bizzXceleration: Performance, Value and Profit

 

The heart of the conundrum(s) is analyst's estimates of earnings, the P/E multiples being placed on those earnings estimates by investors and the amazing gap between grounded business analysis and more realistic earnings estimates. Repeating an earlier point - while there are some very good analysts by and large they're finance guy's who're good at numbers courtesy of their MBA's. But they lack an understanding of how business works. A point which is reinforced by two charts we've borrowed from Schwab's most recent outlook which a) show the failure of analysts to catch turning points. And b) relate earnings as finally reported to businss cycle turning points such as we're now at. Take a careful...careful look at these charts and ask youself which analysts do you believe ? And why ? How can you check it out ?

And why should you care ? Other than the obvious impacts on the market and the economy we mean :). For a couple or three major reasons. First off the analysts track record for calling turning points is abysmal. Secondly, and perhaps the most important, however this all sorts out, there are going to be some wonderful opportunities to pick up good companies that pass the Buffet filters very cheaply. In other words you can turn this all to your advantage. But not without doing some homework. We'll remind you of some more of Warren's advice - learn to understand business, narrow your "circle of competence" to 30 +/- companies or so and then really dig into them. You only need to be making 5-6 good investments in a focused strategy to do well.

The readings below should be helpful background for how to go about that. First up are two stories about topics that might appear to be far afield. The first is how the Patriots built up a long-term strategy for an effective organization and the second is on Mitt Romney's failure to follow his own prescriptions for doing the same; that is establishing and executing against a realistic vision. Translated - find those companies with Business Models and Strategies that are sound. Then filter them again by finding those that can execute well against the vision. And have the right culture, leadership and controls. The rest of the readings, including a listing of some of the most pertinent prior posts, are more specific guides to business analysis.

General & Special

Your Success Depends on Your Talent Today's business leaders, obsessed as they are with creating sustainable, high-performing companies, would do well to study one of the most successful, high-profile organizations in the news today: the New England Patriots. The story of how Bill Belichick and his front-office leadership team created a dynasty of sorts (a chance for four Super Bowl victories in seven years) provides insight as a case study in how to hire, reward, and retain top talent to drive performance. For starters, unlike many NFL teams and far too many business organizations, the Patriots select and develop talent that will drive their long-term strategy. Under Belichick's leadership the Patriots have turned their backs on the prevailing "win now at all costs" mentality which, given the salary-cap competitive rule, often translates into signing one or two expensive players to long-term contracts. Instead, they've broken with tradition by recruiting underrated mid-tier players with the potential for growth, foregoing the more expensive, sometimes unpredictable, superstars. These players are paid fairly, but on expected future results, not on past performance. This approach has attracted a number of younger players eager to prove themselves and veterans—witness the transformation of Randy Moss—thirsting for their first title with an organization growing in stature and prestige.

 

Romney's missed chance That mantle belongs to former Massachusetts governor Mitt Romney, a wealthy and hugely successful businessman. Yet Romney's chances of becoming the next Harvard MBA in the White House appear to be dwindling. What happened? His 2004 book, Turnaround: Crisis, Leadership, and the Olympic Games, is devoted entirely to the story of how he not only fended off disaster in Salt Lake, but finished the Olympics with a $100 million surplus. The book was clearly intended to serve as a forerunner to his presidential campaign, which is telling. While McCain's autobiography recounts his military heroics and Barack Obama's focuses on his multicultural upbringing, Romney's campaign manifesto is essentially a business book. In Turnaround, Romney lays out four guidelines he used as president and CEO of the Salt Lake Organizing Committee. First rule: Know why you're taking on a job. Second: Assemble the right team. Third: Carry out a strategic audit. And fourth, communicate the vision and challenge the team. Romney tried to apply those principles when he returned to Massachusetts and was elected governor in 2002 - with mixed results. Not until the beginning of this year did Romney even start emphasizing his economic experience on the stump. Until then, he had effectively repudiated his entire career by presenting himself as the candidate for social conservatives rather than economic ones. Which may explain why Republican voters aren't choosing Romney. It's unclear that he can be trusted not to abandon his positions for the sake of political expedience. Romney's pragmatism served him well in business. But in this election at least, voters seem to want a president who will stand up for his beliefs.

 

Business Analysis

You Can't Learn Management in a Classroom Business schools have their uses but they overstate what they can deliver and they may be unintentionally letting down their products -- the students -- by forgoing real-world learning for the classroom. The letters MBA should, if the schools were honest, stand for Master of Business Analysis, because the tools and disciplines of analysis are what the students learn, not management, or administration as it used to be called. Analysis is a necessary part of good management and leadership but it is not the whole of it. Who to trust, how to inspire, how brave to be, how forgiving or not -- these relationship and judgment skills may be discussed in a classroom but they can only be learned by practicing them. You can bring the world into the classroom but you cannot replicate it there.

The Case Against Case Studies Hubbard's so-called decision brief offers less information about a situation than the case study, and it doesn't present the solution until students have grappled with the issues on their own. Too Much Information The stock case study presents a tidy narrative arc, with a protagonist and a clear story line. If this case were a Columbia decision brief, students might see a video interview in which Pollace describes the challenge. They would also be given a few documents on the background of the campaign itself -- the same data a manager at the company would have, but no more. Then, students would discuss possible solutions. Afterward, the group would see a second video of Pollace explaining how she handled the issue before debating whether or not she made the right decision.

Icebergs Ahead: Designing a Risk-Proofed Company  Toyota has made several difficult de-risking choices that include: taking steps to dramatically lower its fixed costs, thereby reducing the financial risk posed by a recession or a sales slowdown; reducing cycle time in both manufacturing processes and new product development, enabling the company to respond more quickly to change; developing a uniquely flexible manufacturing system that permits production of several vehicle models on a single assembly line; creating a broad portfolio of vehicle models, reducing the risk of losses from a decline in popularity of any single style; and taking the steps needed to enhance and strengthen the Toyota brand, including developing and maintaining the highest service and product quality standards in the industry. Is this merely practicing plain old good management? Not at all. It is conscious choices made very differently by different competitors. Detroit automakers, for instance, agreed to high fixed costs, with very low variable cost. That was a bet on steadily rising volumes, and the bet proved wrong. The important point is that, given the essential nature of the industry, it was a much higher risk position. As a result of Toyota's choices, its business design is architecturally sound. When we compare it, point by point, with that of a major U.S. competitor, Ford, we see why Toyota is prepared to survive the strategic shocks and shifts that are constantly occurring in the auto industry.

A Profit Fumble -- or Not? Analysts forecast S&P 500 profits will rise 2.6% in the first quarter and 3.5% in the second, but jump 20% and 50% in the year's last two quarters.

The Flawed Fed Valuation Model There are lots of things that investors believe which I find perplexing. The Superbowl indicator is one, but the oddest to me is the so-called Fed Model, also known as the IBES Valuation Model. It is not that the Fed model is so terribly wrong -- it has been both right and wrong over the years. Rather, it is the way too many people conceptualize it. First, the definition of the Fed Model: Yield on the 10-year U.S. Treasury Bonds should be similar to the S&P 500 earnings yield (forward earnings divided by the S&P price). This, in theory, should inform you of when equities are over-priced or under-priced. Note that the formula contains two variables: While it is commonly described as a way to evaluate when stocks are over- or under- valued, the other variable in the formula above is the forward S&P500 earnings consensus. SPX prices and the 10 year yield are the knowns, but while valuation and forward earnings are the unknowns.  Thus, the Fed model today might be telling you to things: When equities are  undervalued -- or when consensus  earning estimates are too high. Which brings us back to today. We continue to see the Fed model used to rationalize a bullish stance in equities. However, given that it is based in large part on analysts consensus for future SPX earnings, investors need to be extremely cautious relying solely on the Fed model. Why? Analysts are unflaggingly inaccurate at turning points. Example: Q3 S&P500 earnings consensus were +8% -- S&P500 earnings came in at -8%. Q4 has been similarly lowered, undercutting the earlier forecasts of undervaluation. Now let's look at 2008. S&P 500 forward earnings over the next 4 quarters are as follows: Q1 = 3%; Q2 = 4%; Q3 = 20%; Q4 = 50%, according to UBS. So stocks, so we are confronted with two possibilities. Perhaps, equities are seriously undervalued (that assumes earnings  explode in 2H). An alternative explanation, and one I suspect is more likely: Analysts consensus earnings are wildly exuberant for the second half. 

Masterclass: Buffett on Investing and Business Analysis Now at some point you've probably seen Warren's basic principle's in some business article or heard him on Rose or someplace else. Certainly the AAII article does a superb job of translating those principles into a screening set, within the limits. We'd summarize/paraphrase them roughly as: 1) Understand the business and be absolutely confident in it as a business for the long-haul, 2) view investments as buying a piece of the business and be comfortable not trading them for 10 years, 3) look for companies with sustainable competitive advantages that protect the core value proposition and 4) pick companies with good management. Listening to Warren takes those simple-sounding principles and fleshes them out with examples and discussions that makes them meaningufully operational. Beyond that though we got several surprises that, as long we thought we'd been following Buffett, were eye-openers:

·         B2C Wars:Yhoo/MS Merger - Disaster in the Making ?

• Ganesh Filters III: Analyzing Businesses Blueprints
• Think Like a Private Equity Guy ? No, Think Like An Owner !

The Recession Talk Your Board Should Have With regard to the first error, boards waste their valuable time and management's patience when they choose to discuss the operational details of belt-tightening and tactical cost reduction. Whether the remedy is cutting discretionary expenditures, avoiding or delaying investments, implementing hiring freezes, or other "standard" actions, management already knows the options and the consequences better than the board. (After all, every one of these alternatives was probably discussed at length in developing the budget just presented.) The board's role here should be limited to discussing the key issue: How would the shareholders want management to balance the two competing objectives of minimizing the hit to profits should a recession occur and capturing maximum growth should it not? Once the board has chosen its objective, it should then allow management to work out the details. The first error, although it wastes valuable time and unnecessarily stirs up emotion, is less egregious than the second, which wastes something far more precious -- strategic opportunity. The failure to debate whether the company should, in fact, step up its activities and use the recession as a chance to gain position and advantage can be a grave mistake. Studies of previous recessions have shown that a company has almost twice as much chance to dramatically improve its position in an industry during a recession compared to normal times -- and that most (but not all) of the companies that did step up held their gains in subsequent economic recoveries.

The Future Is Now Executives have become increasingly sophisticated at analyzing the value of current operations to help them manage the goal of increasing shareholder value. But they still need to supplement the tools used for value-based management with one that can analyze their company's future value. By the early 1990s, companies were increasingly zeroing in on whether business operations were adding value. Value-based management tools remain popular today, among them EVA, or economic value added, which takes after-tax operating profit and subtracts from it a charge for the capital employed to generate that profit. However, a variety of academics and consultants have pointed out the limited usefulness of EVA and other value-based performance measures, particularly given a propensity toward current-period and short-term, backward-looking performance evaluation. For example, EVA fails to quantify the increased value a company might realize in the future through, say, higher levels of investment in programs aimed at increasing brand loyalty, developing talent, generating patents or bolstering research-and-development capabilities. True value-based management requires executives to look both backward and forward.

Archives (worth reviewing or at least skimming)

1. Earnings
2. Enterprise Performance
   

3. Value Analysis & Valuation