Stig Brodersen  3:12  

Phil is really good at building up characters and you’re definitely right, you feel like he is reliving it, but you’re reliving it with him. It’s not a really a management book or how to make the best business decisions. Quite the contrary, it’s more about his life and his emotions. I think in that sense, you could be a business person reading this or you could be completely another type of person reading this, but just listen to his lessons about life and all that he has seen and experienced, all the disappointments, all the successes. I thoroughly enjoyed that in the book.

Preston Pysh  3:46  

I know it’s a good book when I’m listening to it in my car, because I listened to this one on Audibles. And if you’re listening to this, and you want to listen to this book on Audible, go to our website and click on our link through Audibles because you’ll get your first book for free. But anyway, I know it’s a good book when I’m listening to it in my car and I get to my destination, and I continue to sit there in my car, even though I need to get out and go do whatever it was that I was going to do at the destination. I continue to sit there for like another 15 or 20 minutes, because I’m enjoying it so much. 

Without further talking about our overall opinion of it. Let’s go ahead and just dive in and start talking about the whole book. So this all starts off, and Phil talks about his time in Oregon, and he’s a track runner. He talks about being on the team in Oregon and just kind of what it was like to be a runner for Oregon. More importantly, he talks about one of his coaches that he had at Oregon, and the name of this gentleman, his last name is Bowerman. He always talks about Bowerman in this context of being this authoritative figure and this guy that he really looked up to, and it was really kind of hard on them, but somebody that everyone respected. 

So that was their coach for the team. And so, Phil ends up writing this. And did he go to Stanford when he wrote his? 

Stig Brodersen  5:05  

Yeah.

Preston Pysh  5:06  

He goes to Stanford and he writes this business proposal. It is one of his assignments that he had to write up a business proposal.  He’s talking about going over to Japan and because the exchange rate and everything at this point in time, which is in the early 1960s, because of the exchange rate, he can buy shoes over in Japan at a discount, and bring them back over to the States and sell them for a profit. So he writes up this whole thesis, this whole business plan of doing this when he was a grad student at Stanford. And so, he really was just fascinated with tennis shoes and like, he really got involved in this research and really became fascinated with this whole project that he did. You know, one thing led to another, but he never really kind of hung up this assignment. He just really felt like, “Hey, I could actually do this. This is something that I could do.” 

Stig Brodersen  5:58  

Really, just to put into context. It’s not like today when you can just fly to Japan. But it was very different back then. Clearly, you could also fly to Japan. But the mindset was very different. It was not something you just did. And also keep in mind, this is not too long after Pearl Harbor, and Americans, Japanese weren’t really getting along that well. So for a young kid like that, just to travel to another continent, and not knowing the culture, not knowing the language, and wanting to import shoes, and he had no capital, by the way, either. It was definitely a whole another ballgame than today where you can set up those all those internet jobs and you can have someone else take the risk and the inventory and so on. 

So it was just a very courageous, and some would say a stupid decision. I think, if Phil Knight was here, he would probably say the same thing. We’ll get to some of this later. But just to give you an example, when he started negotiating with these Japanese, again, he didn’t have the money. Sometimes he would place order, and then go to a bank and say, “You know, I already placed an order, could you please help me out with some cash?” Because he knew they would say no, if he did it the other way around. So we’ll get a lot of that later. But it was just that in itself just shows what a unique character Phil Knight was.  

Preston Pysh  7:16  

I think something else unique that he did with the book is came up with this idea to do this thing in Japan. And so he went and asked his father, if his father would pay for him to basically take this trip around the world. How old was he here? He’s in his mid 20s probably. He goes to his father and he’s like, “Hey, can you give me some money to take a trip around the world? I want to go to Hawaii, I want to go to Japan. I want to go to Europe, all these different places.” And he convinces his dad to do this. 

But what’s what’s interesting about in the book is he talks about this emotional relationship that he had with his dad at that point, and like how he was frustrated with his dad. What I love about the way he wrote this, is he wrote it as if he was back in his body back in the 1960s, the way he felt and the way he had this emotional in a response to his father. That all comes out in his writing style. And it’s really quite amazing because obviously his dad was not a bad guy because he paid for the travel around the world back at that point in time when he was in his 20s. So, you know, he obviously had a great relationship with his father. But that didn’t necessarily come out with the Phil Knight of today. He did a great job of being able to relive those emotions and capture that in the way that he wrote this. I mean, the guy’s a fantastic writer. So the writing in this book is just phenomenal. So Stig got a little bit into it. So let’s go ahead and dive down. 

So his dad pays for him to go on this journey. He starts off the journey going to Hawaii with one of his friends. He’s there on the beach. He’s just like, “This is amazing. Do we even want to continue this or do we just want to set up shop right here on this beach in Hawaii and never move ever again?” 

Eventually, he does move on and he flies to Japan. And so, you know, we go back to the episode we did with Jesse Itzler, the billionaire NBA Atlanta Hawks owner. The guy just makes moves. I mean, just totally makes moves. And that totally came out with this book on Phil Knight, the guy flies to Japan. So most people, I mean, you don’t speak the language, you get to Japan, like what do you do now? Like, how do you even begin to set up a meeting with one of these shoe companies as a 20 year old, something, nobody who has no business? He has nothing at this point other than the fact that his dad gave him some money to travel around the world. 

So he finangles a deal to go in and meet with the Tiger Shoe Company. And Phil Knight was one of the main reasons that those shoes came to America. He sits down with the Tiger Shoe Company. And he’s like, “Hey, you know, I think that we could bring this shoe to America and I I would like to be that guy. And I’d like to sell your shoes over there, and whatnot.” So they are very respectful and they asked them, “Well, what’s the name of your company?” Well, Phil didn’t even have a company. He had nothing. He thought of the first thing that he could that came to his mind. And he was like, thought back to his room at his house. He had a bunch of his blue ribbons that he had one from his track races, and his track mates, he had blue ribbons all over as well. And so he just blurted out, “Blue Ribbon was the name of the company.” 

So they are like, “Blue Ribbon, Blue Ribbon,” all down the boardroom where he was meeting with the Tiger Shoe Company. And so, lo and behold, they make him an offer. They’re like, “Okay, well, you know, we need something like $5,000 or $2,000 back then or whatever it was for the first shipment of shoes and we’ll send you however many shoes for that amount of money. Then, if you sell these, let us know, we’ll send you another another set of shoes.”

So they give him a sample and he continues his trip around the world. So let me continue with the rest of the trip. So he goes to Greece. Is this correct? Where the whole name of Nike kind of comes up? And I am absolutely horrible with Greek mythology. I mean, probably one of the worst people on the planet when it comes to Greek mythology. I don’t know any of it. But I do know that the God of Nike is an important character. Stig, can you help me out here? 

Stig Brodersen  11:34  

Yeah, he’s the god who is personified victory.

Preston Pysh  11:37  

That’s how bad I am. So that’s the end of the world trip. So he goes back to America, and he’s just waiting and waiting for these shoes to show up from the Tiger Shoe Company. And they’re just slow and lethargic. Then finally he finally gets his first shipment of shoes. So he takes the shoe because he had so much respect for his old coach at Oregon, Bowerman, and he takes the shoe to Bowerman and he says, “Is this a good shoe?” because one of the things that he talked about early on in the book was Bowerman was absolutely just obsessed with finding the right shoe. He felt that a lightweight shoe that had the right support and everything gave runners a very distinct advantage. And so Phil was like, this is the guy I got to go talk to because he was always so adamant in constantly changing and trying to research what the best shoe would be when I was at Oregon. 

So he takes one of these Tiger shoes to Bowerman to get his opinion and kind of tells him about his research paper at Stanford and how he’s going to start selling these things. And Bowerman, you know, and I think Bowerman had a really quirky personality, the way that he kind of describes him in the book. So Bowerman looks at the shoe and he’s like, “Wow, this is this is a great shoe.” And so he’s there like having lunch or something in a cafe with it with his old coach. You can tell the relationship between Phil and Bowerman is quite awkward like he still looks at him as like an authoritative figure and like he’s the coach and he still feels like maybe the student at this point in time. 

And so, Bowerman looks at Phil Knight and he says, “I like this so much. I’d like to go in 50% with you on your Blue Ribbon company.” And Phil is just totally blown away like he cannot believe that he has and correct me if I’m wrong, Stig, doesn’t Bowerman have this really prestigious background in running? Like he’s won a bunch of major events and train some like amazing people, maybe even like Olympics and stuff like that?

Stig Brodersen  13:38  

Yeah, definitely, and he’s quite the character. I think he bought like 50% for $500, something like that, which might seem like Bowerman is a great businessman, but I’m really not sure because after this actually after they get Nike up and running, he writes a book about how to exercise and it was a huge success, at least in some sense, because it sold like a million copies. But in that book, he’s actually saying, and I see that you’re laughing now, Preston, because you know what I’m about to say that the shoes that you’re running and it’s really not that important. And he owns a shoe company at that point in time. I mean, how is that a businessman for?

Preston Pysh  14:21  

Phil talks about the first time he read this and how upset he was because this was his business partner for the shoe company. So that was kind of their start. So when you think about the start of his business, he’s got these shoes that he’s buying from Japan, probably maybe 50% off of the price that he’s selling them for in the States. And then, he’s going around to all these different shoe stores across, you know, Oregon, down into California area, really kind of just the West Coast, and he’s trying to sell these things to just regular shoe stores. I mean, that’s really his business is he’s a retail or kind of like this distributor, if you will. He’s a distributor to the retailers. 

And so he starts off with 300 shoes, it was the first order, and then it just continued to kind of grow. So he sells 300 shoes, he raises enough money to make another order, and he doubles down. You know, the way that they really talked about was he starts off with 300, 600 and he’s at 1200. And each time he basically had the money from the previous sales in order to buy the next set of shoes. And so from a business model, when you look at his company, and it talks about how you go back to get loans to help him pay for the next lot of shoes because he wanted to buy more because his demand was there from the shoe stores that he was selling it to. But every time he’d go back to the bank, the bank would look at him and be like, “Dude, you have no equity at all in this business, like there’s no retained anything. Every dollar that you make you spend again on more shoes.”

So he had no equity on his balance sheet, if you will. So we talk a lot about the financial accounting, how to look at businesses. This is a business that Stig and I, you know, would absolutely pass on, even considering because the financials were so bad and so the bankers are giving him such a hard time like, “We’re not going to lend you a million dollars. What do we get back if you fail? Like all these shoes from Japan, like, we want some cash in a bank account or something to show for, or at least a building.” You know, he’s running this out of his parents house, he’s still living with his parents. 

So that was his start. He talks about this frustration and anger that he had for the bank and how they couldn’t see what it was that he was doing. And that his numbers were doubling and tripling in like short spans of time and that there was this enormous demand that he was creating by selling these Tiger shoes in America. So I found that discussion just really interesting to hear it because he goes into so much much detail talking about his emotion, what his numbers were and how well it was growing like, it was just a fantastic way to really relive this whole experience. Like if you want to step back and see what it felt like to be like the founder of Nike at the infancy stage, like the startup stage, you’ve got to read this. It is such an awesome description.

Stig Brodersen  17:21  

I think one of the highlights that I have is it really comes back to some of the things that Jesse Itzler said about being passionate. And I think Jesse was using the example of being a musician while being a musician is not only like receiving rewards and have lots of fans, that’s not what it means to be a musician. It means to travel around to be rejected a lot of other things that really comes with the territory.

I think the secret to Phil Knight’s success is because what we’re doing here on the podcast, really is to look at very successful people and really decipher what has made them successful. I think what’s really making Phil Knight successful is really following through this infancy stage that he simply loves everything about it, and it might seem counterintuitive, because if you read the book, it seems like he is… I’m not saying he’s complaining, but he’s talking all about his native emotions or the struggles or the adversity. It’s definitely not an easy ride for him. 

But still, at the same time, at least I got the impression that he still loves it. He loved the *inaudible Japan, he loved the whole tension about, “Will I be bankrupt tomorrow?” And I listened to an interview with him recently. He said, actually, that he was willing to do this all over again. He would love to do this all over again, especially the beginning. I just think it’s interesting that he has so much drive and so much passion for doing this. That’s really his secret to success, because it was not easy at all here at the beginning.

Preston Pysh  18:54  

There’s one thing that really sticks out in my mind from our interview with Jesse Itzler. It really when  he said be passionate about the journey. And man, that man, I will never forget that. And you know what? When you look at this story about Phil Knight, that just reeks out of his writing is that he was so passionate about this journey to create this company. It wasn’t he liked running. He liked the shoes. So a lot of people might say he was passionate about running. But I would totally argue after reading this book and hearing this whole story, he was passionate about this journey of building something big. That’s what he loved doing and I love that point, Stig. 

Something else I want to highlight that I found really, really interesting when we were reading this was that Phil was an accountant. So he got his degree and then while he was trying to start this, he wasn’t doing this full time he was working as an accountant. And so he knew the numbers. He knew the numbers and he understood how accounts worked. He understood that he had to have equity and why the bank was giving him a hard time. 

I really think, and I know Stig and I say this all the time, it is so important for people to understand the terminology of finance in order to be successful in business, because you just understand how the plumbing works wenever you have an income statement moves to the balance sheet. Phil Knight could talk the numbers. He could go over to Japan and talk the numbers with a full blown company that’s bringing in millions of dollars every year. He was comfortable in that space because he had this accounting background. I think that’s so important for people. And Warren Buffett says the language of business is accounting. If you don’t know the language, you can’t communicate with other businesses and people and things like that.

Stig Brodersen  20:46  

So just something to add to that, Preston, I also think I know this is not like an entrepreneurial podcast in that sense, but I think because there is someone out there who’s thinking about starting their own company and I often advise people to start teaching what they’re really passionate about, because then they’ll get a cash flow, while they can start up something else. Plus, they will talk about what they’re passionate about, but other people that are passionate about that.

Preston Pysh  20:52  

I think that this is a really good highlight. So whenever you see these people, like look at the founders of Google, look at Jeff Bezos, look at Phil Knight. Phil Knight, specifically, since that’s the book we’re talking about. He had a bridging strategy, this company, this Blue Ribbon Company that he started. It wasn’t like he was working at the accounting company and he was like, “Hey, I’ve got this idea for a shoe company. I’m going to stop and I’m going to put 100% of my time into this new shoe company that I’m going to start.” 

No, it was a bridging strategy. This was something that he was working two jobs for nearly a decade or whatever it was, until Blue Ribbon became so big that the salary he could pay himself and completely offset his full time job. And it became somewhat stable, but he did that for years. This wasn’t just like a one year kind of thing, and then he transitioned into it. I think a lot of people don’t know that. I think a lot of people think that you got to save a bunch of money, quit my job, and then go all in and dedicate… 

I don’t think most people do it that way. I think most people will literally work two jobs for a long period of time until they know it’s a stable enough thing that they can just transition into it full time. I think that’s the model that typically works. You’re always going to have one offs. But I think when you look back at some of these people that have had enormous, enormous success, they almost always have this bridging strategy where they work two things for years before it takes off. So I think that’s a tip for people that maybe are in that point, or maybe thinking about starting their own business to consider. 

Okay, so let’s go ahead and continue talking about the story here with Phil Knight. And we’ll quickly kind of wrap some of the rest of this up because for me, a lot of the interesting stuff was early on. And once he gets so big, for me, it got a little bit less interesting and to be honest with you, he doesn’t really go that far beyond really kind of 1980. The story really kind of stops there which shows you how much he loved that start and that journey up front.

Stig Brodersen  23:09  

You know, Preston, this makes me think about again the book, “The Power of Habit” that we’re going to *talk about later. And they’re talking about gambling, and how people’s brain react to gambling. One thing that they actually observe is that for some people when they are gambling, and it looks like they’re almost winning, so they were put in front of a slot machine, and then they’ll be like two bars, but then they will just not get the third bar and hit the jackpot. It will really reward the brain with the same chemicals as if they won, to know if you’re addicted. And I kind of feel this the same thing with Phil Knight. So that’s my impression here.

The best thing is to run a business and succeed, but almost as good is running a business and fail. To me that seems like he can’t do anything else. It is so ingrained in him to run a business that he’s willing to take the biggest risks. This is definitely a good story. It’s definitely not how to start up a company book. He had a wife and three kids at the time, and he was willing to put everything on the line to make this succeed. I said before, if he failed, he would be willing to do everything all over. I think, again, it’s not something I would do, but I think is very inspiring, that some people can be so passionate about the vision. And his vision was really to provide the best shoes for the whole world.

Preston Pysh  24:33  

He had a phenomenal spouse that totally supported that as well. He talks a lot about that in the book. It’s not something we’re going to get into with the podcast, but he talks about his wife and how she supported these decisions. It was something that they were, consciously making as a couple. 

Real quick about his employees. So he has a friend that he ran track with at Oregon, and he bumps into this guy, he’s living down in California. So his last name is Johnson and he refers to him in the book the whole time as Johnson. And Johnson was just a workaholic. He hires this guy, pretty much through commission right, Stig? Like however much he would sell, he gets a cut of whatever that is. 

So Johnson’s living down in California. fills up in Oregon. So he’s basically pushing him shoes and Johnson is just selling these things like crazy. He’s a salesman to a tee. And so Johnson has gone around all of California and next thing you know, I mean, this guy is just blowing up California with these Tiger Shoes. And so, Johnson comes up with all these different ideas of like how they can expand and grow even faster. I mean, he is just a growth animal. 

So he’s writing all these letters to Phil Knight, and through the book, Phil just keeps talking about how he ignored all of his letters and how he would never write them back. But then this guy was just making his Blue Ribbon business just explode. So I found that relationship and how honest Phil was with really kind of his bad decision making of how he corresponded with Johnson really refreshing. Like you get this feel of how much integrity Phil Knight has and how he’s really trying to capture the truth behind the entire story of how it all happened. And it was really awesome the way that he describes it.

Stig Brodersen  26:20  

You have a good point, Pres, in terms of honesty, because we talked about stories. We talked about  T. Boone Pickens before we *could also include to turn on the equation as well. It seems like there was something… they were always hiding from us. I kind of feel like I didn’t get the whole story right. And I really felt up the whole story and not all of it was pretty, if anything. I think there were more bad stuff than good stuff, but you just kind of felt like he just just wanted to tell his story, not how he wanted to be remembered. But what actually happened through his eyes.

Preston Pysh  26:51  

Yeah, yeah, I totally agree. It was almost like those other two books that you reference were all about the amazing things that they had done and that they only highlighted those things where this was almost the opposite where Phil Knight was telling you about all the things that he did wrong and like, it was just such a good story. 

So what I want to do is I want to transition to how did he transition from selling Tigers to building the Nike brand. So it gets a little bit at what Stig was talking about. He blows this thing up. He is selling these Tiger shoes almost nationwide at this point. He’s selling them all over the place and Tiger, basically, has an individual… The way that Phil describes him in the book. They have an individual that’s in charge of their operations and growth within the company. There was a Japanese businessman that represented Tiger and he was going to basically cut Phil Knight out and basically take over the distribution in the US to all these different stores that Phil Knight had established that were selling Tigers. They gave him this lowball offer to buy Blue Ribbon but Phil Knight saw the writing on the wall and what was what was going down. 

So Phil starts preparing for all this and he’s like, “I’ve got to create my own brand. I’ve got to go and create my own shoe company, and then sell that to all these stores and all these connections that we’ve established through the years whenever we are building this distribution for Tiger.” 

So he doesn’t tell Tiger what he’s doing. He goes to Japan, he finds a manufacturer, and they create this brand. And this is something that I found really profound in this book. So they get to the point where they’re going to launch their Nike shoes and they’re at this convention for shoes, you know, like, all the different Adidas, Reebok or whatever. They’re all there. And so was Tiger. This was the first time that Phil Knight had basically showed the executives at Tiger that he’s got his own shoe company. He’s talking about how his boxes were orange, which were completely different than any other shoe company that was selling shoes, and they had their their setup and everything. And all the main vendors that they had worked with in the past came over and they looked at the shoe. And there was a bunch of manufacturing issues that he ran into with the very first shoe shoes. He was kind of embarrassed with the way that they looked in the quality of the shoes, but he had to go with it because they were at that point where they’re going to launch. 

So the shoes are sitting there on the exhibit, and these vendors come by, and they’re looking at a shoe and they’re kind of looking at it and Phil just talks about how insecure he is and how disappointed and scared he is as to them just looking at and walking away and not saying anything. But he actually got the exact opposite response. After these vendors looked at the shoe, they came over and they’re like, “Hey, can we buy 10,000 of these shoes from you?” And Phil was just blown away and he says why, like he didn’t understand why they were just so quick to buy this new brand that no one knew anything about and in his opinion, the quality sucks. And he says, “Why?” And the gentleman said to him, “Well, Phil, we’ve been dealing with you for the last 10 years. And you’ve always sold us good quality products, things that flew off the shelves, and you’re somebody that we trust.” 

And that word, “trust,” just stuck with me when I read this. It goes back to that Power of Trust book that Stig and I read probably 10 or 20 episodes ago. And he was able to basically convert that goodwill that he had been establishing for more than a decade with all these vendors, and that immediately turned into a sale for him when he had a completely different product. Something that had never been proven something that was brand new, no one… They had no idea if they could sell these things, it was a brand that no one even knew. But people were willing to put in big purchase orders because of him, Phil Knight, and his team of people, because they were trustworthy, and they represented good business habits. And I can’t tell you how important I feel that that point in this story was.

Stig Brodersen  31:24  

So one thing I would like to ask you, Preston, is how much is luck? And how much is skill here Phil Knight has because that’s something that people always seem to question whenever they hear about an entrepreneur becoming a billionaire with a somewhat odd idea? And what some of the critics are saying is that he has just been incredible lucky. One thing is that you have the whole movement, no one is exercising when you started and then perhaps by chance people started to exercise. I’m just gonna ask you how much is luck and how much is skill you’re thinking in Phil’s example?

Preston Pysh  31:58  

So I got a simple quote that will answer this question. Is it Ford that had this quote, Stig? You already know where I’m going with. So Henry Ford says, “The harder I work, the luckier I am.” And I totally believe in that quote. I think that when you look at where Phil Knight was at this point in time, and the amount of work because he talks about it, and getting up to that point where I just told that story with  launching the new brand, he had just worked his tail off. I mean, he had worked so hard establishing all these connections, understanding what the power of a brand and shoes is all about, which is really celebrity endorsements and all that kind of stuff. Like he understood all this stuff. But the only reason he understood it and had those smarts is because he had worked so insanely hard to get to that point. 

Was he lucky to get that first deal with the tiger shoe company? Yeah, you might be able to argue that he had some luck there. But you could also go back and say he had worked so hard at understanding accounting. He had gone to Stanford, he had worked hard to get to that point even for that first interview, much harder than most kids at 25 years old to get to that point. 

So again, I love that quote, because I think it’s so true. And I think people that run around saying, “Oh, I’m not lucky.” Well, I would argue maybe you haven’t worked hard enough in whatever particular area you’re trying to focus on to have luck, in order to be able to claim that that’s what it is.

Stig Brodersen  33:35  

I really love that quote, Preston. And then another quote I’m thinking of is Woody Allen’s *inaudible in the success is just showing up. I was just thinking who is showing up in Japan in the early 60s? No one well, there was one guy that was Phil Knight. 

Preston Pysh  33:50  

So very interesting start to Nike. Now, he does get into talking about how he how he saw celebrities as being the cornerstone to build this brand. When you hear him talk about this, it’s really quite an interesting conversation. You can see how powerful that is because when kids or adults see a celebrity on TV playing a sport and they go running by and they’ve got a Nike swoosh on their shoe or whatever, that has so much power for him. 

I think we’ll kind of wrap it up there  because really, that’s kind of where it ends. And it doesn’t really go too much further into the story. He gets a little bit into some aerospace engineer who comes to the company with this idea for putting air into the bottom of shoes, which was kind of a little bit of a neat story, but then it really kind of stops and he kind of wraps up the entire book about Nike, before you really kind of get into the Air Jordans. And kind of all the success that he had from 1980 on is not even talked about in the book. So if you’re really wanting that portion of Nike, you’re not going to get it, but if you want everything before, you’re absolutely going to get it in tons of detail.

Stig Brodersen  35:01  

It seems like after all his early struggles and he really become successful, the stores it tells there. Well, first of all, they’re really not that interesting. And it just doesn’t seem that important to the story either. He goes into a lengthy discussion about whether or not should go public. Eventually, it actually does go public, and how it is to be running a company that is always cash strapped. And it seems like it can go under every day, but at the same time, it’s extremely valuable how to handle that. I think that’s something that most entrepreneurs can probably relate to. I can only say that’s really to understand how it is to be a business owner from early successes and the next two decades, I think this is probably the book to read just for that.

Preston Pysh  35:44  

Okay, so something that Stig and I really want to do because we haven’t done this for a really long time is play a question from our audience. So right now that’s what we’re gonna do. Okay, so this week’s question comes from Neptali.

Neptali  35:57  

Hi, Preston and Stig. My name is Neptali. I’d like to thank you for this wonderful community you guys have built, which has really enabled me to learn a lot, and it’s helped my friends and I take their first steps into the value investing world. 

When I tried to calculate the margin of safety, I like to look at the book value and imagine what would happen were the business to liquidate tomorrow. If I buy a company for less than its book value, and it goes bankrupt, that could actually make a profit. But in reality, there are many companies that trade for below their book value. 

For instance, Fiat Chrysler, is it possible that the numbers in the books don’t reflect the real liquidation value of the company? What tools can I use in order to estimate the true liquidation value of the company? And what other ways do you guys recommend that can more accurately assess my true margin of safety? Thank you very much.

Preston Pysh  36:42  

So I love this question. I absolutely love this question because I think a lot of people when they start out with value investing, they latch on to book value because it’s very easily understood. For somebody listening to this and you might not know what book value is, it’s simply the equity that’s in the company.

So let’s just take Nike, for example, if we were going to take Nike today, and we were going to add up all their assets, subtract their liabilities, and the money that would be left would be the equity. And so when you talk about book value, all you’re doing is you’re taking that equity, and you’re putting it into a per share basis. So let’s say that the equity is $100,000 and there’s 100,000 shares, the book value would be $1. That’s how you would figure that out to make it simple for everyone to understand. 

So what Neptali is talking about is he’s saying, if I can go in and I can buy a company that’s below its liquidation value or its book value. So let’s go to that Nike example. Let’s say the book value is $1 per share. If I could go in there and I could buy Nike, let’s say it was selling on the stock market for 90 cents a share. I’m actually buying it at a cheaper price, than their equity that they have on the books. And so you will see this in real companies right now, even with super high market valuations, you will find companies that are in this situation right now, because the market is very high and overvalued. You can find companies like this, but I almost guarantee you what you’re also going to find with a company like that is that they’re not profitable. They’re not making money. 

And so what the expectation is, is because that company’s not profitable, they’re not making money on their income statement because when you’re talking about value and all the assets, liabilities, you’re talking to the balance sheet. When you’re talking about companies like this, and they’re losing money each quarter, the expectation is that the book value next quarter will be lower than it is this quarter, because they’re losing money on their product or their service. So that’s the consideration. That’s what you’ve got to think about when you’re buying a company potentially below its book value. Why is it so cheap? Why are other people not willing to pay a high price for this? Well, it’s because the company is losing money, they’re not even profitable. So that’s a strong consideration. You have to look at that. 

So what I would tell you is, depending on where you’re at in the credit cycle is where I would look at where this is more common versus not common. If you’d go back to late 2008-2009, even 2010, and you saw companies trading below their book value, they could be profitable companies, but they’re just being punished because of the severe credit contraction that occurred during that point in time. So I would look at a company much differently back then, than I would today, where market prices are sky high if I saw a company that had a price selling below its book value, because now you gotta know your consideration at this point, if it’s selling below its book value with a sky high market price, and when we’re at today’s market in 2016.

As credit contracts and it becomes harder to pay off those debts, a company that’s not even profitable today is definitely not going to be profit as credit contracts and it gets harder, and that environment gets harder. You’re gonna have a much harder time staying profitable if you can even stay in business at that point. 

Now, I have one other thing that I want to talk about. And it’s this idea that just because a company has a positive equity or a positive book value today, does not mean that they would go bankrupt at that price. The thing that you see with companies, whenever they start to go bankrupt, is that they will suck every last drop of equity that’s left out of that business, before they would go bankrupt. They’re going to take on all sorts of debt, they’re going to do all sorts of tricky things with preferred stock, they’re going to be selling bonds, they’re going to be doing all these things that put any value that’s left in that business way ahead of your common stock, equity position, and you will lose all of that money. And that’s something that I think a lot of people don’t have an appreciation for, is just how desperate corporate management gets, and how much money they borrow trying to keep that business alive. 

And you really kind of have two paths, it will play out either that’ll play out, and it’ll just be total destruction, and you will get nothing from your common stock. Or another company will come along and buy it and who knows where the price will end up compared to where you bought it.

Stig Brodersen  41:22  

Yeah, so I really liked the question. I think it’s a very insightful question. As Preston also mentioned, the book value is something a lot of people look at, especially in the beginning. But I also think it’s something that when people get more experienced, they simply don’t look at too much because it’s really not a margin of safety.

At least to me margin of safety is more, finding a really good, stable business, profitable business that has a higher intrinsic value than what you’re paying for it. That’s really my margin of safety. I think if you look at margin of safety in terms of liquidation value, as Preston said, it’s probably than not what’s going to pan out anyway. 

And I think the reason why we talk so much about it is, even though this is a general stock investing podcast, we really have our roots in Benjamin Graham and Warren Buffett and the whole value investing approach. I can see at the base of that it makes sense to look at book value, because if you read “The Intelligent Investor,” and if you read “Security Analysis,” there’s a lot of emphasis on how do you figure out what the liquidation value is.

And I just think, in general, I think it’s not a good approach for 99.9% of investors to focus on that. You might look at book value because it might give you a glimpse of whether or not the business is overvalued, undervalued, sort of like, you can look at the PE ratio, and it might be 4, and it could be an indication that it’s undervalued. But you just need like 99 again percent more before you have a coherent analysis of that stuff. 

But if you want to look at the balance sheet and see what is the true liquidation value, I would just without being too geeky, look at how the balance is weighted. How much is at the top of the balance sheet? And when I say at the top of the balance sheet is because the most liquid assets at the top of the balance sheet… So the most liquid is cash. The more current assets you have, typically, and when I say current assets is the assets that you intend to become turned into cash or is already cash within the next 12 months. That’s probably what should be looking for. If you see too much long term fixed assets, it’s probably not going to turn into cash.

Preston Pysh  43:35  

So I would say, if Warren Buffett would be responding to this question about margin of safety specifically, the thing he’s going to really talk about is a durable competitive advantage of being able to keep the earnings and profit margins, where they’re able to keep your margin share of the overall business. 

So if you’re selling shoes, a company like Under Armour coming in would be imposing on that competitive advantage. That’s something that he would be looking at as far as being able to protect that. That’s giving him a margin of safety. And most importantly, his margin of safety really comes down to the price that he’s paying, whatever that discount rate that he’s expecting to get, call it, if I buy Nike today, and I get a 10% return and the rest of the markets giving me 5%. That’s a margin of safety because I’m getting such a larger return at the current price that’s being offered. Those aren’t the real numbers. I’m just using those as examples for people. But that’s where he sees his margin of safety. 

When you talk about book value, and Benjamin Graham and where this whole idea of book value originated was with Benjamin Graham back in the early 1930s. This was more for a person that had enough money to take a controlling share of a business and basically liquidate the company because they were able to take that controlling share. That’s where that’s at. As an individual stock investor that won’t be able to take that size of a position where you actually control and have the ability to liquidate the company, you can’t do that kind of stuff. But that’s what Warren Buffett and Benjamin Graham were doing back in the day was they’d find these companies that were trading below their liquidation value, they could take a position high enough in the company to actually influence that. That’s where a lot of that stuff comes from. 

Alright, so Neptali, we’re gonna send you a free signed copy of our book, the Warren Buffett Accounting Book, for asking your question. It was a fantastic question. If somebody else out there wants to get their question played on our show, go to asktheinvestors.com and you can record your question and if we play it, you get a free sign book in the mail. 

So that’s all we have for you guys. If you’d like to read this book, via audio, make sure you go to our website, click on any of the links for Audibles. You’ll get this book completely for free or any other book that you want for your first book. We can’t promote that highly enough because you get a free book and you get to use an awesome service that Stig and I use literally every single day, as we’re driving or whatever, it helps us to be able to do multiple things all at the same time by reading audiobooks. So that’s all we have for you and we’ll see you guys next week. 

Outro  48:07  

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