admittedly had a dad who did get him started investing early and taught a lot of the stock market to me.
But somebody, in my case, where I never even took a business class. Never took a finance class all the way through all of my learning because I stopped after my four undergraduate years at the University of North Carolina at Chapel Hill. So every week you’re hearing from somebody who came from outside of the industry. We’re not Wall Street. We’re Main Street at The Motley Fool. Most people — I bet you, too — are Main Street and as it turns out, that can be a great advantage.
You know, I think a lot of people who have been more formally trained in the markets and finance tend to think things that I highly disagree with. They tend to think things like it would just be lucky to beat the stock market averages. Or index funds are the only way to go. Or valuation is the real key to figuring out how to beat the stock market.
In fact, I want to take that last assumption. A lot of effort is put toward valuing things when you get a finance degree, and yet I feel like that is one of the last advantageous skills for actually beating the stock market averages. A lot of people, of course, don’t think you can beat the stock market averages, and in part they think that the markets are so efficient, so numerical, so already factoring in all known information that how could one reasonably expect to beat the market averages given those circumstances.
But in my experience, the stock market has already valued our stocks every day. At whatever price your stock is trading right now, buyers and sellers just shook hands on that price. I don’t think you’re going to get a big edge as an investor. I don’t think you’re going to beat the market long term because of your ability to value things.
At least in my experience (and there is more than one school of experience here and more than one viewpoint), but at least in my experience you’re going to do best by thinking about where the world’s headed (where the hockey puck is going proverbially) and getting there in advance. And I think that is not something that requires a formal financial degree. You don’t have to have played basketball to create a national championship contender. And that’s takeaway number one.
Takeaway number two. When underdogs choose not to play by Goliath’s rules, they win the majority of the time. You heard me earlier quote Arreguín-Toft’s numbers and it’s such an important strategy, then, to play to your strengths while hiding your weaknesses. I highlighted that earlier.
But for me — and actually Gladwell does a better job than I can articulating this — the reason Goliath wins most of the time is because Goliath is Goliath. The Goliaths of our culture and our world have effectively shaped the world so that we all conform to the mores, the standards by which Goliath will dominate.
And so it’s when, again, when underdogs choose not to play by Goliath’s rules. In David’s case, he used a slingshot and as Gladwell’s article points out, it wasn’t just that he used a slingshot. It’s actually that he charges forward and surprises Goliath. You wouldn’t expect this little guy with a slingshot to actually charge forward away from his ranks and take the shot that he did, and that’s part of the reason it worked.
So as investors, what are some of your weaknesses? Well, I’ll share with you one of mine, and I kind of alluded to it in my previous point. I don’t have a lot of great ability to factor in or value stocks directly. I haven’t spent a lot of time. I certainly have calculated my P/E ratios over the course of time. Looked at my price-to-sales multiples and various other ways of valuing stocks, but I’m not an expert in it.
And in fact, I think I benefit, in part, because of that. Because so many people assume you have to have a target price on a stock. Because so many people assume that you can value a stock down to the tenth or the hundredth of a decimal place, and if that’s one of my weaknesses, I hide it in these two ways.
The first thing that I do is I specifically love to find companies that aren’t that easy to value. So when you’re finding companies that don’t have profits, it’s hard to construct a price-to-earnings ratio. When you’re finding companies that are in hypergrowth mode, there are no standard models by which we can easily value those companies. In the past many times on this podcast, I’ve said (and I know I’ll say it in the future), that I invest — you should invest, I think if you’re a rule breaker — like a venture capitalist.
And venture capitalists don’t have a lot of history to go on when they decide to invest or not in somebody’s latest start-up. They’re using a lot of other factors to assess whether or not to invest in that start-up. Things like the total addressable market. Things like looking the person in the eye and asking, “Is this somebody who’s visionary enough to get me that total addressable market?” So again, we can hide our weaknesses. For me, I’m not really great or that interested in valuing stocks in the traditional manner. But what I do is I find companies that aren’t that easy to value in the first place.
And the second aspect of that is that I think a lot about the future. Now I think a lot of people who value stocks tend to look backwards. They’re using the most recent quarter’s numbers. Looking back over five years. But I think you and I can play to our strengths if we can start to see the future, and I think at our best, this is what we’re doing when we’re picking stocks like Netflix before Wall Street has found it. And so the key takeaway point number two, then again, is know your strengths, play to your strengths, and in so doing, hide your weaknesses.
And then my third and final point (and again, Gladwell does this so much more eloquently and more concisely than I can do in this podcast, and that’s why I so hope you will enjoy his article, “How David Beats Goliath”). There is what he calls — he captures it with the phrase “socially horrifying.” Socially horrifying. There are socially horrifying aspects to taking unconventional strategies and making them your own.
In the case of naval war games, it was the PT boats that Doug Lenat, the Stanford computer scientist, dreamed up to purchase. Those PT boats were going down. If you were aboard one of those PT boats, you were defenseless, and it wasn’t a presumption that you mattered that much, and that is certainly socially horrifying to humanity.
But for me as an investor, what’s a good analogy for us as rule breakers? What’s socially horrifying? And I think it all centers on losing. I think as investors we hate to lose. Psychologists remind us that the pain of loss is three times the joy of gain. And I think a lot of us as investors — a lot of people worldwide — are trying not to lose all of the time or too much of the time.
But for me as an investor — and I’ve talked about this with you a lot over the last couple of years on this podcast — I have lost many times, and sometimes lost big. It’s the equivalent of shooting (in a basketball frame of mind this month) air balls 10 times in a row, maybe, at the line. And if you were watching a talented college or a pro basketball player literally airball a free throw more than a few times in a row, you’d be asking, “Is that person any good at all, and what am I doing paying for a ticket to watch this?”
But the reality is that does happen to me as an investor. Through some really tough markets, you might well feel like nothing you’re doing is really working, and actually in some tough markets, nothing you’re doing is, at that point, working very much. And so that to me is the closest thing to socially horrifying, in Gladwell’s phrase, that I can think about us as investors.
Gladwell writes in the article, “The price that the outsider pays for being so heedless of custom is, of course, the disapproval of the insider.” And I even want to modify that a little bit, just to say that the price that the outsider (I would say, here, the Fool) — the price that the Fool pays for being so heedless of custom (that Fooldom in the most court-jestery unconventional sense) — is, of course, the disapproval of the insider.
I think about how Wall Street reacted to The Motley Fool when we first showed up in the 1990s and I very much can get back in touch with that sense of being disapproved of by the insiders. And even you or I today, if we are self-directed investors, we’re doing something that most people think is a little bit crazy.
And so the key takeaway number three, here — the strategy that you and I should adopt — is just to not be too concerned with other’s opinions. In fact, contrarily, sometimes the surprise or outrage that you might be provoking when you buy Facebook right after it has had a “failed IPO” (a couple of months later cut in half from where it had IPO’d), contrarily that might warm you up even more to the idea that that is a good investment.
So not only should you and I not be too concerned with others’ opinions of our approach to investing, or business, or life; but realize sometimes that those might be some of the best indicators that you’re on to the right type of thinking or doing. And that is very much a rule breaker point to close on.
So I want to thank Malcolm Gladwell, again, for an article. It was one of those articles where (and maybe you’ve had this experience before) you read it and you’re like, “I’ve always been doing this, but now I can articulate better why I’ve been doing what I’ve been doing, or why it’s worked.” And Gladwell has that, both in his article and the book spawned from.
And just to summarize those three takeaway points again:
1. The benefit of fresh eyes. Not knowing the conventions of the game can turn out to be your advantage.
2. When underdogs choose not to play by Goliath’s rules, they win the majority of the time. So play to your strengths and hide your weaknesses.
3. And finally number three. There can be a socially horrifying aspect to being so unconventional. And not only should you not be too afraid of that (assuming you’re not doing something really, really wrong, which I certainly hope you won’t be) you won’t be if you’re investing Foolishly. I can say that. But not only should you not be too concerned with what others think, you might even use that as inspiration to realize that you’re on the right path. So a very contrary note to close on.
And speaking of being contrary, I just want to spend about one minute mentioning Fool School to you. Would you like to be taught by Fools? Well, more specifically, is there a K-12’er in your life that you think could benefit from this?
This is a program we have at The Motley Fool, Fool School. If you oversee a class or a scout troop in the greater Washington, DC area (or maybe you’re coming to our nation’s capital this spring) and you want to give your K-12 students a special hour; Fool School, The Motley Fool’s answer to providing free education for K-12’ers about money, is right here in Alexandria, Virginia, and the best news of all is it is free.
So if you’re a teacher, a leader, or a mentor of kids who believes they’ll benefit from some Foolish talk about money at a formative age, you can book with us this spring by emailing us at FoolSchool@Fool.com. That’s FoolSchool@Fool.com. You can follow us on Twitter, as well at @TMFFoolSchool. So maybe I’ll say, in thematically closing, help your kids beat Goliath.
All right, next week it’s going to be our monthly Mailbag. And yes, you have about 24 hours if you’re hearing this on Wednesday to get us your question or thought. RBI@Fool.com or just tweet at us @RBIPodcast on Twitter.
You can check out past episodes of Rule Breaker Investing and all The Motley Fool’s podcasts at our podcast center. Just go to Podcasts.Fool.com. I should mention, by the way. Rule Breakers is a service that highlights disruptive growth stocks like Tesla, Under Armour, and MercadoLibre, and a new issue of our Rule Breakers service comes out with two new, we hope, Goliath-defeating stock recommendations from me the last Wednesday of every month, including this one. So if you’re interested, head to RuleBreakers.com to learn more.
Thanks a lot. Talk to you soon. Fool on!
As always, people on this program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don’t buy or sell stocks based solely on what you hear. Learn more about Rule Breaker Investing at RBI.Fool.com.