#070 Assessing the Quality of Management, The Process of Judging an Investment Process And Portfolio Allocation Approach
Hi, Welcome to the 70th Edition
Brief Overview of What We will cover in this Issue
Detailed Key Takeaways from the book I am reading Currently
The Process of Judging an Investment Process
Portfolio Allocation Approach
Key Learning from FundSmith Annual Shareholder Letter
Joel Greenblatt's Latest Video Interview
Horrible Experience Of Macroeconomic Bets using Borrowed Money (Video Clip)
Secrets of Wild successful Stock Picker Peter Lynch (Video Clip)
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The Investment Checklist (Part-4)
Evaluating a Company’s Ability to Reinvest Excess Earnings
Avoid jumping to the conclusion that one business is better than another business just because it has a higher ROIC.
What counts is the ability of a business to reinvest its excess earnings at a high ROIC, which is what creates future value. You need to determine the percentage of excess cash flows that the business can reinvest and whether the ROIC on new investments will be the same.
For example, lubricant manufacturer WD-40 generates a high amount of free cash flows, which it is unable to reinvest in the business. The reason it can’t reinvest very much capital back into the business is that WD-40 does not have many growth opportunities.
How to Improve ROIC
ROIC can be improved by: 1. Using capital more efficiently, such as managing inventory better or managing receivables better, or 2. Increasing profit margins, instead of through one-time, nonoperating boosts to cash earnings.
A business can be more productive with its long-term fixed assets. If a business can generate more sales for each dollar of property, plant, and equipment it owns then it will be able to generate a higher ROIC.
business can improve its ROIC through higher inventory turns (cost of goods sold/ average inventory) because operating with higher inventory turns requires less capital to finance the business.
When ROIC Is Less Useful
when the investment base does not add to the earnings of a business.
This is typically the case in knowledge-based businesses such as money management, information services businesses, or other non-capital-intensive businesses.
Do Not Rely on Historical ROIC When Making Forecasts
One common mistake investors make is they rely too much on the historical ROIC and project it indefinitely into the future without considering that returns typically decline over time or that a business is limited in the amount of capital it can redeploy in the business.
Evaluating the Distribution of Earnings (Cash Flows)
The future is inherently unknowable. No one can say with certainty that a business will generate a given amount of earnings two or three years from now, but we can estimate with some certainty what the range of earnings might be.
Businesses with recurring revenue streams or those selling consumer staples have a much narrower distribution of future earnings.
For example, at Procter & Gamble, the range of outcomes for future earnings is very narrow: You will not see a 50 percent drop in the use of Tide detergent in one quarter. When the distribution of earnings is narrow, you can use single-point-estimate valuation methods, such as earnings yield, free-cash-flow yield, and price-to-earnings ratios. In contrast, if the distribution of earnings is wide, as in a cyclical business, you need to use other valuation methods, such as scenario analysis.
Your ultimate goal in determining whether management uses liberal or conservative accounting methods is to help you determine the true operating earnings of that business.
In most cases, you will need to make adjustments to the accounting numbers to understand how much a business actually earns. The reason for this is that there are many ways to calculate financial numbers under GAAP standards.
Read the Income-Tax Footnote
A good place to begin learning if a business’s reported earnings approximate its actual earnings is to read the income-tax footnote found in the company’s 10-K report.
A business keeps two sets of books. The first one is based on GAAP accounting and the other is used to calculate the amount of taxes a business owes to the IRS. The IRS books tend to be conservative most cases firms seek to minimize their the other hand, management can select from various accounting methods to calculate GAAP income. If there is a large difference between earnings for these two sets of books, it will be captured in the income-tax footnote. The footnote reconciles the difference between GAAP taxes on earnings (known as the income tax provision) and the amount of tax paid to the IRS (known as current taxes). In the income tax footnote, compare the differences between the Income Tax Provision and Current Taxes for at least 5 to 10 years. Calculate how much book earnings are overstated or understated compared to current taxes.
Compare Cash Flow from Operations to Net Income
If net income closely approximates cash flow from operations, then there is less likelihood that it is being manipulated. However, if net income is consistently higher (more than 30 percent) than the cash flow from operations, this may be a sign that management is managing earnings.
Evaluating Whether Management Manipulates Earnings
If the accounting is too complicated to understand, this may be a signal that management does not really want you to understand how the business makes money or how well they are running the company.
Earnings are most often manipulated to cover up deteriorating earnings within the core business. Other times, management wants to meet the quarterly expectations of Wall Street analysts by shifting earnings from good years to bad years or by shifting future earnings to the present.
Look for any (or all!) of the following:
Improperly inflating sales
Under- or over-stating expenses
Manipulating discretionary costs
Changing accounting methods
Using restructuring charges to increase future earnings
Creating reserves by manipulating estimates
Does the business generate revenues that are recurring or from one-off transactions?
It is easier to forecast the future revenues for these types of businesses because a recurring revenue business’s starting base isn’t zero, but a certain percentage of last year’s level of sales.
Other advantages of businesses that earn recurring revenues include:• Less dependence on new products.
These types of businesses depend on orders that come in one at a time, with no guarantee or predictability in the revenue stream, and are therefore more difficult to value.
To what degree is the business cyclical, countercyclical, or recession-resistant?
In general, if a business’s earnings decline during an economic downturn, the business is classified as cyclical. If earnings increase during an economic contraction, we call it countercyclical. It is important to determine the degree to which a business is cyclical or countercyclical when forecasting earnings.
When the economy is shrinking, it is cyclical. For example, the following businesses are cyclical:• Household furniture• Apparel• Appliances• Vacation travel• Automobiles• Homebuilding• Big-ticket luxury manufacturers• Residential construction These are products that consumers can defer purchasing in tough economic times. The longer a consumer can defer purchasing these items, the more cyclical a business will be.
Some products and services are less cyclical. Customers buy less, but do not completely defer the purchase— for example, businesses in these industries:• Advertising• Medical equipment• Drugs• Periodicals• Insurance carriers• Dairy products• Legal services• Accounting services• Bakery products Countercyclical businesses do well when the economy is contracting; for example:• Discount retailers• Private-label products (store brands versus nationally branded products)• Medical care
While rare, certain industries operate independently of the economic cycle. In this case, the product or service may be more of a necessity; for example:• Tobacco companies, where customers are addicted to the product• Pipelines carrying oil and gas• Student-housing REITs• Funeral services
If a business is recession resistant then its earnings will not be impacted as the economy enters a recession, thereby making it easier to value.
Recession-Resistant Businesses
Start by reading the MD& A section found in the 10-K. Read about the reasons for changes in the financial statement line items, such as sales, so you can gauge the effect of recessions. Read articles written about the business during the recession as well as historical conference calls.
It is highly likely that analysts and journalists will be asking company management how their business is responding to the recession, and management’s answers will yield many insights.
Degree of Recession Resistance The degree to which an industry or business is affected by recessions depends on several factors:• The amount of recurring revenues a business generates (more recurring revenue means less volatility in earnings and more resistance).• The percentage of the customer’s budget that is spent on that business’s product or service (if a small percentage of the customer’s budget is spent on that business’s product or service, the customer is less likely to drop the product or service).• The percentage of its customers that are exposed to business cycles and how sensitive they are to these cycles (if a business sells to homebuilders, that business will be greatly affected by cycles in residential construction).
Past Recessions Many industries and businesses are labeled as recession resistant because they were able to survive a previous recession without a large drop in revenues. Be cautious when you see an industry labeled as “recession-resistant” because not all recessions are created equal, and each recession impacts businesses in different ways. Be sure to understand if there were complicating factors, such as supply/ demand imbalances in previous recessions. Such factors can mask the true effects of a downturn.
Types of Businesses with High Operating Leverage
The following businesses typically have high operating leverage:• Businesses that have a high labor component• Businesses with high capital-expenditure requirements• Manufacturers with high material and production costs• Businesses that are required to invest a lot of money in inventory These types of businesses include:• Airlines• Aluminum manufacturers• Auto manufacturers• Bond rating firms• Chemical manufacturers• Gaming businesses• Hotels• Mining companies• REITs• Retailers• Steel makers• Supermarkets• Theme parks• Universities Calculating the Degree of Operating Leverage Businesses
To calculate the degree of operating leverage (i.e., how much earnings are influenced by changes in sales), divide the percentage change in operating income by the percentage change in sales. The higher the degree of operating leverage, the more volatile the operating-income figure will be relative to a given change in sales.
Case Study: Why Theme Parks Have High Operating Leverage
A theme park has very high fixed costs and low variable costs. A theme park requires significant capital investment in terms of land and equipment. Each year, a park has to make significant investments in new attractions in order to attract more customers.
Fixed costs do not change with the number of customers and a lot of these costs are still incurred even when the theme park is closed. After reaching a certain level of attendance, where a theme park achieves its break-even point, every new customer’s ticket revenue drops straight to the bottom line which contributes to high marginal profit. Therefore, it is in the interest of a theme park to increase attendance.
Calculating Break-Even Sales Ideally, you would want to understand at what level of sales a business would generate break-even earnings. This way, you would be in a better position to understand at what level of sales operating leverage will start to work against the earnings of the business or in its favor.
Here’s a method used to calculate break-even sales: If a business generates $ 1 million in sales and has a 30 percent gross profit margin (GPM) and incurs $ 200,000 in fixed costs, it will earn $ 100,000. Therefore, break-even sales would be $ 666,667 (Sales × 30 percent = $ 200,000), assuming everything else stays equal. Unfortunately, in the real world, everything else does not stay equal, which makes it difficult to calculate at what level of sales a business will break even.
How does working capital impact the cash flows of the business?
By understanding working capital, you will be able to assess whether a business can grow by using its own capital, rather than having to depend on its customers and suppliers to finance the business. The faster a business can turn its inventory and collect its receivables and the longer it can stretch out its payables, the higher the operating cash flow.
Calculating a Company’s Ability to Generate Working Capital: Using the Cash Conversion Cycle (CCC)
The CCC calculates the number of days that cash is invested in inventory and accounts receivable, and the extent to which the cash outflow is covered by accounts payable.
Negative Working Capital
Negative Working Capital When a business has more current liabilities than current assets, it has negative working capital. This means the customers and suppliers are financing the business, which is a less expensive way of funding growth.
A common attribute of businesses that benefit from negative working capital is that cash flow from operations exceeds net income. Here are two examples, from 2009:• At online retailer Amazon.com, cash flow from operations exceeded net income by $ 2.4 billion.• At the online travel website Expedia, cash flow from operations exceeded net income by $ 377 million.
This means these businesses were able to generate more cash flow from operations than net income. Many times the excess free cash flows are invested in short-term investments, such as cash, which generate interest income that drops straight to the bottom line.
Negative Working Capital Only Works in Your Favor When Sales Are Growing You cannot rely on negative working capital being a consistent, meaningful source of cash flow, especially if growth isn’t strong.
Does the business have high or low capital expenditure requirements?
Determining the capital-expenditure requirements of a business will help you understand how much free cash flow the business is able to generate. If the capital-expenditure requirements are high, then the cash flows of the business need to be continually reinvested in the business just to maintain existing assets.
You can find the capital expenditures of a business by reading the company’s cash-flow statement, and you can find further explanation of the breakdown in the MD& A section. Some businesses will differentiate between capital expenditures needed for growth and capital expenditures needed to maintain a business.
Whenever you are unable to calculate the maintenance capital expenditures, you can use depreciation as a rough approximation. It is easier to use depreciation if the business has a low or well-defined growth pattern or steady state.
For any business you’re considering investing in, you will need to determine how long the assets will last before they need to be replaced.
Assessing the Quality of Management— Background and Classification: Who Are They?
Most investors overlook the human aspect of operating a business, yet, in most cases, the future success of a business is directly tied to the quality of its people.
Instead of focusing on management, many investors spend their time determining whether a business has a competitive advantage or if it is trading at a low valuation, because they believe that products or operational strengths are what set the most successful organizations apart, such as Microsoft’s ubiquitous Windows operating system.
The truth is that, over time, these advantages can be imitated, and if the talented managers who created these advantages leave the business, then the business will struggle to continue to innovate and create value.
As an outside investor, you cannot know every detail of what’s going on inside a business. There are too many variables that impact the future valuation of a business. You must trust management to make the right decisions.
In order to trust managers, you need to gain insight into their character and their ability to execute.
It is best to evaluate a management team over time. By not rushing into investment decisions and by taking the time to understand a management team, you can reduce your risk of misjudging them. Most errors in assessing managers are made when you try to judge their character quickly or when you see only what you want to see and ignore flaws or warning signs.
Your overall strategy should be to develop a working picture of a manager and the management team. You can start learning about management by gathering all of the historical and current articles written about each manager.
Interviews are especially useful because managers tell you a great deal about their business philosophy or how they operate the business.
Some of the best sources of information are trade journals and local newspapers where a business is headquartered. Subjects often reveal more information to industry journalists than they will to a national publication such as the Wall Street Journal.
As you read articles, look for evidence in four basic areas: passion, honesty, transparency, and competence. Look for the ability of a manager to recognize and learn from mistakes and also try to see how quickly they are able to recover from mistakes. Look for articles that talk about how a manager helps employees become engaged in the business or keeps customers happy.
What type of manager is leading the company?
if you are investing in a new management team that has limited experience serving the customer base of the business, the odds are not in your favor.
Owner- Operator 1 (OO1)
Warren Buffett earns $ 100,000 in salary and directly owns 37.1 percent of the stock. These managers take a long-term perspective when making business decisions and identify their personal success with the survival and growth of their businesses. These managers take a long-term perspective when making business decisions and identify their personal success with the survival and growth of their businesses. Much like a parent who will do anything to save a critically ill child, these CEOs will go to great lengths to ensure the survival of their businesses.
Owner-Operator 2 (OO2): This is an owner- operator who is passionate about running the business but is in between the two extremes of being completely stakeholder-oriented and operating the business for his or her own personal benefi t.
Owner- Operator 3 (OO3): OO3 Managers are owner-operators who are passionate about the business but primarily run the business for their own benefit. They do not take shareholder interests into consideration and will often siphon off profits to themselves through egregiously large compensation packages. You can usually identify these types of managers by viewing the Related-Party-Transaction section found in the company’s proxy statement, where you might find such items as personal use of company aircraft, estate planning, personal or home security, and real estate that is owned by the CEO and then leased to the business.
What are the effects on the business of bringing in outside management?
Many investors will bid up the stock price of a business when an outside manager or CEO enters the business. These investors believe that management skills are transferable and react positively when a new management team enters a business, especially one that has been mismanaged.
If this person was a great manager at The Coca-Cola Company, the thinking goes, then he or she will be great at operating any other business.
Investors also often make the mistake of underestimating the importance of the support networks these managers had at their prior company that helped make them successful in the first place. When these managers then enter a new business, they often run into problems because they don’t have that support network, and many fail to perform.
In addition, most of these managers are great cost-cutters but fail when it comes to growing the business. There are very few cases where a manager is good at both cutting costs and building a business such as Steve Jobs, founder of Apple.
When he returned to Apple in 1997, Apple was on the brink of bankruptcy. Jobs was able to cut costs to keep Apple out of bankruptcy and then rebuilt its entire product line and organization.
Jeffrey Immelt, CEO of General Electric, said, “You see that the most successful parts of GE are places where leaders have stayed in place a long time. Think of Brian Rowe’s long tenure in aircraft engines. Four or five big decisions he made— relying on his deep knowledge of that business— won us maybe as many as 50 years of industry leadership. . . the places where we’ve churned people, like reinsurance, are where you will find we’ve failed.”
In addition, relative to managers who have been at the business for long periods of time, outside managers have a more limited understanding of a business’s resources and constraints. The risk you take as an investor is that instead of building on an existing business’s capabilities, they deviate from them. Therefore, a new management team creates unpredictability.
There are some industries where specialized knowledge of the business is especially critical: for example, pharmaceuticals, chemicals, and insurance. It is difficult for an outsider to successfully manage these types of businesses, and you should probably avoid investing in them if an outsider does become CEO.
There are a few cases where outside managers tend to be good hires: For example, when a business needs to break from past strategies or needs to cut costs quickly. If the industry changes very quickly, this will also improve the odds that an outside manager will succeed, but if the industry is stable, then industry knowledge is more important.
Another simple way to categorize management is to classify management teams as either lions or hyenas.
As he learned about how lions and hyenas interact in the wild, he felt that their behavior was very similar to that displayed by managers.
Lions typically hunt together in a group (called a pride), so that they can go after bigger games, which means more food for everybody. Instead of having a single dominant leader, as is commonly believed, males have equal status, as do females. In contrast, hyenas group together only when hunting is easy: After an easy kill, they disband. On their own again, they go back to scavenging carcasses. Status is extremely important to hyenas, with a higher rank netting more respect within the troop.
For example, investing in a team and sustainable infrastructure takes a lot of time, which a hyena manager does not have the patience to do. The hyena continually enriches himself by repeating the short cycle of building and selling five-story buildings.
In other words, they are nice to people they consider to be important but disrespectful to others whom they consider beneath them.
If you are engaged in a conversation with someone and a higher-status person walks into the room, does your conversation end as they quickly leave to join the higher-status person? This is a hyena characteristic.
For example, I remember attending Berkshire Hathaway's annual meetings and speaking with many of the CEOs who run subsidiaries of Berkshire Hathaway. Often, someone else would walk up to them and tell them that someone important, such as another CEO, wanted to speak with them. Even though they did not know me, they continued to answer my questions and didn’t cut me off. In contrast, most of the money managers I knew well would immediately walk away mid-sentence if someone passed by whom they thought was more important. Look for managers that display the lion characteristic of showing respect for people, regardless of status. It is a strong predictor of their ability to command the respect of others and an important leadership characteristic.
How did the manager rise to lead the business?
You can then fill in the gaps of the manager’s career by reading articles written about the CEO and the other top four managers over a 10-year period. For example, by using a combination of historical proxy statements and articles, my firm compiled the career of Larry Young, CEO of Dr. Pepper Snapple Group, shown here:
Ask questions such as:• Does the manager have a background in operations, marketing, or finance?• Did the manager jump from job to job, or does he/ she have a long tenure in the industry?• Why are there gaps in his or her employment history?
Does the Manager Have Experience with Most Operations of the Business?
What Was the Culture Like at Businesses Where This Manager Worked in the Past? You need to understand the culture of the businesses where the manager has worked in the past. This will give you tremendous insight into how he or she is likely to manage the current business, especially if the manager worked at the prior business for a long period of time.
Start by reading articles about the culture of the former business where the manager worked, as well as articles about the CEO this manager worked for. Were the CEO and the culture aggressive and hard-charging, or transparent and authentic?
How are senior managers compensated, and how did they gain their ownership interest?
Look for CEOs Who Have Low Salaries and High Stock Ownership Some of the best long-term-performing stocks have been run by CEOs with the low cash compensation and high stock ownership. These managers generally have a long-term
Be Wary of Managers Who Hold Stock Options: One of the most common ways that management is compensated is through stock options, which give the owner the right to buy shares at a specific stock price. They represent a potential payoff to the manager with no risk: The downside is zero (if the stock price doesn’t increase, there’s no payout to the managers, and if the stock price does increase, then they benefit).
The problem is that stock options often reward managers for things that they are not responsible for, such as broad economic gains or industry growth. As one investor said: “The argument that someone is worth tens of millions of dollars in compensation per year because his or her company’s market value went up many times is so ludicrous that I’ve always been amazed anyone can espouse it as fair with a straight face.”
Be Wary of Companies that Offer Mega-Equity Grants to CEOs or Other Managers
Look for Managers Who Don’t Monopolize Stock Options but Offer Options to All Employees
Beware of Companies that Use Compensation Consultants: If a compensation package is determined by consultants hired by the board of directors, this should serve as a red flag.
Have the managers been buying or selling the stock?
Many executive officers have learned that by buying stock, they can increase the price of the stock because the media reports these purchases. You have to be aware that the top executive officers may be attempting to manipulate the stock.
In order to be a useful signal, the insider buying or selling must be significant compared to the total net worth of the insider— for example, representing 15 percent or more of their total ownership.
Unless you see these high-conviction purchases, then purchases and sales are just noise, and you need to be careful not to regard them as useful indicators.
Whenever you see a former founder buying so much stock using loans to fund his purchases, this is a strong buy signal.
If you see senior managers or board members selling a lot of shares, this is not a signal that you should sell your stock, but it is a signal that you should question their long-term faith in the business. You are looking for extremes rather than an insider selling a portion of his or her holdings: After all, that manager could be remodeling a house or have other reasons that have nothing to do with his or her confidence in the business.
If you see a stock whose price is continually dropping, yet insiders are selling, this is a warning sign.
Determine the Motivation When Management Purchases or Sells Company Stock
If you are unable to determine the motivation behind the purchases or sales, then you do not have enough information to draw a conclusion, and you need to be careful to not make assumptions.
Some of the most common reasons are listed here a:
10b5– 1 programs
Tax purposes
Margin calls
Personal reasons, such as commitments to charities that need to be funded
Assessing the Quality of Management— Competence: How Management Operates the Business
We’ll look at management styles; strategic planning and day-to-day operations; organizational structures (i.e., centralized versus decentralized); how managers treat their employees and whether they know how to hire well; whether management knows how to intelligently manage its expenses; and whether management is disciplined or undisciplined in making capital allocation decisions.
one of the most compelling is that truly competent managers are able to quickly adapt to changing environments.
Another less direct but substantial benefit of partnering with proven and competent management teams is that it frees your time to focus on other investment opportunities. If you partner with incompetent management teams, you have to spend a lot of time monitoring their actions.
In contrast, when I have partnered with competent managers such as Bruce Flatt, CEO of asset-management-holding company Brookfield Asset Management, I do not have to scrutinize each management decision in detail. I know that if top managers make a mistake, they will quickly recognize the mistake and correct it. By investing in proven and competent management teams, you will rarely be disappointed. This will help you maintain an opportunistic attitude.
Does the CEO manage the business to benefit all stakeholders?
“Longterm profits,” says Mackey, “come from having a deeper purpose, great products, satisfied customers, happy employees, great suppliers, and from taking a degree of responsibility for the community and environment we live in. The paradox of profits is that, like happiness, they are best achieved by not aiming directly for them.”
Some examples of businesses that manage the business for customers and other stakeholders instead of maximizing profits are below:• At Costco, CEO Jim Sinegal says that by treating employees fairly and making sure that customers receive a good value, shareholders will benefit over the long haul.
David Packard, the co-founder of Hewlett-Packard, was also known for taking a broader view of stakeholders. One story describes the 37-year-old Packard in 1949 listening to a group of business leaders who were apparently focused solely on profits. Uncomfortable with their views, Packard told them plainly, “A company has a greater responsibility than making money for its stockholders!” Of course, Hewlett-Packard went on to become the premier technology company under Packard and Bill Hewlett.
Does the management team improve its operations day-to-day or does it use a strategic plan to conduct its business?
One reason investors think great performance results from a brilliant strategy is that it is often reported to seem that way in the popular business media. These stories are popular for a couple of reasons: First, they are easy to write; second, people enjoy stories about flash and charisma far more than stories about CEOs who grow their businesses through continuous improvement. These articles often contribute to increases in the stock price as investors buy into the hopes and dreams of the charismatic CEO. Investors tend to have short memories, and they forget that many of these businesses eventually derail in dramatic fashion later on.
Here are a few examples of businesses operated by CEOs who do not follow well-formulated strategic plans but instead improve the business day by day.• Henry Singleton, CEO of Teledyne Inc. from the 1960s through the 1980s, believed the best plan was no plan. Under his tenure, Teledyne’s stock compounded at more than 20 percent for more than 20 years. He believed it was better to approach an uncertain world with an open mind.
Singleton once remarked at a Teledyne annual meeting, “. . . we’re subject to a tremendous number of outside influences, and the vast majority of them cannot be predicted. So my idea is to stay flexible. I like to steer the boat each day rather than plan ahead way into the future.”
Dave and Sherry Gold, co-founders of 99 Cent Only Stores, started the business in 1982 and grew it to more than $ 1 billion in sales in 2005. Dave Gold said, “The people who are making long-term projections usually do not have accountability, and people often forget what they said years before. If you have a strategy for growth for the next 5 or 10 years, it gets changed so much in that time period. I don’t think you can plan out more than 2 years from now. I don’t think that far ahead. If you do, you just get into dreaming.”
Thomas Stemberg, the founder of office retail chain Staples, said, “I don’t get hung up on business plans. I read them, of course. But whatever the plan says, the company will end up looking different.
Bob Graham, co-founder of one of the nation’s largest AIM Management Group Inc., mutual fund companies said, “When we started AIM Management Group Inc., we never had a plan. We followed opportunities as they came along. Our plan changed along the way, depending on what opportunities presented themselves. We had no idea that we would be in the money market funds business or in the equity funds business, nor did we have an idea of how big they would get.”
Why Do Strategic Plans Fail? When CEOs set a strategic plan, they risk becoming committed to it and may fail to consider other alternatives. In the book Influence, author Robert Cialdini writes about “the commitment and consistency principle.”
After making a commitment or taking a stand, people are more willing to agree to requests that are consistent with their prior commitment. In other words, once you make a public statement, it makes it difficult for you to change your mind. Setting strategic plans has the same effect: A CEO is very likely to do things to remain committed to meeting his or her stated plans because the consequences of not meeting them are that the stock goes down, thereby reducing the value of stock options or tarnishing the reputation and credibility of the management team. The management team thus becomes committed to only one way of doing business.
Strategic plans fail because they often shut out other opportunities. When an opportunity comes up and it does not fit into the strategic plan of a business, then the management team will likely pass it up. The truth is that most management teams often stumble upon their best ideas.
Setting specific financial targets
Many CEOs often make such announcements as “the business will generate $ 100 million in revenues in three years” or “we will sell 1,000 units per week by the year 2012.” However, what happens in most of these cases is that when the CEO focuses on a specific financial target, they neglect other areas or take on more risk.
In other words, it was locked in. To try to make that number, the company burned through billions of dollars, launching new models in many market segments.
Paul Larson, the editor of Morningstar StockInvestor, offers a great analogy of why it is dangerous to set specific financial targets:
“It’s like you’re driving somewhere and you tell yourself you will drive to a certain destination at an average speed of 63 mph. Instead, the way you should do it is to go as fast as road conditions will allow. If you have a set projection, you might go too fast and crash, or maybe it is a wide open road and you can gun it.”
Hugh Grant, CEO of the agricultural biotechnology company Monsanto, once declared that his goal was to double profits within five years. To meet this goal, he needed to shift the business’s focus away from herbicides to its more profitable biotech seed business. By 2010, Grant announced that they were unlikely to meet such a goal and that he was abandoning those plans. Grant later declared, “I’ll tell you from the school of hard knocks, I don’t think you’re going to be seeing us laying out long-term targets.”
In the late 1960s, Ford had begun to lose market share to its competitors who were making small fuel-efficient cars. Ford CEO Lee Iacocca decided to challenge his engineers to produce a car that would cost less than $ 2,000, weigh under 2000 pounds, and complete it by 1970. Talk about specific goals: This was a trifecta! The result was the Ford Pinto, best known as the car that could ignite on impact. Not only was the car design defective, lawsuits later revealed that Ford’s top managers knew that the car could ignite. So committed were Ford’s managers to their strategic plan that instead of fixing the faulty design, they decided to go ahead and manufacture the car. They figured the costs of the lawsuits from the Pinto fires would be less than the cost of fixing the design.
Do the CEO and CFO issue guidance regarding earnings?
For example, a CEO and CFO who give guidance may dependable period-to-period growth by inherent in a business. Unfortunately, in the real world, a business does not grow in a constant fashion. The majority of businesses face a lot of volatility that CEOs and CFOs cannot make disappear. Growth is almost always subject to seasonality, cyclicality, and random events.
Once a business begins to set guidelines, it may also adopt a short-term outlook at the expense of long-term growth. A CEO and CFO may fear disappointing Wall their stock price plummets. guidance goal, they may do things that are not in the best interests of the business to make up the difference. Once they start this process, it is difficult to stop it.
Then management begins to borrow from the future in order to sustain the present and begins to participate in the earnings game. The game has little to do with running a business and instead becomes a major distraction that detaches the CEO and CFO from the fundamentals of the business.
For example, a CEO may push more products onto its customers in order to meet the current quarter’s guidance. Or the CEO may refuse to invest in long-term capital projects that do not contribute to profitability in the short term.
You need to be cautious with businesses that issue guidance. Ideally, you should look for managers who promise only what they can realistically deliver and do not bow to analysts’ demands for highly predictable earnings. If management is constantly worried about its stock price, then this is an indicator that management is worried more about managing the perception of the business than operating the actual business.
Instead, management should be clear about all of the risks and uncertainties involved and should outline how a business is progressing toward meeting its long-term objective. Some businesses have even stopped issuing quarterly financial targets because they no longer want to subject themselves to the unnecessary pressure to meet external goals.
If a business does issue guidance, you need to be careful that managers are not managing quarterly or annual earnings per share of the business. Create a chart that shows the guidance given by management, and count how many times they beat their estimates. If management is consistently beating its own estimates, you can classify these management teams as “dedicated guiders.” This should serve as a warning signal, and you should closely scrutinize its accounting to understand how the business is consistently beating its guidance. earnings. Start by comparing the estimates to the actual earnings
Is the business managed in a centralized or decentralized way?
Louis Vuitton Moët Hennessy’s (LVMH) stock price has increased more than 10 times in value from 1989 to 2010, under the leadership of Chairman and CEO Bernard Arnault. Arnault attributes much of this success to the company’s management structure, stating, “One key element of management of a group like this (LVMH has 83,542 employees26) is decentralization. You need the right team of inspired managers. I want all of my managers to take charge of their divisions as though they were family enterprises.
How Do You Identify a Business That Is Managed in a Centralized or Decentralized Way?
Herb Kelleher, the founder of Southwest Airlines, brought model employees into the hiring process. For example, pilots made hiring recommendations for new pilots because they were in the best position to judge the abilities of potential candidates.
For example, experienced salespeople will try to determine how important job titles are in a business. If titles are not important, then this is a sign it is decentralized.
Excerpts and Learning from Articles/Blogs
1) FundSmith (Terry Smith) 13th Annual Shareholder Letter
→ It is a lot more comforting to own businesses which are performing well fundamentally when the share price goes down than to be found playing Greater Fool Theory in the shares of a company with no cash flows, profits, or even revenues
→ Consistently high returns on capital are one sign we look for when seeking companies to invest in. Another is a source of growth — high returns are not much use if the business is not able to grow and deploy more capital at these high rates.
→ Cash flow is an acid test of a business but it is also a more volatile measure
than profits which are based on accrual accounting and spread some cash flows between periods.
→ Sending good money after bad is never a recipe for success.
→ We have held five of our portfolio companies since our inception in 2010. Why is this important? It helps to minimize costs and minimizing the costs of the investment is a vital contribution to achieving a satisfactory outcome as an investor.
→ it’s easier to change the management than to change the business. However, when we are continually ignored there is another even easier option to sell the shares which we turn to when all other remedies fail
On Underperformance
Whilst a period of underperformance against the index is never welcome it is nonetheless inevitable. We have consistently warned that no investment strategy will outperform in every reporting period and every type of market condition. So, as much as we may not like it, we can expect some periods of underperformance.
On Interest Rate Rises
It is inevitable that when interest rates rise, as they have now to combat inflation, longer-dated bonds fall more than short-dated ones, and so it is with equities with more highly rated shares — which are discounting earnings or cash flow further into the future — suffering5 more in the downturn than lowly rated or so-called value stocks. This effect can be seen in the bottom five detractors from the Fund’s performance in 2022:
Non-Cash Expense
What are the justifications for removing share-based compensation from measures of income and earnings? A common excuse that companies give for adjusting profits so that the debit for share-based compensation is removed is because it is a non-cash expense. This argument makes no sense. Plenty of income statement items are partially or entirely non-cash. Depreciation is non-cash, but it still reflects the very real cost associated with a company’s long-lived assets (although many of the same people who adjust out share-based compensation and many others try to get analysts to focus on EBITDA in order to ignore the inconvenient depreciation and amortization cost). Deferred income taxes are non-cash but are nevertheless recorded in the P&L account. Parts of revenue can be non-cash as well, but we certainly don’t see many companies removing them from their results. As long as accrual accounting is the standard, the ‘non-cash’ argument simply does not pass muster. If you want to review cash items, then look at the cash flow statement, not an adjusted P&L account
Please refer to the full letter for a more detailed explanation of the adjusted EPS.
2) The Process of Judging an Investment Process
The ability to say no over and over again. : The trick is having the ability to say no to good or even great investments when they aren’t in your wheelhouse or when they aren’t a great fit within your portfolio or risk profile. A good set of guidelines about what it is you won’t invest in is just as important as outlining those characteristics that you will invest in.
The ability to judge the character of a portfolio manager and an organization’s culture. : In some ways, you almost have to be better at judging people than judging investments to succeed in this endeavor.
Everyone will talk about what differentiates their firm or process from the market and their competition. Everyone has a great pitchbook of marketing materials and a highly educated staff. You can’t get caught up in the narrative or become blinded by the brilliance of a slick portfolio manager.
The ability to know when a process is done working and when it’s just out of style. : One of the hardest decisions to make in the investment world is distinguishing between an investment process that’s out of favor and one that doesn’t really work anymore.
You have to be able to understand why something works over the long term, but not right now, and also why it should continue to work in the future.
Having the ability to admit when you made a mistake is huge, but something highly intelligent people have a hard time accepting.
3) FOMO The Worst Financial Trait
Most ambitious people’s intuition is to ask, “How can I get smarter? More informed? Find new skills?” In many fields those are the right questions. Money is a rare exception where asking questions like, “How can I be less dumb, less greedy, less impatient?” can be more effective. And there’s one trait whose removal from your personality can do more to improve your financial situation than anything else: The fear of missing out.
Having No FOMO might be the most important investing skill.
FOMO is recklessness masked as ambition. You see someone else getting rich and think, “If they can do it, I can too.” That feels like a good emotion – it feels like you’re learning through observation and following a data-driven path to success. But what’s actually occurring is you are outsourcing your emotions to people whose quick windfall has probably left them in a fragile emotional state to begin with.
If you only bought an investment because it went up, you’ll be the first to panic when it inevitably goes down.
Charlie Munger once said: Someone will always be getting richer faster than you. This is not a tragedy… The idea of caring that someone is making money faster than you are is one of the deadly sins.
4) Portfolio Allocation Approach
Let’s deep dive into 5 truths about portfolio allocation:
1. The story of a too-diversified portfolio
I don’t know anybody who can really do a good job investing in a lot of stocks except Peter Lynch.- Bill Rouane
If you look at this portfolio closely you will observe two things: first, you will observe that there will be a few winners which go up by 200-300%. Then there are a few losers which go down by 60-70%. The best thing about a widely diversified portfolio is that you will never go bust as an investor. You will ensure that you will survive for a long period of time. However, on the other hand, the bad thing about a widely diversified portfolio is that you kill optionality. You won’t ever have a life-changing investment. Even if you have one, what's the point of owning 1% in a stock that goes up by 1000%?
2. The story of a too-concentrated portfolio
This is often the story with more than half the multi-baggers in one’s portfolio. You bet on something, yet something else which is even more powerful works out.
The biggest downside of a concentrated approach is that you won’t be able to live to tell another story. Yet, the upside is such when it really works out. Then you attribute everything to your skill of adequately allocating. When the outcome can be equally credited to luck. Just like excessive diversification, a concentrated approach that hits the speed breaker of bad luck often again ends up killing the optionality (Your survival in the markets). One lesson over the years I have seen with people experiencing good or bad outcomes with concentration is: Never let optionality die. Some risks are just not worth taking as a do-it-yourself retail investor.
3. Is there an optimal way?
We all have heard about the circle of competence and why it is important. The inverse of the circle of competence is the circle of ignorance. What it means is that, In spite of investing in things that we only know we can still make a mistake. Make peace with the fact that there are some things that we will never know in spite of spending a number of years in the sector. For e.g. Warren Buffett who’s been renowned to pick financial stocks well. Still went wrong in his bet in the Irish Banks and similarly, he read IBM’s annual report for over 50 years and understood the business well. Yet, he still went wrong on the growth aspect. If such a great investor can go wrong and then mere mortals like us will also go wrong.
This is what I personally follow: I view diversification as a strategy of aggression, as diversifying across sectors and companies in the small-cap space with 15-20 good businesses that can potentially grow at 20% +. I use allocation as a strategy to concentrate on where my understanding and conviction in the cash flows are really high. This is how I cherry-pick the best of both concentration (optionality of huge winners) and diversification (ability to survive).
I have been recently reading a book about Genghis Khan and how he was able to conquer the world in 25 years. Here’s a passage from the book which really hit me:-
In each struggle, he combined the new ideas into a constantly changing set of military tactics, strategies, and weapons. He never fought the same war twice.” When it came to war and conquering empires. Genghis Khan was practically a learning machine. The ability to learn, adapt and be agile is what gave him an edge in conquering vast territories of land within a span of one lifetime.
The best thing about Do It Yourself Investing is not the returns. But, in the continuous process of learning, you learn something new every day.
Small Video Clips
➢ Joel Greenblatt Interview (Latest)
On Teaching & Writing Books on Investing (04:15 to 08:12)
Definition Of Valued Stock (09:47 to 13:38)
Is Now A Good Time For Value Investing (13:56 to 20:07)
On EV/EBITDA, Free Cashflow, and Buybacks (21:01 to 24:45)
On Why Cheap Stocks keep getting cheap and cheap (25:15 To 29:48)
Upcoming New Book “The Little Book that still fits market” (30:49 to 36:45)
Overvalued Stocks (36:57 To 39:48)
➢ Joel Tillinghast (Fidelity Superstar) Interview | RWH Podcast
Horrible Experience of Macroeconomic Bets using Borrowed Money (19:36 To 27:49)
On a Similar Note:
It's not only difficult to predict macro events, it's difficult to predict how the market will react to it and when they will react to it. The market is thinking months ahead. Even if you knew the exact events, you would still make mistakes by messing with this stuff.
Story of Hiring By Peter Lynch (32:00 to 37:04)
Secrets of Wild successful Stock Picker Peter Lynch (43:17 To 46:25)
Key Learnings from investing career: Know yourself (54:20 to 56:10)
How he thinks about Diversification, 880 Stocks, Yes you read that right, Not a typo :) (56:40 To 01:04:40)
A case study of Monster Beverage's 1000X returns and how he was able to hold such a long (01:08:04 to 01:16:17)
That’s it from my end for this week. Thanks for reading.
See you again next week!
Dhaval.
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Packed with golden insights! Always love starting my early mornings with these Editions! Keep it up! :-)