Fortune's Formula (17 page)

These differences are not fundamental. Any type of random event has a “probability distribution.” This is an accounting of every possible outcome and its probability. For a simple casino game, there may be just two outcomes (win and lose) with associated probabilities and payoffs. You could represent this distribution as a bar graph with two bars for “win” and “lose.”

For a stock investment, the probability distribution is more like a bell-shaped curve whose shape changes gradually with time. You tend to end up somewhere in the middle of the curve, with a middling degree of profit. There is a small chance of doing much better, or much worse, than usual. Statisticians are at home with both types of probability distributions, and both arise in information theory.

Kelly’s tale of a gambler with inside tips presupposes exactly what the efficient market theory denies. No one is supposed to have advance knowledge of what the market is going to do. In the simplest conception of an efficient market, everyone gets all financial news simultaneously and acts on it all at once. This isn’t literally true, of course. More realistic models of the efficient market admit that it takes minutes, hours, or days for people to act on news. Throughout this process, there must be people who are temporarily better informed than others.

Some economists hold that even though some people
do
have an informational edge, they are unable to profit from it. Transaction costs are often mentioned as a reason. The gains from inside information may be smaller than the commissions. It may also be that the arbitrageur is taking unacknowledged risks. What he believes to be a “sure thing” is not. The usual small profit comes at the expense of accepting a small risk of a catastrophic loss. And one way or another, no one beats the market in the long run.

Kelly’s analysis raises doubts about this tidy conclusion. If the only limit to profit is the information rate of the private wire, then it is hard to see why transaction costs must always be larger than profits. With a sufficiently informative private wire, an investor could overcome costs and beat the market.

“You know the economists talk about the efficient market where everything is equalized out and nobody can make any money really, it’s all luck and so on,” Shannon once said. “I don’t believe that’s true at all.”

Shannon had already tasted his first market success. This had nothing to do with arbitrage and everything to do with social networks.

In 1954 Charles William Harrison, a Bell Labs scientist Shannon knew, started his own company. Harrison Laboratories made power supplies for the promising new field of color television. Shannon bought a block of stock. Harrison Labs is not a familiar name today because it was acquired by Hewlett-Packard in 1962. The stock’s price zoomed, and Shannon got a handsome chunk of Hewlett-Packard stock in the merger. The size of the paper profit convinced him that there was real money to be made in stocks.

The experience with Harrison made Shannon receptive when another friend, Henry Singleton, spoke of starting his own company. Singleton was a close friend of Shannon’s from MIT graduate school. They played chess together. For a while, Singleton lived in Greenwich Village near Bell Labs. Then he moved west to work in the booming defense industry. In 1960 Singleton and George Kozmetsky founded Teledyne, a defense contractor selling digital navigation systems to a still-analog Pentagon. Shannon bought a couple thousand shares at the initial price of $1 a share. It became one of the red-hot stocks of the 1960s. By 1967 it hit $24.

As the company’s shares skyrocketed, Singleton used the inflated market value to buy other companies. He bought about 130. Teledyne came to own insurance companies, offshore oil wells, and the manufacturer of Water Pik teeth cleaners.

In 1962 an MIT group founded Codex Corporation to provide coding technology to the military. Shannon bought Codex stock. Codex marketed the first modem for mainframe computers (9,600 baud, for $23,000). Few businesses could use it because it was illegal to attach a third-party modem to AT&T’s phone lines. A 1967 FCC ruling overturned AT&T’s equipment monopoly, and Codex’s modem business surged. Codex merged into Motorola, giving Shannon another success story.

These three savvy choices were not the only new technology offerings the Shannons bought. Some of the new issues they bought fizzled. In at least one case, they sold too early. They bought Xerox and sold at a profit, losing out on what could have been a vastly larger gain.

In his early years as an investor, Shannon tried to do market timing. One day in 1963 or 1964, Shannon warned Elwyn Berlekamp that it was
not
the time to buy stocks. Like most grad students, Berlekamp barely had money for rent. When Berlekamp politely asked why, Shannon explained that he had invented an electrical device that mimicked the flow of money into and out of the stock market.

It was an analog feedback circuit that must have been something like Kelly’s football circuit. (No one I spoke with remembers whether Shannon’s or Kelly’s circuit was first.) One of the puzzles of the market is that stock prices are more volatile than corporate earnings. This is often attributed to feedback effects—the phenomenon that causes the head-splitting shriek of the principal’s microphone in the high school auditorium. When people put money into the market, the buying pressure causes prices to rise. The people who have made money talk about it. Envy motivates friends into buying stock too. This continues the positive feedback—for a while.

Prices can’t go up forever, not when earnings haven’t increased apace. At some point, bad news triggers a panic selling (negative feedback). The “bad news” does not have to be all that bad. It is only a catalyst, the pinprick that bursts the bubble. Shannon evidently had a way of adjusting the inputs to his electrical circuit to match the flows of investment funds. He concluded the market was overdue for a correction.

The market was then in the midst of a bull market that lasted through 1965. This was followed by a 13 percent drop in the S&P 500 in calendar year 1966. Neither the timing nor the magnitude of the 1966 pullback supplies much evidence in support of Shannon’s device.

On one of his visits to the Shannons’ home, Ed Thorp saw an equation on a blackboard in the study. It read:

2
¹¹
= 2048

Thorp asked what it meant. Both Claude and Betty turned silent. After a moment’s hesitation, they explained that they had been trading hot new stock issues. They had been doubling their money about every month. They were figuring how much money they would have. Every dollar invested would turn into $2,048 after eleven doublings.

S
HANNON WAS NOT
the only one turning spectacular profits from new issues. At the time Thorp met him, Manny Kimmel was planning a stock offering of his parking lot business—an IPO of his slice of Murder, Inc.

The idea that chance or chaos determines the fates of markets and corporations is one many find hard to accept. Surely God does not play dice with the stock market. The tale of Kimmel’s stock offering may serve as an amusing counterexample.

The first thing to remember is that Kimmel got into the parking lot business literally on a lucky roll of the dice. Kimmel incorporated that business in 1945, calling it the Kinney System Parking Corporation, after Kinney Street in Newark, where the first lot was located. Ownership of Kinney was unclear, however. Longy Zwillman left no will. In 1960 a man named Howard Stone happened to be dating Zwillman’s daughter. Zwillman’s widow told Stone that the Zwillman family owned Kinney Parking and several Las Vegas hotels. If he married into the family, it could all be his someday.

The February 1962 prospectus for the stock offering, to be called Kinney Service Corporation, did not mention Emmanuel Kimmel or Abner Zwillman. It claimed that the largest block of stock was owned by Kimmel’s firstborn son, Caesar. The younger Kimmel reportedly owned 169,500 shares, making up 10.8 percent of the company.

In March 1962 Kinney began trading on the American Stock Exchange with the symbol KSR. The offering price was $9 a share. This made Caesar Kimmel’s (whoever’s?) shares worth $1.5 million.

Kinney Service Corporation began publishing glossy annual reports like any other American company. The first annual report boasted, “Service is our middle name.” The corporate culture retained traces of the old days. “One day, a black guy came in and tried to steal a car,” said Judd Richheimer, who worked for Kinney in the early 1960s. “Butchie [the garage foreman] turned the air compressor on so there would be a lot of noise; then he took the guy downstairs and broke both his arms and both his legs and threw him out on the street.”

Kinney had recently entered a new line of business: funeral homes. Just before the stock offering, it merged with Riverside Memorial Chapel in New York. The funeral parlor was doing better than the parking lot business was. A further advantage of the merger was that Kinney gained the talents of a young undertaker named Steve Ross. Despite his unlikely background, Ross was a capable manager and brilliant deal maker. It was Ross and not the Kimmels who was soon running the company.

Ross was a natural gambler. He read
Beat the Dealer
, and Manny Kimmel gave him lessons in card-counting. Ross was willing to take gambles in building the company, too. The sixties was the age of conglomerates. Ross diversified into businesses that had no visible connection to the already odd marriage of caskets and parking spaces. He bought office cleaning services, DC Comics (publishers of
Superman
),
MAD
magazine, and a talent agency.

In 1969 Ross made a daring bid for Warner Brothers, the film studio and record company. It is a reflection of those giddy times that two other conglomerates were also trying to buy Warner. Ross narrowly prevailed in the bidding war. Kinney acquired Warner for $400 million. By 1969 Kinney stock was selling for over $30 a share. That represented about a 19 percent annual return from the offering price. The year after the merger, Caesar Kimmel’s shares were worth over $6 million.

The merger put Kinney in the spotlight. In 1970
Forbes
magazine called it a “Market Mystery” that Kinney was selling for twenty times earnings. It alleged dubious accounting practices. To top this off, the magazine ran a sidebar mentioning rumors linking Kinney to the Mafia. A reporter asked Caesar Kimmel for comment. The younger Kimmel, shown in a photograph, was a clean-cut guy who could have stepped out of a Brooks Brothers ad. “I’ve lived with this over the years—the charge that we are run by the Mafia,” Kimmel told the magazine. “It just isn’t true. We don’t wear shoulder holsters. We’ve never been under the influence of any underworld group.”

He told the magazine that he was the head of the company’s acquisition committee. “We could have acquired a lot of businesses which in our opinion were corrupt. We didn’t touch them with a ten-foot pole.”

Asked whether his father, Manny (“a big gambler”), had owned the parking lot company, Kimmel answered, “Never.” He attributed the stories to the incidents in the late 1940s in which the company’s midtown lot had been used for limousines taking players to crap games in New Jersey.

The
Forbes
reporter was incredulous. “And that’s the event that is responsible for the rumor about the Mafia popping up again and again? The game that your father was involved with from 1948 to 1950?”

“To put it bluntly, I am not my father’s keeper,” Kimmel replied. “He has his world…and I have mine. Print what you want. The rumors are not true.”

After the Warner merger and the
Forbes
article, Steve Ross recognized that Kinney’s past could be an impediment to his future empire-building. He renamed the company Warner Communications. At the end of 1971, the company spun off the parking lot business. The funeral home business was sold, too.

In 1990 Warner merged with publishing giant Time-Life to create Time-Warner. Warner’s shares rose to $70. Time-Warner became the world’s largest media corporation, with about $10 billion annual revenue and $15 billion in stock market value. This deal was itself dwarfed by the $350 billion merger between Time-Warner and America Online in 2000. A note in the interest of full disclosure: One of Time-Warner’s smaller subsidiaries published my last book.

Manny Kimmel died in Boca Raton, Florida, in 1982. He left behind an attractive young Swedish wife, Ivi, who had been in her twenties when she married him.