#3 Sanjay Bakshi: Why Mental Models
53:21 Share

Welcome to The Knowledge Project. I'm your host, Shane Parrish. I'm the author of the Farnham Street Blog, a website with over 65,000 readers that's dedicated to mastering the best of what other people have already figured out. In The Knowledge Project, I interview people from around the world so we can learn from them, expand our minds, and challenge our thinking. Welcome to The Knowledge Project.

In this episode, which was recorded live in New York, I have on the show one of my favorite people, Sanjay Bakshi. Sanjay is one of India's best recognized finance professors. He teaches a course entitled Behavioral Finance and Business Valuation at the Management Development Institute.

And while he probably doesn't want me to mention this, not only is he a teacher, but he's also a practitioner. He's one of the most successful investors you'll ever come across. In this interview, we talk about a host of things, including why he prefers to read on a Kindle, how he incorporates multidisciplinary thinking and mental models into both his investment decisions and life decisions, and how his approach to investing has changed over time. That's it. So without further ado, I hope you enjoy the conversation with Sanjay.

If you enjoy it, please let me know your feedback. I'm at Farnamstreet, F-A-R-N-A-M, street, S-T-R-E-E-T, on Twitter. And thank you for listening.

The IKEA Business Network is now open for small businesses and entrepreneurs. Join for free today to get access to interior design services to help you make the most of your workspace, employee well-being benefits to help you and your people grow, and amazing discounts on travel, insurance, and IKEA purchases, deliveries, and more. Take your small business to the next level when you sign up for the IKEA Business Network for free today by searching IKEA Business Network.

I'm here with Sanjay Bakshi, who's been described, self-described as an opinionated professor of value investing at the Management Development Institute in India. Welcome. Thank you, Shane. How are you? I'm very well. Thank you for coming all the way from Canada to meet me here in this lovely hotel in New York.

It's such a pleasure to meet you. I've known you for so many years and I'm so glad that I'm meeting you now. It's a pleasure to meet you as well. So Sanjay and I have been emailing back and forth for years now. And being here in person and meeting him, it's an amazing experience. He's everything that I thought he would be soon. Happy to meet you. Yeah. I have to say that I'm envious of you for many reasons. One of them, of course, being that you have a library much bigger than mine.

And I have a very large anti-library thanks to you because I end up buying virtually all the books that you recommend. And the list keeps on growing. And in order to find time, I have to compromise many things. But it's really worth it. I appreciate that. I definitely have. My bookshelves are starting to overflow, so it's getting to be a bit of a problem. But...

I have to persuade you to get into Kindle then. Well, actually, let's dive into that. Like talk about the Kindle versus the physical book. What do you prefer? Why? How do you use that? Well, I used to prefer the written one, of course, because you can underline and you love the smell of the paper and you have a nostalgic feeling.

associations with the physical book, what it looks like and where you read it, which you kind of lose when you do it on a Kindle. But over time, I realized that these are prejudices that should be let go of because there are other things that are possible with the Kindle, which are not possible with the physical book. And for me, as a professor, it really helps me to be able to

know that I've read this somewhere, you know, the kind of associations that occur in memory when you're experiencing something, you know that you have read about this particular aspect in some book, but you don't know which one. And if it was all physical book, you would go crazy looking for that book. But if you just do a search for a term across all your books in your Kindle library, it comes up in a flash.

And the interesting thing is that you sometimes discover things that you didn't know existed. The serendipitous discovery of wonderful words of wisdom about a certain topic in your Kindle library are amazing. And when that happens, I have my eureka moments.

And the other reason why I love Kindle is because you can underline stuff and write your own notes and they get synced to the cloud. And once they're in the cloud, you can copy paste. You can use it for your lectures and it's very helpful. So I'm very grateful to Amazon. And of course, it's environmental friendly. You don't have to waste paper. Do you read exclusively on the Kindle now? Yes, I like to, but only for books. Of course, there are annual reports and there's a lot of wisdom in annual reports of businesses that I like to read.

study and that you don't get on kindle i i don't like reading on computer monitors it's very strenuous to the eye kindle therefore is much better because it doesn't have any eye strain

Then, of course, there are letters written by other investors which are not available on Kindle usually. So I look at, I read on Kindle any book that is available on Kindle. Some books are not. Then you have to buy the physical ones. And you're a prolific reader. So do you notice... Well, about 5% of what you are. Do you notice a difference in what you retain when you're reading on the Kindle? Or...

I guess, not your physical, your takeaways from the book, but in terms of how your brain is storing or organizing. I mean, there's been a lot of studies that say that reading on a screen and reading a physical book impacts your memory and how you make connections and associations. Sure, that's true. But I think there's a trade-off here. You might retain more when you read a physical book.

and you might retain a bit less but that kind of gets offset by the fact that you are creating a document on the cloud which contains the best things that you have read in a book the ones which influence you the most because you have underlined them sometimes the underlined portions of a book span many pages

And all of that gets synced to the cloud and when you work on that particular passage again in the context of something that you're trying to evaluate, then all of that comes back. So in a sense, I think there is a trade-off here. While reading on a book, you get to underline physically and you may have a moment of reflection and you may write things on the side. You can do that in a Kindle as well. So net-net, I think I don't feel the loss of memory.

if I am using a physical book. So what's your process for reading? So you purchase a Kindle book, you get it to your Kindle. Take me through how you read in terms of are you reading one book at a time? Are you reading multiple? Do you put it aside at the end and then go back to it? Or do you immediately take your notes out?

Well, I don't like to read one book. I mean, I maybe read about three or four books at any given point of time and I finish them, then I'll pick up another two or three books to read. One reason is you get kind of bored by reading the same thing, same subject.

And, you know, based on what Charlie said that you should have multidisciplinary mindset. So it's good to have different books from different disciplines and read them. And then one of the amazing things that I discovered is that you kind of associate one with the other ones.

And that really is helpful to me. So far as note taking is concerned, I underline stuff on the fly as I read it. And once the book is over, I go back on the cloud and take out whatever I've underlined in that particular book, whatever notes I have, whatever annotations that are there.

and I would put them in a different document and then I let that be because I've already studied the underlying text the second time so I've done in a sense a second reading of the things that I like the most in that particular book and I let that be because

kind of reside in my memory for some time. And then when I'm experiencing the world out there and there is a moment when I would remember that there is, this is something which relates to something that I read somewhere, then I can always go back to the document and, um,

be able to pull out whatever is useful. So you have a different document for each book? Not always, but I have a master document because once you have it on the cloud, you can always copy and paste it, any annotations, any underlined text for that particular book in a different document. I do that for some books, though not all of them. That's awesome. That's a really good way to do it. Do you use Evernote or anything, or is it all? I do. I use Evernote. That's been helpful to me. I use...

Other tools like the brain which is a wonderful piece of software available. What is that? It's a it's it's kind of replicates what a human brain does it helps you create thoughts and it helps you connect different kinds of thoughts and

and you can put your emails in it and you can put your sound files in it and you can put any kind of document in it and then you can look at any particular topic from the perspective of a thought. So you have all these thoughts which are connected and this is exactly how the human brain works and new associations are created. So when you're looking at that brain screen you see and your actual brain is thinking about those associations

new associations get created. So in a sense, it's an external brain which is working for you and the size of that thing keeps on growing and it's virtually infinite. You can keep on adding stuff in it. So how do you go about teaching that to your students about multidisciplinary learning

thinking and connecting and associating and synthesizing and distilling and is that... Well, Charlie's already taught us how to do that. We just follow what he says, you know, we try to look at a problem from multiple perspective and that's I think the correct way of doing it. When you are trying to evaluate something, you're trying to ask the question why? Why did this happen? And when you reflect upon it, you find that the answer sometimes comes from multiple disciplines.

and you get down to that and try to figure it out. It is very enjoyable to do it in that way. The process for me has always been to ask the question why and wait because the mind will tend to jump to a certain answer and that's not the only answer. So, you know, the way I think about it

is whenever there is a complex question which I'm trying to answer, I always start with the words, part of the reason is this. And which means that there must be other parts too. And I like to think about what those parts could be. And they don't have to be 20 of them. Even if there are three or four of them, that's better than one. So it helps me ask the question why and then look for answers. That's an awesome, do you think that's like a mental trick as well? Where when you respond saying that's part of the answer, you

remain uncommitted in a sense to a firm and definite answer and then therefore you're more willing to be open-minded at the end? Absolutely. And the way to do that is to always answer a question why by the phrase part of the reason because that removes the availability heuristic, the first conclusion bias.

because in a world which is full of complexity there are multiple answers. There are second order effects and third order effects. And you can think of those, I think especially well, if you start your answers with the phrase "part of the reason".

So multidisciplinary thinking is incredibly popular in the value investing kind of community in the sense that people look up to Charlie Munger, Warren Buffett, and yourself, and they try to bring that approach on their problems. Do you know anybody outside of value investing who's taking that sort of approach and trying

how they're applying it to broader policies or anything? Or is it just, do you think that it resonates with people in this particular context or...

I think it's wrong to assume that the idea of multidisciplinary thinking that Charlie Munger talks about should be applied only to investing. In fact, you should use investing merely as an excuse to be able to illustrate the idea that you can use multidisciplinary thinking in pretty much everything that you do. And I think that's a very useful skill to acquire and Charlie offers you a way to do that. And of course, the way he has done that is to be a, you know, invest...

successfully. But if you read through his letters and his talks, he is very rarely actually only talking about things which have to do with investing. There are other applications. And if you look around the world, the really good thinkers, they do think in terms of multidisciplinary applications. I do think that there are a lot of Charlie Munger fans out there, even though they don't know of Charlie. And I think there is an important

And a role that people like you are playing in bringing that kind of knowledge to the world out there, it's not just about investing. You have to be able to apply it in other disciplines as well. So not only are you a professor, you're a prolific, world-renowned investor. You started in 96. Did you, I think investing is... 94. 94. Did you originally take the multidisciplinary approach? Oh, not at all. I had no idea about all of that. Not until 2004.

So I was a one trick pony at that time. I was only, I was an accountant. I knew how financial statements get created from transactions.

I knew all of that, but I had no idea what a good business and what is a bad business and what is a mediocre business and why. And I was studying at the London School of Economics in 1990 when I chanced upon an article on an obscure guy operates out of Omaha, has a wonderful track record, says the markets are quite inefficient, which is quite the opposite of what I was being taught at the LSE. So I found that very interesting.

And that particular article also said that he writes wonderful letters and you can get them for free if you write to him. So I wrote to Mr. Buffett and within four days I got those annual reports.

Debbie, his secretary, wrote a letter to me that you have to send the postage money, which was probably the best investment I ever made. So I got those annual reports, letters of Bakhshya Hathaway. As I read through them, I discovered Graham.

And I picked up on Graham because I was an accountant as I mentioned earlier and I could relate to what Graham was saying. Up until now I knew that there is how financial statements get prepared, what is book value and what is profit and what are margins and I knew all of those things but I had no idea whether this was cheap or expensive.

And Graham provides a very good framework for people who are good in accounting to be able to figure out fairly quickly whether this is cheap or expensive. So I found that very interesting and I started practicing Graham style investing from then onwards.

It's only much, much later that I chanced upon the idea that there could be different kinds of businesses and some businesses could be remarkably having remarkably good quality and one should ask why do they have this good quality and then of course once you start talking about that you end up discovering Charlie Bunger and once you pick up Charlie Bunger you ultimately discovered the power of multi-disability thinking. So all of that happened

It took me about 10 years to get there. So I started practicing value investing in '94. But I discovered Charlie's talk on multidisciplinary thinking only in 2004. And that was a very significant event in my life because as it happens, that was the year when my family was coming to the United States for a holiday and I came across this talk.

And my course was to commence in September and this was in June or July. And I told my family, I'm not coming with you. Please leave. And they were supportive and they left me alone. And that's how I decided to change my course and turn it into what is now called behavioral finance and business valuation.

So that particular idea of the psychology of human misjudgment and the mental model talks, they helped me a lot. Was it as simple as coming across that talk and then being inoculated and changed forever? Or was there something else going on? Absolutely. There was nothing else going on. I was alone. I think it was...

It was stupendous to be able to read it over and over again, make notes, try to relate to the power of the ideas that he has laid out in those couple of talks. It was so powerful for me and I had the conviction to teach it and learn it through teaching and it's been very helpful for my students and for me.

my journey as a value investor is not complete unless I bring up my discussion on mental models. So what was the course before? It was pure Graham style investing. It was called security analysis and I would mostly talk about risk arbitrage, about

bankruptcy investing, about investing in cash bargains and statistical screens that Graham used to create and talk about in his books. It was purely that. The idea that there could be a great business out there and the idea there could be a competitive advantage out there was not even known to me at that time. And most of the discussion was revolving around financial statement analysis instead of going to the reason as to why is this business successful and when you go into the question why

The answers come from many sources. Why does a customer buy this product? What is it that the customer likes? Why does he not buy somebody else's product? Why would a competitor not enter this market? Why wouldn't they even try? Those are very profound questions and you won't know the answers to those questions unless you ask them and the answer comes from different disciplines.

So the role of mental models and multidisciplinary thinking has played an incredible role through investing for you and changed the way that you teach. Has it changed the way you live outside of those domains? How so? It has in many ways. And...

When you look at the world out there, you can't think about it without thinking about incentives. And that's one of the most important lessons that Charlie has given, that you must have a two-tiered system in trying to understand the world out there. And we talk about economics, and economics is incomplete without psychology.

And we have all these notions about the rational man, models in economics. Most of economics is based on the idea that human beings are rational, but most of social psychology actually tells you that we are quite dumb. Very often we make very foolish mistakes. And I think both the disciplines of economics and psychology are kind of connected.

And if you put that in the context, let me give an example. As an accountant, I learned about the idea of shutdown point. That there is a point in a business's life when you should shut it down. But if you study Charlie and if you study Warren Buffett's life, you'll find out that actually you should shut it down well before when it makes sense for you to shut it down because you have to think about opportunity costs.

And a lot of people will not shut down even if it makes sense to shut down because they figured that the other guy is going to blink first. So they operate in a competitive market and we're seeing that right now in many industries. Look at what is happening to shale or oil production even in Canada or in the US.

compared to what is happening in the Middle East. People will keep on producing things even though it doesn't make sense for them to produce it because they think that somebody else will shut down before they would. And sometimes they are right and often they are wrong. And when they are right, often they are right because they have a backing of somebody who is going to fund them. And in today's world you have these markets which will fund you. And we are seeing that in India. We have an e-commerce bubble going on. There are three or four players

And they are essentially giving huge discounts to consumers to purchase their products and to not go to bricks and mortar stores. And people are doing that.

But all of these e-commerce companies, they have bleeding cash. But they have rich investors who are willing to give them money to gain market share. And as long as that money keeps on coming, it's going to be very difficult for the bricks and mortar players to be able to effectively compete. So we see a kind of situation where if you want to understand the situation, you cannot understand it without thinking about psychology. What gets a business to continue to operate even though it doesn't make economic sense? Why does that happen?

That helps. And do you think, like you mentioned the shutdown point, do you think that that transfers to relationships and friendships and books and a whole bunch of other things and the concept of there's a point at which you should stop reading, there's a point at which a relationship becomes unhealthy, there's a point at which, do you think about it in those ways or do you approach outside relationships differently or do you always have that kind of multidisciplinary mental model filter on?

I think there's something to be learned on that from the experience of Charlie and Warren. I think we all know this, that they rarely sell out of a business, even though it's not doing well. Even though economically it should be closed, but why don't they shut it down? Why don't they get out of a business? Usually they don't. And I think the reason is that they've created a culture when they want to be a natural partner for a business to be owned.

by Berkshire and you don't get to that kind of state if you start treating businesses as a game of rummy. You don't discard your least performing businesses and I think they've done that and they've done that over decades.

and I've created a position in the minds of the owners of admirable businesses out there that here is a place where I can give my business to somebody and that's not going to be sold off to a private equity investor or to be liquidated because it doesn't make sense.

Even though in the short term it might cost Berkshire some money in the long run it has created a huge reputational advantage for them and of course that has helped Berkshire. I think there is something to be learned from that but you know when you're running a fund

when you have investors who can pull the money out at a short notice, you probably cannot think on those lines and which is something which Buffett and Charlie are familiar with and they don't have that structural disadvantages.

So you have to be very careful about these notions because you have to have the structural advantages that some people have to be able to have the privilege of thinking along those lines. How conscious are you about setting up your environment to allow for that in the sense of... It's a journey. It's a journey. And there were times in my life when I did not have that privilege. As I evolve over the years, I think I'm closer to

that utopian kind of a situation where I can say that I can truly think long term. I'm not fully there yet though. But I think it's important to think really long term and you can't do that unless you're financially independent.

One of the big lessons that I have for my students is that the first thing that they need to get is financial independence. Once they have that, then they can look at the world the way it really is and they can perhaps think much longer term. But things could be a lot better, I have to admit. So outside of the structural reasons, how do you set up your actual physical environment to encourage rationality or...

or better decisions or so. I mean, Buffett is the one who moved from New York to Omaha in part because he felt like somebody was always whispering in his ear and the assumption or, you know, reading between the lines there is that I think they're more conscious about how they set up not only their structure of the company, like when,

Him and Munger owned almost 40% of Berkshire, but also their physical environment to maximize their personal ability to make rational decisions. And I'm wondering what yours looks like. Yes, I think that's absolutely the right way of thinking about it. And I completely agree with you that you have to have a physical environment. One way I've done that is to give up on television. So I don't have a television.

The other thing which I did recently was shut out, take away Yahoo Finance as a bookmark on my website.

on my browser. So I don't get to see stock prices as often as I used to. And it does look a bit odd in the beginning, but if you do this long enough, I am more at peace. Apparently there is a lot of volatility in the markets as we speak right now, but I have no idea as to what has happened to a specific business because I've not looked at the stock price. I think that's very helpful to me.

Guy Spear has written a marvelous passage in his book where he wrote about creating a physical space where you have shut out a lot of the distractions of life. So he writes in his book that there is a room where he has no electronics and he cannot be disturbed when he is in that room and I think that's a very

useful way of doing things and I'm not there yet but that's one of my aspirations to have a room where there is no electronics and no distraction and there's a big do not disturb sign outside and where you can just sit and think which is exactly what I think Buffett does or what Warren does and what I think most successful investors do.

And it's not just about investing, it's about everything in life. If you want to make decisions, you need to shut out a lot of the noise. You have to really focus on things that really matter. And sometimes the things that really matter are far fewer than what it appears. How do you go about determining what matters and what doesn't? I mean, we live in a world where everybody, including Farnham Street, I mean, it competes for eyeballs and it competes for attention and everything.

Those are scarce resources on behalf of people. And it seems like the pace or the velocity of that information coming at you is increasing. People feel overwhelmed. They feel like they can't separate the signal from the noise. Is there anything that you do that helps you eliminate, reduce, filter, sift? Yes.

So depends on what context we are speaking about. Let me pick up the context of analyzing businesses.

you have all this data, I mean there is real time information out there, there is Bloomberg and I don't have Bloomberg and there is CNBC and I don't have a television so there are all these sources of so called information, most of it is in my view noise so if you shut out all of it you have filtered out a lot of the noise but there is more as you go through analyzing a business you come across data for example quarterly results

you start thinking about See's Candy. If you think about See's Candy, See's Candy loses money as, if I recall correctly, about eight months in a year. It loses money. Four months in a year it makes money. And it's a fabulous business. We all know that.

So here is a business which is a fabulous business, which has created a wonderful cash flow, which has helped Berkshire become what it is today. But it loses money eight months in a year, which means there are several quarters when it is loss making. And there is one big quarter when they make a lot of money. I think that's a very powerful way of thinking that there are these businesses out there

which are not going to do well and therefore if you put a lot of emphasis on short term quarterly results you are really looking at noise and therefore you should focus on what really matters and if you focus on the idea of competitive advantage the idea of what Buffett likes to call as a moat out there then it's by definition a moat is not going to get eroded in a day it's not going to get eroded in a quarter

So in effect if you are focused on investing in a business which you think has a durable competitive advantage then quarterly results are going to be almost insignificant. What really matters over there is the durability of that advantage over a long period of time and how the business can scale. I think those are two or three things you have to focus on and when you do that a lot of things which are irrelevant

which are available to you, you don't have to focus on them at all. You can remove them from your screen. There's different types of modes. I think you teach that there's, I forget how many that you distinguish, right, between low cost and differentiation. Do you find that any are more sustainable modes

in general if all things are considered like which would be the best moat to have if you could have one one moat would it be a product differentiator would it be a low-cost provider would it be it would be a low-cost provider if you think about it the reason why brands are successful is because they give you scale and they give you a cost advantage um i think the low cost

model is a far more sustainable model, it's actually a very admirable model in capitalism because there is less wastage. If you look at a costco which we both know is a very admirable business model then why is it an admirable business model because

It deals with the paradox of choice. You don't need 50 ketchups. Why do you need 50 different kinds of ketchups? It's not good for civilization. If you think from a Charlie Munger's perspective, to have consumers get 50 different kinds of ketchup, three or four are good enough. And when you have only three or four in a business which has scale, then you can offer them at a lower price because you're buying them in large quantities, much larger than other vendors who have 50 ketchups.

So I think that's very admirable from a civilization's point of view. But if you could have something that will be good for civilization, which means enough choice but not so much, that creates a paradox of choice. At the same time, you can earn a high return on capital and also pay your employees well, which is what Costco does. I think that's an extremely admirable combination of things that are happening over there.

And when you combine that with the fact that customers are funding a lot of that business because they pay upfront a fee to get a privilege of shopping with you and that gives you float, which I think is another aspect of a wonderful business. I think all of that combines together to produce something which I think is absolutely fabulous.

So in a sense, when you have scale, you have a low cost advantage, you pass on most of the benefits to your customers that creates loyalty. They want to come back to you again and again, and they don't mind paying you an annual fee to get a chance to shop with you. And with the cash flow that you generate, you have a system where you are keeping your employees very happy. You pay them more than your competitors pay their employees.

And that creates a wonderful culture of meritocracy. It's a nice karmic feeling about it. That you're doing good, you're doing something pro-social for civilization. And in the process, you're not compromising on creating wealth for your owners. I think even if you make slightly less money, net-net, I think civilization is better off having businesses where you have low cost advantage.

Now, you know, we're not very far from Fifth Avenue, which is a place where you go to buy all those wonderful overpriced brands. But if you think about it, really speaking, the consumers who buy those products

$5,000 bags are really paying a price which is way more than the cost of manufacturing that bag. So you have huge gross margins in those businesses and they use that extra gross margin to advertise, to create a perception that you really do need that bag because if you don't have that bag, then your life is not full, it's not complete. You're incomplete without that bag.

I don't think of that as a very admirable business model. I'm not being very judgmental here. I'm just saying things from my own perspective that if you had a business where you have a low cost advantage, where you're selling something that is really good and cheap, and it has got a brand and it is creating a

brand loyalty and you're selling it at a price which is a really low price and in the process you can still earn a high return on capital I think of that as far more admirable business model than where you are selling at ridiculous prices because you're creating a perception in the minds of the consumer that this is worth a lot more than what it really is do you think that that's a short term strategy doing that?

And then, because long-term that's not a win-win relationship in the sense that, as you said that, it struck me that if you're creating unhappiness in my life because I don't own your product and I buy your product and I'm still unhappy and you're still creating that unhappiness,

How can that take advantage of compounding on a long time scale? Whereas Costco, for instance, much better kind of model in terms of consumer wins, the employee wins, the shareholders win. It seems pretty win-win for everybody involved. The suppliers win. I don't know if I get the same feeling as you were talking about, like the high-end brands on Fifth or somewhere else. You're right.

But I don't think we can say this is short term or long term Because clearly many of those brands have been around for a long time and they're very successful Businesses is just that if you notice that you don't usually find a Berkshire Hathaway owning them. Why why you know

You know, why don't they own any of that? Why do they have something which gives genuine happiness? Why do they own businesses which provide something which is genuinely useful to society? I think there is something to be thought about on that. But I don't think, you know, there's a saying that there's a sucker bond every minute. And there are all these people who believe that if they have become wealthy, then they need to have certain product.

even though it is indistinguishable from something else which is far cheaper and the supply of those people is actually going to increase over time. So I don't think we can say that those businesses are not going to thrive in the long run. They probably will.

But to me that doesn't matter because I am much more in awe of businesses which do something pro-social for society and also make money for the stockholders. So there is no trade-off there. I mean, you're not really doing charity. You're doing something good and still make money. I think that's far better than a business where you're making a fool of somebody. Yeah.

And a business model which essentially involves making a fool of somebody, in this case your customer, I don't think it's as admirable as a business model where everybody goes home happy. As you were talking about Costco, it sounded a lot like Amazon up until you got to company culture. But the other thing that I think that Costco does, which plays to psychology a little bit, is when I go in there and buy my ketchup, I have no idea what eight liters of ketchup should cost.

because I have no reference point. Whereas when you're... You have a reference point. It's called trust. Yes, yes. It's a business model, which is, Charlie keeps on saying, a seamless web of deserved trust. Which I completely understand. Like I know if I go to Walmart and I go to a grocery store, they're selling the exact same bottle of ketchup.

So I have a general sense of how much that should cost when you get into Costco. And I've looked at the financial statements, so I know they're not making a ton on this stuff. They make enough to pay their employees, basically, and then they try to make their money, if I understand it correctly, through the memberships. Well, Costco, I think, makes about 20% return on equity, which is actually quite healthy if you look at interest rates over this part of the world.

and it has a PAT margin of less than 2%. So it has very high capital turns. And it can do that only because it has scale. And it can get scale only because it has fewer SKUs. So I think it's a nice virtuous circle. It's a nice positive feedback loop in play out there.

that. And do you think that that's more resistant to some of the types of e-commerce stuff that you were talking about before in terms of not only the physical kind of bricks and mortar stores, but against the online sort of efficiencies that Amazon... I mean, it seems like they're not really impacting Costco as much as other stores like Walmart. Yes, that's true.

You know in a sense Amazon has picked up some of the best ideas of Costco. If you look at Amazon Prime that takes money from customers upfront to give you certain privileges that's an idea that they I think they copied from Costco but it has certain other advantages it offers you

amazing amount of availability which Costco doesn't so it kind of gives you and it has one shop it doesn't have a lot of the costs which which which Costco has so clearly I think there is in capitalism you will keep on finding all kinds of businesses that are evolving over time and I think the Amazon business model is very misunderstood particularly people who think that they don't make any money I don't think that I think Costco

So let's switch gears just a little bit here from...

investing specific to acquiring, organizing, and synthesizing kind of knowledge. As a prolific reader, you read a lot, you integrate that into the Word documents afterwards. Do you also integrate it into your courses? And how do you go about connecting the different ideas other than, you mentioned the Kindle search earlier, but how do you go about adding or refining, I guess, the mental models that you have in your head? And

adding new mental models and how do you know you've come across a new model? Well, over a period of time when you experience something and you find answers to that questions that keep on occurring in a manner which provides you with answers which are different from what you thought earlier, then you might have chanced upon a new model.

You never know for sure, of course, and it's just a way of organizing your thoughts. So you're trying to evaluate a situation and maybe five years ago you would have looked at it differently. Today you look at it differently because you read so many things.

and you have a better understanding of the world and maybe some answer to that question will help you figure out the problem better than five years earlier then I think there's a good reason to give a name to that and that's how I do go about doing that and Charlie has provided you with a

with the framework and there are all these disciplines and there are all these names he uses things like the boiling frog syndrome which is a model which deals with the low contrast effect which talks about the idea that slow changes tend to go unnoticed and that's a very powerful notion if you think about it because if you look at a business hugely value creating business or a value destroying business and if you look at their financial statements

or a quarterly period you will miss a lot of the change but if you put gaps in between if you look at data five years ago and today you will see huge change and that tells you why you notice change because you removed a lot of the columns you removed a lot of the quarterly information

Charlie likes to give a name to model like this a boiling frog syndrome and I think we already know that that there is this myth that if you put a frog in boiling hot water it'll jump out and escape but if you put a frog in lukewarm water and boil it slowly it will stay there and it's absolutely a myth but I think the human equivalent of boiling frog is there in all of us.

And therefore if you can notice change over a period of time by removing periods where change was not likely to be noticed, it's going to be very very helpful. So I use that a lot. So in a sense I like to look at a business 20 years ago, 15 years ago, 10 years ago, 5 years ago and today.

That helps me understand what competitive advantage could be and whether it is increasing or reducing over time. So it's useful to have these models, give them names which are very useful for recall because you can give a technical name to boiling frog but

I think it's very important to have these notions in your head because you can retrieve them very quickly. Once you have names which, to specific models, which you can recall immediately, it will be very helpful. So I like that particular point that Charlie makes that you can give them your own name and he uses things like

Deprival super reaction. He doesn't use the word loss aversion because loss aversion is a technical word, technical phrase to illustrate a very powerful point that he makes. Deprival super reaction. I think when you read through his letters and whenever he's talked about deprival super reaction, it immediately hits you. And of course, Charlie has filed them away in his head by giving these descriptive names. And I find that very useful.

So the names are great. And for Charlie and for you, you can probably just mentally go through this list. How do you feel about checklists? Or how do you make sure that you've thought about things from, it seems like ever since Atul Gawande's book, The Checklist Manifesto, there's been a movement, not only in the value investing community,

but a movement in hospitals and a movement to go back to maybe the airlines are doing something right. Maybe the low fatalities and the very methodical approach to things has an advantage. How do you make sure that you're capturing all the mental models that you have and bringing them to bear on a particular problem?

So when you think about checklists, I think what you're trying to do is to reduce your rate of error. And there's a trade-off here. I think what Atul Gawande has done, he's done a marvelous service to civilization by giving us a framework of how to reduce error. And it could be domain, it has to be domain specific. It could be flying a plane, as he talks about in chapter one in that book. It could be about running a hospital operation. It could also be about running an investment operation.

But all of that is focusing on how to reduce error. But that's just one aspect of it. Because reducing error is not always the most optimal thing to do. You also have to be creative. If you're going to be creative, you're going to make mistakes. If you look at any business which has been innovative, you'll find that they have made mistakes.

So there are two things here. You need to have the framework to create insights, which means you need to have a creative mindset, which means that you should be willing to experiment and sometimes make mistakes. At the same time, when you are actually making big decisions, you need to also have a framework to reduce error. And I think

Atul Gawande's work and the movement that he's created that you're referring to deals very well with that aspect. It doesn't deal at all with the idea that you want to be creative. So you need both. You need to have the ability to have unique insights, and you also need to have the ability to reduce your error rate. So there's a tension between those two, but when you go inside an organization and you're, say, a mid-level manager...

your job is almost effectively reducing error, reducing variance, which, you know, is at odds with creativity and possible film. Because I think there was an article in The Atlantic that put it really well about creativity and

I'm kind of going off the cuff here, but they basically said that creativity is connecting things that other people haven't connected before. And if it works, you're a genius. And if it doesn't, you're basically in the madhouse because people think you're crazy. So when you're trying to get promoted and the psychology of being that mid-level manager in an organization who's very career-oriented and has a lot at stake in reducing the variability, how do you go about implementing creativity?

How do you balance that tension? And some companies do it really well, and I have no idea how they do that. So that's a great question, and I thought about that over the years. And over the years, I've come across a few entrepreneurs which have, I think, been what I would describe as what Charlie would call as a learning machine. They made mistakes, they learned, and they haven't made those mistakes again. And as a financial analyst, I do know a few things about risk management.

So, the way I think about it is that I'm looking for businesses that are risk averse but not loss averse. And those two things are very different. So what you're really looking for is somebody who doesn't mind making a few small bets. Many of them will go bad, but they have potential. And if they pay off, they'll pay big. And if none of them pay off, it won't impair the company. It won't impair the business. And that's exactly what Hal Buffett thinks.

So when he is in a position to write an esoteric insurance policy, which will maybe pay off if he has to make good on his promise, he may have to pay a couple of billion dollars or even more than that. But the premium that he receives in return of that promise is several times more than the actual value of that bet.

And the reason why he can do that is because nobody else is willing to make that bet. And the reason why nobody else is willing to make that bet is because of the point that you just made that they have the people who have to make that bet have career issues, they have career risk associated. So they are, they are they are loss averse. And they are risk averse, they don't want to take a chance. But Buffett doesn't mind doing that. I think that's very interesting, because you can use that in analyzing a whole variety of businesses out there and find entrepreneurs

which in aggregate are not taking a significant risk because if all of these bets don't work out you're still fine and the way to think about that is to look at the quality of the balance sheet if for example you're not borrowing money to expand and if you're doing multiple expansion projects you're introducing different products in different markets in different geographies

And you know that each and every one of those bets have great potential, but it's a probabilistic world out there. You have no idea whether they will work or not. So you're giving a lot of respect to uncertainty. You don't know what will work. You're just being driven by data. It's exactly what happens in Amazon.com. You're trying to do a lot of experiments. You don't know which ones will pay off. But even if none of them pay off, it won't ruin the company because it has got other earning streams. It has zero debt on the balance sheet. I think that layer of financial uncertainty

discipline, when you combine that with an innovative culture, is a very good mix. And I think you find that in some entrepreneurs, and when you find them, you should look at it with a bit of admiration. That's a really good way to think about it. As you were talking, you were answering there, I was trying to think of the differences between Jeff Bezos and Steve Jobs. And one would be, if you had to categorize him purely analytic, and the other would be driven by an intuitive sense of design. Yes.

and yet they're both incredibly or were incredibly successful. I think often I'm wondering if we just straddle, we try to be a little bit of both, and that strategy is effectively ineffective because instead of trying to compete or better yourself in one area, you're trying to better yourself in two areas by which you can't be an expert at both in that sense. Or maybe you can be, and we just haven't come across that.

examples of people that I can come off the top of my head. But how do we move forward with that tension in terms of, is it better to pick one? I know myself and you can't really make these decisions until you know yourself. And therefore, I will be a data-driven person and I will make these decisions. Or I know myself and I have a more intuitive sense of design and that's the path I want to pursue. And then burn your bridges to the other one? Or do you still, how would you approach that?

I would do that from a data-driven perspective. There are these intuitive people out there. In capitalism, we have found Steve Jobs who can create something beautiful that people relate to and they become price insensitive. They just want what he is offering to the world out there and it is beautiful.

But you can't spot these people at the beginning of their careers. You can spot them maybe in the middle of their careers. So there has to be past track record of somebody who's intuitive and right over and over again. Once you found that, that's based on actual data.

And on the other hand, you have these other kinds of entrepreneurs who are like Jeff Bezos, who are data driven, who don't mind, who have no idea about what will happen, but who don't mind making a series of small bets on a number of hundreds of experiments and have the ability to be absolutely unbiased about where to put money. And they would bet heavily when they know that this bet is likely to pay off and then

If bets that are not being out, they wouldn't hesitate to withdraw capital from those. I think there is in capitalism as investors for

for us, it's, uh, we, we shouldn't have, um, at least I don't feel the need to have a preference of one or the other. If you can find both kinds of entrepreneurs, it's wonderful because you're trying to build a portfolio. That's a really good way to think about it. So there's three questions I do at the end of every interview. And so we're coming to the end. So I want to ask you these three. And the first one is what book has influenced you the most in your life or, um,

That's easy. Poor Charlie Zalmanak. Poor Charlie Zalmanak. Yes. It never stops influencing me. Every time I pick it up, if I read it, it gives me something more to think about. How often do you reread it or go back and think about it? I read it about three times in a year. But some talks I end up reading more.

Every year I go and teach a course on behavioral finance and the talk on psychology of human misjudgment is helpful because every time I read that talk I come up with new examples. I've learned something else over the last one year and every time I read that book, that particular speech that he gave, it helps me come up with new associations, new examples and I think I'm a better thinker after having read

what he, what Charlie had said so many years ago and related to my new experiences and be able to teach them and in the process learn more through teaching. Uh, so that's, so some talks I will read more, uh, and some I will read less, but I would pretty much read that book about three times in a year. So with the talk, the psychology of human misjudgment, do you listen to it or do you read the, I read it. I know there, there is a audio version of the first talk. Right. Uh,

But I prefer to read it because it's so profound. I mean, you have to pause. If you are listening to it on audio, then I guess you need to constantly pause and think about it. Maybe you can do it, but I just don't find that very easy to do. So I'd rather read it and then let it be.

Read a passage and then think about it. Maybe spend a few hours thinking about it. And is your copy of Poor Charlie's Almanac marked up? Oh, yes. Yes. Oh, yes. What book are you reading right now that you're really enjoying? Oh, I have to pick up. I'm reading so many of them. Let me open up. I picked up one book which you had recommended a few weeks ago, which I...

Find very useful. Let me just pull that up. Pebbles of Perception. That's a book that you wrote about in one of your posts. And I picked it up and I'm reading that. It's a fabulous book. I've just read about 30% of it. I think it's a fabulous book. It's an amazing book. I think what I said was it deserves a place on everybody's shelf besides seeking wisdom. Right. And he's an amazing person. Right.

And then the final question is, if you could have anybody else interviewed on the Knowledge Project, who would it be? Who would you like to see me interview? Charlie Munger. I'll try to make that happen. Sanjay, thank you so much for your time. I really appreciate it. It's been an amazing experience meeting you and speaking with you. Thank you, Shane. It was a pleasure meeting you as well. Thank you. Hey, guys. This is Shane again. Just a few more things before we wrap up.

You can find show notes at farnamstreetblog.com slash podcast. That's F-A-R-N-A-M-S-T-R-E-E-T-B-L-O-G dot com slash podcast. You can also find information there on how to get a transcript. And if you'd like to receive a weekly email from me filled with all sorts of brain food, go to farnamstreetblog.com slash newsletter. This is all the good stuff I've found on the web that week that I've read and shared with close friends, books I'm reading, and so much more.

Thank you for listening.