Patrick Byrne visited Dartmouth’s Tuck School of Business this evening. It was something of a local event, since Patrick and his father, Jack Byrne, both attended Dartmouth. The 90-minute format was was structured such that three ’09 Tuck students each asked a question and then the audience asked a bunch of questions. His answers were very complete thoughts with muti-minute responses.
Jack was president of GEICO insurance which was owned by Berkeshire Hathaway, owned by Warren Buffett. Because of this Warren was a regular houseguest at the Byrne’s in the 1970s and Patrick grew up hearing Buffett describe his approach to thinking about business. Some Buffett pearls:
On buying companies: “Always try to buy a dollar for sixty cents, forty if you can.” Byrne continues, “Sometimes, every once in a while, like now, maybe twenty cents for a dollar.”
On buying stocks: “Here’s something adults don’t understand. When you buy a stock, don’t think of it like a piece of paper that moves up and down. Instead, if you buy the stock, and the stock market closed tomorrow and you had to hold the stock for five years, would you still buy the stock? That’s the question. Act like you’re buying a part of the company that you’re going to own. Because you are.”
On buying bankrupt RTC real estate in the ’80s: “If you’re not going to kick a man when he’s down, when are you going to kick him?”
After graduation Byrne started a nine-month master’s program in philosophy at Stanford. He was diagnosed with cancer, and during the next four years (age 22 – 26) was in and out of treatment. He said he had three rounds of remission and return, each putting him in the hospital for three to nine months at a time. An interesting side-effect of this was that having fallen so far behind his peers he was never trying to keep up or prove anything. After beating cancer a couple of times he decided to live his life in six-month blocks, hoping for the best, and doing things he wanted to do. He went on to obtain a master’s degree from Cambridge University as a Marshall Scholar, and a Ph.D. in philosophy from Stanford.
During this time he alternated between school and various real estate deals, sometimes with his brother. Often this involved buying RTC properties, doing a company turnaround, and selling for decent profits. They purchased a large (one million ft2) mill building in Manchester NH (“a skyscraper lying down”) for $3.5 million (“the price of the carpet”) and sold it 20 months later for $10 million.
In November 2000 the Wall Street Journal delivered an ego-puffing profile that covers this era pretty well.
Byrne spoke passionately about education reform. He is a strong supporter of school vouchers. He ties this issue directly to our competitiveness in the world economy. Byrne believes Americans are living in a cloud of illusion. We think we’re such a great world competitor, but we forget at the end of WWII we had bombed all of our industrial competitors to destruction. We cleared the table and ran the house. But now the world has rebuilt it’s industrial and educational capacity, and we have become the consumers, not producers. We cannot ever be competitive in the world with our current 140 year old educational system. We spend $11,000 per pupil per year, significantly higher per capita than other industrial countries, yet by any measure we rank in the bottom quintile of performance. We cannot fix this problem by throwing more money at it. The “guild” (teacher’s unions, administrative apparatchiks, etc.) has little left to argue its case except fear of change.
Along the way he had alluded to structural corruption in the American capital markets, closing with an anecdote about a news story in India that presented America as a cautionary tale of capital corruption. At this point a student asked if he could be more specific in his criticisms of the capital markets, and we transitioned into a long segment on financial corruption.
The Wikipedia entry covers the basics, but essentially he claims there are loopholes in the stock settlement system – originally designed to allow some flexibility and elasticity in the case of systemic issues – that allow “options market-maker exceptions to rule 203b1.” He joked this could be more memorably named, “The Madoff exception.” This is related to changes in Regulation SHO exemptions. The whole ball of wax you may also know as “naked short selling.”
This is wicked complicated, and I’m sure I don’t fully understand it, but what I gather is: When you buy a stock a seller has sold you the stock. The two of you need to “settle” the deal, where they get cash and you get a numbered stock certificate. Sometimes, for a variety of logistical reasons, the stock certificates cannot be physically transferred at the exact moment the cash arrives. So the settlement company is allowed to write an IOU for the certificates. Most buyers don’t take possession of the certificates, so they don’t actually know this has happened.
He wrote an infamous slide deck about this called The Miscreants’ Ball.
For a long time the SEC took the position that this didn’t matter. People didn’t abuse these IOUs! But then in 2007, the SEC changed their mind and wrote:
Regulation SHO’s grandfather provision was adopted because the Commission was concerned about creating buy-side volatility through short squeezes if large pre-existing fail to deliver positions had to be closed out too quickly….
That’s secret code for, “If we forced everyone to deliver on the IOUs the market would realize those stock certificates had been sold several times over on various small foreign exchanges, sucking $2 trillion out of the system without anyone noticing. We don’t want them to notice all at once, so we’re going to forgive all the ones we know about and pretend they don’t exist.”
In other words, what supposedly wasn’t happening yesterday is today so bad that if we acknowledge it the financial system would collapse. Again, this is wicked complicated, and I’m sure I don’t fully understand it. But I have a feeling he’d agree wholeheartedly with Catherine Austin Fitts.
Long story short, when he took Overstock.com public they were the first company to do an IPO dutch auction – an OpenIPO – Google followed them two years later. They took a lot of flack from Wall Street, and since he had worked there people he knew told him he would be a pariah. He got an unusual phone call from a guy who told him he was living in South America out of a backpack so the Mafia didn’t whack him, and Patrick needed to watch out. Byrne didn’t believe him, but the guy said, “Watch. What’s going to happen is: First these five prominent business journalists will write hack jobs on you or your company. Next you’ll find your stock trading on exotic foreign exchanges where you’ve never listed. Then you’ll have a Federal investigation that will amount to nothing but will take a lot of time and money. Finally, you’ll find your company on the top-30 list of stocks with fail to deliver positions.” Over the next four months all of those things played out, Byrne got in touch with the guy, and they started to piece together how it all worked.
Byrne’s blog is Deep Capture, where all this is laid out is long-form detail. It’s worth noting that he has critics. After last year’s financial meltdown, he feels the intellectual argument is over.
He said he’s paid millions of dollars over the past four years on attorneys and economists to gather freedom of information act requests, sue hedge funds and options market makers, and fend off the SEC. He believes the SEC is a “captured” regulator. In this case “captured” doesn’t mean “control” but more like “cognitive capture,” in that the industry behavior is considered so normal, and so obviously correct – it’s a market, after all – that if there’s a rule violation they must have written the rules wrong, because this is in fact what the industry does.
Toward the end someone asked about the supply chain he built with Overstock.com, and how it’s different. He thinks supply chain theory is the most important and a highly undervalued aspect of retail business. The short version is the normal retail distribution system can’t deal with small quantities and odd lots. Overstock built their system to account for this. Their warehouse is “random load” – there isn’t a single place where items sit, because the items are always changing. Took a long time to get it right.
Byrne told the story of where the fair-trade worldstock idea came from. Again, the bio covers the basics:
During a vacation in Southeast Asia Byrne found many village artisans were held back by the lack of retail channels, as their production was fragmented and the quantities produced were small. He further realised the Overstock model was perfectly suited for their needs.
In this case “during a vacation” meant cruising the country on a motorcycle, before eventually driving over the edge of a bank and fracturing his arm, 15 hours from medical care, and being carried to a family’s hut. When they say, “he further realized,” what they mean is, while smoking whatever it was the family gave him to smoke – “I didn’t ask” – to take his mind off his broken arm, awake and alone blazing in a hut in Southeast Asia in the middle of the night.
Byrne called it the best idea he’s ever had.