Saudi America
by Bethany McClean

On Aubrey McClendon, founder of Chesapeake

• McClendon went all-in on shale buying land in Austin Chalk region when he saw Devon energy’s success drilling horizontally.
• McClendon would overpay for land. His world-class salesmanship would allow him to raise capital more effectively than competitors.
• He would be bailed out in 2000s when oil and gas prices rise and shale lands were in high demand.
• By 2012, Chesapeake was trying to rebuild after the crash of 2008 and gas prices depressed. They would raise capital globally and make deals with pipelines that would require them to produce large quantities of gas regardless if price. They were basically funding themselves by selling the equivalent of naked puts on gas.
• The board was replaced and McClendon stripped of chairmanship. Icahn even took a seat. But the company and governance were a disaster.
• McClendon left and started AEP which would create a portfolio of companies with an interest in specific drilling operations.

• Known as the “Apple” of oil
• In 1999 Enron spun off EOG (“Enron oil and gas”) when Jeff Skilling became dismissive of businesses requiring hard assets.
• EOG and Continental (Harold Hamm’s co) were first in the Bakken where production would increase 10x in the first decade of 2000s.
• Encouraged that the fracking technology worked although unspectacularly (the industry and academics were still skeptical) they started acquiring land in Eagle Ford for under $500 an acre. Then in 2010, at the 4 Seasons Houston they announced there was 900mm barrels contained in Eagle Ford.
• A look at EOG which has positive returns.
  • Only wells with at least 30% irr since about half of that is required to cover overhead including land and infrastructure.
  • Requires profitability at $40 oil so that it can survive full price cycles.
  • Means that there is limited capacity to invest since land prospects can be much worse (“better rock is exponentially better”)

Fracking is 2 technologies

• Horizontal drilling and high pressure water to crack open rocks. A proppant (ie a sand usually from Wisconsin) is used to keep the crack open to let the oil or gas flow.

Shale depends on unsustainable economics

• In 2015, Einhorn at the Sohn conference showed that even with oil at $100 the shale industry was incinerating cash. He called out Pioneer in particular (a descendant of a merger with Pickens Mesa Energy). Shale Wells have too steep a decline rate. A Bakken well declines 69% in year 1 and 85% in 3 years vs 10% pa for conventional). Einhorn argued that frackers’ pitches don’t account for cap-ex and cost to acquire leases. He showed that they embellish their estimates of reserves to investors (vs what they report to SEC standards). He and SailingStone of SF showed how comp was tied to production, not profitability. They both agreed that has was much better biz than oil.
• Pension backed PE firms are financing shale 2.0 which is marked by better technology and more precise operations. 35% of horizontal drilling is done by private PE-backed companies. Rates of return remain unsustainable for all but the most efficient operators who are generating positive albeit still uninspiring returns.
• Decline rates always mean you need to spend more to stay in place. The shale transformation was a Lollapalooza effect of Bakken, Eagle, and Permian hitting all at once. It may very well be a one-time price effect. And the more efficient we become on drilling the faster we deplete the wells.

The crude oil export ban

• The crude oil export ban had been in place since the 1970s.
• But there was now a growing movement to overturn the ban backed by oil producers while refiners and environmentalists opposed it.
  • Many saw it as a counterweight to the political leverage of unfriendly powers such as Russia and the Middle East. Europeans were already grateful for the US agreeing to export LNG, keeping Russia from having a near monopoly on gas sales in Europe esp in Germany.
  • Many argued that the decline in global prices would more than makeup for the reduction of domestic supplies and that in boosting global supplies the political premium baked into oil prices would ease.
• The collapse of oil prices in 2015, the “condensates” exemption, and being part of a larger spending bill provided cover from detractors as the bill was passed in Dec 2015. Environmentalists would gain an extension to solar and renewable subsidies.

My takes plus a Munger insight

• The byproduct of commodity businesses is really an investment product.

A levered slice of volatile returns. The companies are closer to derivatives than they are businesses. The derivative is on the price of the commodity. The leverage is operational (call option struck on breakeven cost structure) and financial (companies have debt financing). The derivative is economically tied to the commodity via land rights which collateralize additional debt financing.

• Sloppiness can occur when policies are seen as good for the public.

Greenspan saw rising energy prices as a threat to the economy and he suggested we invest in LNG import terminals. The fear of risings prices hastened the 2005 Energy Policy Act which exempted drillers from disclosing the chemicals used in fracturing.

• Is Saudi’s timing of their portfolio rebalance performance-chasing?

• While increasing the security of US energy supplies seems like a net positive it’s unclear what the ramifications are longer term.

Shale for example has reduced our reliance in unstable regimes. But many of those regimes such as Nigeria were not major threats. If an insecure bully has some moderate economic leverage against you it may be better to pay them to control them. If you remove the leverage you also destabilize the equilibrium. An equilibrium you were ultimately in control of. You may find yourself now facing a desperate, rabid adversary who despite a smaller stature now has its back to the wall. You have exchanged a stable, modestly negative state for a wildly uncertain modestly incrementally positive (perhaps fleeting) state. This is especially true when the dog whose bark is louder than its bite is in a region concerned with terrorism and nuclear proliferation.

• Munger: we should be conserving oil and delaying gratification until we are certain about the extent of its future needs.

This is because fertilizer, pesticides and other ag products are made with hydrocarbons and there is no technology that has replaced that. “Like the topsoil in Iowa, you wouldn’t want to use it as fast as possible” he believes the shale boom was lucky and we shouldn’t just consume the gift. He recommends we commit to production enough to remain competitive in its technology while maintaining reliance on foreign oil. Let them deplete their reserves until we have a better understanding of what the future barrel is worth. Remember that the US being the first to switch to unconventional oil and gas required it to be the first to run out of conventional oil and gas.

Shale has been a subsidy to the economy and it’s very unclear to what extent we should drill aggressively or more thoughtfully since the future demand for oil is devilishly uncertain (there is more certainty around gas supplies). Is this another example of being short-sighted and drilling at all costs while oil execs and consumers win or if we’d be better off with higher near term prices and renewables even more competitive?

Chop Wood, Carry Water

by Jason Medcalf

Quick Summary and Review

A sensei teaches a modern day student to be a samurai archer in Japan. The focus on process is wax-on, wax-off a la Karate Kid. As an apprentice, the protaganist spends most of his time “chopping wood, and carrying water” which he is initially impatient with. Of course, as anybody familiar with Mr. Miyagi would forsee, the mental and physical effort is transferable to the mastery of archery. The lessons are communicated with contemporary parables. Sticky and timeless. This book would be a perfect gift for a teen or recent grad.

Why Try To Be Great

You have one life

Pain of regret lasts longer than the pain of failure.

Don’t pretend you get to live twice.

You will be irreplaceable even if you are not the best.

• When you go on a self-directed journey you’re learning things and developing skills that make you highly irreplaceable.

You don’t find traffic after going the extra mile.

A bold new world

• Things that used to be virtually impossible to build and create on your own can now be done with just a few clicks.
• Very few people have woken up to that truth, because doing so requires getting uncomfortable and breaking away from much of what they’ve known their whole lives. They would rather have the perceived illusion of safety with a consistent job, even if it’s one where they are completely disengaged doing things they don’t believe in, all while complaining about how unfairly they’re being treated, despite being able to quit at any time. They have been so brainwashed by a system that encourages disengagement, passing tests, and buying stuff you don’t need to impress people you don’t like, that they can’t see the reality: that there are fields all around them, just waiting to be farmed.
• Very few people understand this because they have been studying old maps their whole lives. The territory is new. 

Falling in love with process

Start small and focus on what you can control.

• Chopping wood and carrying water is the price for admission to reach sustained excellence. Like the roots of a bamboo tree, it is a long and arduous process of invisible growth, where you are building the foundation that is necessary to sustain success. For many years it may feel as if nothing is happening, but you must trust the process and continue to chop wood and carry water, day in day out.

The importance of little things. Inches

“Now you see how much an inch is worth. Every adjustment at the firing line means the difference between hitting the target or missing it. And the same is true in life. Every little thing we do, no matter how mundane, matters greatly when it is multiplied by the number of times you do it. Over time, even the smallest habit or choice can change our lives immensely. Do you know what separates most wildly successful people from everyone else, John?”

“Luck?” Akira shook his head, no. “Hard work?” Again, no. “Coming from the right background?”

Akira just smiled, “Inches, John. That’s all that separates them.” (This was pretty much Al Pacino’s speech in Any Given Sunday).

Think about your group of friends from high school. You’re all from the same area, you’re all the same age, and most of you have had a very similar set of opportunities. And right now, someone might look at all of you and be unable to really see much of a difference in your lives. But in ten years, an underachiever might be incredibly successful, while another who flourished in high school may be struggling to even survive. But I can as the difference in their lives will always come down to inches.

Most people are so consumed with their day-to-day lives, that they never pause to see the big picture. And in the big picture, every single choice matters, no matter how small. Everything you choose to read, listen to, or look at. Everything you think about, dream about, or focus on. And especially, your circle the people you surround yourself with and allow to influence you can make all the difference in who you become. Inches might look small up close, but added up over the right amount of time, they can cover any distance in the universe.

You don’t rise to the occasion you sink to the level of your training.

What to Expect on the Path to Greatness

Loneliness

• Don’t believe the myths. Greatness is far from sexy, it is dirty, hard work usually required to be done in the dark. When no one is watching your dreams are so far off they feel like fairy tales.
• There will be distractions. There will be people who tell you that you are stupid or crazy for doing it.
• Most people do not try to realize their potential because they’d rather protect their ego.
  • People won’t understand. Most are more invested in their ego than a mission.
  • Evil’s greatest weapon is discouragement.
  • When we see people who were like us achieve greatness we often retrofit labels like “talented” or “chosen”. This protects our egos which did not do what it takes to achieve greatness. (It reminds me of how people’s perception of Tom Sawyer when they discovered he had money. And how they retroactively applied that perception, seemingly having forgotten the orphan’s rascal behavior.)
• Cites 74% of people knowingly give a wrong answer to not stand out.
• “Greatness isn’t for the chosen few. It’s for the few who choose.” – Jamie Gilbert
• Everyone wants to be great until it’s time to do what greatness requires.

Temptation to take shortcuts

• There will be people who try and lure you off the path with quick fixes and get rich quick schemes. But you must be wise and stay the path, and continue to build your foundation by chopping wood and carrying water every day. Greatness isn’t sexy, it is the dirty, hard work that is often very boring. Your greatest challenge during your time here will be to faithfully keep your focus on the process, while surrendering the outcome.

Comparison traps

• Comparison is the thief of joy and short-sighted. Compare to yourself. Your former self and your potential.

The grass is not greener on the other side. It is greener where you water it. 

Don’t give advice unless asked

• There will be people who ask you for wisdom but you must never cross boundaries without an invitation.
  • When the student is ready, the teacher appears. Often a good idea to ask if the person is looking for advice or just venting and wanting to be heard. 
• “The difference between a pest and a guest is an invitation.” – James Richards

Improve Your Mindset

Rewiring your brain for encouragement

• We don’t remember experiences as objective events. We remember them by the stories we tell about them. By focusing on what we did well, we can turn our memory into encouragement. Rewiring is tedious work.
  • Example: writing down at least 15 positive things that you did or happened that day. This is an action which promotes a growth mindset.
  • Instead of seeing moments as tests, view them as opportunities to learn.
  • Another good habit: write at least 2 things you learned that day.

“Humility is not thinking less of ourselves it’s thinking of ourselves less.” – CS Lewis

• To fuel yourself with encouragement watch your inputs: what you consume, who you surround yourself with, how you talk to yourself, what you visualize.

How to stop comparing

• Enumerating what you are grateful for including basic like health and clean drinking water.

Reframing setbacks

• Just as the dimples on a golf ball allow it to travel further, hardship prepares you to persist. Talent or winning a lottery can be a curse since it skips the character-building that is usually required to get far. So look at setbacks as investments which will pay off in the future.

Talent is nothing without character.

Talk to yourself instead of listening to yourself.

• How you label your feelings affects how you filter their meaning which affects their impact. Are you “nervous” or “excited”?
• Ask yourself, “what is one thing I can do to make the situation better?” rather than “why is this happening to me?”
• Nobody is forcing you to do anything. You choose what you do.

“There is only one thing you have to do in life, and that is die. You are always doing what you want to do because there is always a choice. You may not like the choices or the consequences, but you always have a choice. When you tell yourself that you have to do something it creates a negative internal energy, but when you realize you want to do something it creates a more beneficial internal energy.”

Remember this next time you think you don’t have enough time.

My Favorite Takeaways

The advice is simple and timeless

• Just not simple to execute. Like losing weight. The strategy is straighforward but it is not easy.

Surrender what is out of your control while committing to what is.

Living by principles instead of feelings

• Feelings are fickle.

Many days, you aren’t going to feel like working out and honing your craft. Many days, you aren’t going to feel like treating people really well. Many days, you aren’t going to feel like being unconditionally grateful. Many days, you aren’t going to feel like giving your very best.

But the principle says you are going to reap what you sow. The principle says that diligent workers are going to serve kings instead of ordinary men. The principle says to turn the other cheek. The principle says to seek wise counsel. The principle says to speak life and not death.

At the end of principles there is life, freedom, hope, joy, and peace.

The most you can expect from feelings is happiness. But like every other feeling, happiness doesn’t last. That’s exactly why trillion-dollar industries try to keep you chasing it because it is perpetually unavailable.

You are building your own house

• The achitect parable

The architect, desperate to retire, is implored to design one final house. Since his heart is not fully in it, he cuts corners. Only at the end of the project does he learn that the firm that commissioned it, built the house for him. If he only know he was building his own house he would have designed it with maximal effort and pride. In life, we are all “building our own house”. 

Progress is not steady

• Zoomed in it can look random with ups and downs and detours.
• Zoomed out it is a step-function.

Remember this when you hit the inevitable detours and plateaus. 

Setbacks are investments

• The grit it takes to overcome setbacks will be the basis of your confidence when hard times come. And they always do. By doing hard things you are training for life.
  
  

You are not as alone as seems

• Curate your inputs and who you surround yourself with. Fill your environment with inspiration not naysayers.

Some select highlights from Tom Sawyer by Mark Twain

Human Psychology

When Tom tricks his friends into painting the fence…

He had discovered a great law of human action, without knowing it — namely, that in order to make a man or a boy covet a thing, it is only necessary to make the thing difficult to attain.

How money influences perception…

There are wealthy gentlemen in England who drive four–horse passenger–coaches twenty or thirty miles on a daily line, in the summer, because the privilege costs them considerable money; but if they were offered wages for the service, that would turn it into work and then they would resign.

When the approval of others is worth more than the prize…

It is possible that Tom’s mental stomach had never really hungered for one of those prizes, but unquestionably his entire being had for many a day longed for the glory and the eclat that came with it.

How admiration from others encourages you until the point of fraud…

They began to tell their adventures to hungry listeners-but they only began; it was not a thing likely to have an end, with imaginations like theirs to furnish material.

Reverse psychology defined…

Now he found out a new thing-namely, that to promise not to do a thing is the surest way in the world to make a body want to go and do that very thing.

We want what we can’t have. There’s a lesson about artificial scarcity here…

however-there was something in that. He could drink and swear, now-but found to his surprise that he did not want to. The simple fact that he could, took the desire away, and the charm of it.

Status alters our perceptions…

Mr. Benton, an actual United States Senator, proved an overwhelming disappointment-for he was not twenty-five.

When Tom and Huck are found to be rich (they found stolen $$) confirmation bias sets in and the narratives about them are retrofit to account for their newfound brilliance…

Wherever Tom and Huck appeared they were courted, admired, stared at. The boys were not able to remember that their remarks had possessed weight before; but now their sayings were treasured and repeated; everything they did seemed somehow to be regarded as remarkable; they had evidently lost the power of doing and saying commonplace things; moreover, their past history was raked up and discovered to bear marks of conspicuous originality. The village paper published biographical sketches of the boys.

Sometimes you just need someone to talk to…

It would be some relief to unseal his tongue for a little while; to divide his burden of distress with another sufferer.

On taking loved ones for granted…

Tom, you’ll look back, some day, when it’s too late, and wish you’d cared a little more for me when it would have cost you so little.

On the temperment of mob psychology. Here Potter goes from being considered guilty without a trial to be exonerated on hearsay…

As usual, the fickle, unreasoning world took Muff Potter to its bosom and fondled him as lavishly as it had abused him before. But that sort of conduct is to the world’s credit; therefore it is not well to find fault with it.

Mental well-being means physical well-being…

such a laugh was money in a-man’s pocket, because it cut down the doctor’s bill like everything.

Mocking customs

When Tom purchases his way to an honor that was meant to be earned…

Tom was therefore elevated to a place with the Judge and the other elect, and the great news was announced from headquarters. It was the most stunning surprise of the decade, and so profound was the sensation that it lifted the new hero up to the judicial one’s altitude, and the school had two marvels to gaze upon in place of one. The boys were all eaten up with envy–but those that suffered the bitterest pangs were those who perceived too late that they themselves had contributed to this hated splendor by trading tickets to Tom for the wealth he had amassed in selling whitewashing privileges. These despised themselves, as being the dupes of a wily fraud, a guileful snake in the grass. The prize was delivered to Tom with as much effusion as the superintendent could pump up under the circumstances; but it lacked somewhat of the true gush, for the poor fellow’s instinct taught him that there was a mystery here that could not well bear the light, perhaps; it was simply preposterous that this boy had warehoused two thousand sheaves of Scriptural wisdom on his premises–a dozen would strain his capacity, without a doubt.

Customs are often illogical…

Often, the less there is to justify a traditional custom, the harder it is to get rid of it.

On the banality of conformity…

A prevalent feature in these compositions was a nursed and petted melancholy; another was a wasteful and opulent gush of “fine language”; another was a tendency to lug in by the ears particularly prized words and phrases until they were worn entirely out; and a peculiarity that conspicuously marked and marred them was the inveterate and intolerable sermon that wagged its crippled tail at the end of each and every one of them. No matter what the subject might be, a brainracking effort was made to squirm it into some aspect or other that the moral and religious mind could contemplate with edification. The glaring insincerity of these sermons was not sufficient to compass the banishment of the fashion from the schools, and it is not sufficient today; it never will be sufficient while the world stands, perhaps.

How mindless ritual corrodes ingenuity (Twain is critical of organized religion)…

Tom went about, hoping against hope for the sight of one. blessed sinful face, but disappointment crossed him everywhere. He found Joe Harper studying a Testament, and turned sadly away from the depressing spectacle. He sought Ben Rogers, and found him visiting the poor with a basket of tracts. He hunted up Jim Hollis, who called his attention to the precious blessing of his late measles as a warning. Every boy he encountered added another ton to his depression; and when, in desperation, he flew for refuge at last to the bosom of Huckleberry Finn and was received with a Scriptural quotation, his heart broke and he crept home and to bed realizing that he alone of all the town was lost, forever and forever.

Humans are susceptible to quackery and superstition

Describing his Aunt Polly who falls for remedies…

She was one of those people who are infatuated with patent medicines and all new-fangled methods of producing health or mending it. She was an inveterate experimenter in these things. When something fresh in this line came out she was in a fever, right away, to try it; not on herself, for she was never ailing, but on anybody else that came handy. She was a subscriber for all the “Health” periodicals and phrenological frauds; and the solemn ignorance they were inflated with was breath to her nostrils. All the “rot” they contained about ventilation, and how to go to bed, and how to get up, and what to eat, and what to drink, and how much exercise to take, and what frame of mind to keep one’s self in, and what sort of clothing to wear, was all gospel to her, and she never observed that her health-journals of the current month customarily upset everything they had recommended the month before. She was as simple-hearted and honest as the day was long, and so she was an easy victim. She gathered together her quack periodicals and her quack medicines, and thus armed with death, went about on her pale horse, in disguise, to the suffering neighbors.

And how confirmation bias reinforces their gullibility. Here’s Aunt Polly falling for Tom’s claim of ESP…

Sereny Harper shall know of this before I’m an hour older. I’d like to see her get around this with her rubbage ’bout superstition. Go on, Tom!

The bizarre epistemology that the superstitious employ…

The other boys agreed that there was reason in what Tom said, because an ignorant lump of bread, uninstructed by an incantation, could not be expected to act very intelligently when set upon an errand of such gravity.

Observations of people

There will always be people whose lenience will seem excessive of the facts…

Injun Joe was believed to have killed five citizens of the village, but what of that? If he had been Satan himself there would have been plenty of weaklings ready to scribble their names to a pardon-petition, and drip a tear on it from their permanently impaired and leaky water-works.

Careful what you wish for. On miswanting…

Huck Finn’s wealth and the fact that he was now under the Widow Douglas’ protection introduced him into society-no, dragged him into it, hurled him into it-and his sufferings were almost more than he could bear.

He had to eat with a knife and fork; he had to use napkin, cup, and plate; he had to learn his book, he had to go to church; he had to talk so properly that speech was become insipid in his mouth; whithersoever he turned, the bars and shackles of civilization shut him in and bound him hand and foot.

I got to wear them blamed clothes that just smothers me, Tom; they don’t seem to any air git through ’em, somehow; and they’re so rotten nice that I can’t set down, nor lay down, nor roll around anywher’s; I hain’t slid on a cellar-door for-well, it ‘pears to be years; I got to go to church and sweat and sweat-I hate them ornery sermons! I can’t ketch a fly in there, I can’t chaw. I got to wear shoes all Sunday. The widder eats by a bell; she goes to bed by a bell; she gits up by a bell-everything’s so awful reg’lar a body can’t stand it.” “Well, everybody does that way, Huck.” “Tom, it don’t make no difference. I ain’t everybody, and I can’t stand it. It’s awful to be tied up so. And grub comes too easy-I don’t take no interest in vittles, that way. I got to ask to go a-fishing; I got to ask to go in a-swimming-dern’d if I hain’t got to ask to do everything. Well, I’d got to talk so nice it wasn’t no comfort-I’d got to go up in the attic and rip out awhile, every day, to git a taste in my mouth, or I’d a died, Tom. The widder wouldn’t let me smoke; she wouldn’t let me yell, she wouldn’t let I never see such a woman! I had to shove, Tom-I just had to. And besides, that school’s going to open, and I’d a had to go to it-well, I wouldn’t stand that , Tom. Looky-here, Tom, being rich ain’t what it’s cracked up to be. It’s just worry and worry, and sweat and sweat, and a-wishing you was dead all the time. Now these clothes suits me, and this bar’l suits me, and I ain’t ever going to shake ’em any more. Tom, I wouldn’t ever got into all this trouble if it hadn’t ‘a’ ben for that money; now you just take my sheer of it along with your’n, and gimme a ten-center sometimes-not many times, becuz I don’t give a dern for a thing ‘thout it’s tollable hard to git-and you go and beg off for me with the widder.” “Oh, Huck, you know I can’t do that. ‘Tain’t fair; and besides if you’ll try this thing just a while longer you’ll come to like it.” “Like it! Yes-the way I’d like a hot stove if I was to set on it long enough. No, Tom, I won’t be rich, and I won’t live in them cussed smothery houses. I like the woods, and the river, and hogsheads, and I’ll stick to ’em, too.

The value of time depends on your wealth…

Huck was always willing to take a hand in any enterprise that offered entertainment and required no capital, for he had a troublesome superabundance of that sort of time which is not money.

Adults and children are fundamentally different (and some humor on marriage as the end of the line)…

SO endeth this chronicle. It being strictly a history of a boy , it must stop here; the story could not go much further without becoming the history of a man . When one writes a novel about grown people, he knows exactly where to stop-that is, with a marriage; but when he writes of juveniles, he must stop where he best can. Most of the characters that perform in this book still live, and are prosperous and happy. Some day it may seem worth while to take up the story of the younger ones again and see what sort of men and women they turned out to be; therefore it will be wisest not to reveal any of that part of their lives at present.

Statistics Done Wrong
Alex Reinhart

https://www.statisticsdonewrong.com/

P Values

• Measure of ‘surprise’. The smaller the p the larger the ‘surprise’. P values work by assuming that there is no difference between the 2 samples. If you want to show a drug works you counterintuitively show that “the data is inconsistent with the drug not working”
• P values say nothing about the magnitude of the effect. A small p can reveal a massive effect or a tiny effect with great certainty (say if you collected massive data). Statistical significance does not mean practical significance! Similarly, statistical insignificance does not mean zero and is simply the best evidence-based on the trial data you studied.
• Neyman-Pearson uses p-values in a conceptually different way. They estimate an acceptable false positive rate called ‘alpha’. Statistical significance allows us to reject the null hypothesis for the established alpha or false positive rate. This rate is informed by the experimenter’s understanding of the procedure.

Confidence Intervals

• These are preferable to p-values since they provide a point estimate and a measure of uncertainty and if they can be supplied instead of just p-values they should.
• They are less common in the literature perhaps b/c they can be very wide

Statistical Power

• The probability that a study of a given amount of data is capable of showing statistical significance. For example, how many coin flips do you need to be 95% sure that your experiment can reveal a biased coin that is 60% weighted towards heads? Statistical power is a function of :
  • The size of the effect; a smaller effect requires more data
  • Sample size; more data means the study has higher statistical power
  • Measurement error; more subjective measurements have less power
• Many studies are underpowered because there is not enough data. This often occurs because it is expensive/risky (ie drug studies) or unethical (studies on animals)
• While an antidote for multiple comparison problems can be to require lower p values, the trade-off is that studies will become underpowered
• The concept of power is often forgotten because it is not taught in intro stats and is not readily intuitive. Again, confidence intervals which are wide can reveal a lack of statistical power again supporting their use over p values.
• Truth inflation or type M error (‘magnitude’) is the effect of there being many experimenters ‘competing’ to publish extreme results.
• Small samples have more variance; be careful to draw conclusions from them since they are more likely to be underpowered
  • Rural states have counties with both the lowest AND highest kidney cancer rates; this is likely due to small populations, not a real effect. The same is true for test scores in smaller schools; we may interpret them to be ‘better’ based on test scores but this is because their average extremes are higher than the average extremes of bigger schools!
  • Remedies for this include shrinkage. Weighting the average from a small sample with a weighted average from a larger population (ie weighting a small county with a higher weighted national average). This will, unfortunately, bias truly abnormal cases too much towards normal. The best remedy is to try to find a larger sample (ie use congressional districts instead of counties). Shrinkage is a good technique in measuring average product reviews (products with few reviews are shrunk towards a generic version of the product).

Pseudoreplication

• Using additional measurements that are highly dependent on highly correlated to previous data. This form of replication doesn’t allow you to generalize inferences.
• If you cannot eliminate hidden sources of correlation between variables you must try to statistically adjust for confounding factors.

Base rate fallacy

• A low p-value is often touted as evidence of significance but significance also depends on the base rate. Consider Bayesian examples like mammogram testing. If mammograms have a false positive rate of 5% and a 90% chance of accurately identifying cancer then if you test 1000 people and 50 of them test positive then it is still quite unlikely that most of those people have cancer. Why? Because the base rate is a mere 1%. Only 10 people in that sample have cancer and we expect 9 of them to be accurately identified but more than 50 will test positive! When testing for conditions with very low base rates false-positive rates will swamp true positive rates.
• An extreme example of these false discovery rates you are looking for an effect which definitely does not exist, no matter how low you set your p threshold we know your so-called significant results are still false positives, and you are bound to record significance results with a large enough sample.
• Combatting false discovery rates with multiple comparisons is challenging but important since you expect many false discoveries. Tips include:
  • Remember p < .05 doesn’t mean there’s a 5% chance your result is false
  • When making multiple comparisons using a procedure such as Bonferroni or Benjamin-Hochberg will make your required p values much more conservative by accounting for the number of tests
  • Be aware of stat techniques specific to your field for testing data
  • Have an idea of base rates to estimate how prevalent false positives are likely to be

Confounding variables

1. Correlation is not causation

• Because you do not know if there is a confounding variable. If you create a model that predicts heart attack rates based on weight, exercise, and diet it’s tempting to say that if you change one of them x% that the heart attack rate will change by y%. However, that is not what you tested. You didn’t change the variables in a real experiment and measure the outcomes. It is not clear that a confounding variable is actually influencing the heart attack rate.
• Also, to say a variable changes all else equal is a fantasy. In reality, it is unusual for single variables to change in a vacuum.

1. Simpsons Paradox

• When a trend in the data disappears when the data is divided into natural groups. It tends to occur in observational studies with biased samples thus obscuring a confounding variable.
• Examples:
  • Berkeley admission bias against women in 1973. In aggregate, women looked discriminated against but at the department level, the opposite was true. The bias occurred bc women applied in higher numbers to competitive, underfunded departments. The bias happened earlier in the process: women were systematically pushed towards these fields
  • Penicillin appeared to improve outcomes for meningitis cases in the UK. At a closer look, the sample was biased since it was only administered to children who were not rushed to the hospital so they were the milder cases. Isolating the sample to those who visited a general practitioner first we find that penicillin, in fact, seemed to correlate with worse outcomes (there are theories about the breakdown of the contagion causing shock but there aren’t experiments for testing if penicillin actually causes meningitis patients to die)
  • Looking at aggregate data United flights are delayed more frequently than Continental. But at individual airports, the trend reverses. The aggregate data doesn’t account for the fact that United flys out of more airports with bad weather.

How Not to Be Wrong: The Power of Mathematical Thinking
by Jordan Ellenburg

• Math gives you tools to extend your common sense of reasoning and logic. He uses the analogy of Ironman’s suit.
• Competitions including war are often decided by small edges. Being 5% better at x or y can decide the outcome over a long enough game. (Similar to my experience with boardgames. A more efficient engine in a game of 7 Wonders or Settlers can save you actions; like reducing the cost of capturing winning victory points.)
• Zooming in on points of a curve they look and can be approximated by lines. Trajectories are curves influenced by gravity but objects appear to move in straight lines. Using lines to approximate curves is the basis of calculus and even the derivation of pi as the area of a circle (Archimedes did this by iteratively computing the edges of a circumscribed circle as a polygon. Imagine an octagon, then a polygon with 64 sides, and so forth until it looks like a circle. You can then use trigonometry to compute the area of the triangles you keep creating until the sum of all the area approximates the area of the circle)
  • Critics of this method like Zeno highlighted the uncomfortable paradox of constantly halving something until you get nowhere. Comically, the skeptic Diogenes countered Zeno by simply walking across the room to make the point that motion is indeed possible!
• The law of large numbers explains why South Dakota can have the highest rate of brain cancer and North Dakota the smallest. They both have small populations. Be careful when comparing quantities from 2 very different sample sizes. Small samples are more volatile. If you flip 10 coins, your odds of getting 8 heads is unlikely but real. But flip 1000 coins it’s nearly impossible to get 800 heads.

Data mining 

“The more chances you give yourself to be surprised the higher your threshold for surprise had better be.”

“A significance test is a scientific instrument and like any other instrument, it has a certain degree of precision. If you make the test more sensitive by increasing the size of the studies population, for example, you enable yourself to see ever-smaller effects. That’s the power of the method but also the danger”

• An underpowered study has the opposite problem. You dismiss an effect that your method was too weak to see. A good example is the original 1985 hot hand studies. They rejected the idea of a hot hand but it turns out the methods they used rejected a hot hand even on data sets that were generated by simulations that deliberately baked in a hot hand! In fact, their methods failed to notice even the effects of good vs bad defenses which we know influences offensive shooting percentages.
  • The final verdict is there may be some hot hand effect but it is too difficult to detect because if it exists it is very small. In fact, players who think they are hot take harder shots and perform worse so it’s best for them to not believe in the effect since it will be more than offset by an unjustifiably confident shot selection.

The Bayesian examples in the book are great.

• In a Bayesian framework how much you believe something after you see the evidence depends not just on what the evidence shows but much you believed it to begin with. Posterior probabilities still depend on the strength of your priors.
• On conspiracy theories: “If you do happen to find yourself partially believing a crazy theory, don’t worry — probably the evidence you encounter will be inconsistent with it, driving down your degree of belief in the craziness until your beliefs come in line with everyone else’s. Unless, that is, the crazy theory is designed to survive the winnowing process. That’s how conspiracy theories work”.

Tradeoffs and cost of perfection

• Stigler type arguments that optimal decisions often leave a margin for error. Getting to the airport early enough to have a 100% chance of making the flight is probably so conservative it’s wasteful (depends on your utility curve but almost certainly wasteful to be 100% certain vs say 95%). When you read a story about social security overpaying people bc they were actually dead, it turns out that mistake represents less than 1 basis point of payments. In other words, they do a great job not making this mistake and the cost of being 100% compliant may simply not be cost-effective to be worthwhile.

St Petersburg and the role of expected utility

• Fran Lebowitz utility curve of money: she would drive a cab each month until she could eat and pay rent. Afterwards, she would write. In other words, she had a linear utility curve which flattened abruptly. If you raise her taxes she works more as opposed to someone with a logarithmic curve who is at the point of indifference between work and leisure
• Ellsburg Paradox highlights the limitations of utility theories. It highlights the difference between what Rumsfeld called “known unknowns” or what mathematics refers to as risk vs “unkown unknowns” or uncertainty. Utility theory may help with uncertainty but formal math is less useful.

Regression to the mean explains many phenomena that are usually attributed to another reason.

• Examples, best-performing companies (competition attribution), musician/writer sophomore slump, RB after signing a big contract, dietary fiber speeding or slowing digestion, Scared Straight juvenile detention program, diet effects when people are at their peak weights. When something is at an extreme we should expect reversion simply bc of math and therefore be very careful of attributing to an intervention.

Correlations between variables reduce the information content of the variable.

• You try to identify criminals by foot and hand size you are choosing highly correlated variables.
• Strong correlations lie behind how we compress images and music files. A green pixel is probably next to a green pixel.

Berkson’s Paradox

• (via Wikipedia) The most common example of Berkson’s paradox is a false observation of a negative correlation between two positive traits, i.e., that members of a population which have some positive trait tend to lack a second. Berkson’s paradox occurs when this observation appears true when in reality the two properties are unrelated—or even positively correlated—because members of the population where both are absent are not equally observed.
• Wikipedia summarized Ellenberg’s attractiveness example:

Suppose Alex will only date a man if his niceness plus his handsomeness exceeds some threshold. Then nicer men do not have to be as handsome to qualify for Alex’s dating pool. So, among the men that Alex dates, Alex may observe that the nicer ones are less handsome on average (and vice versa), even if these traits are uncorrelated in the general population. Note that this does not mean that men in the dating pool compare unfavorably with men in the population. On the contrary, Alex’s selection criterion means that Alex has high standards. The average nice man that Alex dates is actually more handsome than the average man in the population (since even among nice men, the ugliest portion of the population is skipped). Berkson’s negative correlation is an effect that arises within the dating pool: the rude men that Alex dates must have been even more handsome to qualify.

Asymmetric domination effect

• Aka “decoy effect”. When an clearly inferior option is introduced in one’s menu of choices it makes the clearly dominant choice appear even better than it did against its prior competitor. He uses the example of slime mold behavior which implicitly rak preferences between more food (oats) vs dark environments.
  • More examples via GoHighBrow.com

Marketing is the most common domain of the decoy effect, but it’s also present elsewhere.

• Price tables: These, like The Economist example above, frequently display the decoy effect.

• Menus and wine lists: Putting an expensive option at the top of a menu makes the other meals seem cheaper (remember anchoring?). Similarly, wine lists make use of the decoy effect: “People often order the second cheapest wine on the list and not the cheapest because they don’t want to look too stingy. Most of the time, the second cheapest wine is the one that has the highest profit margin.”

• Romance: Ariely offers some dating advice: If you are looking to meet that special someone in a social setting, he recommends bringing someone who looks similar to you but is less attractive. They will act as a decoy, making you seem more attractive by comparison. And if a “similar but better-looking friend of the same sex asks you to accompany him or her for a night out, you might wonder whether you have been invited along for your company or merely as a decoy.”

• Elections: Studies show that third candidates and minor parties influence your voting preferences by acting as decoys.

Democracy as tool for rightness not fairness

This was an interesting comment on what is at heart a question of whether democracy is both positive and normative. And how many ideas about fairness are never considered in light of their normative merit.

Condorcet thought that questions like “Who is the best leader?” had something like a right answer, and that citizens were something like scientific instruments for investigating those questions, subject to some inaccuracies of measurement, to be sure, but on average quite accurate. For him, democracy and majority rule were ways
not to be wrong, via math.

We don’t talk about democracy that way now. For most people, nowadays, the appeal of democratic choice is that it’s fair, we speak in the language of rights and believe on moral grounds that people should be able to choose their own rulers, whether these choices are wise or not.

This is not just an argument about politics—it’s a fundamental question that applies to every field of mental endeavor. Are we trying to figure out what’s true, or are we trying to figure out what conclusions are licensed by our rules and procedures? Hopefully the two notions frequently agree but all the difficulty, and thus all the conceptually interesting stuff happens at the points where they diverge.

The Lessons of History
by Will and Ariel Durant

Geography

• As technology evolves, the influence of geography is diminished
• The prosperity of civilizations is closely tied to geography notably rivers and coasts
• Ultimately, humans create culture, not the earth

Biological lessons of history

• Life is competition
• We rely on the protection of our tribes and may cooperate within its confines but this is adaptive behavior in service of a wider competitive landscape. Until a group is as large as a state it will “continue to act like individuals and families in the hunting stage”
• Life is selection
• Nature knows nothing of our egalitarian ideals or Bill of Rights. “Freedom and equality are sworn enemies”. If people are free, relative advantages will grow nearly geometrically. Inequality is inborn, we can only aspire to ideals such as equal access to education and justice.
• Natural selection benefits from the diversity and range of natural ability as it is the basis of evolution.
• Life must breed; birth rates shape history
• Nature cares only about the species, not the individual. Diversity and large “litters” are the fertile grounds that natural selection needs as fuel. Nature’s check on overpopulation is famine, pestilence, war.
• Higher birth rates can give rise to stronger tribal powers while progression into a higher standard of livings and industry appears to slow the birth rates as the tribe advances.
• To track the future of ideas, it may be instructive to watch birth rates; weakened ties to ethnicity or tribalism can leave the incumbent group vulnerable (Caesar and Augustus were aware of this and sought to penalize birth control; Italy’s ethnicity diluted over time making the empire vulnerable to its neighbors)
• On race: “A knowledge of history may teach us that civilization is a cooperative product, that nearly all peoples have contributed to it; it is it common heritage and debt; and the civilized soul will reveal itself in treating every man or woman, however lonely, as a representative of one of these creative and contributory groups.”

Government

• Monarchy has been the historical norm while democracies have been ‘hectic interludes’
  • Roman democracy crumbled under class wars giving way to Pax Romana, a 200 year succession of benevolent dictators until the murder of Caesar. This period was followed by disgraceful monarchs including Caligula before giving way to the greatest succession of monarchs ever, the last being Marcus Aurelius. Some of these monarchs had no heirs and promoted by merit until Aurelius died. Afterward his son Commodus ruled when no heir was named.
  • Monarchy has a mixed record, typically at its worst is when it is determined by blood and accompanying incompetence
• Most modern, complex governments  are oligarchies — ruled by a minority
  • Aristocracy by birth
  • Theocracy by religion
  • Democracy by wealth
• Plato reduced the cycle to monarchy->aristocracy->democracy->dictatorship. Repeat. This was based on Greece and repeated with the Romans. Democracies are overthrown or conquered as envy amongst the majority tires of the ‘sham’ of having a vote and uses the state to seize wealth. Other oligarchies fall when they wield their great power to narrowly or incompetently.
• The US democracy started from a wider base and in unity against British rule. Rural land-owning enhanced the sense and dedication to freedom, while geographic isolation created a national sense of freedom. These conditions have given way as land as sparse and cities have grown “Every advance in the complexity of the economy puts an added premium upon superior ability and intensifies the concentration of wealth and [power]”
• Democracy is a difficult form of gov’t since effective mob rule requires widespread intelligence to avoid manipulation by ‘the forces that mold public opinion’.
• Democracy, however, has done the most good and it can maintain its promise only if it affords equal opportunity for education [my own thought is this will always be uneven, and the unevenness grows with population size. For a small population, it is reasonable that the average access to education can be even]
• “If a race or class war divides us into hostile camps, changing political argument into blind hate, one side…may overturn the hustings with the rule of the sword. If our economy of freedom fails to distribute wealth as ably as it has created it, the road to dictatorship will be open to any man who can persuasively promise security to all”

History and War

• Competition via war is often for the same reasons as competition amongst individuals however while individuals are restrained by law and morals a state ‘acknowledges no substantial restraint either because it is strong enough to defy any interference…or because there is no superstate to offer its basic protection, and no international law or moral code wielding effective force’
• Religious wars in the 16th century and the wars of the French Revolution were battles between aristocracies leaving the masses to maintain mutual respect for their foreign counterparts while wars of the 20th century in accordance with technology and ‘means of indoctrination’ made war all-consuming ‘struggles between people’ and completely destroying centuries of labor and property.
• He presents the general case for the inevitability of war — competitive human nature, envy, beliefs so fundamentally different that cannot be settled by negotiation. Perhaps and only if we were united against aliens could we imagine our species not warring with each other. The opposing view is that the imperative to avoid large scale war because of the destructive power of current technology will prevail over any disagreements over ways to organize our lives and economies.

Progress

• Are we the ‘same trousered apes’ merely armed with increased tech, locomotion, and knowledge but weighed down by the persistent features which moor us to our primitive ancestors? Progress is defined not by happiness or similar measure but to the degree in which we may control our environment. By this standard, as evidenced by our increased adaptability and lifespans we have made tremendous progress. While subject to lapses and regressions, the avergae human has been the beneficary of an accumulated history and knowledge which has been succeeds in being recorded and transmitted to subsequent generations so that they may continue to build on this heritage from its most advanced point.

The Rebel Allocator
by Jacob L. Taylor

Summary

Using a Socratic device, the author creates a Buffet/Munger composite doppelganger named Mr X to help guide Nick, a young left-leaning journalist turned investor. Nick is disillusioned by the business world from his seat at Big Rock, a cartoon of a private equity firm whose short-term, scorched earth practices give capitalism a bad name. Through his regular lessons, Nick learns the principles of sound capital allocation and sees them applied within billionaire Mr X’s nationwide burger chain. The book covers a broad array of ideas that underpin business and strategy, while its narrative structure makes the lessons more enjoyable and practical than the dry texts that typically teach these topics.

The Profit Constraint

Apply this: revenue – profit = expenses aka pay yourself first.

• Yarak: “hungry but not weakened”
  • A bird in this state is the purest expression of its genetic capabilities.

3 Key qualities in employees

Integrity, intelligent, energy

• 2 out of 3 will do so long as you have integrity!

A compass for what to focus on

4 hours a day spent on something that will make other things easier or unnecessary

Zero-based budgeting

Every year budget items are subject to a ‘delight’ test. If the expense doesn’t delight the customer it’s non-strategic and subject to trimming. Don’t paint the (unseen) fourth wall.

Effect of compounding improvement

365 days of 1% improvement is 37x return

Iron Law of Economic Survival

Cost, price, value triangle (straws model introduced in ch 19)

1. Cost is true economic cost not accounting cost.
2. Price can be based on lifetime revenue.
3. Value is subjective,context dependent, and variable.

• Trade-off between profit (price minus cost) and brand (value minus price).
• By flying under the radar with lower profits you may be able to store brand in your customer’s mind.
  • Profit would alert competitors and regulators! Brand is poorly measured.
  • Me: Interesting to think of underpriced companies as those storing economic value in their brand which exists in the customer mind.
  • Net promoter score surveys compare the percent of people who are superfans vs those who are ambivalent or detractors

Customers don’t want a quarter-inch drill bit they want a quarter-inch hole

A business should consider its competition broadly with the criteria of who else fills the need. (ie Southwest airlines early on was competing with Greyhound for short trips).

Understand your edge

​Franchise model allows parent company to do what it does best: source ingredients, craft customer experience, marketing. The franchisee is really in the real estate business. (in the 4 seasons model this is same). Real estate unlevered returns are close to inflation while the fictional McDonald’s is closer to 12%

Effective capital allocation requires evaluating all options

Mr X looking at an empty plot poses the question, how many ways could we build a restaurant?

Student answers buy a plot, hire a construction crew and build one. But there are more strategies:

1. Buy land and erect building later
2. Buy land and wait
3. Buy competitors store and convert
4. Buy public stock
5. Buyback your own stock
6. Just waiting

• Your next best option is your opportunity cost. Important to not define menu too narrowly
• If you were trying to improve the experience of traveling across the country one option is to fly faster. This will cost substantial additional fuel and maintenance. Installing TVs on the planes may provide a better ratio of benefit to cost to the consumer.

2 kidneys for a reason

Tradeoff between efficiency and survival: virtue of cash and less leverage

Trees don’t grow to the sky

There are feedback loops which lead to mean reversion

The virtues of efficient capital allocation

“Good capital allocation means doing more with less to create happier customers. The pressure to continually deliver value is one of the wonders of the free market. Roll up all of those customers into society at large. When you are able to provide value for the least required cost, you free up resources that can go toward adding value somewhere else.

Imagine that inside you are all of these different locks. Each lock represents one of your wants or desires. You have a lock for food, a lock for shelter, a lock for water, a lock for the opposite sex. Now imagine that each capital allocation project creates one key. Ideally, the entrepreneur knows the lock their key will fit beforehand. A restaurant provides you food, a hotel gives you shelter, shoes protect your feet. The role of business is to use the least amount Of resources to create the key that fits a certain lock. Doing a proper job spares resources to create more keys for other locks. In this sense, profit should be celebrated as a signal that an entrepreneur provided value while consuming the least amount of resources to do so. When all of society’s businesses are properly allocating capital, more locks get keys, and we’re all better off.

That’s all technology really is: the means for us to turn more locks using fewer and cheaper keys.”

When simple models outperform experts

Simple models thrive when:

• Problem is ill-structured and complex.
• The information is incomplete, ambiguous, and changing.
• The goals are ill-defined, shifting, or competing.
• The stress is high, due to time constraints and/or high stakes.

Invisible Heart
by Russ Roberts

Thinking like an economist: Second Order

Price modulates supply/demand

“Children don’t anticipate the future very well, so we treat children differently from adults. But when we start treating adults like children, we start taking away the essential human challenge of coping with uncertainty and making decisions”

• A life without consequences and costs has no meaningful choices. A life without meaningful choices is the life of a “child, animal, or robot”
• The connection between choices and rewards is the essence of responsibility

Chapter 13: The Rules of the Game

• Thought experiment about designing the perfect law highlights the reality that every choice is a trade-off. If you had access to a “Dream Machine” a construct referenced from Nozick’s Anarchy, State, and Utopia then you would fast forward to the goals and prizes but the seeking, trials, failures and risks of the world would never be endured but remember without valleys, there are no peaks.
• When people are laid off it sharpens our focus on them. What’s blurred is the competition which rose to combat the cost-cutting company. The employees of those competitors get to have jobs.
• Maimonides thoughts on charity. The giver and receiver must be considered.

On an ascending level, they are as follows:

• A key to the self-regulating property of economies is private property. Regulation can make far more sense when dealing with a common resource that nobody owns. How did Zimbabwe turn such a resource into a form of ownership, thwart poachers and increase elephant populations? Making the villages able to charge to hunt them. This gave villages an incentive to care for the elephant population since elephants were now a source of revenue. While some conservationists found it reprehensible others found it practical. If you care more about elephant populations it turned out to be an effective strategy.
• “The human heart has its reasons that reason cannot know”. A divorce is complex and its cause is never as simple as one reason (ie infidelity). A divorce is the “product of a thousand misused moments”. The legal system is smart enough to recognize this and not try to determine whose fault it is. This is a good lesson when thinking about using courts to adjudicate discrimination. While some cases may be cut and dry most will not be and the ability of courts to intervene leads to changing incentives and potential for unintended consequences.

The Accounting Game: Basic Accounting Fresh from the Lemonade Stand
by Darrell Mullis and Judith Orloff

Balance sheet

Assets = Liabilities + Equity

Income statement

The movie that connects a period’s beginning and ending balance sheets which are snapshots.

Sales

-COGS
-Labor

________________

Gross Profit

-Expenses

________________

Net profit

For service businesses:

Sales

-Cost of services

_________________

Gross profits

-Expenses

_________________

Net profit

• Income taxes are deducted on the income statement to compute a net income after taxes.
• If you sell an asset at a value higher/lower than book value you will register a gain/loss on the income statement

Inventory

• The inventory from a beginning balance sheet will be part of the COGS in an income statement.
• Inventory on balance sheet can be divided into raw materials and finished good. It takes cash (for example to pay labor) to turn a raw material to a finished good so there can be cash “locked” up in the balance sheet in the finished goods that can only be realized by making sales.

Valuing inventory

• In an inflationary business where the cost of materials rises over time, LIFO accounting will value the inventory and COGS higher, in turn, reducing paper profits and taxes.
• Most businesses start using FIFO which is operationally easier but switch to LIFO for tax reasons. In fact, LIFO records are expensive to maintain and usually only done by companies with large inventories.
• The IRS must grant permission for your business to switch methods a second time and require any back taxes be paid.
• Where it was possible to report cash balance sheets to the IRS and accrual ones for investors it is required to be consistent with method used to value inventory (LIFO or FIFO). So accounting statements will usually footnote whether the assets are being under or overstated based on the method used.
• If it is easy to value the inventory individually (ie each item has a serial number) then some businesses will average the value of the inventory.

Accrual vs Cash Accounting

• Accrual accounting is more accurate but leads to higher profits than cash accounting so it leads to higher taxes. Companies prefer cash method for IRS but accrual method for investors.
• Service companies have the advantage of being able to use cash accounting but companies who have inventories as a significant portion of business are required to use the accrual method. Otherwise, they could easily shield profits by spending cash on hand to buy inventory and reduce reported earnings.

By allocating items, we can allocate items in a way that lends economic insight into the business and price services correctly.

Capitalizing an asset vs expensing it

Plants and buildings are fixed assets although costs to maintain them would be recorded on the income statement as expenses.

• Equipment is also a fixed asset but usually separated from plants and buildings which are stationary.
• Whether a purchase is treated as an asset or expense really depends on:

1. duration of its use. If it is many years then capitalize it as an asset. If it’s treated as an expense it will reduce earnings in the current period.
2. Its cost. You can set a dollar limit, and any item which exceeds it will be capitalized.

Cash Statement

Keeps track of cash flow which is necessary when doing accrual accounting. For example, if you made a sale on credit in a previous accounting period and the cash for that sale comes in we do not adjust the income statement since we already accounted for the sale. However we will update the cash statement.

Depreciation

Shows up as an expense on the income statement reducing earnings. The balance sheet will be kept in balance by reducing the value of the fixed assets by the same amount as the expense.

• It is a rare Non-Cash Expense allowing us to reduce earnings without losing cash!
• Buildings must use “straight line” depreciation while equipment can use “straight line” or “accelerated”. There are a few types of “accelerated” schedules and the IRS intermittently changes them. “Accelerated” depreciation uses the updated “base” (ie the asset’s value after the last depreciation period) to calculate the new depreciation amount. The resulting curve will allow you to save taxes near term by taking steeper depreciation expense.

Categorization of Assets

“Current Assets”: assets such as cash, receivables, inventory and prepaid expenses which are probably convertible to cash within 1 year.

“Net Fixed Assets” or “net book value of assets”: gross fixed assets (using purchase price) + accumulated depreciation

• By breaking net fixed assets into gross + depreciation we can estimate how old the assets are.
• Assets are typically listed on a balance sheet in descending order of liquidity (ie cash is first).

Understanding the difference between earnings and cash

When you are investing in a business you may find that it has little cash and even if the business is very profitable it is very possible to have high retained earnings but no cash. Retained earnings are not cash! It is not a sum just sitting in a bank. It reflects that the business has been profitable, and also your ownership but it is not spendable like cash. It can be tied up in assets.

• On a daily basis, cash runs the business!