Diversification in Investing and the Importance of Understanding Underlying Drivers

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If you want to get rich and to pass money to your kids, listen closely to Howard Stevenson. Here’s condensed wisdom from the heart of the investing world delivered with dry humor and charm. Professor Stevenson was a co-founder of storied Baupost Group and helped hire its legendary manager Seth Klarman. He began the study of entrepreneurship at Harvard Business School and eventually became HBS’ biggest fundraiser.

His book “Wealth & Families” gives invaluable advice on how to make money and keep enough of it to hand down to the generations. My personal favorite is illustrated by this quote from the interview:

“Whereas, some of my colleagues were going off consulting ... They were making a lot of money every day, and they go their XKE (Jaguar XKE, a coveted sports car of the era) quite quickly. I went off to places like Lima, Ohio, and I was paid $300 a day, but I got 1% of the company.”

Howard Stevenson was forgoing high current income, and consumption, for the ability to own promising assets that would build his wealth in the long term. This approach contributed to Professor Stevenson becoming rich enough to need a family office to manage his money.

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This dynamic conversation includes:

• Howard Stevenson Bio
• How Howard Stevenson Started His Career
• Fear of the “Velvet Rut” Causes Howard Stevenson to Leave a Tenured Position at Harvard Business School
• Howard Stevenson: “A lot of people are fairly miserable in their job, but they fear change more than they look for the optionality that comes in change.”
• After a Sojourn in Entrepreneurship & Real Estate, Howard Stevenson Was Lured back to HBS
• Sal Daher: “There are not a lot of people that would turn down tenured positions at The Harvard Business School…” Howard Stevenson replies: “That's sad. I'm a trustee at Olin College, and they have no tenure. It's amazing what that does, because people are there voluntarily.”
• Howard Stevenson on Building Wealth: “I've always been experimental, because I don't believe I understand and can predict the future. By the way, when you look that the facts, very few people can.”
• Howard Stevenson’s 400x Investment in a Company with a “Stupid Business Plan”
• Howard Stevenson’s Four Criteria for Investing
• Howard Stevenson’s Portfolio Returns; Warren Buffett-Like
• Howard Stevenson on whether Entrepreneurship Can Be Taught
• Howard Stevenson’s Definition of Entrepreneurship
• The Best Due Diligence Is Time
• How Baupost Got Started and How Investing Wizard Seth Klarman Was Hired
• How Howard Stevenson Shops for Cars
• Howard Stevenson’s Advice for How Young People Can Build Wealth
• Mitt Romney & a Young Colleague on Spending
• Why You Should Review this Podcast on iTunes – It Really Helps Us iTunes Podcast Page Where You May Review & Subscribe
• "Most of the wealthy people I know, are better at making money than managing it."
• Howard Stevenson’s Journey in Investing Began by Reading Graham, Dodd & Cottle in 1961
• "I was smart that I recognized the quality of the people. But, whether it was coming out at 2X or 400X, wasn't in my control."
• Talking to Your Kids About Money

Transcript:

Sal Daher: Welcome to Angel Invest Boston. Conversations with Boston's most interesting angel investors and founders. I'm Sal Daher, and my goal for this Podcast, is to learn more about building successful new companies. The best way I can think of doing this is by talking to people who have done it. People such as entrepreneur, angel investor, and scholar of entrepreneurship, Howard Stevenson.

Professor Stevenson, Howard, I'm elated for the opportunity to interview you on this the 29th episode of our podcast. Thanks for hosting us at your offices. In this recording session outside our usual studio. This is what's normally called a remote.

H. Stevenson: Well it's not so remote, it's right in Harvard Square.

Sal Daher: That's right. Not too far away.

Howard Stevenson Bio

Howard Stevenson founded the storied Baupost Group, and is the father of entrepreneurial management, at the Harvard Business School. Howard has served on many boards, and his advice is prized by so many wealthy people. He has written extensively on business and social ventures. He has been generous with his time and treasure, towards philanthropic causes in which he believes. It is said that he has raised more money for Harvard Business School than anyone else. There is now a chair professorship named after him at HBS, in recognition of his outsized achievements.

Starting out as a math major, Howard has had a methodical approach to wealth during his entire career. While he measured assiduously the growth of his net worth, he also paid close attention to choosing work that was satisfying to him, and valuable to others. Informed by fear of the “Velvet Rut” that can trap tenured academics. Howard found his own career trail in several industries. By taking astute long-term bets, he has become wealthy enough to need his own family office, though he does not like the term.

In preparing for this interview, I read his latest book, Wealth and Families: Lessons from My Life Journey. Written with his longtime collaborator Shirley Spence. The book is a remarkable document, in that it grew out of another book. A book that he had written for his family, titled: Howard's Journey: Lessons from the Game of Life. This other book was written to impart his hard-earned lessons to his family. The family book was shared with a few close friends, who urged creation of a public version, which became Wealth and Families. Which, is the book we'll refer to in this conversation.

In concluding my introduction, I'd like to read a beautiful blurb of the book by Howard's colleague, Kenneth A. Fruit of Harvard Business School. "It is hard to fathom, even once you've read it. The compactness of the wisdom and insight Howard Stevenson provides in this short book. His perspective is practical, yet enormously synthetic. Don't be confused by the direct "Oh shucks" tone. The simple folksy-sounding analysis of the complex problem of intergenerational wealth, belies Howard's incorporation, and absorption of much more of the magic of mathematically rigorous laws of compounding and diversification. Sprinkling in a foundational knowledge of the tax code and the law. It's that he has in his own mental frame incorporated a sense of people's humanity, their strengths and weaknesses, their goals and actual accomplishments. Based on successfully watching and doing for all these years. The wisest teachers have all along been life's best and most observant students. Howard and this integrative little book that you and your progeny should share, are just that."

That's really beautifully written.

H. Stevenson: Yes, and I didn't even pay him.

Sal Daher: I know. I know those things are tremendous.

How Howard Stevenson Started His Career

As a service to our younger listeners Howard, I'd like to ask a question about how my massively successful guests got started in their careers. Tell us about the choice that confronted you when you completed your undergraduate in mathematics at Stanford, and what you chose.

H. Stevenson: Well it was fairly easy. I discovered when I was at Stanford, there were people who were smarter than I am, love math more, and worked harder. I decided I didn't want to compete with them.

I had looked at both law school, and business school, and in my great wisdom I discovered law school was three years long. Business school was two, and I chose business school.

Sal Daher: A math major, you could count.

H. Stevenson: I could count. Even on one hand. And, then I discovered that in fact Harvard gave me a bigger scholarship than Stanford for my continuation. End of story on the career that got me into Harvard Business School. Staying on to teach was another decision, which I think is, I've always loved learning, and what better way to learn than to teach. So, I did that for a couple of years, and then played investment banker with a friend on doing deals for small companies. Then I came back to the business school to do ... Well I came back to tell them I wasn't coming back, and they said, "What are you going to do?" And, I said, "Well I'm going to be a VP of Finance of a real estate company."

That meant that they thought that I knew something about real estate. I'd never read a book on the subject. I never had done anything in the field, and they said, "Do you want to teach the course?" And thought, "What better way to learn?" So, I came back to the business school, started a real estate course, or took over one that was sort of moribund. And, did that for five years. I came up for tenure, and I got tenure, and the Dean told me to do something important. So, I left again.

Fear of the “Velvet Rut” Causes Howard Stevenson to Leave a Tenured Position at Harvard Business School

But, part of the motivation of leaving was that I saw a lot of people in this “Velvet-lined Rut’. That it's very easy when you're successful, to keep doing what you're already doing. But, in fact the only way you can get from doing the wrong thing to the right thing, is probably doing the right thing poorly. And, so you have to learn, and I watch people who run the top of little hill, who didn't want to go down in the valley to try something new.

Sal Daher: This is very interesting. Very, very interesting. I wanted to elucidate a little bit, what was meant by the Velvet Rut. You think that academics tend to perhaps specialize a great deal? Become the most knowledgeable in a field, but are afraid to venture out, where they're not as knowledgeable?

H. Stevenson: Or where there're people who won't think they're as knowledgeable. But, I don't think that's restricted to academics.

Sal Daher: Mm-hmm (affirmative)

Howard Stevenson: “A lot of people are fairly miserable in their job, but they fear change more than they look for the optionality that comes in change.”

H. Stevenson: A lot of people are fairly miserable in their job, but they fear change more than they look for the optionality that comes in change.

Sal Daher: Ah, yes. The optionality that comes in change.

H. Stevenson: And, we can never predict the results of change.

Sal Daher: No. No.

H. Stevenson: So, for me I said, "Look, I can always get a job." I think the dean, at that point was not interested in what I was doing, which was entrepreneurship and real estate. And I said, "Why do I want to work at some place where they don't value what I'm doing?"

Sal Daher: Mm-hmm (affirmative)

After a Sojourn in Entrepreneurship & Real Estate, Howard Stevenson Was Lured back to HBS

H. Stevenson: That led me to work with a private company. Became VP of Finance of a private company. Helped them raise money. Got some control systems in place. A whole bunch of things. So, I had a lot of learning, but after five years the learning went away and I ... The dean had heard that I was dissatisfied, and came and said, "You want to do something in entrepreneurship?" And this was a new dean, and he was a person I knew and trusted, and so I said, "Yes".

Sal Daher: It's a new direction and a new discipline that challenged you at the time. So, you felt that that did not have the risks of constraining you within this rut.

H. Stevenson: Absolutely not, and beyond that I knew that I could leave again.

Sal Daher: There are not a lot of people that would turn down tenured positions at The Harvard Business School. No, that is impressive.

Sal Daher: “There are not a lot of people that would turn down tenured positions at The Harvard Business School…” Howard Stevenson replies: “That's sad. I'm a trustee at Olin College, and they have no tenure. It's amazing what that does, because people are there voluntarily.”

H. Stevenson: That's sad. I'm a trustee at Olin College, and they have no tenure. It's amazing what that does, because people are there voluntarily.

Sal Daher: Yes, yes. That is a remarkable organization.

We're going to talk a little bit now about building wealth. What type of early stage investments have you made, and how have they turned out over time?

Howard Stevenson on Building Wealth: “I've always been experimental, because I don't believe I understand and can predict the future. By the way, when you look that the facts, very few people can.”

H. Stevenson: I've always been experimental, because I don't believe I understand and can predict the future. By the way, when you look that the facts, very few people can.

Sal Daher: That's right.

H. Stevenson: We've always tried to invest in places where, in the early stage, I prefer to invest when people have some revenue. Because, it points to the fact that there is somebody that's willing to have a cash-ectomy performed on their wallet.

Sal Daher: Mm-hmm (affirmative)

H. Stevenson: We like to be broadly diversified. I'm not trying to guess what's going to be in the next public market.

Sal Daher: You prefer companies that are post-revenue? That are ...

H. Stevenson: Post revenue.

Sal Daher: Earning, okay.

H. Stevenson: And ...

Sal Daher: In a growth stage?

H. Stevenson: In a growth stage, where they need the money to ... If it's in biotech, I prefer something where the scientific risk is out.

Sal Daher: Mm-hmm (affirmative)

H. Stevenson: But the market risk is still there. The best investment I ever made was in a company that had a really stupid business plan. But, the people were fantastic.

Sal Daher: Yes.

Howard Stevenson’s 400x Investment in a Company with a “Stupid Business Plan”

H. Stevenson: They were in an industry that I thought was very interesting. I thought that what they were doing in that industry made no sense. Over a couple of years, they morphed, and that's probably returned 400 to 1.

Sal Daher: Oh, the 400 to 1 return that everybody's looking for, to pay for the rest of the portfolio.

H. Stevenson: Yes. But ...

Sal Daher: Which company was that?

H. Stevenson: It's a company called Asurion.

Sal Daher: Asurion.

H. Stevenson: And, they are very quiet, I'm still invested.

Sal Daher: Yes.

H. Stevenson: They're doing very well. One of my friends, who's a noted venture capitalist, turned them down because the business plan was too stupid. That's been one of the worst decisions he ever made. Whereas, one of the other venture capitalists that put a little money in, it's the best decision he's made in his life.

Sal Daher: I know, those kinds of investments are few and far between, and when you turn one of those down, it's hard to live it down.

H. Stevenson: You have to live life forward, you can't live with regrets.

Sal Daher: True, true, true, but I think there is some room for learning.

Howard Stevenson’s Four Criteria for Investing

H. Stevenson: I think the thing that I've learned is. I have four criteria for investing in companies I know and love. Is the person honest? Because, if they're not honest they'll screw you some way.

Sal Daher: Oh yeah, that goes without saying.

H. Stevenson: Now how do you figure out if they're honest? Well, there're two ways: 1. You know them. Or, 2. One of my favorite questions is, "Tell me about the sharpest deal you ever did?"

And, it's amazing what people will tell you. One guy told me how he cheated the IRS. And you say, "Well if they can send you to jail, and I can't, and you're still willing to do it, I think I know something about your value system."

Sal Daher: That is remarkable, that is remarkable.

H. Stevenson: The second criteria, that I like to use in investing is: Are they nice? By that I mean, are they looking out for somebody other than themselves?

Sal Daher: Mm-hmm (affirmative)

H. Stevenson: I've had experience in start-up or early stage investments, where the entrepreneur takes care of themselves really well, and the early stage investors not so much.

Sal Daher: Left hold the proverbial bag.

H. Stevenson: Well, or holding nothing.

We have one that just went public, and I think compared to my investments, I'll make 10 cents on the dollar, even though the company was successful. And, I went through three or four rounds, and I discovered what the person was.

But, trying to figure out are they nice, that means talking to people that know them. Looking at past decisions. I've had investors ... Or, I've had companies where we lost all the money, and they gave me stock in the next venture they did. Which is a good sign that they are nice people.

Sal Daher: Yeah, that is a nice sign, yeah.

H. Stevenson: The third element is: Are they curious?

Because if you believe that the future is impossible to predict, then anybody who thinks they know the future absolutely, is not looking around the corner. I go back to my example of the best one we ever did. They had a bad plan, but they were curious, and they said, "Where can we serve this group of customers, with a very profitable notion?" And, they found it.

Howard Stevenson’s Portfolio Returns; Warren Buffett-Like

And the last is: Are they smart? Because, this is a very complicated field. Now you ask how we've done. We've been doing it for about 25 years, since I sold down some of my position at Baupost, and left active management. I was the president for the first eight years. We probably return 17% or 18%. Probably 12% without the real big winner.

Sal Daher: Mm-hmm (affirmative). So, a little bit ahead of what Baupost has done in the same time?

H. Stevenson: Yes. I guess I look at it, and I say, when I've done the analysis ...

Sal Daher: Probably a lot higher beta.

H. Stevenson: Yeah. It's actually interesting, I've divided things into five categories. Stuff happened, I don't use the word stuff when I'm talking about this.

Sal Daher: Yes. I understand.

H. Stevenson: That was a ... The guy got a pancreatic cancer soon after we invested. The Tanzanian government it over, because it was too profitable, and they wanted their cousin to own it. And, you can go through some, but there weren't a lot of those.

There was the wrong on the bet category.

Sal Daher: Mm-hmm (affirmative)

H. Stevenson: It was a good bet, but it didn't work. And, I think in a lot of what we're doing, you've got to differentiate between, is it a good bet, and did it work?

Sal Daher: Yes.

H. Stevenson: Because, on a high variance bet, it's not going to work out all the time. But, one of the things we always try to do is say, "What are we betting on? What are the three or four conditions we're betting on?" And, then sometimes they're not going to work.

Sal Daher: Mm-hmm (affirmative)

H. Stevenson: Then there is, we made it safely through. Then there was a few good things happened. If you take the bottom three categories, I think we got about 7% out of that total pool because ...

Sal Daher: Wow! Well that's not bad, yeah.

H. Stevenson: When you're post revenue, in some ways you don't ... You're not going to lost everything.

Sal Daher: No, no.

H. Stevenson: But one of the interesting ...

Sal Daher: I've had at least one post revenue company that lost everything, because they were so highly leveraged. That's the thing, if they have revenue, there's a temptation to borrow.

H. Stevenson: Yeah, but I think that one of the things about it is, that if you're working with the right people, they are ready to say, "It's not working". Then they turn their task to getting something for the company. Instead of, as some people are, they'll just throw the dice, until they run out of money. Somebody who's nice and curious, is probably going to spend some time saying, "It really isn't working, is there some way we can salvage something for us, and the investors?"

Sal Daher: Yeah, that really is remarkable wisdom.

H. Stevenson: Then some good things happened. Largely that was when somebody else wanted it worse than we did.

Then there's the wows, and there are probably five wows. The one I told you about is by far the biggest one, but there were quite a few that returned 30 to 1.

Sal Daher: Wow.

H. Stevenson: And you say, "What field were you in?" They were all over the lot.

Sal Daher: Wow, so no specialization?

H. Stevenson: No specialization.

Sal Daher: Interesting. I was having a conversation with a young venture capitalist yesterday, who is a part of MIT angels. He says, "I'm very specialized in biotech. Everyone, of these deals I can see all the problems with them, and solve them and so on." And he said, "I don't understand how you can make money, without that level of specialization." The answer for me at least, is that I'm investing much earlier than he is. So, my judgment isn't really based on knowing exactly what the industry is, and so forth. It's much more based on character, and so forth. The sort of thing that you're talking about. That is what makes it possible for you to be investing. If, you're investing early enough. The remarkable thing is that you're investing in post revenue, and you're still making those judgment calls based on character, and making money. Which is tremendous.

H. Stevenson: I think that part of it is that nobody knows the future, no matter how many PhDs you have.

Sal Daher: Mm-hmm (affirmative)

H. Stevenson: In the biology field, I've had people present things to me. They say, "This is absolutely unique." And, I walk back to my office, and I get a business plan, that if I just crossed out the names, it would be the same.

Sal Daher: It would be the same, yes.

H. Stevenson: So, my belief that you have a unique upside. Just think, even Uber. How many examples are there of Uber?

Sal Daher: That's right. The ones that failed, there were many of them, and Lyft, which is still extant. But the reality is that, ideas are a dime a dozen, and execution is very, very hard.

H. Stevenson: One of my favorite stories about this is, in 1993 and the personal computer is coming out. We said, "There's got to be a role for this in home accounting."

Sal Daher: Ah.

H. Stevenson: We found a guy from Procter and Gamble, because we knew you'd need marketing.

Sal Daher: Mm-hmm (affirmative)

H. Stevenson: They'd written a software. It was good software. It worked fine on the apple. Unfortunately, not on the PC. And, it started literally within a week of Quicken.

Sal Daher: Ah!

H. Stevenson: So, you look and you say if I took two business plans, look at the resumes of the people, I couldn't tell the difference.

Sal Daher: No.

H. Stevenson: One is wallpaper, and the other is a fortune.

Sal Daher: Quicken, they managed to establish a process for developing a product. Which was really, tremendously impressive.

H. Stevenson: That, but I think they may have gotten into Staples slightly before we did.

Sal Daher: That's all part of the product development process.

H. Stevenson: Yep.

Sal Daher: The product is developed enough, that Staples can distribute it. As a matter of fact, I'm trying to think of who it is that I interviewed recently who has the founder of Quicken as his ...

H. Stevenson: Scott Cook?

Sal Daher: Scott Cook, yes is his idol.

H. Stevenson: Mm-hmm (affirmative)

Sal Daher: I think it came out in the podcast.

H. Stevenson: Yeah, a P&G guy. He's not a technology guru.

Sal Daher: Well, he's another P&G guy, because you guys were backing a P&G guy as well.

H. Stevenson: Yes.

Sal Daher: Well I'm in the process of writing ...

H. Stevenson: HBS guy too.

Sal Daher: HBS guy. Well I'm in the process of writing a check right now to P&G, J&J, HBS guy. So, I hope it's going to work out.

H. Stevenson: I can guarantee you won't know until it does.

Sal Daher: I know. That is absolutely true. That is absolutely true.

Howard Stevenson on whether Entrepreneurship Can Be Taught

You've done a lot of research, and given all your business experience. This is a tough question. Do you believe there are certain personality types that are more conducive to entrepreneurship, or can it just be taught to anyone? Bill Aulet, thinks it can be taught.

H. Stevenson: Can I answer no, to both questions?

Sal Daher: Absolutely.

H. Stevenson: Well, in the old days before I started to work in entrepreneurship, there were people who said, "Well, they've studied it carefully and you need ... Being a first born helps, because 44% of the entrepreneurs are first born." Failing to notice that 44% of the population is first born.

There were other deep studies of locusts of control, and other things. It turns out to be nonsense. I don't think that there's a personality type. Because, if you're going to run a cable television company, you could be the wallflower at the accounting convention.

Sal Daher: Right, right.

H. Stevenson: If you're going to run a promotion based ... Look at Steve Jobs’ personality. I mean ...

Sal Daher: Absolutely.

H. Stevenson: I can go through Ken Olsen.

Sal Daher: Mm-hmm (affirmative)

Howard Stevenson’s Definition of Entrepreneurship

H. Stevenson: You look at the great entrepreneurs, and if you can find a single personality type, I think you've got a flawed test. So, I would reject that. On the other hand, I don't think that you can teach entrepreneurship to anybody. What I always thought we're doing when we're trying to teach entrepreneurship. Is if you take the students who come to Harvard Business School, they're opportunity driven. And, as you may know, I tried to define entrepreneurship as the opportunity beyond the resources you currently control.

Sal Daher: Yes.

1. Stevenson: Almost any kid, who walks into Harvard Business School, Sloan School. They didn't get there because they were shy, retiring ...

Sal Daher: No.

1. Stevenson: Just hoping to make it to the first level of the company, and then they'll stop.

Sal Daher: Mm-hmm (affirmative)

1. Stevenson: What we tried to do is, to show them that somebody like them could accomplish it. So, you had the cases on women, you had cases on African Americans, you had cases on people who started late, people who started immediately. Although, I tried to discourage people from starting early. Because there's a lot of research that shows, you got to know something about your customer in your market place.

Sal Daher: Mm-hmm (affirmative)

1. Stevenson: You ought to be known. Because you're going to go out to raise resources, and the more that other people know you and trust you, the better off you are. But, I think what you have to do is have the self-knowledge to say ... Probably politically incorrect say, "I know there's a lot of money to be made in China, but it won't be made by people that look like me."

Sal Daher: Mm-hmm (affirmative)

No, really the problem of information, and the fact that it's broadly disseminated, and people who have local information have an advantage, over someone coming from the outside. That is broadly recognized. I see the point that you're making, that you think that what the academic experience can do, is inspire people with models.

1. Stevenson: Mm-hmm (affirmative)

Sal Daher: That have, through cases and so forth. They can get people thinking, "I can do that." Which is a little bit of what I hope to do through this program, with angel investing. Is, to get people saying, "I don't have to be Mark Zuckerberg, to invest as an angel. I can be a guy who has built a business, who's got some experience and so forth. And, I can probably help some young person who's building a business."

1. Stevenson: Well, what I said about ... There were two things that I was trying to do, accomplish. One was planting time bombs in people's mind, that exploded when they stepped on the opportunity.

Sal Daher: Mm-hmm (affirmative)

1. Stevenson: The second thing that I think you try and do, is keep them from doing really stupid things.

Sal Daher: Ah, okay.

1. Stevenson: I have a sign in my office at home that says, "It's great to learn from other people's mistakes, and you've been a real blessing to me."

Sal Daher: Yeah. The ability to learn from other people's experience. It's a lot cheaper than learning from your own experience.

1. Stevenson: That's what you try and do as a teacher is ... But, you also have to say there is no one right way. The business plan, no I've never had a business plan that worked out the way it was written.

Sal Daher: My first interview with Michael Mark, who's founded several companies as a technology founder. And, he said he had invested in more than 200 startups, and he could think of one business plan that went according to plan, Progress Software. All the other ones necessitated pivots.

1. Stevenson: The first thing I would say is, the fact that writing a business plan can be helpful, because you have to express the bets that you're making. So, you actually know what you're shooting at.

Sal Daher: Absolutely.

1. Stevenson: But, if you think that the business plan has foreseen all possible combinations ... Even just timing is at best, a random event in some ways.

Sal Daher: That's right.

In your book I think you quote Eisenhower saying, "Planning is everything. Plans are nothing."

1. Stevenson: That was my doctoral dissertation. Had a lot to the defining strengths and weaknesses. Didn't matter what you wrote down at the end. It was, you were asking the question, "How do we compare to the other people trying to accomplish the same thing we are?"

Sal Daher: So, going through the process of planning, you develop understanding. Even though things don't work out as you expect, at least you know a little bit about the lay of the land. So that when things change, you can regroup and do an informed approach.

1. Stevenson: I would also say that one of the things that I look for in a business plan, is have they looked honestly at the competition.

Sal Daher: Ah.

1. Stevenson: I can't tell you how many business plans and software I've read that says, "We've done this for $300,000, and it would take everyone else 2 million."

Sal Daher: I've seen a lot of those, yeah.

1. Stevenson: There's a lot of competition out there, and you need to have some humility on the part of the entrepreneur and the investor to say, "We're going to be out there in a tough market. How are we going to win? Where do we have a competitive advantage?"

Sal Daher: In those situations, one trick that I've learned from some of my colleagues in Walnut Ventures is, give them a little time. If they're at the beginning of the race, don't tell them that you're going to invest with them. Give them three months, and then see where they are, in those three months. See how much progress they've made during that time. They've told you everything about where they are now. If, in three months they're still telling you the same things, and they have competition, so that they're not very good at implementation. So, they're not going to get anywhere.

The Best Due Diligence Is Time

1. Stevenson: We always say the best due diligence is time. In fact, I was talking to one of the famous venture capitalists, who was a former student, and a good friend. And I said, "Isn't due diligence highly overrated?" And he says, "Yeah, I need to make five calls." He said, "I just need to know, which five people I talk to." I think that's true in most of this area for us as investors is, do you know somebody that knows the field? Do you know somebody that knows the person? Do you know somebody that knows the state of the financial markets for that particular fashion element? There's a lot of stuff ...

Sal Daher: Absolutely.

1. Stevenson: That, you don't need to talk to everybody in the world. And, getting a 2000-page report from Bain and Company, or McKinsey, is not going to help you understand where the world is going.

Sal Daher: No, no it's not. It's not.

How Baupost Got Started and How Investing Wizard Seth Klarman Was Hired

Howard, I'm very curious to hear the story of the founding of Baupost. Hiring of Seth Klarman. For those listeners who do not know of Seth Klarman, think Warren Buffett a quarter century younger.

1. Stevenson: I'll start with a recent search that I was working on for a not for profit. The people said, "We need to hire somebody like, X." And I said, "No you're going to be hiring someone like X was 30 years ago."

Sal Daher: Yeah.

1. Stevenson: That was true of Seth. Here you had an extremely bright young man, who loved two things.
2. He liked stocks.
3. He liked betting.

Baupost was founded because, Bill Poorvu had sold WCVB, or was selling CVB, and I had worked with him quite a bit. And, Jordan Baruch ...

Sal Daher: Bill Poorvu, fellow professor at the Harvard Business School.

1. Stevenson: Yes.

Sal Daher: Who had been owner of the television station, WCVB channel 5, here in Boston.

1. Stevenson: A part of it, yes.

Sal Daher: A part of it, yeah.

1. Stevenson: And, Jordan Baruch was a professor at MIT.

Sal Daher: Mm-hmm (affirmative)

1. Stevenson: Who, was one of the early ... I think he was employee number four, Bolt, Beranek & Newman.

Sal Daher: Okay, okay.

1. Stevenson: And Isaac Auerbach was one of the early employees of UNIVAC.

Sal Daher: Okay.

1. Stevenson: And, he was a good friend of Jordan's.

Sal Daher: Mm-hmm (affirmative)

1. Stevenson: So, as Bill was about to receive some money he said, "Help me how to figure out how we get the money managed." So, the first hire was an administrator. Deloitte's going to come in, you better make sure you can account for it.

Sal Daher: You can put it in somewhere.

1. Stevenson: Well, make sure you can account for it first.

Sal Daher: At least cash the checks.

1. Stevenson: Yes.

Sal Daher: Right.

1. Stevenson: Then Seth was a student of Bill's, and he said, "This is an unusual guy. What are we going to do with him?" And I said, "Who knows?" We started out looking at, how do we select money managers?

Sal Daher: Mm-hmm (affirmative)

1982. Stevenson: This was 1982. After you talk to a number of money managers, you say, "We can do better than that."

Sal Daher: The industry was not highly developed at that time.

1. Stevenson: The industry, it was ... White shoe, everybody was into recreational vehicles.

Sal Daher: Mm-hmm (affirmative)

1. Stevenson: It was a screwy industry, and always has been.

Sal Daher: Right, right.

1. Stevenson: We hired Seth. We looked at ...

Sal Daher: But what is it that you saw in Seth, that set him apart?

1. Stevenson: The same things that I talked about earlier. He was honest. He'd worked for honest people.

Sal Daher: Mm-hmm (affirmative)

1. Stevenson: I wouldn't hire somebody from, you can name the firm.

Sal Daher: Absolutely, yeah.

1. Stevenson: He doesn't even need to work there, I don't want to work for me. He certainly understood the charitable notions that I think the other founders had. I think they were all deeply committed to other people, and that was attractive to him.

Sal Daher: Mm-hmm (affirmative)

1. Stevenson: It wasn't, they were trying to make the most money, and so you saw the niceness come through there. Clearly curious, you don't work the pink sheets, if you're not curious.

Sal Daher: Mm-hmm (affirmative)

1. Stevenson: Because, nobody else was covering them.

Sal Daher: No, no. Mm-hmm (affirmative)

1. Stevenson: That was one of the things I liked about him is, he was willing to do original research. Rather than call up Goldman and say, "What's hot today?"

Sal Daher: Yeah.

1. Stevenson: And their answer is, "Whatever I got a lot to sell off."

Sal Daher: Exactly, exactly.

1. Stevenson: And, he's clearly smart. He's a Baker Scholar. So, we saw that and ...

Sal Daher: But the idea of patient investing, of buying things that are deeply underpriced, and holding them until they are, not fully valued, I know you always sold early. But, until other people begin to have an interest in them, that is something that's attracted me to him. Because, it's a lot similar to what my partner and I did in emerging markets. We were always early, buying stuff at incredibly cheap, and selling into the market as it began. People made a lot of money buying stuff off of us. And, the same thing with Seth Klarman. So, how did you detect that? That quality in him.

1. Stevenson: I like to think I even taught him some of that. The expression we gave was, "Feed the birdies, when they're hungry."

Sal Daher: Mm-hmm (affirmative)

1. Stevenson: And, he transitioned into being the president after about six years. Because, people don't want to give a 26-year-old all of their money. And, we had all of the money, of all of the clients.

Sal Daher: Mm-hmm (affirmative)

1. Stevenson: So, there was concern. This is a different approach. I think one of the things that also Seth has been brilliant at, and I like to think I had something to do with it. Is, not ... Because we had all the money, you didn't get stuck on we're buying big cap stocks. It was ...

Sal Daher: Ah, okay.

1. Stevenson: So, a lot of the success was, you moved from sector to sector. So, you bought real estate, when real estate was dead cheap. You bought busted bonds. I can go through the history and ...

Sal Daher: And, given the composition of the investors, the original investors. They were a small number of people, who had a long-term outlook. They had a much healthier attitude towards the market, than a lot of people have today. Because if you're a young, rising fund manager, you live or die by your last results. In your ...

1. Stevenson: No. And, frankly as we're building the business, we turned down a lot of those people.

Sal Daher: Mm-hmm (affirmative)

1. Stevenson: We didn't think the acquisition of assets was important as the acquisition of good clients.

Sal Daher: Mm-hmm (affirmative)

1. Stevenson: Also, we were interested in who the family was. Not, do they have a name.

Sal Daher: Right, right.

1. Stevenson: But, how they dealt with each other.

Sal Daher: Right.

1. Stevenson: Because, you were trying to create something, and I think Baupost still has that feeling that it's everybody's in it together. So, it was, everybody participated in the performance fee, down to the secretary. Everybody ate from the same pizza box.

Sal Daher: That is wonderful. That's something Warren Buffett complains says his secretary pays a higher tax rate than he does.

1. Stevenson: Yes.

Sal Daher: In this case, even the secretary is paying a high tax rate.

1. Stevenson: Yep.

Sal Daher: A low tax rate, I should say.

1. Stevenson: Yes.

Sal Daher: Because, she is benefiting on the ... Or he, in the ...

1. Stevenson: Right. That was certainly the case then, and they tried to spread through.

Sal Daher: That's really laudable. I have great admiration for the firm that you helped put together, and its outcome is really impressive.

1. Stevenson: Well it's Baruch, Auerbach, Poorvu and Stevenson, is where the name came from.

Sal Daher: So it's Baruch.

1. Stevenson: Baruch, Auerbach.

Sal Daher: Auerbach.

1. Stevenson: A U B A

Sal Daher: B A

1. Stevenson: A U

Sal Daher: A U

1. Stevenson: P O and S T

Sal Daher: And, S T of Stevenson.

1. Stevenson: Yes.

I think it happened with a piña colada somewhere on the Caribbean.

How Howard Stevenson Shops for Cars

Sal Daher: Howard, I find the way you shop for cars, particularly instructive. Please elaborate.

1. Stevenson: I don't shop for cars. When my oldest child turned 16, I handed him a signed check and said, "Go buy me a car." And, people look at me like I'm crazy. But, in fact what I was trying to say to him is, "I trust you. I believe you'll do good research, and I respect your judgment." Because part of the process of educating kids is not saying, "I'm smarter, better, faster than you are." It's saying, "I am asking for your help in important things." I look at buying a car ... First, I hate dealing with car dealers, so I look at it as a pain. I was reasonably sure my sons, who love cars ...

Sal Daher: Mm-hmm (affirmative)

1. Stevenson: Would spend more time harassing car dealers. Which, made me feel like I was getting even with these guys. But, in fact they really do the research thing. So, they come back with a great knowledge of the packages that are available. What you want, what you don't want, and what was my risk? A couple thousand dollars, at worst?

Sal Daher: Yeah, you might overpay a little bit for a car, but your kid will learn.

1. Stevenson: But, I don't think I ever overpaid. I am absolutely sure that they got better deals than I would. Because, I'd walk in and say, "Oh, I like that car. How much it cost?" Because, I want to get out as fast as I can.

Sal Daher: That's interesting, my father-in-law used to do that with his children. He used to give them, when they went to college, the money for the whole year. Give them one check and say, "Here, you've got to pay tuition, your cost of living, everything." Of course, he was overseas in Argentina, and they all came here, and it all worked out. But, sometimes it goes wrong. My dad had a cousin, who when he was away at a university, his family sent him money for the year, and he took the money, and he gambled.

1. Stevenson: Yeah.

Sal Daher: So, he didn't have any money for tuition, or anything like that, and then he was afraid to go back home, when everybody else graduated, because he still hadn't studied.

1. Stevenson: Well, but again a car is a different thing.

Sal Daher: Absolutely.

1. Stevenson: I would know whether they bought the car or not.

Sal Daher: There are guardrails, yeah.

1. Stevenson: And, they probably do have fraud and collusion among the dealers. There's lots of reasons why that's, trust but verify in some ways.

Sal Daher: Mm-hmm (affirmative)

1. Stevenson: But it leads to a lot of trust in the judgment. But, it's also a sign of respect for their work, and their ability to think, and their ability to plan. And, I think they figured out that they would get the used car. So, they bought cars they wanted on the next round.

Sal Daher: Yeah, so they're highly incented to do that. And, it's consonant also with your idea of having the children be brought in early on wealth, brought in early on responsibility for money, and so forth. Which unfortunately nowadays, children really don't have much of a sense of that, of responsibility with money, and so forth. They don't work, they don't make their own money. At least in my experience, children in America work a lot less, than they used to 20, 30 years ago.

1. Stevenson: The rules are harder to comply with, if you're a company.

Sal Daher: Yes, absolutely.

1. Stevenson: We have a friend who owns a car dealership and he got an OSHA citation because he had his 15-year-old son sweeping the floor. So, to me the question of how do you teach responsibility?

Sal Daher: Mm-hmm (affirmative)

1. Stevenson: How do you teach trust?

Sal Daher: Yes.

1. Stevenson: How do you live by example? Are the critical things in Wealth and Families.

Sal Daher: That is really beautifully said.

 Now what advice would you give a young person about building his or her own wealth?

Howard Stevenson’s Advice for How Young People Can Build Wealth

1. Stevenson: I think the most important thing you can start at is, assets are more important than income. At least for me I can speak only in the things I tried to teach the kids. But, if you have a high income, you usually have high expenditures. Whereas, some of my colleagues were going off consulting their ... Consulting was a euphemism for teaching in outside courses at GE. They were making a lot of money every day, and they go their XKE (Jaguar XKE, a coveted sports car of the era) quite quickly. I went off to places like Lima, Ohio, and I was paid $300 a day, but I got 1% of the company.

Sal Daher: Ah.

1. Stevenson: I always tried to look at the assets side, because I couldn't spend it.

Sal Daher: Mm-hmm (affirmative)

1. Stevenson: Which meant, if I was right, I was saving it.

Sal Daher: So, you looked towards building assets?

1. Stevenson: Yes.

Sal Daher: Instead of building income, necessarily?

1. Stevenson: Yes.

Sal Daher: And in time these assets will generate income, but you weren't looking about income today.

1. Stevenson: I wasn't looking for income today, and I was always trying to say, "How do I use my current income to pay the taxes?" So, I could compound after tax, rather than pre-tax.

Sal Daher: Yes. And, another thing that is mentioned in your book. You emphasize very clearly that a house, is not an asset.

1. Stevenson: No, and a mortgage is ... I think of a mortgage as a funny beast.

Sal Daher: Mm-hmm (affirmative)

1. Stevenson: Because when I didn't have any money, as I said, "I was a scholarship student."

Sal Daher: Right.

1. Stevenson: Then a mortgage was a functional equivalent of rent.

Sal Daher: Mm-hmm (affirmative)

1. Stevenson: I still have mortgages, even though I don't need one. But I think of it as the cheapest way to lever my investment portfolio.

Sal Daher: Well yes, if you have been reliably producing 16%, 17% returns every year, it makes sense to borrow at 3% or 4%. That is remarkable. So, I really like that advice. Concentrate on building assets, and think about high income leads to high expenditures. That reminds me of a story of Mitt Romney.

1. Stevenson: Mm-hmm (affirmative)

Mitt Romney & a Young Colleague on Spending

Sal Daher: This is after he had had his initial success. He was with Bain Capital already. A young associate got his first bonus check and he went out and he bought a fancy sports car, and he gave Mitt a ride. Mitt was famous for beat up station wagons. Are you familiar with this story?

1. Stevenson: No, no. I know Mitt well, he was a student of mine. Same class as George Bush, by the way.

Sal Daher: I'm not going to ask, who got the higher grade.

1. Stevenson: You don't need to.

Sal Daher: I know, no. But, anyway ... So, the young partner said ... Is driving Mitt around, and Mitt was very impressed, he says "Geez, I wish I could afford a car like this." And the young associate said, "Well, Mitt you're worth hundreds of millions of dollars. You can afford this." And the kid didn't get the sense that Mitt didn't think he could afford the fancy sports car. This young kid with his first bonus check goes out and blows it on a fancy car.

1. Stevenson: Well, I think the other thing Mitt would probably say if you got him under sodium pentothal. He doesn't drink so ...

Sal Daher: Yeah, I know. That's the darned thing with Mormons, you can't get them drunk.

1. Stevenson: I was raised in Holladay Utah, so I understand it.

But I think it's also what behavior you're modeling for your kids.

Sal Daher: Right.

1. Stevenson: Because, as my grandmother would say, "Your actions speak so loudly, I cannot hear a word you say."

Sal Daher: That is very wise, very wise.

Why You Should Review this Podcast on iTunes – It Really Helps Us iTunes Page for the Podcast Where You Can Review and Subscribe

Coming up next, we will be shifting to managing your wealth. A matter about which Professor Stevenson has deep experience. However, before we do that, I'd like to take the opportunity to thank listener, SewNow, who left this review on iTunes. "Definitely worth a listen. The series is full of very useful information. It is clear to me that Sal has put a lot of effort into it." SewNow, you have done your part to support the podcast. We bring stellar guests like Professor Howard Stevenson. We come to you free, with no schlocky ads, and professional sound, and you can help by following the example of SewNow, and leaving a review on iTunes. The listenership is growing with every episode, breaking records. It's something like 10% or 15% every month, that they're growing now. That growth combined with more reviews, will eventually cause the iTunes algorithm to start featuring the show. Thus, your review is critical to us. Thanks

"Most of the wealthy people I know, are better at making money than managing it."

Howard, in your book Wealth and Families you state, "Most of the wealthy people I know, are better at making money than managing it." Please take this opportunity to elaborate on taking on the responsibility of managing your wealth.

1. Stevenson: Well I believe firmly that, you're accountable for your own actions. And, not everybody takes that to the management of their wealth. They think they can outsource it, and the results are often what you'd expect. But, I think it's also, you have to know your own objectives. Why am I interested in wealth? Is there an amount beyond that, it's for charity, or for my kids? I think that thinking through clearly, what your objectives are, and when I use the word your, I mean your spouse, and you probably. Because, if you start early enough, the kids don't have major voice.

Sal Daher: Mm-hmm (affirmative)

1. Stevenson: But it's also a subject that's quite un-discussable. I don't know how wealthy many of my friends are, because we never discuss the subject.

Sal Daher: Right.

1. Stevenson: It seems to me that at least within the family, you've got to say, "Here's where we are. Here's where we're going. Here's how we're going to get there."

Sal Daher: Mm-hmm (affirmative)

1. Stevenson: That involves a lot of decisions that are complicated. That's before you get to what you do with it, when you have it.

Sal Daher: Right, right.

Howard Stevenson’s Journey in Investing Began by Reading Graham, Dodd & Cottle in 1961

1961. Stevenson: I guess for me, the question is ... Most people would rather talk to their kids about sex than money. So, you don't learn it at home, in most cases. So, you have to in fact reach out to say, "what do I need to know, to be successful?" So, I started by reading Graham, Dodd, and Cottle in 1961.

Sal Daher: Not a bad start.

1. Stevenson: It's probably as good a start as you can have if you want to be a value investor.

Sal Daher: Absolutely, absolutely, yeah.

1. Stevenson: That probably is one of the things that made Seth appeal to me. But, all along I felt like, I had to take ownership of my own results. That didn't mean you didn't use brokers. That didn't mean you didn't hire a financial planner occasionally, but you had to take responsibility for your own results.

Sal Daher: Mm-hmm (affirmative)

1. Stevenson: But that's humbling.

Sal Daher: It is, it is.

1. Stevenson: Because, you'll never know all you need to know.

Sal Daher: And, taxing because you will inevitably have reverses.

1. Stevenson: Yes.

Sal Daher: And people have the attitude that if they ever lose any money, they've failed. But the goal is not to never lose money. The goal is to grow over time.

1. Stevenson: Well, and anytime you lose money ...

Sal Daher: Mm-hmm (affirmative)

1. Stevenson: It helps to say, "Why?"

Sal Daher: Right.

1. Stevenson: And you go back to my five categories. Stuff happened, there's nothing you can do.

Sal Daher: Right.

1. Stevenson: I was wrong on the bet. I knew the bet, but something happened that was different than I was betting on.

Sal Daher: Right.

1. Stevenson: Also, the humility on the other side to say, "I wasn't a genius because I invested in X."

Sal Daher: Mm-hmm (affirmative)

"I was smart that I recognized the quality of the people. But, whether it was coming out at 2X or 400X, wasn't in my control."

1. Stevenson: "I was smart that I recognized the quality of the people. But, whether it was coming out at 2X or 400X, wasn't in my control."

Sal Daher: Right, right.

1. Stevenson: Whereas, I can assure you, if you listen to many of the professional investors they will say, "I knew it all along."

Sal Daher: Right.

1. Stevenson: And, in fact many of the 100% losses I had were done when I was investing side by side with professional venture capitalists.

Sal Daher: Right.

1. Stevenson: Because, their motive is to shoot for the moon.

Sal Daher: Right, right. That is pretty deep. Very good.

I guess we talked about this a little bit, but could you go a little bit more into hiring the professional help you need, beyond the financial planner and CPA. When someone starts to accumulate significant wealth. Give us some hints. This is well explained in your book, but maybe give some teasers, that will lead people to look in your book for a really well-developed approach to it.

1. Stevenson: Again, like most things, I'm somewhat humble about giving the absolute rules. But, there are people you know and trust. The first thing is, I don't require a lot of due diligence if Bill Poorvu calls and says, "I want to do this."

Sal Daher: Mm-hmm (affirmative)

1. Stevenson: You say, "How much can I come in for?"

Sal Daher: Right, right, right.

1. Stevenson: After working with him for 43 years, I have a great deal of faith in his judgment.

Sal Daher: Mm-hmm (affirmative)

1. Stevenson: And, they're not all going to win, but when you know and trust people you can get by with little due diligence, and you can ... Also, it's going to be low cost. I don't pay him a fee.

Sal Daher: Right, right. In contrast to the process that you went through when you're setting up your family foundation. The Stevenson Family ...

1. Stevenson: Charitable Trust.

Sal Daher: Charitable ... No, no, not the trust but the one for managing the funds of the family and ...

1. Stevenson: That we just did ourselves.

Sal Daher: Right, right, but you had quotes from ...

1. Stevenson: We had quotes from ...

Sal Daher: From various people, and they were just absurdly high. So, you brought your son into it, and then you hire people to do particular chores, and so on and so forth. So, you don't have a lot of high overhead of a normal family office.

1. Stevenson: Well you can see looking around, we don't have a lot of high overhead.

Sal Daher: No, no, there's not a lot of overhead.

1. Stevenson: The mahogany furniture from IKEA is ... Shows through.

Sal Daher: It's extremely functional, very functional.

1. Stevenson: But, then when you start to say, "The next level is things that come with recommendation." But, even with recommendation you have to actually go out and talk to people.

Sal Daher: Mm-hmm (affirmative)

1. Stevenson: It depends on who recommends them. Because, there are people that are chasing the last hot deal, and I don't want to be in with them. So, I have to know not only if it's recommended, but who's recommending it.

Sal Daher: Who's recommending, that's right.

1. Stevenson: And, why it is.

 Then if you're trying to go out to the rest of the world, it requires a lot of due diligence. It's probably going to be expensive.

Sal Daher: Mm-hmm (affirmative)

1. Stevenson: So, for me, I've tried to stay in those first two rings, of people I know and trust, and people that come recommended by people that I know and believe in. There you're going to pay more fees, but that's okay.

Sal Daher: Still you're probably much more involved in the management of your wealth, than most people who are comparably wealthy. Perhaps also, because you know so much more. I think that, that is certainly a great lesson here.

1. Stevenson: Think about how hard it is to earn a million dollars.

Sal Daher: Yes.

1. Stevenson: I'm not saying how much I have, but if you have a hundred million dollars, it's easy to lose a million dollars.

Sal Daher: It is.

1. Stevenson: Or, to make it.

Sal Daher: That's right.

1. Stevenson: What I say is, "the first million dollars is really hard, and the second million is a matter of time."

Sal Daher: Exactly, exactly.

1. Stevenson: So, having the long-term perspective, and I could go through some fancy math to show you that in fact, having long term perspective actually is highly beneficial. Because, most of the world is interested in the first two or three years of return. Warren Buffett is the classic example where I think, if you look at his results, it's largely because he bought long duration cash flows.

Sal Daher: Ah. He's not buying the first three years, he's buying 15, 20 years out.

1. Stevenson: He's buying the 3 to 15 year.

Sal Daher: Right.

1. Stevenson: And, he's not competing against the ...

Sal Daher: Which most people are not interested ... Oh no, that's ...

1. Stevenson: That's too uncertain.

Sal Daher: Mm-hmm (affirmative)

1. Stevenson: So, he spends a lot of time looking at how stable it is. He talks about building moats.

Sal Daher: Mm-hmm (affirmative)

1. Stevenson: All those kinds of things, and I think that's a ...

Sal Daher: Right, right.

1. Stevenson: I didn't learn it from Warren Buffett, but when I started to examine his way of dealing. I think that's what we've always tried to do is say, "Look, I can't outguess the professionals that have better information, quicker execution, all that in the first three years."

Sal Daher: Yes. Mm-hmm (affirmative)

1. Stevenson: But if I can find things, that have long duration cash flows.

Sal Daher: Mm-hmm (affirmative)

1. Stevenson: I'll probably do quite well over time, because even if you buy something at 10 times earnings, and it’s got 5% growth, you've got a 15% yield.

Sal Daher: Right, right. Now that is a ...

1. Stevenson: It's a pretty simple ... You don't need the higher math to ...

Sal Daher: No, you don't.

1. Stevenson: Make small amounts of growth, and good profitability ...

Sal Daher: And, consistent growth over time.

1. Stevenson: Consistent ...

Sal Daher: Yes.

1. Stevenson: It doesn't mean you don't have down years, because one of the things ... My experience is like in one of my other wow investments, was yeah ... But, they were willing to make the investments when it mattered.

Sal Daher: Mm-hmm (affirmative)

1. Stevenson: So many of the people would have done really well. See, the first thing we do is serve our customers. The second thing we do is we do it at a profit.

Sal Daher: Ha.

1. Stevenson: But the first question is doing, are we serving our customers well?

Sal Daher: Mm-hmm (affirmative) because ...

1. Stevenson: That goes back to what we talking about in terms of criteria.

Sal Daher: Because serving your customer well is what assures continued growth, continued profitability over the long term, and not just the short bursts in the first few years.

1. Stevenson: The profit is absolutely critical, because whether you're not for profit, or for profit, if you don't have profit, you're out of business.

Sal Daher: Something's got to float the boat.

1. Stevenson: Yes.

Talking to Your Kids About Money

Sal Daher: Yeah. I really like your approach to letting kids know about family wealth and bringing them up early, and so forth. As a matter of fact, I love that little exchange at the HBS that I attended. A gentleman of advanced years, after you explained that you have to let your children know early on said, during the question and answer session, "So how do you think I should tell my children?" And you looked at him and said, "Looking at you, I think it's a little too late."

1. Stevenson: Well, I do get myself into trouble.

Sal Daher: I know, it's just ...

1. Stevenson: It seems to me, that many people underestimate, particularly in this internet age, how much the kids know. They know how much your house is worth.

Sal Daher: Right.

1. Stevenson: They can go on Zillow.

Sal Daher: Mm-hmm (affirmative)

1. Stevenson: Or their friends will.

Sal Daher: Yes.

1. Stevenson: They can find salaries. They can find the size of your private foundation, if you have one. There's no limit to the data they can have. And, by the way, there's no limit to the data they can make up, or their friends can make up too.

Sal Daher: The imagination.

1. Stevenson: Imagination.

Sal Daher: Gallops way ahead of reality, yes.

1. Stevenson: they can look at the prices of your cars. But it seems to me, if you start talking to your kids at 10, 12 about, "Well aren't we fortunate. We've been very lucky. We have to work hard at making sure that it's there, and we're working with honest ..." You start talking about what the criteria are to work with people. You start denigrating the get rich quick schemes.

Sal Daher: Yes, yes.

1. Stevenson: you start to in fact have them start thinking about, their own financial planning. You also have to help them understand that if you want to be an investment banker, you'll have one life. And, if you want to be a social worker, you'll have another life.

Sal Daher: Yes, yes.

1. Stevenson: You're not telling them that one is good and the other is bad, because at least to me, I never wanted the kids to think that having money was the measure of success. Having money is a measure of the options you have for the future. But, if you want to do something that doesn't make you money, you're going to use up some of your capital, and that's fine with me. I'm not going to measure my life on whether you've made money.

Sal Daher: So, your job is to explain the consequences of the choices they are making. So, that they make decisions in a way that makes sense. And, they can make the tradeoffs. There's nothing in life that's not a tradeoff.

1. Stevenson: Yeah, well my sons said that I raised him by the case method. I said, "What do you mean?" He said, "if you really like something, you'd say if you'd thought it through, go do it."

Sal Daher: Right.

1. Stevenson: If you've really hated something you'd say, "Have you thought it thorough carefully, because here are some things that you might want to think about."

Sal Daher: It's a case study method.

Now please explain your thinking behind tracking of your family's total wealth, rather than your own net worth. I found that quite valuable.

1. Stevenson: Part of it is, when you start to think about giving away money. You probably start thinking when the kids are young with some charity. As the kids get older, when do I transfer wealth to them? As you have more money, you start to say, "Okay, my assistant needs help with the mortgage." Or something.

Sal Daher: Mm-hmm (affirmative)

1. Stevenson: Now if you only track only your net worth, you feel poorer every time you do that.

Sal Daher: Yes, right, right.

1. Stevenson: If you start to say, "Okay, I want to include the wealth of transfer to other people." And, even the taxes you can say, "I'll feel very good, even though my net worth, as reported on gap basis, may be 15% of the money I've made." But, I'm measuring my contribution to the economic wellbeing of people I care about, except for my Uncle Sam.

Sal Daher: Mm-hmm (affirmative)

1. Stevenson: So, I try to minimize that.

Sal Daher: Yes. You care about your whole family, except your Uncle Sam.

1. Stevenson: As I say, "I like my kids, or I love my kids. I can stand my grandkids. I hate my uncle."

Sal Daher: Oh! Listeners, I forgot to tell you. Howard's book has cartoons. Here's one. Dogbert is sitting behind a desk talking to Pointy Hair Boss under the caption, "Dogbert Financial Advisor"

Dogbert: You should invest all your money in diseased livestock.

Dogbert continues: It would be unwise to invest in just one sick cow, but if you aggregate a bunch of them together, the risk goes away.

Dogbert concludes: It's math.

 Pointy Hair Boss replies: Suddenly I feel all savvy.

 Kindly distinguish between a herd of diseased cows and real diversification.

1. Stevenson: I think that one has to ask the question, "What are the drivers?" And obviously diseased cows are diseased mortgage backed securities, have a single driver.

Sal Daher: Right.

1. Stevenson: In spite of the fact that somebody from your alma mater might say these are diversified portfolios, because they are uncorrelated having real estate in Miami, Las Vegas.

Sal Daher: Yes, yes.

1. Stevenson: Phoenix.

Sal Daher: Mm-hmm (affirmative)

1. Stevenson: And Boston.

Sal Daher: Right, right, right.

All under written very poorly to a certain sector of the economy. Likely to lose their job and certainly ...

1. Stevenson: All at once.

Sal Daher: All at once.

1. Stevenson: In our investing, as I said earlier, as somebody said, "What are your guidelines?" And the answer is, "We have no guidelines."

Sal Daher: Mm-hmm (affirmative)

1. Stevenson: You look at some things and you say, "I think this is a fairly stable way of investing. I don't like to put into funds that lock me up for 10 years. Not because I need the liquidity, but because I want to be able to change my mind."

Sal Daher: Mm-hmm (affirmative)

1. Stevenson: I just looked at a fund today that had a 20-year time frame.

Sal Daher: Oh, wow.

1. Stevenson: Now that's fine for me.

Sal Daher: Mm-hmm (affirmative)

1. Stevenson: If I control when to sell.

Sal Daher: Right.

1. Stevenson: It's less fine for me, if they control when to sell.

Sal Daher: Yes.

1. Stevenson: I won't get into some statistics I've done on the leverage buyout groups. But, I think I could prove to you that their average holding period is under three years.

Sal Daher: Oh, yeah.

1. Stevenson: In spite of the fact that they try to tell you they've done a great job with managing, but lever it up.

Sal Daher: Yeah ...

1. Stevenson: Take a bit out, and get out of there. So true diversification to me is, look for the underlying drivers. And, if they look the same ...

Sal Daher: Mm-hmm (affirmative)

1. Stevenson: That's not diversification. Let's take the example that everybody thinks Spider is diversified.

Sal Daher: Right.

1. Stevenson: Let's see, what percentage of the Spider is high technology unicorns? It's like 25%?

Sal Daher: That's right.

1. Stevenson: The top 10 stocks?

Sal Daher: Yeah, yeah. They're swinging the index now.

1. Stevenson: Yeah. And, is that diversification, just because you have 500 stocks, if it's all dependent on this one group of ...

Sal Daher: At one point, I remember Apple was 3% of the market cap…

1. Stevenson: Well it ...

Sal Daher: Of the S&P.

2001. Stevenson: In 2001, I think ... I'm getting old and senile, but as I believe, technology represented well over 50% of the S&P in 2001.

Sal Daher: Mm-hmm (affirmative)

1. Stevenson: So, anybody who thought they were diversified, was smoking stuff that smelled funny.

Sal Daher: So, that sets up our last question here.

In your HBS talk, you mentioned starting your professional career when blue chip stocks like, Nabisco sold at four times earnings. Today, cyclically adjusted price earning rations of the S&P 500, is closing in on 30. How does one manage one's money when all investments, not just the S&P 500, but all investments are priced to perfection?

1. Stevenson: I think it was Bernard Baruch who most of your young listeners, won't know who he was.

Sal Daher: Mm-hmm (affirmative)

1. Stevenson: He was one of the great investors of the '30s and '40s.

Sal Daher: Mm-hmm (affirmative)

1. Stevenson: He said, "Sometimes the best investment is going to the beach." As you might know from Baupost's history.

Sal Daher: Yes.

1. Stevenson: Many times, we have 45% cash.

Sal Daher: Mm-hmm (affirmative)

1. Stevenson: 30% cash. In our case, now we do things that structure deals. I'm not expecting to shoot the moon. We've structured some preferred stocks like Warren Buffett does. He just did a deal with an 8% preferred.

Sal Daher: Right.

1. Stevenson: And a big chunk of equity in the company.

Sal Daher: Mm-hmm (affirmative)

1. Stevenson: So, trying to figure out how preferences, and structure protect you is probably the thing you have to do right now.

Sal Daher: Right.

62. Stevenson: That's very different from when stocks were selling at four times earnings you say, but I started investing for other people in probably '62. Then stocks yielded more than bonds, because bonds were more secure. Now, stocks yield more than bonds, because bonds yield nothing.

Sal Daher: Yeah, exactly.

1. Stevenson: By the way, anybody that says bonds are secure now, doesn't understand, A: What's underlying a lot of those. And, B: That interest rate changes can have a devastating effect of a bond price.

Sal Daher: Everything has duration, not just bond, but stock.

1. Stevenson: To me the answer to your question which is not a good answer is, you got to look to structure.

Sal Daher: Okay, so cash and structure.

1. Stevenson: Mm-hmm (affirmative)

Sal Daher: Howard Stevenson you've been most gracious to have us to your office, and to answer our questions. I'm sure our audience will find your deeply considered advice as valuable as I do.

1. Stevenson: Well thank you for the opportunity. I tried to give you answers, and sometimes I believed them.

Sal Daher: It's been great fun, it's been great fun.

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 This is Angel Invest Boston. Conversation with Boston's most interesting angel investors and founders.

I'm Sal Daher.

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