Bad Blood: Secrets and Lies in a Silicon Valley Startup – Book review

Last week I made a quick stop at the library after picking up my kid from school to pick up a few books and while I was there, I checked out the personal finance/business section to see what books they had around that seemed interesting. I stumbled upon “Bad Blood: Secrets and Lies in a Silicon Valley Startup” and thought “Aha! this might be a quick interesting read”.

For those of you that may not know, this is a book about Theranos, a health technology company founded in 2003 by Stanford-dropout Elizabeth Holmes, that made tall claims about being able to perform several blood tests using a small amount of blood (from a finger prick) in an automated fashion using machines developed in-house. The claims also stated that the machines would be small enough such that the consumers could have these setup at their homes, and have their lab tests done and ready within a few hours instead of relying on a doctor and/or third-party labs and wait for days to have their test results. As one could imagine, this was such a big deal because it would revolutionize lab testing and the associated industries.

There was one tiny problem though: Theranos’s technology simply did not work and their claims were based on a mountain of lies. This is probably the largest scandal after the infamous Enron scandal that saw the downfall of one of the largest companies in the US. At the time of writing this, Elizabeth Holmes is being charged with wire fraud and the jury is deliberating on this case.

For what it is worth, I had already seen some documentaries on this topic and therefore knew a lot of the story beforehand. That said, I wanted to read the book by John Carreyrou, as he was the journalist that broke out the story on Wall street journal that marked the beginning of the end for Theranos. I have now finished this book and it did not disappoint one bit.

I chose to write about it here. Why? Not because I wanted to restate the same story over here. But rather I wanted to talk about interesting learnings from this book, as several investors were duped investing their capital in this business. While this is not one of those classical books on investing, there are important takeaways that are worth pondering over.

And they were all fooled…

So on the face of it, Theranos’s claims had a lot of appeal. Even a lay person, who does not necessarily have a background in lab-testing technology, could see the potential of how such a business could be profitable, if they had a solution that actually worked. What else did Theranos have going for it? It had a star-studded panel board of directors, ranging from former US Secretary of States (Henry Kissinger, George Schultz), to top defense lawyers (David Boies), to a retired 4-star marine (Jim Mattis). On top of that, it had political connections (association with Clintons) and backing from other high-profile investors (Rupert Murdoch, Larry Ellison etc.).

Furthermore, Theranos struck deals with Walgreens and Safeway allowing them to open up “wellness centers” within these stores and have patients sign up for a variety of lab tests at cheaper rates.

To top this off, Elizabeth Holmes was being covered heavily on the media, her face was everywhere, and this whole narrative of the “next Steve Jobs” was being drummed up.

Surely, the board of directors and these high-profile investors were not dumb enough that they could not have seen through the lies. Did they not do their due diligence? Or was it a case of the bandwagon effect or herd mentality i.e. Everyone is buying this stock, therefore it must be a good business. To me it seems more like the latter. None of these investors were savvy in the field of medical sciences, and they had not seen the technology demonstrated or understood it well enough. They simply believed that since some other big names had invested their capital, this business must have some merit.

What about Walgreens (ticker: WBA), a name that is quite popular in the dividend investing community? They have been around in the retail pharmacy business for such a long time. Surely, they would have seen through Theranos’s BS. This is their area of expertise after all, right? Well they didn’t. A lot of this probably points to a highly inept management at the helm when this deal was struck. But then there is also the possibility of being blind-sided by the question: “What if we do not invest in this opportunity and CVS did and this took off?”.

Takeaways

Here in lies my three biggest take-aways from this book:

  • High-profile investors also make mistakes: To think otherwise would defy logic. This is where investing in a business simply because popular investors like Warren Buffett have invested in it, would be dangerous. There are several reasons for this.
    • The average retail investor does NOT have the same information available to him/her as Warren Buffett does, to tell if this investment choice makes sense to their specific situation and portfolio.
    • The amount of downside may be different. If this investment turns out to be a loss, this might mean different things to you or me as it would do to Warren Buffett.
    • Warren Buffett could be wrong. Yes, the Oracle of Omaha, like all of us, had also made investing mistakes.
  • FOMO is not restricted to the average retail investor: It is equally applicable to big corporations and other high-profile investors as well. IMO, this well and truly affected Walgreens in particular.
  • Do not overlook the quality of the management running the company: Far too often, we investors are so hyper focused on the quantitative aspects of the business and use that to value it. Yes, this is important, but this is not all there is to valuing a business. It is also important to know that companies can do all kinds of “engineering” in their financial statements to portray a rosy picture. IMHO, the qualitative aspects are just as equally important in valuing/understanding a business. One of the qualitative aspects is the management that is leading the company. Neither one of Elizabeth Holmes or Sunny Balwani, the former president and COO of Theranos, had a background in medical science or lab testing technology. To top it off, they simply could not tolerate being challenged or questioned on the merits of their technology. This made the working environment at Theranos very caustic and unhealthy. As a result, Theranos saw a very high attrition rate with people being fired left and right if they would even raise a question about the technology or bring-up any concern whatsoever. These were massive red flags and unfortunately they were simply ignored by the board of directors and the other investors.

Summary

Overall, I really enjoyed reading the book. I think John did a pretty good job of not missing any important details of the entire story. The writing was engaging and very gripping and I kept coming back to read some more. I would like to share one of the stories from the book that I found particularly hilarious. As I had stated earlier, the working environment at Theranos was far from ideal with strict surveillance, people being fired randomly. In one such incident, an employee had had enough and decided to quit, emailed his resignation, served his notice period, picked up his belongings and was about to leave when he was confronted by Elizabeth and Sunny who stated that he could not leave without signing a non-disclosure agreement. The employee refused stating he had already signed a confidentiality agreement when he was hired, had already served his notice period and was free to leave. As he pulled his car out of the parking lot, Sunny sends over a security guard to stop him, the employee ignores the guard and drives off. Sunny then calls the cops and when an officer finally arrives, Sunny complains about how the employee had quit and departed with company property. When the officer asked what was taken, Sunny responds “He stole property in his mind.” This just goes to show the kind of paranoia that was present in the working environment at Theranos.

The Theranos story is far from over and we will learn more about this as time passes by. It is also worth nothing that such incidents are not isolated. I can see a lot of parallels with the story for another company called Nikola, whose founder is also in the dock for similar securities fraud.

I will end this post by wishing my readers a Merry Christmas and a Very Happy New Year. Here is hoping that y’all have a very happy and prosperous year ahead and make great strides in your personal finance journey.

Until next time…

The Dhandho Investor – Book Review

I have decided to launch a new category on this blog where I will discuss my insights gained from reading investing books written by famous investors. It is widely acknowledged in the investing community that the knowledge gained from reading such gems will be lot more fruitful for the average investor. So it seems like a good idea to (re)read them and also discuss the learnings within the community.

For my first book in this series, I decided to pick a book written by an investor whose name has come up so many times in the recent past in my readings on value investing: Mohnish Pabrai.

Who is Mohnish Pabrai?

Mohnish has an interesting history. Born in Mumbai, India, Mohnish first came to the US to pursue a degree in Computer Engineering at the Clemson university. After graduating, he worked at Tellabs as an engineer first and then in the marketing division. In 1991, he quit Tellabs to start his own IT consulting firm called TransTech. He did so by cashing out his 401(k) retirement account, which yielded about $30,000, along with a credit card debt of $70,000, giving him the capital to start his company. He eventually sold his company for about $20 million in 2000. Mohnish founded the Pabrai Investment Funds in 1999 and continues to run that to this day. Interestingly, he was motivated to get into investing after reading another classic investment book (and something I hope to cover in the near future) called “One Up on Wall Street” by Peter Lynch.

Pabrai Investment Funds started out with a sum of $1 million, which as of 2020 has mushroomed into almost $469 million. Compared to the NASDAQ-100 index (ticker: QQQ) which offers a CAGR of about 8% in the same time frame, Pabrai Investment Funds offers a CAGR of around 12%.

Mohnish proudly states that he is a student of the Charlie Munger/Warren Buffett school of investing. In fact, he even goes on to state that the Pabrai Investment Funds was setup by copying ideas that he learned by studying The Buffett Partnerships. This includes ideas such as fee structure, portfolio management and other operations.

Dhandho?

So what does the word “Dhandho” mean? Dhandho is a word from a regional Indian language called Gujarati (from the Indian state of Gujarat). It literally means “business”. People from Gujarat in India are especially known to have an acumen for entrepreneurship. It comes as no surprise that one of the richest men in the world, Mukesh Ambani, who inherited his wealth from his father Dhirubhai Ambani, hails from this same state in India.

Mohnish begins his book by a discussion of a community from this state called “Patels” and how they have staked ownership for a sizeable percentage of motels in the USA. The book goes on to present several such case studies discussing more well-known names such as Richard Branson and how he launched Virgin Atlantic, Lakshmi Mittal and how he became a steel baron, and finally himself and how he launched Pabrai Funds.

All of the case studies are based on the one fundamental principle of a low-risk high-return bet i.e. a coin toss that is based on the following premise: “Heads: I win, Tails: I don’t lose much!“.

The Dhandho Framework

So Mohnish distills all his learnings from the case studies presented into the following core principles:

  1. Invest in existing businesses.
  2. Invest in simple businesses.
  3. Invest in distressed businesses in distressed industries.
  4. Invest in businesses with durable moats.
  5. Few bets, big bets and infrequent bets.
  6. Fixate on arbitrage.
  7. Margin of safety – always.
  8. Invest in low-risk, high-uncertainty businesses.
  9. Invest in copycats rather than innovators.

The first two are pretty simple and straightforward to understand. Mohnish suggests to invest your money in publicly traded companies i.e. the stock market, and to treat that as owning a piece of that business. This is far more convenient and easier to manage than starting a new business venture, has a better chance of generating a return than the other investment vehicles available. In a similar vein, businesses that are simpler to understand are easier to reason about. And why is this important? It is easier to estimate the intrinsic value of a business if it is simple to understand, because you want to know if the price you are paying for a share of a business is worth its value. Mohnish suggests using the Discounted Cash Flow (DCF) analysis to estimate the intrinsic value of a business.

The suggestion to invest in distressed businesses relies on the understanding that the markets aren’t efficient always. There are always some businesses whose current stock price have deviated from the actual health of the business itself. The suggestion here is to look past the negative headlines and to dive into the fundamentals of such businesses, while ensuring still that the business is simple to understand and within one’s circle of competence.

The suggestion to invest in businesses with durable moats is also self-explanatory. Businesses that have a competitive advantage in their domain will last for a longer time. And for the compounding of wealth to work its magic, you need business that will last decades and not a few years.

The next five suggestions in the framework are when things start to get interesting. Each of these deserve further elaboration.

Kelly’s Formula

Here Mohnish introduces us to this rather simple formula to determine how much money should you be investing in a particular business depending on the probability of winning, probability of losing and the payoff if you win.

The formula can be simply put as follows:

(P* W – L)/P = percentage of your money you should be betting

where P = payoff if you win.

W = Probability of Winning

L = Probability of Losing

So to illustrate this with a simple example: Let us consider a simple coin toss, where on Heads you win $1, on Tails you lose $1. The probability of winning and losing here is 0.5. Therefore, applying Kelly’s formula, you get (0.5 * $1 – 0.5) / 1 i.e. percentage of your money you should be betting on such a bet is 0. And that is not surprising since there is a equal probability of you winning or losing this bet. However, if you were to take the same coin toss example with a mispriced bet, where on Heads you win $2, on Tails you lose $1. In this example, Kelly’s formula suggest that you invest (0.5 * $2 – 0.5)/ 2 i.e. you should be betting 25% of your money on this bet.

Obviously, it is not as simple to estimate probabilities, but the general idea with this formula is that it will steer investors away from business bets that have a low payoff and high-risk (or high probability of losing). And with reasonable estimates, it should allow investors to determine how much percentage of their portfolio should be invested in what businesses.

The crux of this principle is: Bet big when the odds of winning are overwhelmingly in your favor.

Arbitrage opportunities

This is the Dhandho principle on steroids, where the outcome of a coin toss could lead to the following results: “Heads: I win; Tails: I break even or even win!“i.e. the investor gets decent returns at virtually no risk. Mohnish provides several examples to illustrate this point. One such example is comparing GEICO’s insurance business to that of AllState or StateFarm. Given GEICO’s business model of directly underwriting insurance policies out of call-centers of through geico.com, they have a 15% cost advantage over StateFarm and AllState, who operate through brick and mortar stores independently owned by a commissioned agent. Mohnish states that while this arbitrage spread will eventually disappear, if the savvy investor can find such an opportunity and determine that the spread will last for a while, the investor can make decent returns with very limited risk.

Margin of Safety

This is perhaps one of the core founding principles of any investor, but especially true for a value investor.

One of the best books on investing titled “The Intelligent Investor” was written several years back by the godfather of value investing, Benjamin Graham. This book has a chapter dedicated to this subject of “Margin of Safety”. Graham states the following at the start of the chapter:

Confronted with a like challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY.

At the heart of it, the principle is simply the following: When buying a business, ensure that the price you are paying is way less that what you think it is worth. Thus, when attempting to estimate the intrinsic value of a business, after you have arrived at a figure, you pad that with some extra percentage for uncertainty in your calculations, similar to how a structural engineer would add a “margin of safety” to his/her specifications for a building/design project.

Investing in low-risk and high-uncertainty businesses

Mohnish draws a distinction between businesses where the range of possible outcomes of investing are very large versus the odds of permanent loss of capital. He states that Wall Street confuses the aspects of uncertainty and risk and this confusion can result in an opportunity for the watchful investor. Mohnish argues that Wall Street prefers the low-risk low-uncertainty businesses and these, therefore, typically trade at very high multiples. He gives examples of ADP (ticker: ADP), Paychex (ticker: PAYX), Procter and Gamble (ticker: PG), Costco (ticker: COST) as low-uncertainty businesses and suggests to avoid such businesses since they rarely trade at a discount.

I can see where Mohnish is coming from in this context when viewing these as value investing opportunities. However, as a dividend growth investor, my perspective is slightly different here. PG and ADP are fantastic companies from a dividend growth investor perspective, they are dividend aristocrats. They have been around for decades, have a stable cash flow and, in my opinion, should find their place as a core/foundation stock in a dividend growth investor’s portfolio.

Investing in copycats rather than innovators

Mohnish states the following:

Innovation is a crapshoot, but investing in businesses that are simply good copycats and adopting innovations created elsewhere rules the world.

Mohnish provides several examples to emphasize his point. One such example was regarding Microsoft (ticker: MSFT). Mohnish argues that the origins of the MS-DOS operating system can be traced back to the QDOS (Quick and Dirty Operating System) developed by Seattle Computer. MSFT went out and bought the rights for this and scaled it.

In relation to MSFT, Mohnish also contends the following:

  • the original idea for mouse and GUI for the PCs were inspired from Apple’s (ticker: AAPL) Macintosh computers.
  • Excel’s features were lifted from Lotus 1-2-3 and VisiCalc. Word inspired from WordPerfect.
  • Xbox was inspired from Nintendo and Sony’s PlayStatation.
  • …and so on

While I can see where Mohnish is going with this, I have to disagree with this principle slightly. I certainly do not see innovation as a crapshoot and a copycat as a homerun in all cases. Take MSFT’s Bing search engine versus Google’s search engine. Google dominates the search space in comparison to Bing. MSFT’s Internet explorer browser, which has been around for a lot more longer, is a joke in comparison to Google’s Chrome browser. The Internet Explorer was created to trounce Netscape Navigator, and MSFT tried everything in their might to achieve that, but Netscape lives on today in the form of Firefox which is an awesome internet browser. There are several other such examples: Zune Portable media player vs Apple’s iPod, Windows Phones vs Android etc.

When to Sell?

In this regard, Mohnish states the following:

any stock that you buy cannot be sold at a loss within two to three years of buying it unless you can say with a high degree of certainty that current intrinsic value is less than the current price the market is offering.

In other words, Mohnish recommends holding a stock for two-three years at a minimum. Why two-three years? Why not a few months? This is because any meaningful change in a business takes some time to play out. Why not five years or more? Because the cost of waiting is appreciable and there is the associated opportunity cost wherein the same capital could have been invested in some other business.

What about after three years and if the stock price as crossed our estimated intrinsic value? Mohnish recommends selling if we are convinced that the stock is overvalued while also considering the capital tax implications of such a sale.

As a dividend growth investor, I will only sell a stock if the underlying fundamentals of the business have changed with respect to my original investment thesis and reasons for investing in the business. I am a buy-and-hold investor and the compounding effect of the dividend snowball can only be realized if I can hold onto a stock for not three years, but several years. Selling a stock would kill that compounding growth machine, and that is something I cannot afford in my strategy.

Final Remarks and Summary

So there you go! Those were my takeaways from this book. It is nicely written in a very easy-to-read language. I am pretty confident that I would have been able to breeze through this book in a single sitting. Some of the ideas discussed are in sync with what I have read in other investing books. And while I did not necessarily agree with some of the principles, I enjoyed the slightly different perspective of approaching the same underlying philosophies. There is a LOT of reference to Charlie Munger and Warren Buffett’s letters and quotes, not at all surprising in a book authored by Mohnish Pabrai.

I will re-read this in a few years from now, just to see if the ideas presented in this book provide a renewed perspective to my outlook on investing.

Have you read this book? If yes, what are your takeaways? What are your favorite books on investing? Please share in the comments below.

Thank you for reading thus far.

Disclosure: Long MSFT, AAPL, PG, COST