BEYOND BUY OR SELL: WHAT A BUSINESS LEADER REALLY CAN LEARN FROM AN ANALYST’S REPORT

Imagine if a CEO, when reading an analyst’s report, focused more on the analyst’s insights and analysis of the particular company’s strategy that on the analyst’s buy or sell recommendation. Imagine further that the CEO applied one or more of those insights to his or her own company. Imagine, then, the CEO’s reaction when the application of something in that analyst’s report increases his or her company’s market share or profit. This author and analyst describes11 principles often found in an analyst’s report and that a CEO can apply to his or her own company.

Business leaders using the recession as an opportunity to re-examine business practices would do well to leverage the management insights of professional investors. However unlikely this might seem, there is a very compelling reason why the habits and observations of professional, institutional investors can help business leaders revive and even save their companies: Equity analysts and portfolio managers at mutual funds, hedge funds and other investment companies are among the most assiduous, well-resourced students of business practices around. We invest – or do not invest — based on our assessment of a particular business; thus the fate of billions of dollars rests on our evaluations. We have seen firsthand what it takes to be a moneymaker, namely an exceptional business leader who consistently delivers results.

Institutional investors have rarely shared these insights, preferring to use their knowledge solely for buying and selling stocks. However, with so many businesses struggling in the current environment, we can no longer remain silent about what we’ve learned, especially since we have repeatedly seen pitfalls in the prevailing management practices. In researching and writing The MoneyMakers, I interviewed almost 50 of my peers, professional investors who identified numerous examples of counterintuitive strategies successfully applied. Specifically, we uncovered numerous companies that were solid investment opportunities – and that we valued highly – because the leaders of those companies adopted unconventional, but effective, management practices. From among them, I have distilled eleven principles that, rigorously applied, can help many of today’s business leaders pull their companies out of the trough of recession. I describe each of these principles briefly in this article.

1. Simplify your business by thinking like an investor

Conventional wisdom holds that professional investors oversimplify matters when we boil every business down to three to five essential elements. Yet who better understood the situation at Lehman Brothers prior to its demise — CEO Dick Fuld, who refused in the summer 2008 to sell assets to reduce the firm’s leverage, or investors like David Einhorn, the president of Greenlight Capital, who issued repeated warnings of the firm’s perilously high debt?

To evaluate a wide range of companies, professional investors focus primarily on a company’s ability to generate economic profit (profitability over and above the capital used to generate those profits) and the “value edge” that generates those profits. We hone in on the value created for customers and the edge a business has in creating that value to simplify our decision-making. Managers can benefit from simplifying their business in this way.

Having a clear understanding of your business’s value edge is particularly important during tough economic times. Fewer available customer dollars intensifies competition, so businesses can only win when and where they have a strong edge. Nintendo recognized this principle in the early 2000’s, when it developed its next-generation video games. Its competitors, Sony and Microsoft, had made it clear that they were going to spare no expense in creating the most advanced, graphically rich video-game systems. Nintendo, a much smaller company, had no edge in competing directly with these two behemoths, so it found a different approach to offer value to customers. By focusing on motion-sensor technology, it developed the Wii, a breakthrough product that built a vibrant business, even without the superior graphics and realism of its competitors.

2. With information-roach motels, problems won’t check out

To use value edges to guide decisions, business leaders must have a clear view of their business’s capabilities. Yet institutional investors are regularly surprised when senior executives are caught short by developments in their businesses. Many of us subscribe to the “cockroach theory,” the idea that earnings shortfalls and other problems are like cockroaches: there’s never just one. As a result, stocks commonly sell off more than an earnings miss seemingly warrants. The cockroach theory works because business executives rarely take the vigorous steps necessary to ensure that bad news reaches them. All too often, problems get stuck in the metaphoric roach motel, where they fester. The conventional wisdom that leaders will undermine confidence if they acknowledge mistakes creates an environment where bad news is swept under the carpet, rather than addressed.

Yet problems don’t age well. Raytheon, the $23-billion manufacturer of defense and aerospace systems, has thrived because it has built a disciplined process, its Integrated Product Development System (IPDS), to expose and root out bad news in the early stages of projects, when the fixes are easier. The IPDS gives project managers incentives to identify problems early on (and assesses penalties for not doing so), thereby counteracting the natural tendency to postpone addressing problems. Raytheon further supports this effort with its Company Evaluation Team, a swat team that reports directly to CEO William (Bill) Swanson and conducts spot evaluations of projects, aggressively seeking out problems before they fester. These dedicated efforts link employees’ economic self-interest to their effectiveness in keeping problems from getting trapped in roach motels. They have enabled Raytheon to continue to deliver strong results for its customers, employees and shareholders.

3. Avoid the trap of profitless growth

Even with a clear view of their edge, executives often cling to their mania for achieving growth regardless of the cost. Profitless or uneconomic growth – that is, an increase in earnings that doesn’t improve return on investment — is equivalent to running on the spot or worse. For years the Detroit auto manufacturers have pursued profitless growth, keeping car sales high by racking up debt in financing subsidiaries. With credit now constrained, this profitless growth has jeopardized the companies more than necessary, had management only right-sized operations in the 2001-02 recession.

To create real economic growth, moneymakers focus as much on reducing investment as they do on growing income. When James (Jim) Cantalupo became CEO in 2003, McDonald’s started to reverse a profitless growth strategy that resulted in stores cannibalizing one another and poor customer satisfaction scores. He slowed the opening of new locations and instead added new offerings, thus creating new revenues through the existing infrastructure. This focus on low-investment growth is enabling McDonald’s to win even today, when so many other businesses that focused on growth through expanded investment are struggling.

4. Don’t be a customer fanatic

When you’re seeking profitable growth, conventional wisdom overestimates the value of listening to customers. Customers are just as likely to be as shortsighted as you. They rarely understand the value/cost tradeoffs inherent in your offerings, and they always want lower prices. Moneymakers think beyond their clients; they better understand what clients will want and will accept than even their clients do.

Cisco, the $39-billion-networking gear company, ignored its customers after the telecom bubble burst in 2002. At the time, CEO John Chambers was advocating the next advance in networking, computing using remote resources over networks rather than on local storage and computers. Customers, who were still digesting past capital spending programs, rejected the idea when Chambers approached them. Yet, he devoted a substantial portion of his R&D budget to developing the products necessary for this offering. In 2006, business had improved, customers were able to look forward again, and Cisco was ready with products, all because it had not listened to its customers earlier.

5. Get more reward for the risk you take

Discounted cash flow analysis (DCF) is commonly regarded as the definitive tool for assessing the worthiness of any new project. It’s the building block of most of the theories of finance and many CEOs swear by it. It also systematically underestimates risk. Almost all DCFs depend on the terminal value, the profits to be generated many years hence. Yet, no one knows what the world will look like that far out, whether a project will be completely superseded by a new technology or other unforeseen developments. Discount rates are rarely large enough to account for this risk.

Moneymakers appreciate the risks in projects with lots of upfront investment and long-term cash flows, no matter how great the eventual payoff. Apache, a mid-sized energy exploration and production firm, has become a moneymaker by focusing on earning its money back quickly. While other oil producers go for the big strike, investing billions in projects with the potential for producing for decades, Apache has built its business by acquiring oil fields that are near the end of their lives, and that have often cast off by larger producers. Since fewer firms pursue these fields, Apache can buy them cheaply, earn back its investment in two to three years, and then earn a few more years of strong profits before the fields dry up. Though it has to work harder to replace its continually declining production, Apache generates better risk-adjusted profits. In the current environment, with collapsing oil prices and the potential for environmental legislation to increase risks, Apache’s strategy gives it the flexibility to respond to changing conditions, adjust its investment levels quickly, and protect its profitability.

6. Economics trumps management

In the heat of competition, executives often lose sight of economics, particularly the law of supply and demand. They add supply without factoring in the inevitable impact on prices. Retailers from Starbucks to Circuit City are currently facing difficulties rooted in overexpansion. Similarly, the auto industry globally and especially in North America, has been adding capacity at a far greater clip than demand has increased. General Motors created the Saturn brand but never reduced capacity or eliminated other brands until forced to by the prospect of bankruptcy.

Contrast Detroit’s response with that of Paccar, a $15-billio, U.S. manufacturer of heavy-duty trucks. Operating in a similarly cyclical and capital-intensive industry, Paccar has managed its capacity responsibly. When sales slowed down, both in 2000-01 and in 2008, it trimmed supply to maintain prices, even indefinitely delaying the opening of a new engine plant in the first quarter of 2009. While decisions to close factories and lay off employees are not taken lightly, the firm has higher long-term growth prospects because it actively manages new supply to maintain prices, both for its new and used trucks. Strong resale prices keep healthy Paccar’s customers and dealers, who rely on the asset value of used trucks, the primary asset on their balance sheets. Strong prices benefit Paccar too; its finance subsidiary retains a healthy AA- rating at a time when many firms’ finance arms are struggling. By heeding the law of supply and demand and making hard decisions to control its supply, Paccar is preserving jobs long term.

7. The best companies to invest in are the worst to work for

The conventional wisdom that posits that happy employees make for productive workplaces has it backwards. Professional investors have repeatedly observed that productive workplaces make for happy employees. Southwest Airlines is widely regarded as one of the best places to work, and many attribute its success to its warm, folksy culture. However, observers overlook the fact that Southwest has one of the most demanding work environments of any North American airline. It requires pilots to fly planes actively, not rely on automatic pilot systems as they do at other airlines. Its ground crew has to unload and reload planes in less than 25 minutes, whereas most airlines take more than an hour. By holding its people to higher work standards, Southwest has created a powerful value edge that makes the organization stable and offers its people opportunities to advance. These characteristics make Southwest an admired and desirable place to work.

8. Good performance requires inefficiency and duplication

Among the most basic lessons business managers learn is the one that urges them to root out inefficiency and duplication. However, there are times when the most efficient structure on paper produces suboptimal results. Businesses need some internal competition, even if it results in duplication, and a measure of happenstance and attendant inefficiency. The more creativity a particular function or department calls for, be it new-product development or operational processes, the more duplication, multiple approaches, stops-and-starts, and inefficiencies moneymakers will tolerate.

Industrial giant 3M saw innovation slow dramatically earlier this decade, when new CEO James McNerney strove to make the firm’s R&D processes more efficient. While his drive for efficiency in 3M’s manufacturing processes was effective, the attempt to streamline research by requiring every project to move smoothly from concept to mass production – and the attendant cuts in the research budget – resulted in a dearth of new products. When George Buckley came in as CEO in 2005, one of his first moves was to loosen up the R&D process and increase the budget. Tolerating and even encouraging a relatively sloppier innovation process enabled 3M to refuel its growth engine.

9. Megatrends start as ripples

One irony of planning for the future is that it is often easier to predict outcomes ten years hence than three years out. In the longer time frame, one merely needs to get the general trend right, while the shorter term requires forecasting the path that a trend will follow. To ride megatrends, moneymakers keep an eye on the future while preparing part-way solutions that work for customers today.

Crucially, part-way solutions allow for staying power, as trends rarely develop quickly or as smoothly as predicted. Plenty of projects and executives have fallen by the wayside by betting too much too early. In 1998, AT&T CEO Michael Armstrong merged the company with Tele-Communications Inc, at the time the United States’ largest cable provider. Armstrong envisioned great synergies from combined offers of pay television, internet service and telephony. Though this “triple play” is now the lead offer for most telephone and cable companies, Armstrong didn’t last long enough to be hailed a visionary. When his vision and foresight were not realized fast enough, his AT&T was sold off in pieces to pay down its debt. Similarly, Toyota’s Prius, a part-way solution for the move to more environmentally friendly cars, relied on incremental investments. Therefore, the project lasted until customers were ready for the car. . This outcome contrasted with the failure of General Motors’ EV1, a completely electric solution, which couldn’t be sustained when customers did not immediately adopt it. Moneymakers have shown that, by keeping an eye on long-term trends and making incremental moves to gather feedback on them, companies can cost-effectively position themselves for the future.

10. We’re all dead in the long run

Professional investors much prefer that companies make incremental moves instead of betting the company on one big decision. This preference comes from evaluating the risk inherent in projects with upfront costs and distant payoffs. The timing of the business cycle is unreliable, trends rarely play out as expected, and shifts in the competitive environment are unpredictable. Progressing incrementally, while not as thrilling as a long-shot investment that pays off is ultimately the surer way to achieve business success.

In the late 1980s, JB Hunt, a $3.7-billion trucking company, identified intermodal (combination train and truck transportation) as a more cost-effective way to serve its customers than its traditional long-haul truck service. As Armstrong did with AT&T, Hunt could have bet the company’s future on the trend to intermodal by selling off the traditional trucking business. Had it done so, it would have died before the trend took hold. In the late 1990s, the U.S. railroads experienced enormous operational difficulties, mainly the result of trying to integrate multiple mergers. However, because it had its traditional business to fall back on, Hunt was able to survive the growing pains. Now it is a preeminent intermodal operator. The example of Hunt makes one wonder how companies will manage in the current recession. For instance, when telecom equipment provider Juniper increases its R&D budget in the face of declining sales, it is effectively betting the company that it will find a breakthrough product and that demand will recover in time. Since the odds of such a bet are long, investors justifiably shy away.

11. The best way forward is often to take a step back

Even by taking incremental steps and following other best practices of moneymakers, bad things sometimes happen to good managers. Here too, the counterintuitive approach works better. When business is not thriving, moneymakers shrink to grow. Bolting additional operations onto an already struggling business only creates more problems; creating economies of scale rarely cure a troubled enterprise. Consider how much worse shape Citigroup would be in today had it acquired Wachovia, as it wanted to.

Walmart’s relative success in the current environment is often attributed to its low price points. But this is not the whole story. Other low-price retailers, such as Target, are struggling despite the fact that customers trading down. Walmart is winning today because it adopted a “shrink to grow” strategy when faced with anemic same-store sales growth in the last few years. CEO Lee Scott and his team sold the German operation in 2006, which allowed them to focus on more promising countries such as Mexico. In 2007, as the cost of building new stores was rising, inventories were bulging and customer ratings of stores were dropping, senior management cut the growth rate of supercenters by 25 percent. The team refocused on the quality of stores, moved district managers into regions so they could be more responsive, and honed their apparel strategy by refocusing on basics rather than fashion-driven items. With its operations focused on higher-return opportunities, the firm is now able to grow and gain share.

All eleven of these principles capture professional investors’ insights on how businesses win. The principles also run contrary to conventional wisdom. This outcome is not surprising, since many investors consider themselves contrarians. Yet these counterintuitive rules are not contrarian solely to be different: they are all supported by the extensive study and analysis that my professional investor colleagues and I undertake each time we assess a business. By sharing these principles with readers, I hope I have provided business leaders with the tools needed to overcome the current tough economic conditions and to become moneymakers.

About the Author

About the Author

Anne-Marie Fink is a Vice President at JP Morgan Asset and Wealth Management, where she has served as a portfolio manager and equity analyst.

About the Author

Anne-Marie Fink is a Vice President at JP Morgan Asset and Wealth Management, where she has served as a portfolio manager and equity analyst.

Leave a Reply

Your email address will not be published. Required fields are marked *