ContentsPreface

Acknowledgments

Chapter1:HowtoGenerateInvestmentIdeas

HowInvestment

OpportunitiesAreCreatedHowtoFilterYourInvestmentIdeasUsingaSpreadsheettoTrackPotentialandExistingHoldings

Chapter2:UnderstandingtheBusiness—TheBasics

1.DoIwanttospendalotoftimelearningaboutthisbusiness?2.Howwouldyouevaluatethis

businessifyouweretobecomeitsCEO?3.Canyoudescribehowthebusinessoperates,inyourownwords?4.Howdoesthebusinessmake

money?5.Howhasthebusinessevolvedovertime?6.Inwhatforeignmarketsdoesthebusinessoperate,andwhataretherisksofoperatinginthese

countries?

Chapter3:UnderstandingtheBusiness—fromtheCustomerPerspective

7.Whoisthecorecustomerofthebusiness?8.Isthecustomer

baseconcentratedordiversified?9.Isiteasyordifficulttoconvincecustomerstobuytheproductsorservices?10.Whatisthecustomer

retentionrateforthebusiness?11.Whatarethesignsabusinessiscustomeroriented?12.Whatpaindoesthebusinessalleviateforthecustomer?

13.Towhatdegreeisthecustomerdependentontheproductsorservicesfromthebusiness?14.Ifthebusinessdisappeared

tomorrow,whatimpactwouldthishaveonthecustomerbase?

Chapter4:EvaluatingtheStrengthsandWeaknessesofaBusinessandIndustry

15.Doesthe

businesshaveasustainablecompetitiveadvantageandwhatisitssource?16.Doesthebusinesspossesstheabilitytoraisepriceswithout

losingcustomers?17.Doesthebusinessoperateinagoodorbadindustry?18.Howhastheindustryevolvedovertime?19.Whatisthecompetitive

landscape,andhowintenseisthecompetition?20.Whattypeofrelationshipdoesthebusinesshavewithitssuppliers?

Chapter5:MeasuringtheOperatingand

FinancialHealthoftheBusiness

21.Whatarethefundamentalsofthebusiness?22.Whataretheoperatingmetricsofthebusinessthatyouneedtomonitor?

23.Whatarethekeyrisksthebusinessfaces?24.Howdoesinflationaffectthebusiness?25.Isthebusiness’sbalancesheetstrongorweak?

26.Whatisthereturnoninvestedcapitalforthebusiness?

Chapter6:EvaluatingtheDistributionofEarnings(CashFlows)

27.Arethe

accountingstandardsthatmanagementusesconservativeorliberal?28.Doesthebusinessgeneraterevenuesthatarerecurringorfromone-off

transactions?29.Towhatdegreeisthebusinesscyclical,countercyclical,orrecession-resistant?30.Towhatdegreedoesoperating

leverageimpacttheearningsofthebusiness?31.Howdoesworkingcapitalimpactthecashflowsofthebusiness?32.Doesthebusinesshave

highorlowcapital-expenditurerequirements?

Chapter7:AssessingtheQualityofManagement—BackgroundandClassification:Who

AreThey?33.Whattypeofmanagerisleadingthecompany?34.Whataretheeffectsonthebusinessofbringinginoutside

management?35.Isthemanageralionorahyena?36.Howdidthemanagerrisetoleadthebusiness?37.Howareseniormanagers

compensated,andhowdidtheygaintheirownershipinterest?38.Havethemanagersbeenbuyingorsellingthestock?

Chapter8:Assessing

theQualityofManagement—Competence:HowManagementOperatestheBusiness

39.DoestheCEOmanagethebusinesstobenefitallstakeholders?

40.Doesthemanagementteamimproveitsoperationsday-to-dayordoesituseastrategicplantoconductitsbusiness?41.DotheCEOandCFOissue

guidanceregardingearnings?42.Isthebusinessmanagedinacentralizedordecentralizedway?43.Does

managementvalueitsemployees?44.Doesthemanagementteamknowhowtohirewell?45.Doesthemanagementteamfocuson

cuttingunnecessarycosts?46.AretheCEOandCFOdisciplinedinmakingcapitalallocationdecisions?47.DotheCEO

andCFObuybackstockopportunistically?

Chapter9:AssessingtheQualityofManagement—PositiveandNegativeTraits

48.DoestheCEO

lovethemoneyorthebusiness?49.Canyouidentifyamomentofintegrityforthemanager?50.Aremanagersclearandconsistentintheircommunications

andactionswithstakeholders?51.Doesmanagementthinkindependentlyandremainunswayedbywhatothersintheirindustryare

doing?52.IstheCEOself-promoting?

Chapter10:EvaluatingGrowthOpportunities

53.Doesthebusinessgrowthroughmergers

andacquisitions(M&A),ordoesitgroworganically?54.Whatisthemanagementteam’smotivationtogrowthebusiness?55.Hashistorical

growthbeenprofitableandwillitcontinue?56.Whatarethefuturegrowthprospectsforthebusiness?57.Isthemanagementteamgrowingthe

businesstooquicklyoratasteadypace?

Chapter11:EvaluatingMergers&Acquisitions

58.HowdoesmanagementmakeM&A

decisions?59.Havepastacquisitionsbeensuccessful?

AppendixA:BuildingaHumanIntelligenceNetwork

EvaluatingInformation

SourcesHowtoLocateHumanSourcesHowtoContactHumanSources—andGettheInformationYouWantCreateaDatabaseofYour

InterviewsforFutureReference

AppendixB:HowtoInterviewtheManagementTeam

AskOpen-EndedQuestionsBeAwareoftheDangerofFace-

to-FaceAssessmentsofManagers

AppendixC:YourInvestmentChecklist

AbouttheAuthor

Index

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2011021446

Formywonderfulwife,lovingparents,andbeautiful

daughters.

PrefaceThisbookcanhelpyoumakebetter investment decisionsby helping you trulyunderstand the companiesyou’reinvestingin.If you’re like most

investors,youmakemistakeswhen you rush into aninvestment idea withoutdoing the proper work tounderstand the value of a

business.Byrushing,youareessentially betting onprobabilities that certainassumptions will work out,instead of basing yourinvestment decision on realanalysis.Too often, investors buy

stocks by relying onrecommendations from otherinvestors, or on hunches, orbecause of isolated factsthey’veheardorreadabouta

business. When you makeyour purchase decisions onthese factors and do not takethe time to thoroughlyunderstandthebusinessesyouare buying, you’re moreprone to make investmentmistakes. Your decision-making then becomesdangerous because you don’treally know enough, andyou’re relying on otherpeople and the information

(or misinformation) theyprovide about a particularstock. Instead, yourinvestment purchases shouldbe based on understandingthe value of a businessthrough in-depth research. Ifyou truly understand thevalueofabusiness, thenyouwill be in a position torecognize investmentopportunities and can moreeasily make buy or sell

decisions.Don’t be daunted by the

idea of in-depth research.Thisbookmakestheresearchmanageable (moreabout thatin a minute). Also, I’m sureyou do research all the timebefore you spend your hard-earned money: For example,think about any majorpurchase you’ve made inyour life—whether it’s ahouse, or a car, or an

expensivepieceofjewelryorelectronics.Before you spentallthatmoneyonwhateveritwas,youprobablyspentsometimeresearchingtomakesureyour money would be wellspent. If you were buying ahouse, you (or your realtor)researched the price of otherhouses in that neighborhoodand other amenities thatwould make that housedesirable (e.g., the school

system, ease of commuting,neighborhood parks or poolsor tennis courts or shopping,etc.). The more you knowabout your purchase, themore easily youwill be abletorecognizeagooddeal.Thesame is true when buying orsellingastock.Themoreyouunderstandthedynamicsofabusiness and the peopleoperating it, the better theodds that youwill be able to

recognize a good deal on abusiness.Many professional

investorsbelievethatin-depthresearch is a waste of time.To them, great investmentdecisionsboil down to a fewsimple factors, such as anextremely low stock price. Iused to subscribe to thistheorymyself,butover time,IdiscoveredIwaswrong.AsI came to appreciate that the

valueofabusinesscannotbecondensed into a few simplefactors, I searched for booksthat would teach me how tovalue a business and investintelligently in stocks. I waslooking for a practical bookinsteadofonethatfocusedonbroadconcepts.Inspiteofthefactthattherearehundredsofbooks written on the subjectof investing, I honestlycouldn’t find one that truly

helpedme.My instinct after failing to

find a good investingframework was to over-research potentialinvestments.IoftenendedupreadingeverythingIcouldgetmyhandsonaboutapotentialinvestment. As a result, Isubjected myself toinformationoverloadandwasunable to recognize goodinformation. I also kept

repeating investmentmistakes, such as paying toomuch for a business orpartnering with the wrongmanagementteam.So I set out to establish a

systematic process to forceme to think through myinvestment ideas morecarefully and help me avoidrepeating the sameinvestment mistakes. Overthe past 10 years, I began to

use checklists of questions Ineeded to answer to makeinformed investmentdecisions—questions thatwould guide me in learningabout a business’scompetitive position,customer positioning, andmanagement strength. Tocomeupwiththequestions,Istudied the past mistakes Ihad made investing, and Iread many books about the

common mistakes made byinvestors and executives. Iinterviewed private equitymanagers, venture capitalists,entrepreneurs,chiefexecutiveofficers (CEOs), hedge fundmanagers, mutual fundmanagers, and privateinvestorstohelpmeprepareamore comprehensive list ofquestions. During the stockmarket decline in 2008 and2009, I made significant

improvements to thechecklists as the declineexposed weaknesses in myinvestmentprocess.As I used the checklists, I

discovered that if I couldanswer the majority of thequestions on the checklist, Icould more easily value thebusiness by minimizing thenumberofassumptionsIwasmaking about a business’sfuture prospects. If I was

unable to answer a questiononthechecklist(suchas“areitsmanagershonest?”),thenIcould identify the potentialrisks I was taking in aninvestmentand theareas thatI needed to spendmore timeresearching.My ultimate goal was to

understand how well Iunderstood an investment bythe questions I was able toanswer—and those I was

unable to answer, which isoften even more important.With some companies, Ifound that the more I readabout them, the morequestionsIhadabouthowthecompany operated—and Irealized thiswasan indicatorthatIdidn’treallyunderstandthat business!For example, Ispentalotoftimeresearchingmortgage insurers in 2007beforethecreditcrisisbegan.

YetthemoretimeIspent,themorequestionsIhad.Ineverhadenoughinformationtobeabletocalculateareasonablerange of valuations for thebusinesses. I felt I wasanswering too many of thequestions with assumptionsrather than backing theseassumptionswith evidence. Itherefore determined I wasnot in a position to valuethose businesses and I didn’t

invest in them. That red flagsavedmealotofmoney!The result of all my

research is this book, whichdescribes the checklists I’veused in my own investingoverthepast10years.

HowThisBookCanHelpYou

The Investment Checklist is

foranyonewho’sinvestinginstocks,atanylevel—ifyou’rejust starting out and thinkingaboutwhatyouwanttoinvestin, or if you already have aportfolio (of any size) thatyou want to manage betterandwatch yourmoney grow(after all, no-one wants towatch their investments losemoney, shrink, or disappearaltogether!). That said, thisbook isn’t for stock traders

(aka day traders) or peoplewho invest only for short-termgains.Instead, this book is for

anyone who wants to learnhow to value a business andinvest for the long term: Iwrote it to help you learnwhatyouneedtoknowaboutspecific companies you’reconsidering investing in, andto help you evaluatewhetheror not those companies are

worthinvestingin.Before you read any

further, consider thesequestionsaboutyouandyourapproachtoinvesting(andbehonest): You’re not sharingthese answers with anyoneelse!:

Do you check stockpricesfrequently?Do falling stock pricesmake your stomachchurn?

Do you react quickly topositive or negativenews announcementsabout the companieswhosestockyouown?Do you ever feel you’reunder time pressure tomake buy or selldecisions?Do you have highportfolio turnover? Areyou buying and sellingsharesoften?

Doyoufeelyouneedtodefendyour investmentswhen others challengeyou?

If you answered “yes” toany of the above questions,thisbookcanhelpyoumakebetter investment decisions,byhelpingyouresearchmoreeffectively so you’ll trulyunderstand how a businessoperatesandismanaged.AsIdeveloped my checklists, the

benefitsofcreatingaconciseand easy-to-use frameworkbecameapparent.Inshort,theexerciseofgoingthroughTheInvestment Checklist lowersyour risk by increasing yourknowledge of a business.Here’s how the checklists inthisbookcanhelpyou:

The checklist will helpyou filter out the noiseand instead focus oninformation that is most

important and relevant.There is an unendingstream of informationavailable; don’t getbogged down ininformation overload, asIdidwhenIfirststartedinvesting. This booktells you whatinformation you reallyneed and where to findit.The majority of the

questions can beansweredbyinformationthat is relatively easy tofind. You can findmostof the information toanswer the checklistquestions in publiclyavailable Securities andExchange Commission(SEC) documents orarticles written aboutmanagement and thebusiness.

The questions shouldhelp you understand thebusinessas ifyou’re thebusinessownerandhelpmove you away fromthinking of stocks aspieces of paper. Thechecklistquestionsforceyou to think about thefundamentals of thebusiness rather than justitsstockprice.Worryingabout things such as

fluctuations in the stockmarket (which areoutside your controlanyway!) is a waste oftime. Instead, you willbe able to identify themain factors that drivethevalueofthebusiness,most of the risks thebusiness can encounter,and the things that cangowrong.The checklist will help

you take a long-termview of yourinvestments. Mostpeopletendtorememberrecent events moreeasily. The checklistrequires thatyouanswerquestions using a longtime span, which helpsprotect you fromovervaluingmore recentpieces of information.Researching a business

over a long period oftime allows us to sortthrough thingsrationallyandputsusinapositionto better interpretinformation.The checklist is usefulfor compilinginformation that goesagainst your investmentthesis.Itishumannatureto overweightinformation that

supports yourinvestment thesis andunderweight informationthat is contrary to yourinvestment thesis. Thechecklist questions helpyou ensure you’reaccepting (or at leastrecognizing) divergentfactsaboutthebusiness.The checklist will helpyou improve selldecisions. Knowing

when to sell aninvestment is one of themost difficult decisionsyouhave tomake.Mostsell decisions are basedon judgment, feel, orinstinct. The checklisthelps you learnwhen tosell by helping youidentify when thefundamentals of abusiness, such as thequalityofthebusinessor

managementteam,begintochange.

HowThisBookIsOrganized

The three most commoninvesting mistakes relate tothe price you pay, themanagement team youessentially join when youinvestinacompany,andyour

failure to understand thefuture economics of thebusiness you’re consideringinvestingin.Thequestionsinthis book can help youminimize these mistakes byhelping you gain a deeperunderstanding of how abusinessoperates:

Chapter 1 outlines asearch strategy that willimprove your odds offinding investment ideas

that are worthresearchingfurther.Chapter 2 helps youunderstand the basics ofabusiness:Whatitdoes,howitearnsmoney,howitevolvedovertime,andin what geographiclocations it earns itsmoney.Chapter 3 demonstratesthe importance ofunderstanding the

business from thecustomer’s perspectiverather than your own.These insights will helpyoulearnhowimportanta business is to thecustomersitserves.Chapter 4 helps youevaluate the strengthsand weaknesses of abusiness. These are thequestions that will helpyou evaluatewhether or

not a business has asustainable competitiveadvantage, thecompetitive landscape,and the industry itoperatesin.Chapter 5 helps youunderstand theoperationalandfinancialhealth of a business.You’ll look at key risksfacingthebusiness,howinflation affects it, and

whetheritsbalancesheetisweakorstrong.Chapter 6 looks at thedistribution of earnings(cash flow) of abusiness. You’ll learnhow to assess whetherthe company’saccounting practices areconservative or liberal(so you can avoid acompany like, forexample, the now-

defunctEnron), the typeof revenue it generates,whether the companymakes moneyconsistentlyorincycles,and whether or not it’sresistanttorecessions.Chapter 7 is the first ofthree chapters that showyou how to understandthe quality of themanagement team.You’lllookatwhattype

of manager they are,howtheyrosetoleadthebusiness, how they arecompensated, and otherbackgroundinformation.Chapter8helpsyougaininsight into thecompetence of acompany’s seniormanagement. You’lllookathow theyhandledaily operations as wellas long-term strategy,

how they treatemployees, and howtheythinkaboutcosts.Chapter 9 helps youassess the managementofacompanybylookingat their positive—andnegative—traits: Howthey think, whetherthey’re self-promoting,andothercriticalfactors.Remember, when youbuystockinacompany,

you’re essentially goinginto business with themanagers who run thatcompany,soyouwanttoknow as much aboutthemasyoucan!Chapter10demonstrateshow you can evaluatethe future growthopportunities of abusiness. You’ll look atwhether it’s growingorganically or by

merging with oracquiring othercompanies, whetherhistorical growth hasbeenprofitable,andhowquicklyit’sgrowingandwhether management isgrowing in a disciplinedway.Finally, Chapter 11looks specifically atmergers andacquisitions, to

determinewhether thosecompleted in the pasthavebeensuccessfulandhowmanagementmakesthe decision to mergewith or acquire anothercompany.

Each chapter offerscountless examples ofbusinesses I’ve researched,considered investing in,actually invested in, ordecided not to invest in.

These examples tell you indetail how my checklisthelped me make investmentdecisions, and they’ll showyouhowyoucanmakebetterinvestmentdecisionsforyourown portfolio. In addition,each chapter endswith “KeyPoints to Keep inMind,” soyoucanzeroinonthecriticalfactors in each set ofquestions.Now, let’s get started by

learning how to generateinvestmentideas!

AcknowledgmentsThis book would not havebeen written without theencouragement and help ofJudd Kahn and Bill Falloonwho championed this bookfromtheearliestproposal.Noone deserves more thanksthan my partner Ann Webb.Her willingness to make

everything she touches asuccess is foreverappreciated. Ruth Millssimplified the book-writingprocess for me and I can’timagine finishing this bookwithouther.Dr.SandyLeedswas a true devil’s advocate.Those who have Sandy intheir corner, both studentsand friends, are veryfortunate. My friend Jeff“Falcon” Sokol helped

ground the book and at theearliest stages attempted toconvinceme not to endeavorin this project. As such, allcritics need to talk to Jeffabout improving his powersofpersuasion.Iwanttothankmy mentor and intellectualcoachJohn“Chico”Newmanwho always providespracticaladvice.I would also like to thank

the following for their

contributions to the book:Bob Aylward, CiccioAzzolini, Ron Baron, PeterBevelin,Dr.PaulBobrowski,Jean-Philippe Bouchard, Dr.John Delaney, Pat Dorsey,Matt Dreith, Ryan Floyd,Meg Freeborn, Ben Gaddis,Francesco Gagliardi, Daveand Sherry Gold, BobGraham, Todd Green, DavidHampton, Norman Hecht,Casey Hoffman, K.K., Paul

Larson, Brad Leonard, SteveLister, Chris Lozano, JohnMackey, Denise Mayorga,Bob Miles, VincentNordhaus, Francois Rochon,Robert Silberman, PaulSonkin, Jim Sud, SengHockTan, Lee Valkenaar, andMatthewWeiss.On a personal note, a

heartfelt thank you to themost important people inmylife. My parents have never

wavered in their support ofmy ventures. Their patienceallowed me to find my ownpath.Most of all I thankmywife for her steadfast love,support, andguidance.And Iwant to give a specialdedication to my beautifulgirls who have foreverchanged my life in the mostwonderfulway.

CHAPTER1

HowtoGenerateInvestmentIdeas

Therearemanywaysyoucangenerate investment ideas,some qualitative, somequantitative. Quantitative

methods include looking atspecificfinancialoroperatingmetrics, whereas qualitativemethods rely on moresubjective characteristics,suchasmanagementstrength,corporate culture, orcompetitive advantages.Whether you are running acomplicated stock screen orsimply getting ideas fromother investors, all methodshave their own advantages,

limitations, and risks.Ultimately, the best methodofgeneratingideasforyouisthe one that gives you thelargest number ofopportunities.This chapter explores why

stocks become undervalued,how to generate investmentideas, how to filter theseideas, and how to keep trackof them. These steps arecritical to creating a pool of

stockideas.

HowInvestmentOpportunitiesAreCreated

You can’t manufactureinvestment opportunities.Instead, you need to bepatient, and you have to beready for the right

opportunities. It is importantto understand that goodinvestmentideasarerare,andconsistent success in thestockmarketiselusive.Thoseinvestors who believe thatthey can make money yearafteryearinthestockmarketare setting themselves up fordisappointment. Mostinvestors are far toooptimistic: They often thinkthey’ve found great ideas

whentheyhaven’t.In contrast, investors with

the best long-term trackrecords have made most oftheir money with just ahandful of investment ideas.For example,WarrenBuffettstates that his investmentsuccess is due to fewer than20 ideas, such as theWashington Post newspaper,Coca-Cola, and GEICO. Inshort, you need to mentally

prepare yourself in advancewiththeideathatyouwillnothave many outstandinginvestments in your lifetime.Most investments you makewill produce mediocreresults,butafewcanprovideoutstandingresults.The best investment

opportunitiesusuallycomeinbig waves, such as whenentiremarkets decline.Therehave been several recent

examples:theAsianfinancialcrisis of 1997 to 1998, theInternet bubble ending in2000, and the recessionstarting in 2007. There weremanybuyingopportunitiesin2008 when the S&P 500dropped36percent.Thiswascausedbyforcedselling.Themarket sell-off wasexacerbated by theindiscriminate selling ofstocks by money managers

who were forced to sellstocks to fund clientredemptions. Even if thesemoney managers knew thesestocks were undervalued,theyhadnochoicebuttosell.This forced selling createdartificiallylowprices—whichcreatedarareopportunityforinvestors.Other kinds of forced

selling include situationswhenstocksarethrownoutof

an index because they nolonger meet the minimumstandards to remain in anindex. Many investmentmanagers who exclusivelyinvest in stocks found in aparticular index (such as theS&P 500) are forced to sellwhen the stockmovesoutofthe index.Spin-offs (whereabusinessdivestsasubsidiary)create a similar situationwhenthebusinessthatisspun

off does not fit the investingcriteria of an investmentmanager. Forced sellingdecreases prices—whichcreatesopportunities.Besides broad market sell-

offsthatcreateforcedselling,thestockmarkethasawayofmagnifyingdifferent typesofbusiness and industry-widerisk that cause the stockprices of businesses to drop.To learn which area of the

stock market is in greatestdistress, look for those areaswhere capital is scarce.Scarcityofcapitalcreateslesscompetition for assets,whichdecreases prices. Askyourself, what areas of thestock market are investorsfleeing,andwhy?Youmaywant to begin by

looking at the percentagechange in prices of certainindustries found in common

indices suchas thematerials,energy,orfinancialssubsetoftheS&PComposite1500.Forexample, the priceperformance for componentsof the S&P Composite 1500from April 23, 2010 to June7,2010showedthat:

Materialswere down18percentEnergy was down 17percentUtilities were down 9

percentWith that information, you

might start researching thematerials industry, lookingfor stocks that havesignificantlydroppedinprice.Ideally, you want to identifythose stocks where the babyhasbeen thrownoutwith thebathwater—and then rescuethatbaby!Most stock price drops are

due to some type of

uncertainty about thebusiness, and there aremanypossiblereasons:

LitigationfearsAccountingirregularitiesAccusationsoffraudHealthconcerns(suchasswineflu)Execution problems duetoaflawedstrategyManagementconcernsExecutivedepartures

GovernmentinterventionorregulationLossofacustomerTechnologicalchangesCredit ratingdowngradesCompetitorannouncementsOr a myriad of otherreasons

In most of these cases,investors automatically

assume the worst-casescenario and tend to sellstocksfirstandaskquestionslater.Oncetherealitystartstoset in that the ultimateoutcomewillnotbeasbadasexpected, then stock pricesadjust and typically rise.Ideally, you want to identifythoseareaswheretheoutlookis most pessimistic andidentify whether the sourcesof pessimism are temporary

or permanent. Let’s look atanexample.

CaseStudy:Investors’PessimismaboutHeartlandPaymentSystemsProvedUnfounded

In 2009, Heartland PaymentSystems found itself in whatappeared to be a disastrous

scenario. Heartland helpssmall and mid-sizedmerchants with credit-cardtransactions, providing thephysical card machine andpayment-processing servicesthat enable customers to usecreditanddebitcardsinretailstores. In 2008, computerhackers installed spyware onHeartland’s network and hadgained access to the systemsthat process Visa,

MasterCard, Discover, andAmerican Expresstransactions.After discovering the

problem, Heartlandannounceddetailsconcerningthe breach, including thenumber of months thespywaremighthavegatheredcardnumbersandthenumberof transactions that thecompany usually processed.Framing it as potentially the

largestdatabreachinhistory,the New York Times notedthat600millionormorecardaccounts were vulnerable,and quoted a data securityanalyst who said that therecould be as much as $500million in losses and otherexpenses if you added it allup.Early estimateswere thatHeartlandwould have to pay$2 per card for MC/Visa toreissue each affected card.

The result? Investors quicklysold the stock. The priceplummeted from $18 pershare before the breach wasannounced (on January 6,2009) to as lowas $3.78pershareonMarch9,2009.However, other investors

with a solid base of researchon thecompanyand industryknew several things thathelped them take advantageofthissituation:

First, they focused onHeartland’s transactioncount of 100 milliontransactions per month,and theyrecognized thatnotallofthosewouldbefrom unique accounts.People tend to go thesame places more thanonce. Later, moreconservative estimatesof stolen cards emergedat about 140 million

cards, instead of 600million.Second, there waspublicly availableinformation about asimilar case involvingretailers TJ Maxx andMarshalls that had beensettled recently. In thatcase, the averagesettlementperaccounttothe issuing banks toreplace cards was about

70¢percard.In 2010, Heartland agreed

topayMasterCard,Visa,andAmerican Express $105million—notthe$500millionthat was originally estimatedby news sources. Thisamount, which averaged 81¢per card, was similar to therecent TJ Maxx andMarshalls case. Moreimportant for investors wasthefactthatthiswasafarcry

from the first potential lossestimates. Investors whoalready held stock inHeartland shouldn’t haveimmediatelysoldthestockonthe news. They would havebeen rewarded if they hadpurchasedmore of the stockto decrease their cost basis.Also, investors who didn’talready own Heartland stockshould have bought at thistime because this one-time

event was nowhere near asdevastating as the sources inthe press made it out to be.After investors realized thatthe liability from the breachwas lower than theyanticipated, the stock pricerecovered to more than $13pershareseveralmonthslater(bytheendof2010).In sum, if you had

purchased the stock after thebreach was announced, you

could have tripled yourinvestment!

BeWaryofExcitingNewTrendsthat

TurnouttoBeFadsYou must also learn toidentify those areas of thestock market that arebenefiting from abundantsources of capital, whichdrives up prices, so you can

be careful investing in them.Wall Street is good atpitchingstories,andinvestorstend to get excited by whatthey believe is an importantnewtrend.However,manyofthese exciting major trendsturn out to be fads that arebased on speculation, ratherthanfundamentals.Let’slookatacoupleofexamples.In the 1960s, investors bid

up the stocks of

conglomerates that wereincreasing their earningsthrough acquisitions.Businesses such as JamesLing’s LTV (Ling-Temco-Vought), bought unrelatedbusinesses to increase anddiversify their revenuestreams. Growing quickly,they used their high stockprices to purchase otherbusinesses. LTV acquiredcompany after company,

growing from the 204thlargest industrial company in1965 to the 14th largest in1969—onlyfouryearslater!Yet by 1970, under the

pressure of enormous debt,antitrust threat, and agenerally bearish market,LTV’s stockhadplummeted,asdid thestockof severalofthe other recently balloonedconglomerates. From a highin1968of$136persharetoa

1970s low of $7 per share,LTV ended up selling manyofitsacquisitionsatclearanceprices.1

The 1990s gave us anotherkind of speculative boom,whatwenowcalltheInternetbubble. Technology stocksprovided rates of return thatdwarfed their actual growthor profits (if they had anyprofit at all). For example,computer manufacturer and

services company SunMicrosystems was oncevalued as high as 10 timesrevenues when its stocktradedfor$64pershare.CEOScott McNealy recalls thatheady period: “At 10 timesrevenues, to give you a 10-year payback, I have to payyou 100 percent of revenuesfor 10 straight years individends.” McNealy notedthathisassumptionsincludea

few major obstacles such asgetting shareholder approvalfor such a plan and notpayinganyexpensesortaxes.Furthermore, McNealy notedthatSunMicrosystemswouldalso have to maintain itsrevenue run rate withoutinvesting in any R&D.McNealy asked, “Now,having done that, would anyofyouliketobuymystockat$64? Do you realize how

ridiculous those basicassumptionsare?”2

HowtoSpotInvestmentBubblesTo understand where currentbubblesexist, ask, “Where isa lot of money being madevery quickly?” Look at theForbes magazine list ofbillionaires. What industriesare the new billionaires

coming from? For example,intheearly1980s,theForbeslist was populatedmainly byindividuals in theoil andgasindustry.Also,monitorinitialpublic offerings (IPOs)coming to market. Are theIPOsthatarequicklyrisinginpriceconcentratedinacertainindustry, as Internet stockswere during the technologyboomof1998to2000?Whencapitalisabundant,it

searches for other similarbusinesses to duplicatesuccess. The IPOs oftechnologybusinessescausedmany other technologybusinesses to be formed andseek togopublic.Hereareafewsignsofabubble:

LotsofavailablecapitalHigherlevelsofleverageDecreased disciplinefrom lenders as they trytogethigherreturnsthan

through conventionallendingguidelinesDecreased responsibilityfor the borrower,combininghighleverageandlooserlendingterms

Oneofthelessonsfromthe1980s real estate boom/bustwas that there was a graceperiod in which everybodyhad money in their pocketsand they did not have toworry about whether tenants

would occupy the buildingsor whether the assumptionsabout future cash flowsweregoing to be proven correct.Buildings were built on aspeculative basis, as lenderswere in essence throwingmoneyatdevelopers tobuildnew projects and did notworry if the builders hadtenants to occupy thesebuildings. Eventually, therewas an oversupply of real

estate, which caused pricesfor real estate to drop.Lendersanddevelopersfoundthemselveswithmany emptyproperties, and there weremany bankruptcies duringthis period. This just goes toshowthatareaswherethereisan abundance of capital areusuallypoorhuntinggroundsfor great investments.Investors who got caught upin thehypeof the1980s real

estate boom or technologybubble of the late 1990sultimately ended up losingmostoftheircapital.Now that you know more

about how to generally lookfor investment ideas, thefollowing sections of thischapter describe a few moreformalized ways to beginlookingforinvestmentideas.

UsingStockScreens

A stock screen is a toolinvestors use to filter stocks,using pre-selected criteria.For example, if you’re aninvestor looking for cheapstocks, you could enter a setoffilterssuchas:“companiesthat have enterprise value toearnings before interest,taxes, depreciation, andamortization(EBITDA)ratiosof less than five times thatalso have market

capitalizations over $100million.”This produces a list of

businesses that fit the limitsyou’vejustset.There are many different

types of screening toolsavailable. Services rangefrom free services to thosewith high-end fees, withfeaturesandcoveragevaryingby service. The higher-feeservices cover a greater

number of businesses,including microcap stocksand international stocks, andtheyoftencomebundledwitharangeofanalyticaltoolsthatcan help you further refinesearches, such as “search forbusinesses with more than$100millioninrevenuesthathave CEOs over the age of60.”Oneofthemainlimitations

of stock screens is that they

use Generally AcceptedAccounting Principles(GAAP)accountingnumbers,which rarely present arealisticfinancialpictureofabusiness.Forexample,ifyouare looking at a multiple oflast year’s earnings, this canbemisleadingifthecompanyreportedabiglossintheprioryear. Investors often need toadjust GAAP earnings tounderstand the real earnings

ofabusiness.For example, in 2006 and

2007,theaveragetrailing12-month price/earnings ratio(P/E) for retailer 99 CentOnlyStoreswasmorethan90times.3 After adjusting theearnings for special charges99 Cent Only Stores took inthosetwoyears,IlearnedthattheadjustedP/Ewascloserto12 times rather than the 90timesbeingreported.

Onastandardstockscreen,manyofmybest investmentsshowed up as having a P/Eratio of more than 50 timesbecauseGAAPaccountedforsuch factors as restructuringcosts that reduced earnings.After I made GAAPadjustments, I found thattheseostensiblyhighprice-to-earnings-ratio businesseswere really trading at onlyfive times earnings, not 50.

Had I relied exclusively onstock screens, I would havemissed many of my bestinvestments.For example, when I was

researching thestockofFourSeasons Hotels, which haddropped in price after theSeptember 11 terroristattacks, its P/E ratio was 85times earnings. Four Seasonshad just taken severalrestructuring charges, which

reduced the earnings of thebusiness. After adjusting theearnings of the business forthese restructuring charges(which were due to GAAPstandards rather than actualcash charges), the P/E ratiowas closer to 10 timesearnings.Hadmy firm reliedon a stock screen, wewouldhave never found thisinvestment,whichdoubledinprice in a short period of

time.

KeepinganEyeonNew-LowsLists

Newspapersandwebsitescanprovide other idea sourceslike new-lows listings. Forexample, the online site fortheWallStreetJournaloffersdailyandhistoricalnew-lowslistingofU.S.stocks—thatis,those reaching new 52-week

price lows on the NYSE,AMEX,andNASDAQ.Also, Value Line regularly

publishes stock listings suchasthosethathave:

The widest discountsfrombookvalueThe greatest percentageprice changes over theprevious13weeksHigh 3- to 5-year priceappreciationpotentialCurrent P/E multiples

andprice-to-networkingcapital ratios that are inthe bottom quartile oftheValueLineuniverse

Paul Sonkin, manager oftheHummingbirdValueFund(amicro-capfund),usesstockscreens and new-lows lists,buthebelievesthesetoolsaremisused by investors 99percent of the time.According to Sonkin, “. . . alot of investors will put

together a screen of lowprice-to-bookorlowprice-to-earnings stocks, but usually90 percent of the companieson thescreenarecheap foragood reason. Many stay onthese lists for a long time.”4Sonkin believes the properway to use a screen or new-lows list is to run them on aweekly basis and look fornewcompaniesthatappearonthe list. This way, you are

able to separate thecompanies that deserve to bethere from those that mayonly be suffering from atemporaryproblem.Myfirmhasbenefitedfrom

tracking new-lows lists. Forexample, I missed anopportunity to invest inApollo Group, the for-profithigher-education businessknown as the University ofPhoenix, in 2001, when the

stock pricewas near $20 pershare.Bytheendof2001,thestockprice rose tomore than$30 per share, and by themiddle of 2004, it rose to$100pershare.Although I missed the

opportunitytoinvestin2001,I continued to researchApollo Group by attendingindustry conferences,listening to conference calls,and keeping up with SEC

filings.Fiveyearslater,Iwasable to act decisively whenthe stock price dropped from$60pershareatthebeginningof 2006 to $35 per share onNovember14,2006duetoanoptions backdating scandal. Iwas able to discover theopportunity because I wascontinually monitoring thenew-lows lists and saw thatApollo Group’s stock pricehaddropped.Also,because I

hadconsistently followed thebusinessoveralongperiod,Iknew investors wereoverreacting to the scandal.By thebeginningof January,the stock was trading formore than $40 per share andby July it appreciated to $60pershare.HadInotpreparedin advance and monitorednew-lows lists, I would havemissed the small window ofopportunity to make this

investment.

ReadingNewsletters,AlertServices,

OnlineRecommendations,

andMediaRecommendations

There are many publicationsthattoutstocks.Itisbettertosticktothoseservicesthatare

fact-based, such asBankruptcy Week orDistressed Company Alert,ratherthanthoseservicesthataremore interested in sellingsubscriptions by marketinghigh rates of returns to theirsubscribers. Fact-basedpublications are those whereno opinion is attached andinstead corporate events arechronicled.Be awareof self-servingrecommendationsand

less-than-transparentpresentationsofresults.Somenewsletters will excludecertain stocks they haverecommended in the pastwhen presenting their overallrates of returns, and insteadpresent only those that havedonewell.

UsingValueLineValue Line is a great source

for you to build knowledgeon certain businesses orindustries. It presents muchcritical information on asingle page. A typical stockreport shows 10 years offinancial information,including sales, operatingmargin, depreciation, netprofit margin, income taxrate, working capital, long-term debt, and shareholderequity. It also shows

historical returns, such asreturn on total capital, returnon shareholder equity, andreturn on common equity.Thereisalsoaquickwrite-upof significant developmentsover the last quarter as wellasahistoricalstockchart.Each week, a new issue

comes out highlighting agroup of stocks within anindustry, such as auto andtruck, precision instruments,

electric utilities, or medicalsupplies. I read each issuefrom beginning to endlooking for new ideas. Thisalsobuildsmyunderstandingof new businesses andindustries. I borrowed thisidea from Charlie Munger,Vice Chairman of BerkshireHathaway,whomentionedatan annual meeting that heleafs through these reportsregularly to learnmoreabout

different types of businessesas well as to findopportunities. The mainlimitation of this source isthat its publications coveronly3,500stocks,andnotall9,000 publicly traded stocksintheUnitedStates.

FollowingOtherInvestmentManagersManyinvestors(professionals

included) generate ideas byclosely tracking the holdingsof well-known investmentmanagerswithabove-averagetrack records. There alwaysseems to be a hot group ofinvestors that others follow,althoughmostaren’tfollowedfor long. These are usuallyinvestors who have hadrecent success, so the mediaconstantly reports their newholdings.

Theproblemwithfollowingothers is that most of thesegreat records were generatedby past investments, andinvestors wrongly concludethat existing and futureinvestmentswillhave similarresults. Many of theseinvestors fall in and out offavor (for example, wheninvestors began to questionthe investment wisdom ofWarrenBuffettwhen hewas

telling investors to avoidhigh-priced Internet stocks in1999), and it is typicallywhen they are out of favorthat you should be followingtheir holdings. Investorswhomanage the largest amounts(i.e.,morethan$100million)have to disclose theirinvestments each quarter inan SEC 13-F filing, sofollowing them isstraightforward (albeit

slightlydelayed).Early in my career, I

occasionally sourcedinvestment ideas from thesemanagers. When the filingscameout, Iwouldbeexcitedto discover that theinvestment managers Iadmiredhadmadesomenewinvestments or significantlyincreased their position in astock.Ifitwasaninvestmentidea I understood, this

excitement translated intohigher conviction, sometimescausingme to cut cornersonmyownresearch.There are several

disadvantages to followingotherinvestmentmanagers:

Most great investmenttrackrecordscomefroma limited number ofinvestments. For every10 investments asuccessful investment

manager makes, onlyone will appreciatesubstantially,contributing outsizereturnstotheinvestmentrecord, while the otherswill either mildlyperform orunderperform.You typically will notknow the reason why acertain investmentmanager is buying or

selling a stock. Perhapsthe investment manageris suffering frominvestment redemptionsand he or she needs tosellstocks.No matter how goodthey are, all investmentmanagers will makemistakes, and you maybe following them intosuchamistake.Investment managers

change their strategies.Recognize that thestrategies the investmentmanager followed in thepast to generate thesuperior investmentrecord is not necessarilythe strategy theinvestment manager isfollowingtoday.

Therefore, in the end, becareful about following theideasofotherinvestors.

CasuallyReadingtheBusinessPress

You can generate ideas fromthe business press byregularlyreadingpublicationssuch as Barron’s, the WallStreet Journal, the FinancialTimes, Forbes, and Fortune.Consider subscribing to tradejournals as well, such asAmerican Banker (if you areinterested in financial-

servicesstocks)orLasVegasReview-Journal (if you areinterestedincasinostocks).As you read the articles,

you’ll not only groundyourself in industry basics,but you’ll uncoverdescriptions of managementteams you’d like to investwith. The best investmentideas usually come fromthose businesses that are indistress. Focus on those

articles that are not successstories but those aboutdistress, to give you betteroddsof findingawell-pricedinvestment.For example, First

Manhattan senior managingdirector Todd Greenremembers how he firstbecame interested in thediversified industrialconglomerate TylerCorporation. Green read an

article in Forbes (in 1990)where CEO JosephMcKinneysaidhewouldnotconsider doing a leveragedbuyout (LBO) because thiswould put him on theopposite side of the tablefrom shareholders. This wasduring the days of a seriousamount ofLBO activity, andthe comment signaled toGreen that the CEO had theright attitude regarding the

alignmentofshareholdersandmanagement interests. Greenpurchased the stock onApril26, 1991 at $3.07 per shareandsolditonJune8,1998at$9.99per share, a compoundrateofreturnofmorethan18percent.5

BuyingSharestoTrackaBusiness

Youcanbuyafewsharesina

stock thatmeetsyourcriteriatoforceyourselftofollowthebusiness. By purchasing avery small piece of abusiness, you’ve guaranteedthat you will not forget thebusiness,andthatyou’llhaveconsistent reminders aboutthat business.PaulSonkinoftheHummingbirdValueFundcallsthishisgrabbag. Inhispersonal account, Sonkin haspurchased one share ofmore

than 300 companies. In themail each day, he usuallyreceives something fromsome of the companies. Hehas followed some of thecompanies for many years,andheuses thismethod as awayoffillinghisin-boxwithcompaniesthathehasalreadyscreenedasbeinginteresting.For example, Sonkin was

able to invest in ControlChief Holdings, a

manufacturerandmarketerofwireless remote controlequipment primarily used inthe railway industry, whichwas trading for $250 pershare. Sonkin had followedthe business over some timeand learned that the businesshadmorethan$147pershareinnetcashandestimatedthatit had $25 per share inearningspower.Therefore,atan enterprise value of $103

per share, Sonkin bought thestock at four timesnormalized net income, anextremelylowprice.6

Don’tIgnoreYourExistingInvestment

PortfolioAdmittedly, it is moreexciting to discoveropportunities outside of yourportfolio, but it’s not

necessarily more beneficial.Manyinvestorsforgettolookat their existing portfolio forideas. Often, your bestopportunities are right infront of you. If a stock youhold drops in price, thismayrepresent the best investmentopportunity for you,especially compared to astockyouknowlesswell.Forexample,whentheS&P

500 dropped 36 percent in

2008,therewasanabundanceof opportunities. Instead ofattempting to analyze manyof the new opportunitiesbeing offered, my firmdecided to analyze our ownportfolio holdings that weretrading at significantly lowerprices than they had justweeks or months before. Atone point, our core holdingWhole Foods Market tradedat close to four times

enterprise value to free cashflow,whichmeanswe couldhave bought the wholebusiness (including debt netofcash)andpaidforitinfouryears out of existingdepressedfreecashflow.Weendedupbuyingmoreofourexisting holdings, such asWhole Foods Market, whichhelped us generate a netreturnthatwasfarsuperiortothe S&P 500. Had we

analyzed new potentialholdings,we probablywouldnot have increased ourexisting holdings and notgeneratedanexcessreturn.

ResearchUpcomingIPOs

You can regularly researchIPOs,spin-offs,andstocksofcompanies that are exitingbankruptcy, all of which are

new businesses to the stockmarket.Youcansubscribe tovariousservicesthatwillalertyou to these new entrants,such as Gemfinder’s Spinoff& Reorganization Report.Oncealerted,youshouldreadthe prospectus thataccompanies an IPO, spin-off, or stock exitingbankruptcy,becausetheseareespecially rich in informationand are much more useful

than a standard 10-K filing.The biggest advantage oftracking these businesses isthatthereisnotapublicpriceto influence you. You cancalculate a reasonablevaluation range for thebusinessinadvance,andthencompare your value to thebusiness’stradingprice.For example, I analyzed

pediatric nutrition businessMead Johnson Nutrition

before it was spun-off fromparent Bristol-Myers Squibb.Because, there was not apublicpricetoinfluenceme,Ideterminedthatthestockwasworth$40pershareandthatIshould buy it at any pricebelow $30 per share. Whenthe price of the spin-off wasset at $27 per share inFebruary 2009, I purchasedthe stock, which quicklyincreasedto$43.70attheend

of 2009. Had I not preparedin advance, I would havemissedthisopportunity.

HowtoFilterYourInvestment

IdeasSo far in this chapter, I haveshownafewofthewaysyoucan gather investment ideas.

The rest of this chapterdemonstrates ways to filterthese results and beginevaluating investmentcandidatesthatyoumaywantto include in your set ofpotentialinvestments.

CriteriaIsaFilterWhen filtering through themany investmentopportunities the stock

market is offering at anygiventime,itisimportantforyoutoestablishcriteriaofthetypes of businesses andmanagement teams you aresearching for. These criteriaserveasafilter,soyoudon’thave to review thousands ofinvestment opportunities andtherefore can rejectinvestment ideas quickly. Ifyou have ever purchased ahome, when you first started

looking, you were probablyoverwhelmed by the numberofhousesthatwereavailable.At some point, you probablybegan toestablishcriteria forthetypesofhousesandareasyou were interested in, andthis helped you narrow thelist of houses that werepotential candidates forpurchase. The investmentcriteria you develop willworkinthesameway.

Your criteria can be assimple as looking for asimplified business with alarge market opportunity,managed by a greatmanagement team, andtrading at a low price. Youcan also set criteria of whatyoudonotwant to invest in.For example, you may wanttoavoidbusinesses thathavea high dependency oncommodityresources,suchas

exploration and production(E&P)businesses,becauseoilpricesaredifficulttoforecast.Byarticulatingandfollowingstrictcriteria,youcanputtheodds of making a successfulinvestmentinyourfavor.Table1.1 issomethingyou

mightwant toconsiderusinginordertomakecomparisonsamong different types ofbusinesses.Youcanlistwhatyour preferences are for a

business,suchasthese:

Table1.1SampleCriteriaChecklist

KEY:√=Possesses,Χ=DoesNotPossess,—=Don’tKnow

A recurring revenuestreamA business with highorganic growthprospects (i.e., growththat isnot accomplishedby acquiring ormergingwithotherbusinesses)Management that has along tenure at thebusinessAcompetitivemoat

Strong existing orpotential financialcharacteristics, such ashighfree-cashflowHigh existing orpotential returns oninvestedcapitalLimitedcompetitionLow capital-expenditurerequirementsA diversified customerbaseAstrongbalancesheet

Acheckmarkindicatesthatthe business possesses acertain attribute, such as ahigh return on investedcapital, whereas the X markindicatesthatitdoesnot.Youcan make a simple tally ofhow many attributes thebusinessexhibits.Thisservesasascoringsystemandhelpsyou compare differentbusinesses from differentindustries.

Evaluating the business ineach of these 10 areas willhelp you understand thetradeoffs you are makingwheninvestinginaparticularbusiness. Perhaps you foundan investment with a strongcompetitive advantage, yetthe business has limitedfuture growth prospects:UsingthecriteriainTable1.1clarifies the advantages anddisadvantages of such a

business as well as itspotential dangers. The morecloselyabusinessmeetsyourstringentcriteria,thelessriskyou are taking. For example,it is easier to monitor abusiness with limitedcompetition rather than onethat has a lot of competition.Ifabusinessmeetsonly fouror five of your criteria, youcan usually pass on thebusiness, as most investment

mistakes aremadewhen youstretchyourcriteria.Onceabusinessmeetsyour

criteria, it is important totrack it. You may want tocreate a spreadsheet whereyou list the businesses thatmeet your criteria, similar totheexampleinTable1.2.Itisessentiallyaformalwatchlistof businesses and can rangefromafewideastohundredsofideas.

Table1.2InventoryofIdeas

Source:CapitalIQ,December14,2010

KEY:TEV=TotalEnterpriseValue;EBITDA=EarningsBeforeInterest,

Taxes,Depreciation,andAmortization;FCF=FreeCashFlow

Once you add aninvestment to your list, youshould begin learning aboutthebusinessandmanagementteam, and track thevaluationof the business usingfinancialmetricssuchas freecashflow(FCF)yieldortotalenterprise value (TEV) toearnings before interest andtaxes(EBIT)toalertyouifabusiness drops in value.

Because of theGAAP issuesmentioned earlier, you maywanttoavoidusingvaluationmetrics such as price-to-earnings ratios. Also, youdon’t need to update thesespreadsheets yourself;instead, there are variousservices you can use toupdatethenumbersonadailybasis, such as Bloomberg orStandard & Poor’s CapitalIQ.

ValuationIsaFilterThe one thing you can’t fixaftermakinganinvestmentisthe price you pay, so it iscritical to remain disciplinedon price. Your future rate ofreturn will be determined bythe price you pay for thebusiness. This is why youshould only consider thoseinvestmentsthataretradingata low price. The following

case study gives you anexample of how investmentmanager Brad Leonardgeneratedhighreturnsforhisinvestors by paying lowprices.Brad Leonard founded

BML Capital Management,LLC in 2004. He hascompounded capital at a rateof 26.94 percent, net afterfees from 2004 to 2010,comparedto3.87percent,net

for the S&P 500. He creditsthis record to beingdisciplined about paying lowpricesforstocks.Hetypicallypays three times enterprisevalue (EV) toEBITDA for astock, and he prefers to buybusinesses thatdonotneedalot of capital expenditures tomaintain theirbusinesses andthose that have little to nodebt.In2009,whenthestockmarket was declining,

Leonardwasbuyingstocksatone to two times EBITDA.Leonardsays,“Whenyouarepaying one or two times EVEBITDA, notmuch needs togo right. If the businesssurvives,youwin.Aslongasthe business does not end,youdon’tneed tomakea lotof great assumptions in youranalysis. If instead I werepaying a 5 percent earningsyield (earnings divided by

market capitalization) ondepressed earnings, it wouldnotreallybethatcheap.”For example, Leonard first

began buying Kirkland’s, ahome décor retailer, at $1.70per share in the fall of 2007.Shortly thereafter, the stockprice declined to $0.70 pershare(whenthestockmarketdeclined by more than 36percentin2008).AsLeonardwas buying Kirkland’s, the

fundamentals of the businesscontinued to improve. Afterreporting negativecomparable store sales in thefourth quarter of 2007,Kirkland’s same-store salesturnedpositiveinthefirsttwoquartersof2008.Cashflows,comparable store sales, andmargins all continued toimprove, yet the stock pricecontinuedtodecline.Leonardsteppedonthegasevenmore

in his purchases. He said,“Everyquarter, the results ofKirkland’s would improve,and it seemed that no onecared.At this time, I thoughtit was likely the companywould post around $20million in EBITDA, so inessence, I was buying thestockaround1to2timesEVto EBITDA.” The stockeventually recovered toaround$2pershareby2008,

andby2009,itwastradingatmore than $20 per share.Leonard’s disciplined buyingwaswellrewarded.7

UsingaSpreadsheettoTrackPotentialandExisting

HoldingsTherearemanyadvantagestousing a spreadsheet to trackyour potential and existingholdings. First, the disciplineof placing newly developedinvestment ideas in aspreadsheet lets the noveltyofthenewideawearoff,andit helps you counter yournatural desire to act onimpulseandbuyastock.You

will not feel as if you areabouttomisstheopportunityof a lifetime because youhave many choices to investin.Mostofuslookforstocksthatarecheapandthenstudythe business and assessmanagement.Bythetimeyouare up to speed on thebusinessandreadytobuy,theopportunityisgone.Afterthishappensafewtimes,youwillbegin to feel a sense of

urgencywheneveryouspotanew investment idea. Youmightbetemptedtoshort-cutyour research process so thatyou will not miss anotheropportunity.Having such a spreadsheet,

however, allows you tooptimizetheuseofyourtimeby allowing you toconcentrate on thoseopportunities with thegreatest upside potential and

lowestdownsiderisk.Insteadof scrambling to analyze themany investmentopportunitiesbeingofferedtoyoubythestockmarket,youcancarefullychoosefromthebest opportunities in yourspreadsheet.The greatest advantage to

maintaining an inventory ofexisting and potentialinvestments is the ability tomakecomparisons.Ifyouare

comparing your existingholdings with hundreds ofpotential investmentopportunities rather than alimited set, you increase theprobability of making goodinvestmentsandavoidingbadones. The more comparisonsyou can make in yourspreadsheet, the higher theprobability of uncovering aninvestment idea. In addition,those comparisons will

increase your awareness ofareasofthestockmarketandindividual stocks that are outof favor. You can graduallybuild your spreadsheet overtimeorproactivelybuildit—two approaches that I’lldiscussinthefinalsectionsofthischapter.

GraduallyBuildingaSpreadsheetof

PotentialInvestmentsWhen you do not haveinvestment opportunities thatyou are ready to act on, youcan use your time to preparefor future opportunities.When you identify a uniquebusiness or superiormanagement team, add thebusiness toyour inventoryofideasorwatchlist,regardlessof its current valuation. This

is the secret sauce toinvesting intelligently,because it allows you to actdecisively when a goodopportunityisinfrontofyou,and it prevents you fromacting imprudentlywhenyoufirst have the idea or insight.In essence, you are lettingtimeworkinyourfavor.

BeProactive

Oneofthebiggestadvantagesofinvestinginpublicmarketsis thatyoucanidentifyeverybusiness in your investableuniverse.Youhavetheabilityto review more than 9,000publicly traded businessesonebyone.Youcanlookforthose businesses that meetyour criteria. Exclude thosebusinesses that you do notbelieve you can accuratelyvalue because this will help

you get through the list at aquicker pace. This will helpyounarrowdownthenumberof businesses you considerinvesting in from 9,000 to amore manageable severalhundred.Once you have some ideas

of the companies you’reconsidering investing in,there are a couple ofpreliminary questions youshould ask yourself before

gettingintothenitty-grittyofresearching those businesses.TurntoChapter2todiscoverthe first several questions ofTheInvestmentChecklist.

KeyPointstoKeepinMind

You will nothave manyoutstandinginvestmentsin your

lifetime.Investmentopportunitiesare createdwhen capitalis scarce.Capitalbecomesscarce whenone or moreof thefollowingeventsoccurs:

Anentiremarket

declinesThereisforcedsellingfromastockbeingthrownoutofanindexorifit

isspunoffThereissometypeofuncertaintyaboutabusinessthatcausesinvestorstosell

theirstock

If you usestock screensto identifyinvestmentideas,understandthatyoumaymiss manyinvestmentopportunitiesbecausemostscreens arebased onGAAPaccounting

numberswhich mayunder- oroverstate theearnings of abusiness.Be carefulwhenfollowinginvestmentmanagers intheirinvestmentideas.Use specificcriteria tofilter out the

investmentideas youdon’tlike.Create aninventory ofideastotrackpotentialinvestmentsthat meetyour criteriaon acontinualbasisinordertoprepareforfutureopportunities.

1.Sobel,Robert.TheRiseandFalloftheConglomerateKings.NewYork:SteinandDay,1984.2.Shepard,StephenB.“ATalkwithScottMcNealy.”BusinessWeek,April1,2002,pp.66–68.3.Standard&Poor’sCapitalIQ.4.Author’sinterviewwithPaulSonkininNovember2010.

5.Author’sinterviewwithToddGreeninMarch2011.6.Author’sinterviewwithPaulSonkininNovember2010.7.Standard&Poor’sCapitalIQ;Author’sinterviewwithBradLeonardinMarch2011.

CHAPTER2

UnderstandingtheBusiness—TheBasics

Once you know you areinterested in a particular

business and ready to beginyour research, you shouldtake a structured approach toevaluatingthatbusiness.Thischapter tells you how to naildown the most basicquestions you encounterwhen analyzing a newcompany:Whatdoesitreallydo, and how does it makemoney? Sometimes this iseasy, but I’ve certainly beensurprised at times. If you

haveasolidunderstandingofwhatacompanydoesandcanexplainitsimply,youarelesslikely to waste time ontangential issues as you gointomoredepth.Essentially, you want to

understand thecompanyas itis todayby lookingathow itevolved.Ibelievethathistorygoes to the heart of why acompanyissuccessful:Wasitreally good? Or was it just

reallylucky?After gathering the basic

information on a business,we’llturnourattentiontothespecial case of evaluating acompany’ssuccess in foreignmarkets.Formostcompanies,globalization has createdinterconnected markets,whichcreatesanewresearchtask for you. Even if thecompany you’re researchingis still mostly a domestic

operator today, you want toevaluate the company’sprofitability and commitmenttoforeignmarkets.Let’s start by considering

whether or not you’re eveninterested in learningaboutaparticular business, and thenimagineyourself intheshoesofthecompany’sCEO.Let’stake a closer look at thesequestions.

1.DoIwanttospendalotoftimelearningaboutthisbusiness?

Beforeyoubegintoanalyzeabusiness, ask yourself if youare interested in learningmore about it. If not, youprobably won’t have

sufficient interest to do in-depthresearchandasaresult,youmaymakeanuninformedinvestment decision. Youcan’t truly understand abusiness in a couple ofweeks. It takes a long time,years in most cases, to trulyunderstand how a businessoperatesandtodeterminethecompetenceandintegrityofamanagement team. It is acontinuous process, and if

your interest begins to waneinacoupleofweeks,youwillnot have the stamina tocontinue to learn about thebusinessoverthelongterm.Ifyouarejustbeginningto

invest, it is best for you toanalyze one business over along period of time. Toooften, even professionalanalysts spend their timeanalyzing too manybusinesses, and they never

develop the ability to fullyunderstand the value of abusiness (i.e., they don’t seethewholepicture).For example, at the

beginning of my investmentcareer, I spent six monthsanalyzing TV ratingscompany Nielsen MediaResearch. I spent my timeinterviewing more than 80percent of Nielsen MediaResearch’s customer base,

and I developed an in-depthunderstanding of thebusiness.Asaresult,Iwasina good position to value thebusiness.Asyoubegintoreadabout

the business, ask yourselfhow steep your learningcurve will have to be tounderstand a particularbusiness.Ifyoufindthatitisextremelydifficult foryou toevaluate the business or that

youaresimplynotinterested,this isasignyoumightwantto pass on the investment.Most of us can eventuallyunderstand a complexbusiness ifwe invest enoughtime, but our understandingmay ultimately still beshallow. Instead of over-investing in a process thatyields less return, try todevelop a deeperunderstanding of businesses

yougenuinelycareabout.Toomanyinvestmentfirms

assign investment ideas totheir analysts withoutconsidering whether thoseanalysts will enjoyresearching the business orindustry. If the analyst is notinterested in learning aboutthe business, he or she mayneveruncoverusefulinsights.It is common sense that youare less likely to succeed at

something you are notinterested in, yet investorsforce themselves to studysuchbusinesses.For example, I remember

researching a bankrecommended by an investorwith a long track record ofsuccessfullyinvestinginbankstocks.As I read through the10-K form, I quickly foundthat I did not enjoy learningabout the bank. Although I

forced myself to continue toread about the bank, I foundmyself looking fordistractions. My lack ofinterest caused me to losemomentum inmy analysis. Iwaited for inspiration tocontinue reading andsometimes would find it,although it was short lived.BecauseIwasuninterestedinthe business, Iwas unable toconductathoroughanalysis.

In contrast, retail heldinstant fascination for me. Ifthere was a term I did notunderstand, I researched itsmeaning or how it wascalculated. I searched forarticles andbooksonhow toidentify an efficient retailer,took classes to learn moreabout retail operations, andstarted going to industryconferences. Thoroughlyengaged and stimulated, I

found that few thingsdistractedme. I recallcuttingphone conversations short soI could get back to learningmoreaboutretail.Mypassionforretailgavemethedrivetoconstantly learn more aboutthe industry and putme in abetter position to evaluateopportunities within thissector.However, there’s an

element of risk to this

passion: Personally liking aproduct or service can leadyoutobelievethatotherswilllike it as well. For example,it’shardtoobjectivelyweighcriticism of your favoriterestaurant:Becauseyourownexperiencehasbeendifferent,you may even discount anegative report. My ownpassion for retail has causedmetolosedisciplineattimes,as I overlooked negative

attributesandinsteadfocusedonthepositiveones.Whetherpositiveornegative,beawarethatyourpersonalpreferencesmay negatively influenceyourinvestmentdecisions.

2.Howwouldyouevaluatethisbusinessifyou

weretobecomeitsCEO?

The goal of any long-terminvestorshouldbetohavethegreatest understanding of theunderlying economics of abusinessandknowhowthosecan change. Ideally, youshould research the businessas though you would betaking over the business inthenext fewmonths as chief

executiveofficer(CEO).Thatis exactly what RobertSilberman, CEO of StrayerEducation,did.I interviewed Silberman at

a Strayer University campusopening in Austin, Texas.The opportunity to take overas CEO of Strayer cameabout when one ofSilberman’s friends, BobGrusky,calledSilbermanandtold him that the private

equity firm he was starting,NewMountain,hadidentifiedStrayer as a company theywanted to invest in. NewMountainwasbuyingouttheformer Strayer CEO, whowas set to retire.Grusky andhis partners needed someonetocomeinasCEOandaskedSilberman to join thecompany.Silberman’s first reaction

was, “How can you own a

university?” He had neverheard of the business modelbeforethisphonecall.At thetime,Silbermanwasthechiefoperating officer (COO) ofCal Energy, which wasowned by BerkshireHathaway. Before formallyaccepting the position,Silbermanspentthenextfivemonths completing an in-depth research study of thefor-profit education industry

andStrayerEducation.From March to July 2000,

Silberman researched thehistoryoffor-profiteducationand the education sector inthe United States. Inparticular, he wanted tounderstandtheroleofprivatecapitalinthissector.Silbermantoldme,“Oneof

the advantages of running aninternationalenergycompanyis thatyouareonairplanesa

lot—I had all these 13-hourflights. After a few hours ofsleep and taking care of myother responsibilities, I wasable to really dive in on anuninterrupted basis. And themore I looked at this as abusiness, the more excited Igot. The renewable energybusiness that I was in hadincredible capitalrequirements, very lowreturns on capital, and all

sortsofextraneousriskssuchas technological risks,political risk, and currencyrisk. The education sector inthis country, at the post-secondary level, was theexact opposite. It had lowcapital requirements, veryhigh demand, very limitedsupply,andifyoureallyranagreat university with a goodreputation, a very widemoat.”

Silberman read broadhistories of higher educationin theUnitedStatesand thenfocused on the for-profitsector. His analysis includedmacroeconomic factors andsector-level data. Heidentified and studied othercompaniesintheindustrythatwere publicly traded, andfinally,heresearchedStrayer.He studied the industry’s

historyinordertounderstand

how the for-profit educationindustry had developed, andhe analyzed the factors thathad driven the acceleratedgrowth of the industry overthe last 20 to 25 years. Tostudy the public companies,he read 10-Ks and 10-Qs,annual reports, and analystreports from competingeducationcompanies,suchasApollo Group, DeVry, andITT Corp. Silberman

analyzed reams of statisticaldata about the for-profitcustomer. He wanted tounderstand who went to for-profit colleges and who didnot. He looked at theoutcomesforthecustomerbyanalyzing data about theearningpotentialforsomeonewhohadacollegedegree.Silberman learned that the

earnings potential for collegegraduateswashighandrising

as the U.S. economy shiftedaway from its manufacturingbase, where a high-schooldegree and limited technicaltraining had been enough tosupport a middle-classlifestyle.AstheUnitedStatesmoved toward a knowledge-and service-based economy,achieving a middle-classlifestyle with only a high-school degree was gettingtougher. The gap in earnings

between educated and non-educatedpeoplewasgrowingwider and creating intensedemandforhighereducation.Furthermore, the supply wasessentiallyfixed.Aspartofhisduediligence,

Silberman visited Strayer’scampuses in Washington,D.C., and he wandered intoclassrooms, where hepretendedtobeastudent.Ashe saw professors and

working adult studentsinteract, he sensed howintense the students’ desirewas to complete theirdegrees.Hecouldseethattheeducational experience waslife-changing.Silberman explains, “Take

a 35 year old, with only ahigh-school degree, who hasbeen working either as apink-collar, blue-collar, orunderutilized white-collar

[employee] for 15 years.Their earning power andability to maintain a middleclass lifestyle has becomemore difficult. When theyattend college, it is anabsolutegamechanger.”Silberman remembers

flying in to Washington,D.C., for a Monday eveningclass. It was fall, and theWashington Redskins wereplaying that night. Having

grownupintheD.C.area,heunderstood how important itwas to watch the Redskinsplay. Meeting just once aweek, the class usually wentfrom5:30 to10p.m.Around9 p.m., the professor startedwrappingupandtoldstudentshe was giving them “aRedskins break” that night.The students nearly started asmall riot in protest.Silbermanthoughtaboutwhat

a serious contrast this waswith his own collegeexperience and how thrilledhe was when a professor lethim out early. At Strayer,however, many of thesestudents were paying out oftheir own pockets for thiseducation. They knew theyneeded it, and they didn’twant to go home and watchfootball. They wanted tofinishtheclass.

Silberman’s research madehim excited about the for-profiteducation industryasawhole,andespeciallyexcitedabout Strayer Education. Itwas a great platform—it hadbeen around for more than100 years, and it hadachieved regionalaccreditation. He saw greatfinancial characteristics, too:a motivated customer baseand a big market. By the

middle of summer 2000,Silberman told his CalEnergy boss that he wasleavingtorunStrayer.Fast forward to 2009:

Silberman’s efforts tointimatelyunderstandStrayerEducation have paid off.Since Silberman assumedstewardship of Strayer in2001, revenue, operatingincome, and earnings pershare have grown at

compounded rates of 24percent, 23 percent, and 22percent, respectively, at theend of 2009. UnderSilberman, Strayer Educationhas been a true compoundmachine. The stock priceincreased from$30per shareat the beginning of March2001to$215persharebytheendof2009.1

Inessence,Silbermanwentthrough the process of

answeringkeyquestionsfromthe checklist. Silbermandeveloped an understandingof how the for-profiteducationindustrydeveloped;the types of customers thattypically enroll in for-profituniversities and the benefitsthese customers receive; andhe visited campuses tounderstandfirsthandthevalueof the education to thestudent. This is the same

process that an investorshoulduseinordertoanalyzeabusiness.

3.Canyoudescribehowthe

businessoperates,inyourownwords?

Tounderstandhowabusinessoperates, read the businessdescriptionfoundinthe10-K.Item 1 of the 10-K providesan overview of the businessand a detailed description ofallofthefollowing:

Each of the business’ssegmentsDistributionchannelsMarketingstrategiesManufacturingactivitiesRegulatoryrequirements

Extensive managementdiscussions of strategiesand risks facing thebusinessIndustrysizeandtrendsInsight into thecompetitiveenvironment

After reading this sectioncarefully, write in your ownwords how the businessoperates. How does thebusiness manufactureproducts or produce its

services? How does itdistribute these goods andservicestothecustomer?Trytovisualizehowaproductorserviceisdelivered.Next, visit the website of

the business to betterunderstandwhat theproductsor services look like. Yourgoal is to be able to explainhow the business operates toa friend who has limitedbusiness knowledge. By

writingitinyourownwords,you will gain a deeperunderstanding of how thebusiness operates than youwouldbyreadingthetextandtakinglightnotes.For example, after reading

Item1 of theForm10-K forcompany VCA Antech,which is 10 pages long, Isummarized the businessdescriptionasfollows:

VCA Antech operates

471 animal hospitals in40 states that offer petphysicals, dental care,neutering, spaying, andspecialty surgeries.These hospitalsrepresent 75 percent of2008 revenue. Theindustry is composed of22,000 companionanimal hospitalsoperating at the end of2006.

Eachhospital employsastaff of between 10 and30 full-time equivalentemployees, whichtypically includesadministrative andtechnical supportpersonnel, three to fiveveterinarians, and ahospitalmanager.Customers choose ananimalhospitalbasedonconvenient hours and

recommendations fromfriends.In addition, it operates44 veterinary diagnosticlabs, which represented21 percent of 2008revenue, where 16,000customers send blood,tissue,andurinesamplesfortesting.In 1999, the companyoperated 194 animalhospitalsand13labsand

then mainly grewthroughacquisitions:

2004: 67 animalhospitals;2005: 46 animalhospitals;2007: 44 animalhospitals.

Main industryassociation surveyindicates that63percentof U.S. households ownatleastonepet.

A source of growth istechnology migratingfrom the humanhealthcare sector intopractice of veterinarymedicine so pets havemoretreatmentoptions.99 percent of customerspayincashatthetimeofvisit.The business marketsthrough targeteddemographic mailings

regarding specific pethealthissues.The business employed9,000 full-time-equivalent employees in2008.2

Ifyouarehavingadifficulttime understanding abusiness, ask what thecustomer’sworldwould looklike without the product orservice. For example, if youwere analyzing Internet

media delivery companyAkamai Technologies andcould not find a simple wayto summarize how thebusiness operates, askyourself, “What does theInternet world look likewithout AkamaiTechnologies?” In a worldwithout AkamaiTechnologies, it would takelonger to download video toyour computer. Content

providers such as movierentalcompanyNetflixwouldbeunreliableandwouldhaveto charge more to delivermovies.Another method you can

use to simplify a businessdescription is to find ananalogy that best explainshow the business operates.For example, AkamaiTechnologies is similar to anair traffic control tower.

Akamai Technology’ssoftware routes data from itscustomer, such as onlinevideo website YouTube, tothe closest server onAkamai’s network. Thecontroltowerchargesafeetothe producer (YouTube), andgets the plane (the video) toitsdestinationfaster.

4.Howdoes

thebusinessmakemoney?

At first glance, this soundslikeasimplequestiontoask,but it is critical for you tosummarize how a businessgenerates earnings. If youcan’t understand how abusiness makes money, thenyoushouldnotinvestinit.Manyinvestorsfallintothe

trapofinvestinginbusinesseswheretheydonotunderstandhow the business generatesearnings.Forexample,ifyouhad asked most investors ininsurance firm AmericanInternational Group (AIG)how the firm generatedearnings, they would havegiven you vague answers.Eventhetopmanagersofthebusiness had difficultyunderstanding each of the

different pieces of thebusiness and how theycontributed to the totalearningsof the firm.AsAIGmoved from its coreinsurance business intoesoteric financial instruments(suchascreditdefaultswaps),it became more opaque,offering little visibility intoits future earnings. Newbusinesses, such asInternational Lease Finance

and the Financial Productsgroup were not easy tounderstand. Most investorsbought into the pastreputation of AIG and itshistorical performance,without understanding howthese new business linescontributed to the earningsand risk of the business.Later, AIG enteredbankruptcy due to lossessustained by these new

businesslines.You want to summarize

howabusinessmakesmoneymuch like Robert Silberman,CEO of Strayer Education,did in his 2001 shareholderletter:Strayer’s revenue comesfrom tuition paymentsand fees paid by, or onbehalf of, StrayerUniversity students. Thatrevenue comes in

essentially three forms.Roughly half is paidthrough federally insuredstudent loans by banks,approximately20percentispaiddirectlytoStrayerby corporations orinstitutions on behalf oftheir employees whoattend Strayer, and theremainder is paid bystudents through theirown sources of credit.

Strayer’s expensesinclude salaries paid tothe faculty at theuniversity who performthe teaching duties,salaries paid to theadministrative andadmissions staff whomanagethecampusesandrecruit the students, andsalaries paid to thecorporate staff whomanage the company’s

affairs. Expenses alsoinclude lease paymentsfor the campus buildingsweleaseanddepreciationfor the campus buildingswe own, as well asadvertisingandmarketingcosts which serve toattract prospectivestudents to Strayer.Finally, our expensesinclude supplies such asbooks, paper, pencils,

desks, chairs, andcomputers necessary tosupport the educationalprocess. Some of thefurniture and electronicequipment is capitalizedon our balance sheet andtheexpenseisrecordedasamortization over theperiod we expect theequipment to last, inaccordancewithgenerallyaccepted accounting

principles.

5.Howhasthebusinessevolved

overtime?A historical perspective on abusiness provides both adeeper understanding anduseful insight into itscompetitive advantage. You

can better understand if thesuccessofthebusinessisdueto managerial brilliance orsimply being at the rightplaceat the right time. If thebusiness you are researchinghas a particularly complexstory or has made manyacquisitions, answering thisquestionisespeciallyuseful.Thefirstplacetostartisthe

company’s website. Mostbusinesses will include a

timeline or history of howtheir business evolved.Writein your own words a shortsummaryofthehistoryofthebusiness.Another great source,

typicallyfoundatalibrary,istheInternationalDirectoryofCompanyHistoriespublishedbyGale,whichprofilesmorethan 8,500 companies. Eachentry is usually a few pageslongandincludescitationsof

news and magazine storiesfor follow-up reading. Itwillgive you the completebackground and history of acompany, including mergerand acquisition activity overtimeandkeydates.If both of these sources

yield limited insight, thengathering and reading thebusiness description using atleast10yearsof10-Kscanbeuseful. Print out the business

descriptions and read them,starting with the first year.Summarize in your ownwords how the businessevolved by notingacquisitions made and newproduct developments fromyear to year. You can thenread articles written for thepast 10 years about thebusinesstohelpyoufillinthegapsinyourunderstandingofhowthebusinessevolved.

6.Inwhatforeignmarketsdoesthebusinessoperate,andwhataretherisksof

operatinginthesecountries?

Overthelastfewdecades,theglobal economy has becomemore interconnected. It isdifficulttobelievethatbeforeWorld War II, the U.S.economy was the largest inthe world, and both Chinaand India represented only asmallpercentageoftheworldeconomy. U.S. businessesnow sell more of theirproductsandservicestoothercountries, and these sales are

becominga largerpercentageof revenues for many ofthem. As a result, it hasbecome increasinglyimportanttolearnmoreaboutthe foreignmarkets inwhicha business derives itsearnings.Whenabusinessfirstenters

a foreign market, revenuesmay grow quickly, whichsignals to investors that theproduct or service will be

successful.Mostmanagementteams will highlight thisrevenue growth in theirannual reports or otherfinancial filings. It isdangerous to project thesehigh initial growth rates intothe future, however, becausegrowth in new markets will,of course, stabilize at somepoint.To determine whether a

businesswillbesuccessfulin

a foreign market, you mustdetermine how committed amanagement team is togrowing in a foreignmarket.Many management teamsoverestimate the potential ofnew foreign markets, andafter theysustain losses, theyreduce their commitment tothesemarkets.Asaresult,thebusiness does not replicatethesuccessithasindomesticmarkets. You need to

understandifthemanagementteam is prepared to commitenough resources to sustaintheirgrowthinthatparticularmarket. Just as in domesticmarkets, the more customersare comfortable and familiarwith an existing product orservice,themoredifficultitisto persuade them to changebrands. To build brandawareness, a business mustcommit to a sustained

presence and invest for thelongterm.For example, Peter

Brabeck,CEOofNestlé,saidthat to have sustainableprofits,hehadtobewillingtoinvest for the long-termevenifithadanegativeimpactonthe short-term.He noted that“the financial community”often thought in timeframesof between sixmonths and ayear, so it was tough

explaining to them what itreally meant to build abusiness in Korea, China, orRussia,where it takes five to10yearstoreachprofitability.Brabeck recalledhisdecisionto stay in Russia during theRussian crisis, saying that ifhe had thought only aboutshort-term profits, Nestléwould have withdrawn “. ..like everybody else.” Hesaid, “It very clearly had an

impactonmyprofitmargins,butin18months,wedoubledour market share inconfectionary.”3

To understand howcommitted the topexecutivesare to growing in foreignmarkets, you need to answerthequestionsdiscussedinthenextsubsections:

How long has thebusiness been operatingintheforeignmarket?

Is thebusiness investingin research anddevelopment (R&D) toadapt its products to thespecific tastes of thecustomers in a foreignmarket?Has the managementteam assigned a specificregional manager toemergingmarkets?

HowLongHasthe

BusinessBeenOperatingintheForeignMarket?

Scan historical press releasesand articles found in newsarchival services to learnwhen the business expandedinto each foreignmarket andthe reasons behind theexpansion. For example, if abusinessstatesthatitoperatesin Europe, find out which

countries it operates in, anddetermine why the businesschose those particularcountries.Also,whendealinginEurope, keep inmind thatit is not a cohesive market.Each European country canbeconsideredauniquesetofcustomers.

IstheBusinessInvestinginR&Dto

AdaptItsProductstotheSpecificTastesoftheCustomersinaForeignMarket?

Fewproducts are so globallyappealing that abusinesscanmarket them around theworldwithoutadaptingthem.Exceptions are products likeMicrosoft’s Windows 7:Microsoft made only minortweaks to its software before

selling it to more than 100countries. Boeing’s airplanesalso travel well withoutdesignchange, andnearly80percent of Boeing’s sales forcommercialairplanesin2010came from internationalcustomers.4 But these areexceptions. It is difficult formost businesses to sell thesame product or service itsells in one market to allmarkets without adapting in

someway.Urban Outfitters, owner of

Anthropologie women’sapparel stores, started itsEuropean business by firstsetting up a local design andmerchandisingunitinLondonsothatitcouldtailorgoodstoEuropean tastes. Thisincreased overhead costs anddelayed profitability inEurope, but it helped UrbanOutfitters successfully

expand throughout Europe.These European stores nowaccount for more than 10percent of revenue and haveclose to the same operatingmarginsasthosebasedintheU.S.5

Similarly, to betterfamiliarize itself with localmarkets, Nokia establishedR&D centers in China andIndia.Asaresult,Nokiabuilta phone that was specialized

to the needs of customers inIndia: It had a built-inflashlight, alarm clock, andradio, all of which helpcustomers during blackouts.Nokia also learned that itspoorer customers sharedphones, so it built handsetswithmultipleaddressbooks.6

Incontrast,whenWal-Martexpanded into Germany andKorea, it did not adapt itsstores to local customs and

tastes. It ended upwithdrawing from these twocountries in 2006 to stem itslosses.7

HastheManagementTeamAssignedaSpecificRegional

ManagertoEmergingMarkets?It is a red flag when a

regional manager overseesbothemerginganddevelopedmarkets, such as the head ofEurope overseeing Africa.The reason for this is thatthese are two differentmarkets that need differentstrategiesandoversight.Forexample,formostofits

history, Nestlé SA hasassigned an executive incharge of emerging markets,rather than having an

executive oversee bothdeveloped and emergingmarkets.ThishascontributedtothesuccessthatNestléhadin emerging markets: As of2010, 32 percent of salescamefromthesemarkets.8

IsRevenueGrowthTranslatingintoProfitGrowth?

You need to determine

whether revenue growth istranslating into profit growthover the long term in aforeign market. The amountofdisclosureforrevenuesandoperating profits earned ininternational markets variesfrom company to company.Most businesses break downtheir revenues and assets bygeographic region in thefootnotestothe10-K,butfewwill disclose enough

information to allow you toassesswhetherthebusinessisincreasing its profitability inforeign markets. If thecompany does not provideadequateinformation,suchasthe operating profits earnedfrom certain geographicregions, be cautious. Thismeans that management isprobably not generatingexcessprofitsintheseforeignmarkets.

For example, in its 200910-K, Western Union brokedownitsrevenuebetweentheUnited States, Mexico, andInternational. TheInternational section is notfurther broken down intoseparate countriesor regions,soitisdifficulttounderstandhow much operating profitWestern Union generates invariousgeographicregions.In contrast, Coca-Cola

breaks out its revenues andoperating income bycontinent: Eurasia & Africa,Europe,LatinAmerica,NorthAmerica, and the Pacific. Italso separates capitalexpenditures and identifiableassets for each of theseregions,which allows you tocalculate financial metrics,such as return on investedcapital.Ifabusinessdoesnotbreak

out its operating income byregion, you can sometimesdetermine whetherinternational expansion hasbeenprofitablebycomparinghistoricalfinancialstatementsof the business before itexpanded into foreignmarkets to recent financialstatements. Review thefinancial margins before theexpansion and then after theexpansion.Has the operating

margin over this periodincreased or decreased? Youwill need to assume that thecore domestic business hasnot deteriorated or improvedduring this time or if it haschanged, you will need tomake theproperadjustments.Keep in mind that when abusinessentersanewmarket,it typically has a higher coststructure,earning less innewgeographic regions than in

more mature markets. Youcan also read press releasesand articles and speak withthe investor relationsdepartment of a business tohelp you obtain moreinsights.

WhatAretheRiskstoaCompany’s

ForeignEarnings?Foreign earnings are

impacted by many factorsthat are often outside of thecontrolofthebusiness.Theseinclude country risks (thepoliticalandsocialclimateaswell as local customs andregulation), and currencyfluctuations. In other words,there isa risk thatabusinesswill lose money in a foreignmarket due to externalfactors. Let’s take a closerlookateachtypeofrisk.

CountryRisksYou need to understand therisks of doing business ineachofthecountrieswhereabusiness earns more than 10percent of its revenue. Forexample, Brazil has acomplicated tax code andarchaic employment laws.(The cost of hiring someoneis usually about 100 percentof that person’s base salary,

permonth, in addition to thebase salary.) Apple does nothave any stores in Brazil,even though Brazil is one ofthe fastest-growing consumermarkets in the world: WhenCEO Steve Jobs was askedwhy he did not operate inBrazil, he said the “crazy,super-high taxpolicies”weretoomuchforhiscompany.9

Becarefulextrapolatingthepastsuccessofabusinessina

foreignmarketintothefuture.Youneedtoconsiderthatthegovernment policies forforeign investment caneasilychange. Many foreignbusinessesoperatinginChinahave had high revenuegrowth in thatmarket.WhenChina first began to open itseconomy to foreignbusinesses, it needed foreigncapital, so it encouragedmultinationals to do business

in the country with manyincentives and benefits. AsChina’s reliance on foreigncapital has decreased, it isimposing tougher rules onmultinationals. Somebusiness executives havesuggested that the Chinesegovernment is reassessing itslong-standing emphasis onopening its economy toforeign business and isinstead favoring state-owned

enterprises (SOEs). Byinstituting toughergovernment policies andregulationsformultinationals,the Chinese government isintensifying domesticcompetition.For example, state-run

media in China reported thatthe government plans toincrease themarket share fordomesticcarmanufacturerstomore than 50 percent of

passenger vehicles by 2015,from44percentin2009.Thiswill hurt non-domesticcarmakers, such asVolkswagenAGandGeneralMotors, who have benefitedfrom the growth in demandfor cars in China and havereportedhighrevenuegrowthratesthereinthepast.10

Another example ofChinese protectionism is inthe wind-turbine industry.

Although foreign technologyin wind turbines is superior,foreign market share hasdropped from 75 percent in2004 to 14 percent in 2009,withnoforeignturbinemakerwinning a national biddingprojectsince2005.11

There are many resourcesyoucanusetounderstandthedifficulties of doing businessin specific foreign markets.You can often learn more

abouttherisksofoperatingina particular country throughthe World Bank, whichpublishes a Doing BusinessReport,whichrankscountriesaccordingtotheeaseofdoingbusiness in them. Brazil, forexample, ranked 127 out of183countriesin2009.Youcanalsouse resources

such as Business MonitorInternational’s (BMI)Country Risk Reports to get

an understanding of thebusiness environment for aparticular country. Thesetypically cover political andmacroeconomic issues andindustryandoperationalrisksineachcountry.

CurrencyRisksOne risk to internationalearnings is changes in thecurrencyrate.Forexample,ifyou have a plant in Canada

that manufactures a productand sells it to the UnitedStates, then the costs for theplant are in Canadian dollarsand sales are inU.S. dollars.If theU.S. dollar depreciatesagainst the Canadian dollar,the margins of the businesswill decrease because eachdollarisnowworthlesswhenconverted to Canadiancurrency.Most businesses protect

their exposure to changes incurrenciesbyhedging,whichallows a business to lock inpredetermined foreign-exchange prices for futurecosts or revenues. Theforward contract (wherecompanies can lock in anexchange rate ahead of time)is the most common type oftoolusedtoreducetheimpactofcurrencyfluctuations.Youneed to determine how a

business protects itselfagainst currencychangesandhow it hedges. The notes tothefinancialfilingswilloftenrevealhowabusinesshedgesits currencies. You can alsoread articles about how thebusinesshedgesitscurrency.Forexample,byreadingan

article, my firm learned thatLincoln Electric (amanufacturer and reseller ofwelding and cutting products

worldwide) has a policy inplace whereby it hedges atleast half of its exposure toanother currency once thatexposure exceeds apredefined threshold.12 Bylearning more about how abusiness hedges itscurrencies, you can measuretheamountofexposureithastocurrencymovements.Manytimes,abusinesswill

disclosetheexposureithasto

various currencies. Forexample,LouisVuittonMoëtHennessy (LVMH, whichmakesandsellsluxurygoodsand spirits) breaks out itssources of revenuedenominated in foreigncurrency in its 2009 annualreport:

Euro30percentU.S.dollar27percentOther currencies 28percent

Yen10percentHong Kong dollar 5percent

Even though LVMHhedges most of its currencyexposure, this informationmay give you additionalinsights.Mostbusinesseswill report

the impact of changes incurrency in their publicfilings.Most of the time, theimpactislowduetohedging.

For example, watchmakerSwatchGroup’s 2009 annualreport shows that foreigncurrencies negativelyimpacted sales by SwissFranc (CHF) 105 million or−1.8 percent, mainly in thesecondhalfof2009.If a business reinvests the

revenue it earns in a foreigncountry back in the samecurrency,thenitwillnotneedto hedge. This is often

referredtoasanaturalhedge.For example, BrookfieldAsset Management (a globalasset manager focused onproperty, renewable power,andinfrastructureassets)doesnot hedge its exposure tocurrencies because it oftenreinvests the money it earnsfrom foreign countries backinto the same country. Thisreduces its exposure tocurrencymovements.

KeyPointstoKeepinMindUnderstandHowtheBusiness

MakesMoneyIf you can’tunderstandhow abusinessmakes

money, thenyou shouldnot invest init.You willgainadeeperunderstandingof a businessif you learnhow thebusiness hasevolved overtime.If you arehaving adifficult timeunderstanding

a business,ask what thecustomer’sworld wouldlook likewithout itsproducts orservices.Tosimplifyabusinessdescription,find ananalogy thatbest explainshow thebusinessoperates.

EvaluateCurrentandPotentialForeignMarketsWhen abusiness firstenters aforeignmarket, itoftenexperienceshigh initialrevenue

growth rates.Projectingsuch growthinto thefuture isusually amistakebecause newmarkets will,of course,stabilize atsomepoint.Amanagementteam that iscommitted toa foreign

marketinvests forthe longterm, adaptsits productsto thespecifictastes of thatmarket byinvesting inR&D, andassigns aspecificregionalmanager toemergingmarkets.

Amanagementteam needsto beprepared tocommitenoughresources inorder tosustaingrowth in aforeignmarket.

1.Standard&Poor’sCapitalIQ.

2.VCAAntech200810-K.3.Ball,Deborah.“SlowandSteadyIsWinningtheRaceandDrivingNestlé.”WallStreetJournal,September25,2002.4.Gunther,Marc.“TheWorld’sNewEconomicLandscape.”Fortune,July26,2010,pp.81–82.5.Arndt,Michael.“UrbanOutfitters’Grow-SlowStrategy.”BusinessWeek,

March1,2010,p.56.6.Gunther,“EconomicLandscape,”pp.81–82.7.Boyle,Matthew.“Wal-Mart’sPainfulLessons.”BusinessWeekOnline,October14,2009.8.Mijuk,Goran.“NestléBetsonEmergingMarkets.”WallStreetJournal,June22,2010.9.Bevins,Vincent.“WorkingtoaDifferent

Beat.”FinancialTimes,December16,2010.10.Browne,Andrew,andJasonDean.“BusinessSoursonChina:ForeignExecutivesSayBeijingCreatesFreshBarriers;Broadsides,PatentRules.”WallStreetJournal,March17,2010.11.“PerniciousInnovation?”ChinaEconomicReview,

September2010,p.10.12.Kroll,KarenM.“CurrencyRisk:ToHedgeorHedgeNot?”BusinessFinance,June2007,pp.35–39.

CHAPTER3

UnderstandingtheBusiness—

fromtheCustomerPerspective

Customers are the lifebloodof a business. In fact, thequality of a business isdetermined by the quality ofits customers. At the end ofthe day, they are thestakeholders who determinethe fate of a business. Ifcustomers are not satisfiedwith a business, they willeventually find alternatives,oranentrepreneurwillcreateanalternative ifonedoesnot

exist. The more you canunderstand a business fromthe customer’s perspective,thebetterpositionyouwillbein to value that business,because satisfied customersare the best predictor offutureearningsforabusiness.As Dave and Sherry Gold,co-founders of dollar storeretailer 99CentOnly Stores,often say, “The customer isCEO.”

One of themain pitfalls inresearching a business isviewing the business fromyourownperspective,insteadofviewing thebusiness fromthe customer’s perspective.Thisisoneoftheareaswhereinvestors make the mostmistakes. Most investorsallowtheirpersonallikesanddislikes to influence theiranalysisofabusiness. Ifyoureally likeNike tennis shoes,

for example, then you willlook at Nike’s business in amore favorable light. Try todisregardhowyoufeelabouta business: What youpersonallylikeisirrelevanttoinvesting.To begin thinking like the

customers and to understandhow they interact with theproduct or service on a day-to-day basis, you need tointerviewrealcustomers.You

need to determine why theyshop at a business or use itsservices and,most important,if they will continue to buyproducts and services fromthebusiness.For example, when I first

researched 99 Cent OnlyStores,Ipaidfortheitemsofmore than 50 customers inordertosolicittheirfeedbackon why they shopped at thestore. 99 Cent Only Stores

carriesavarietyofitems,butit’s really more of a grocerystore. It often sells brand-name products that it canobtain at discount pricesbecause manufacturersdiscontinue certain products,change labels, ormake otherchanges that make an olderversion of the productobsolete. For example, theymight sell candy bars thathavemovieadvertisingortie-

ins: The candy bar is stillgood, but the movie is nolongerplayingintheaters.Mygoal was to understand howcustomers made the decisionto shop at 99 Cent OnlyStores, rather than trying toguess why they shopped atthestore.As part of my research, I

visited 120 out of the 150totalstores.Ittookaboutfourmonths,asIendedupvisiting

about 10 stores each day inCalifornia, Nevada, Texas,and Arizona. Because thestores tend to be fairly closetogether, it was reasonablyeasy to visit so manylocations. Although I didn’tinterview customers at everystore I visited, I did take thetimetospeakwithasmanyasfiveor10eachday.First, I picked store

locations that represented

different ethnicities andeconomic groups, to makesure I was interviewing adiverse and completecustomer base. Once in thestores, I looked for peoplepurchasing more than 20items,which indicated tomethattheyshoppedatthestorefrequently. Then Iapproached them and toldthem that I was researchinghowcustomersshoppedat99

Cent Only Stores and that ifthey agreed to a shortinterview about theirpurchases, then I would buy10 items for them. I waslooking for any patterns intheir responses about whyand how often they shoppedatthestore.Ialsoaskedthemwhat would change theiropinionaboutshoppingthere.I learned that most

customers shopped at the

store because they could buysmaller package sizes andthus increase the variety oftheir grocery purchases.These customers were on atight budget, so if theyshopped regularly in grocerystores or other retailers, theywouldbeforcedtobuyfeweritems to meet their budget.Byshoppingat99CentOnlyStores, they were able tostretch their budgets. This

information helped meunderstand the truecompetitive advantage of 99Cent Only Stores. Once Iunderstood the competitiveadvantage, I could thencarefully monitor any threatsto that advantage, such ascompetitors offering smallerpackaging sizes or thecompany offering lessvariety.Interestingly, Wall Street

analystsspendverylittletimeviewingthebusinessfromthecustomer’sperspective.Moretime is spent constructingdetailed financialmodels andtalking to the managementteam than trying tounderstand the business fromthe customer’s viewpoint.The main reason for this isthat it takes a lot of time tolocate and interviewcustomers, whereas most

management teams arereadily accessible to WallStreetanalysts.

7.Whoisthecorecustomerofthebusiness?

You need to determine whothe core customer of thebusiness is. Many times, a

small percentage ofcustomers will represent alarge percentage of revenuesfor a business. For example,the management team atWholeFoodsMarketused todisclose that it believed 75percent of purchases weremade by 25 percent of thecustomers who shoppedexclusively at the store. Myfirm conducted its own duediligence by speaking with

customers, suppliers,customer demographicinformation services, andcompetitors, and we learnedthat this was generally true.This information helped uscontinuetobuymorestockinWhole Foods Market whenthe economy entered into arecession in 2007 and thestockpricedroppedfrom$37per share at the beginning of2008toaslowas$8pershare

inNovember2008.At the time, many other

investorsbelievedthatWholeFoods Market was a high-priced grocer and that itscustomerswouldabandonthestore in search of lowerprices.However,becausemyfirm had taken the time tounderstand thecore customerof the business, we believedthese loyal customers whoshoppedexclusivelyatWhole

Foods Market would notmove to competitors, butinstead they might simplydecreasethenumberofitemsthey purchased. Within ayear, we got confirmation ofthis, asWhole FoodsMarketdisclosed that sales had notdroppedasmuchasinvestorshadanticipated,andthestockprice recovered tomore than$30pershare.By identifyingthe core customer of a

business, youwill be able togain an in-depthunderstanding of a business,andyouwill be in apositiontocarefullymonitorcustomertrends.Asyoubegintolearnmore

about the business’s corecustomers, you want tounderstand how the businesscaters to them or whether itattemptstocater totoomanytypes of customers. For

example, electronics retailerBest Buy attempts to figureout which customers makethem the most money andthen segments them. It hasnames for each type ofcustomer,suchas“Barry,”anaffluent tech enthusiast, and“Buzz,” a young gadgetfiend. By segmenting itscustomers into differentcategories, Best Buy is ableto tailor its inventory to a

particular location based onthe composition of customertypes in that area. Forexample, to attract Barry,Best Buy has created aseparate department forhome-theatersystemsthathasspecialists who can answermost questions on theproducts.BestBuyalsotrainsits employees to recognizethese customers so that theemployees can encourage

them to spend more at thestore or come back moreoften.1

Paccarisamanufacturerofheavy trucks that is a greatexample of a company thathas built its product aroundits core customer, the owneroperator. Owner operatorsbuy the truck they drive andspendmostoftheirtimeinit.They work for themselves,either contracting directly

with shippers orsubcontractingwithbig truckcompanies. Owner operatorscare about quality first, andwant amenities, such asnoise-proofed sleeper cabinswith luxury-grade beddingand interiors.Theyalsowantthe truck to look sharp, andPaccarmakesitsPeterbiltandKenworth brand trucks withexteriorfeaturestopleasethiscustomer. Paccar also backs

up the driver with servicefeatures, such as roadsideassistance and a quick sparepartsnetwork.Becauseowneroperators want this level ofquality and service, they areless price sensitive, and theywill pay 10 percentmore forthesebrands.In comparison, Paccar’s

competitors sell to largetruck-leasing businesses orcustomers that operate large

fleets. Because thesecustomers buy in bulk, theycan negotiate lower prices.Bychoosingacustomerbasethat is more fragmented anddiscerning, Paccar avoidsselling its trucks at a lowerprice,whichallowsit toearnhigherprofitscomparedtoitscompetitors.2

8.Isthe

customerbaseconcentratedordiversified?

A business that earns itsrevenues from a diversifiedcustomer base has less riskthan onewith a concentratedcustomer base. If a businessis dependent on fewcustomers, then thesecustomers can influence the

price a business charges foritsgoodsor services, and thelossofonecustomercanhavesevere financialconsequences.For example, there are

thousands of auto suppliers,yetonlyacoupledozengiantautomakers. Therefore, ifeventhemostdiversifiedautosupplier lost a couple ofautomakerclients,itwouldbedifficult to make up this

business elsewhere, as thereare only so many giantautomakers. The autosupplier might either gobankruptor loseasignificantamountofitsrevenues.If a business has revenues

from one customer thatexceed 10 percent of totalrevenues, then the amount ofrevenues from each of thesecustomers must be disclosedin the 10-K as well as the

name of the customer. Forexample, the June 30, 201010-K for AmericanWoodmark, a cabinetmanufacturerstates:During the last fiscalyear, AmericanWoodmark had twoprimary customers, TheHomeDepot andLowe’sCompanies, Inc., whichtogether accounted forapproximately71percent

oftheCompany’ssalesinitsfiscalyearendedApril30, 2010. The loss ofeither customer wouldhave a material adverseeffectontheCompany.If a business has a more

diversifiedcustomerbase,thebusinessprobablywon’tevenmention this as a risk.Instead, itmaystate that it isnot dependent on a smallnumberofcustomers.

Also,youneedtowatchfortrends in customerconcentration. For example,clothingmakerLizClaibornebecame more exposed tospecific retailers as manydepartmentstoreswentoutofbusiness. This has increasedLiz Claiborne’s dependenceon a few customers, such asMacy’s, which nowrepresents a large percentageofLizClaiborne’ssales.3

9.Isiteasyordifficulttoconvince

customerstobuytheproductsor

services?Think about businesses thatuse aggressive sales tactics,such as time pressure, to sell

their products or services.You will often see thesebusinesses advertise, “Signup now or lose theopportunity of a lifetime.” Ifa business needs to rely ontheseaggressivesales tactics,then theproductorservice isnot being sold based on itsmerits but instead on theingenuity of the salespeople.Businesses that rely on high-pressure sales tactics to sell

their products or servicestypically do not havesustainable business modelsandaretypicallynotgoodforthecustomer.

10.Whatisthecustomer

retentionrateforthebusiness?

Determinewhetherabusinessisretainingitscustomersorifit is constantly turning themover (churning them). Thelonger a customer is retainedby a business, the moreprofitable that businessbecomes. Most of usacknowledge that it is moreexpensive to gain a newcustomer than to retain avalued one. Another reason:A loyal customer base

generates more predictablesales, which can improveprofits. Customers also oftenserve as advocates for thebusiness,whichbringsinnewcustomers andmore sales. Inthe long run, the businessesthat spend time cultivatinglong-term relationships withtheir customers are morelikelytosucceed.Thecustomerretentionrate

is the most common metric

for tracking customerlongevity.Itisusuallyofferedas a percentage, which tellsyou from period to periodhow many customers aresticking around.Unfortunately, you will onlybe able to calculate or trackcustomer retention rates forcertain types of businesses,such as those that earnrecurring revenues fromsubscriptions or franchise

fees. For example, FactSetResearchSystems,afinancialresearch solutions provider,disclosed (in its 10-K fromAugust 31, 2010) that itscustomer retention rate was90 percent, compared to 87percenttheyearbefore.Also,ifbusinessesthatearn

their revenues throughsubscription models do notdisclose their customerretention rates, this should

serveasa redflag.Thismayindicate they have lowretention rates, making it apoor-qualityinvestment.Onemethodyoucanuseto

estimate customer retentionratesistomonitorthenumberof customers who areenrolled in loyalty programs.If a business has a loyaltyprogram,itwilloftendisclosethe number of members thatareenrolledintheprogramin

the 10-K. Customers whoenrollinloyaltyprogramsaretypicallyrepeatcustomers.For example, in its

December 31, 2009, 10-K,Western Union said it hadmore than 13 million activecardholders in its Gold Cardloyalty program, a 10-foldincrease since the programwaslaunchedin2003.Watchfordeclining loyaltyprogramnumbers as well, as this can

serve as an indicator thatcustomer retention isdeclining.Youshouldalso findout if

the business is makinginvestments to retaincustomers.Youcanoftenaskthe investor relationsdepartmentofabusiness thisquestion, or you can gaininsights by reading historicalarticles written about thebusiness. For example, when

I researchedTesco, a leadingU.K.-based grocer, I readmany articles about Tesco’scommitment to retainingcustomers. In order to learnmore about its customers,Tescobeganissuingaloyaltycard.Tesco’scard, likemost,is used to track customerbehavior, including storesvisited, products purchased,andevenmethodofpayment.Tesco uses the results of its

analysistoinformitsproductdevelopment and selection,which helps it satisfy localtasteswhenitmovesintonewareas.4

It is also helpful tointerview the sales staff of abusiness to understand ifthere isan incentive to retainexisting customers. You donot need to talk to manysalespeople, as your goal issimply to understand how

their incentive structurerelates to customer retention.It is easy to locate mostsalespeople because theircontact information istypically foundon awebsite.Call or e-mail them and tellthem you would like a fewminutesoftheirtimeandthatyouwouldbehappy to shareyourresearchwiththem.Youcan also call or e-mailinvestor relations and ask

themthisquestion.You want to learn if the

salespeople are rewarded forretaining customers. Do theyreceiveacommissionbothatthetimetheymakeasaleandwhen the customer renews?Or do they receive acommission only when theymake a sale? For example,insuranceagentstypicallyaregiven a commission eachtime a customer renews an

insurance policy with theexisting insuranceunderwriter. Therefore,insurance agents have anincentive to retaincustomers.What do you think wouldhappen if an insurance agentwere given a commissiononly at the time they sold aninsurance policy to acustomer? They would needtogoout andconstantly findnew customers, and all of

theirtimeandeffortwouldbedevoted to that goal. This iswhyinsurancebusinessespaycommissions both whencustomers purchase policiesand when they renewpolicies, providing incentivestoagentstoretaincustomers.Onefinalfactortoconsider

as you evaluate the customerretention rate is whether abusinessisselectiveaboutthetypes of customers itwill do

business with. If they areselective, consider it a goodsign. If certain customers aremore profitable because theyare easier to attract or easierto retain, look for the high-quality businesses that focuson these more profitablecustomers.For example financial

research provider FactSetprefers selling its services tomulti-manager asset-

managementfirmsratherthansingle-manager asset-management firms. FactSetbelieves that sales to relatedcustomers under the sameroofarenaturallymucheasiertomakethansalestoentirelynew prospects, who are lessfamiliar with the quality ofthe company’s products andthe level of support it offersitsusers.Byselling tomulti-manager firms, FactSet can

sell more products to relatedcustomers, instead of havingto make single-user sales,which are more difficult tomake.

11.Whatarethesignsabusinessiscustomer

oriented?The more frequently abusiness interacts withcustomers,themorecriticalitis to keep those customershappy. If a business interactsless frequently withcustomers, customersatisfaction is less important.For example, how often doyoureplaceyourdishwasher?Probably not often, so a bad

customer experience may beless important than theperformance of thedishwasher over a longperiod.Askyourselfifthebusiness

is easy to do business with.Think about your experiencewith different businesses:Don’t you prefer to frequentthosebusinessesthatareeasyto do business with? Ofcourse! For example, if you

buyatelevisionatCostcoandit doesn’t work, you caneasily return itwithoutmanyquestions being asked. Youdo not have to go through aprocess of locating asupervisor to explain whyyouare returning the itemorspend a lot of time withlengthypaperwork.In contrast, think about a

timewhenacompanyofferedyou a rebate when you

purchased a product orservice.Completingthemanysteps required to receive therebate probably reduced thepleasure or satisfaction ofsavingthatamountofmoney.Or remember the last timeyou spent fiveminutes in anautomated telephone systemtryingtofigureouthowtogetconnected to a humancustomer-serviceagent.Youneed todetermine if a

business has a customer-service-oriented culture. It isimportant because customersare not loyal to thosebusinesses with poorcustomer service. One studyrecentlyfoundthat40percentof customers who have badexperiences stop doingbusinesswiththecompany.5

Find out if the businesssolves customer problemsquickly and easily. You can

dothisbylearningwhetherabusiness gives its customerservice agents enoughauthority to solve customerissues or whether customershave to go through abureaucracy to get theirproblems solved. Does thebusiness hire knowledgeableemployees or does itoutsourceitscustomerservicecenterstoothercountries?You are looking for

examples either in articleswritten about a business orcustomer interviews thatdemonstrate the business iscustomer oriented. Forexample:

CostcoWholesale has apractice of refusing tomarkupitspricesonanyproducts by more than15 percent.6 In fact,when commodity pricesbegan to fall on many

products,Costcoquicklycut its prices, whereasother retailers tookadvantage of thesituation, keeping theirprices high. CEO JimSinegal said, “It is easytoraiseprices.Itbenefitsyou today, but will hurtyou tomorrow. Thepractice of takingadvantage of customerswill eventually alienate

them.”7

Southwest Airlinesdoesn’t chargecustomers to check twobags, whereas otherairlines have resorted tocharging for bags tooffset reductions inrevenue.Thispolicyhashelped SouthwestAirlines increase itscustomer loads andrevenues per seat as

customers have movedtoSouthwest fromotherairlines.8

Two other great resourcesare the J.D. Power &Associates customersatisfaction rankings and theAmerican CustomerSatisfaction Index (ACSI),developed by the UniversityofMichiganNationalQualityResearch Center. The ACSImeasures the customer

satisfaction with goods andservices purchased fromabout200companiesinmorethan40industries,alongwithsome public sectororganizations as well. It isbased on interviews withmore than 65,000 U.S.consumers each year, and itcovers a big chunk of thetotal goods and servicesproduced and imported. Infact, the University of

Michigan National QualityResearch Center estimatesthat the organizations itstudiesproduce43percentofU.S. gross domestic product(GDP).Some of the findings from

theiranalysisofmorethan16years of data are thatcustomer satisfaction is aleading indicatorof companyfinancial performance, andmany of the companies with

high customer-satisfactionscores produce higher stockreturns than the S&P 500index. Furthermore, they’vefound that the cash flows ofbusinesses that rate high oncustomer service are lessvolatile than otherbusinesses.9

HowDoesManagementStay

ClosetoCustomers?You can evaluate howcustomer oriented a businessis by observing howmanagement maintains itsconnection tocustomers.Thefurther management getsfrom understanding theircustomers’ needs at abusiness, the higher theprobability the business willfail.

Read the biographies fromthe proxy statements todeterminehowlongtheCEOortopexecutiveofficershaveserved a particular customerbase. For example, Cisco’sCEO John Chambers rosethroughthecompanyranksincustomer-facing functions; asa result, he understands theimportance of the customerexperience. If he had insteadrisen through the finance,

engineering, ormanufacturing departments,then it is likelyhewouldnotplace asmuchweight on thecustomerexperience.John Mackey, founder and

co-CEO of Whole FoodsMarket,andDaveandSherryGold,co-foundersof99CentOnly Stores, are both naturalcustomers of their respectivebusinesses. Mackey foundedan organic grocery store

because he liked to eatorganic food, and Dave andSherry Gold co-founded adiscountretailerbecausetheyalwayslikedtofindbargains.Hereareafewexamplesof

howCEOsstayclosetotheircustomers. Look for similarexamplesat thebusinessyouareanalyzing:Jim Cabela, co-founder of

hunting and outdoor retailchain Cabelas, stays close to

customers by personallyreading all of the customercomment cards sent toheadquartersfromeachofthestores.Hethenfollowsuponthe customer comments withthe appropriate manager oremployeeofthestore.10

HowardLester,whoboughtWilliams-Sonoma(anupscalehousewares and furnitureretailer) in 1978, is anotherCEO who reads every

customer letter and commentcard. Lester did not measurethe success of the businesssolely on metrics such asinventory turns, but insteadon customermetrics, such as“How many customers didwe fail to satisfyyesterday?”11

Finally, here are a fewexamples of how a businessremains close to customersand attempts to view the

products from the customerperspective. You will oftenseearticleswrittenabouthowbusinesses stay close tocustomers.Here are a coupleof examples of the kind ofdetail you will find in casestudiesorotherarticles:At Procter & Gamble, the

managers who wereresponsible for the MaxFactorandCoverGirlbrandsspent a week living on the

budget of a low-incomeconsumer. This gave themanagers insight into thelives of these customers,especiallyhowtheybudgettopurchasepersonalitems.12

Intuit, the tax-preparation-software company, oftenstudies customers actuallyusing their products at homeor work to learn more abouthowtheyreallyuseit.13

12.Whatpaindoesthebusinessalleviateforthecustomer?

One of the most commonquestions venture capitalistsask a prospective start-up is,“What pain does yourbusiness alleviate?” Theventure capitalists want to

understandwhatproblemstheentrepreneursaresolvingandwhat customer needs thebusiness is filling. If abusiness does not fill a needor solve a customer’sproblems, then it will fail.Here are two examples ofcompanies that solve aparticularcustomerproblem:

Stericycle, a medicalwastedisposalcompany,helps physicians and

other medical providersavoidpotentialliabilitiesthat come from thedisposal of medicalsyringes and othermedicalwaste.ADP, a payroll andhuman resourcemanagement provider,eliminates the needs tohire in-house employeesto handle payrolladministration.

Justas thesebusinessesaresolving customer problems,you need to identify theproblems that are beingsolvedby thebusinesses youareanalyzing.

13.Towhatdegreeisthecustomer

dependentontheproductsor

servicesfromthebusiness?

To answer this question, youneed to determine if theproductorserviceis“needtohave” or “nice to have” forthe customer. The more acustomer needs to have a

product or service, the lesstheearningsofabusinesswillfluctuate. The morediscretionary a product orservice is, themore earningswillfluctuate.A business whose

customers depend on theproduct or service has asignificant advantage. Thinkofthisasacontinuum:

Need to have. On oneextreme are products

manufactured byMedtronic,whichbuildsmedical devices thatpeopleliterallycan’tlivewithout, such asimplantablepacemakers.Need to have, but notimmediately. In themiddle are products orservices that can bedeferred but at somepoint need to bepurchased, such as car

maintenance.Afterall,ifyoudon’tchangetheoilin your car, the motorwilleventuallyfail.Nice to have, but notcritical. At the otherextreme arediscretionary productsand services, on whichcustomers are lessdependent. These itemsare products or servicesthat a consumer can

defer purchasing for along time (and may noteven purchase at all),such as jewelry, a newcar, a new house, ortravel.

Do not make theassumption that adiscretionary business orindustry will always losesales in tough times,however. For example,manyluxury retailers—such as

LouisVuittonMoëtHennessyor Compagnie FinancièreRichemont SA, which ownsCartier, Montblanc, AlfredDunhill, and Van Cleef &Arpels—were thought to besensitive to business cycles,and their stock prices fellwhen the recession began in2007. However, the stockpricesofthesetwocompaniesquickly rebounded as theircore customers, who are

ultra-wealthy,continued theirspendinghabits,andsalesdidnot drop as much as wasanticipated.

14.Ifthebusiness

disappearedtomorrow,what

impactwouldthishaveonthecustomerbase?

To understand how muchcustomers depend on abusiness, ask what thecustomer would do if thebusiness disappearedtomorrow. Think about whatyouwoulddoifyourfavoriteretailer disappeared. Where

else could you go and why?Isiteasytofindalternatives?For example, when I

interviewed customers ofratings firms Moody’s andStandard & Poor’s, I spokewith customers ranging frominsurance bond departmentsto hedge funds, and I askedthem what they would do ifthe ratings agenciesdisappeared tomorrow. Mostanswered that they would

have an extremely difficulttime buying new bonds andthat itwouldseverelydisrupttheir daily life. In otherwords,mostofthecustomerswere dependent on theservice these ratings firmsprovide.

KeyPointstoKeepinMind

The quality

of a businessisdeterminedby thequality of itscustomers.One of themain pitfallsinresearching abusiness liesin viewingthe businessfrom yourownperspective,instead ofviewing the

businessfrom thecustomerperspective.A businessthat earns itsrevenuesfrom adiversifiedcustomerbase has lessrisk than onewith aconcentratedcustomerbase.The more

frequently abusinessinteractswithcustomers,the morecritical it isfor it tohavehighcustomersatisfaction.You canlearn if abusiness hasa customer-orientedculturethrough

researchstudiesproduced byJ.D.Power&AssociatesortheAmericanCustomerSatisfactionIndex(ACSI).If a businessis out oftouch withcustomers,oris failing tomeet theirneeds or

solve theirproblems, itwilleventuallyfail.The more acustomerneedstohavea product orservice, theless theearnings of abusiness willfluctuate. Tounderstandhow muchcustomers

depend on abusiness, askwhatcustomerswould do ifthe businessdisappearedtomorrow.

1.Boyle,Matthew,SusanM.Kaufman,andJoanL.Levinstein,“BestBuy’sGiantGamble.”Fortune,April3,2006.2.Porter,Michael.“The

FiveCompetitiveForcesThatShapeStrategy.”HarvardBusinessReview,January2008.3.Talley,Karen.“Retailers,SuppliersTussle.”WallStreetJournal,February11,2009.4.Rohwedder,Cecilie.“StoreofKnowledge.”WallStreetJournal,June6,2006.5.Dougherty,Dave,and

AjayMurthy.“WhatServiceCustomersReallyWant.”HarvardBusinessReview,September2009.6.Bary,Andrew.“KingsoftheJungle.”Barron’s,March23,2009.7.Ibid.8.SouthwestAirlines.“CheckedBaggage.”http://www.southwest.com/html/customer-service/baggage/checked-bags-pol.html.Accessed

May11,2011.9.Hart,Christopher.“BeatingtheMarketwithCustomerSatisfaction.”HarvardBusinessReview,March2007.10.Cabela,David.Cabela’s:World’sForemostOutfitter,aHistory.Middlebury,VT:PaulS.Eriksson,2001.11.Shambora,Jessica.“Williams-Sonoma’sSecret

Sauce.”Fortune,July26,2010.12.Rust,RolandT.,ChristineMoorman,andGauravBhalla.“RethinkingMarketing.”HarvardBusinessReview,January–February2010.13.Meyer,Christopher,andAndreSchwager.“UnderstandingCustomerExperience.”HarvardBusinessReview,February

2007.

CHAPTER4

EvaluatingtheStrengthsandWeaknessesofaBusinessandIndustry

Inadditiontounderstandingabusinessfromtheperspectiveof its customers, it’s alsoextremely important for youto analyze the strengths andweaknesses of a business inthecontextof itscompetitiveenvironment. The strongerthe business’s competitiveposition, the higher theprobabilitythatitwillbeabletosustainitscurrentearningsas well as grow them in the

future. After all, acompetitive advantagerepresents long-termprotection from a company’scompetitors. Think of it asbeing in a wrestling matchwhen you’re 50 poundsheavierthanyouropponent.Once you have established

whether the company has acompetitive advantage, youwant to know if the industryis a good one. In some

industries, it’s relativelyeasyfor a business to get a goodreturn on its investment, butin other industries, thehistorical returns arenegative. If the industry isdifficult or unprofitable,you’ll find it harder tomakemoney on your investment,even if you manage to pickthebest companyoutof tensor hundreds of others in thatindustry.

Finally, you want tounderstand how industrysupply chains work. Goodsupplier relations canimprove efficiency andreliabilityofsourcegoods,soI’llwalkyou throughhow toevaluate supplierrelationships, supply chainefficiency, and sources ofsupplychainrisk.Let’s begin by evaluating

whether a business has a

sustainable competitiveadvantage.

15.Doesthebusinesshaveasustainablecompetitive

advantageandwhatisits

source?It is critical to determinewhether a business has long-term protection fromcompetitors, also called asustainable competitiveadvantage. What’s critical tolong-term success and theability of a business to growand remain profitable is ifthatadvantage issustainable,such as when a business is

protected by governmentregulation. If you are unableto determine whether abusiness has a sustainablecompetitiveadvantage,thenitisdifficultforyoutocommittoalong-terminvestmentinabusiness.When you do find an

advantaged business, it iscritical for you to determinethe strength and stayingpower of its competitive

advantage. Therefore, whenyou’re analyzing a business,you should always ask thesetwoquestions:

Howeasilycansomeoneelsecopyor replace thisadvantage?Howquicklymight theydoit?

The more sustainable theadvantage, the more acompanyisworthbecausethecompany can protect its

profitability over a longerperiod of time. Pat Dorsey,formerdirectorofresearchatMorningstar and author ofThe Little Book that BuildsWealthstates:ThewayIthinkaboutthelinkage between moats(competitive advantages)and intrinsicvalue is thatmoatsaddthemostvalueto businesses that havelots of reinvestment

opportunitieswithin theirmoats. A business thathas a large set ofinvestment opportunities“inside the moat” has amuch higher intrinsicvalue than a businesswithout competitivelyadvantaged reinvestmentopportunities because theformer compounds cashflow at a very high rate,whereas the latter is

forced to use cash forsub-optimalopportunities.Microsoft’s moat, forexample, may give aninvestor a reasonabledegreeof confidence thatthe return on capital ofthe core business willpersist, but it adds verylittle value due to thematurity of thecompany’s core business

—cash that is generatedjust sits on the balancesheet, or is invested“outside the moat” inareas like search (i.e.Bing). By contrast, themoats around businesseslike Fastenal or C.H.Robinson—bothofwhichoperate in fragmentedindustries—addtremendous intrinsicvaluebecausecashcanbe

reinvested in the corebusiness at a very highincrementalrateofreturn.Thisrelationshipbetweengrowth, moats, andintrinsic value is centralto understanding whenit’strulyworthpayingupforabusiness.1

This section helps youidentify the sources ofcompetitive advantage andgives you real-world

examples of competitiveadvantages that are eitherexpanding or deteriorating.Let’s start by identifyingcommon sources ofcompetitiveadvantages.

CommonSourcesofCompetitiveAdvantages

To help you identify thesources of competitive

advantage, I’ve borrowedseveral concepts fromfinancial-services companyMorningstar, which usesthese concepts as thefoundation of its stockanalysis. Dorsey distills thesources of competitiveadvantageintofourcategories(Dorsey combines brandloyalty, patents, andregulatory licenses into onecategory titled intangible

assets) which I have brokendownintosixcategories:

1.Networkeconomics2.Brandloyalty3.Patents4.Regulatorylicenses5.Switchingcosts6. Cost advantagesstemming from scale,location, or access to auniqueasset

Let’s take a closer look at

eachsource.

Source#1:NetworkEconomicsOne of the strongest sourcesof competitive advantage isnetwork economics. If aproduct or service becomesmore valuable if morecustomers use it, then thebusiness benefits fromnetwork economics. When

telephonesfirstcameout,noteveryone had one, but asmore people acquiredtelephones, the networkbecame more valuable. Thecustomer was part of theservice itself (another nodeonthenetwork),whichmeantan increased ability toconnecttomorepeople.Thesamehasbeen truefor

Facebook: When it was justfor college students, it had

lessvaluetonon-students.Asit has grown to include non-students, it has becomemorevaluabletoolderadults.Morecustomers (of the right type)again resulted in moreconnection and access, andmorevalue.Timeshare exchange

company Interval Leisure isanother example of acompany that benefits fromnetwork economics. When

someone buys a timeshare,that person usually wants tobe able to trade his or herspecificweekofvacation forother times and locations.Intervalprovidesanetworktotimeshare owners for thesetrades.Ownerspayanupfrontfee to join Interval, and thenthey have access to all othertimeshare traders in thenetwork. More customersmeansmoreplacesandtimes

to choose from. Interval’snetwork benefit is alsoimportant to another of itscustomers, the timesharedeveloper,whoknows that itis much easier to sell atimeshare (and retain itsowncustomers)ifitispartofsuchanetwork.To monitor network

advantages, you need toclosely track the number andqualityofusers.Ifyouseethe

number of users increasingbut more valuable usersmoving to another network,this might indicate adeterioratingadvantage.

ExampleofanExpandingAdvantageMoney-transfer businessWestern Union has beenincreasing the number oflocations in its network. In

2002, Western Union had151,000 locations,butby theendof2009, it hadgrown to410,000 locations. Moreimportant, it is not so muchthe quantity of locations butthequalityofthoselocations.WesternUnionhasbeenableto sign exclusive five-yearagreementswith some of theworld’smostdesirableagents—(i.e., supermarkets,convenience store chains,

postal systems, or banks).The most desirable agentsare, of course, those thatgeneratethemosttraffic.Thismakes Western Union’snetwork more valuable tocustomers who want to sendor receive money, becausethere are more locationswhere they can do this. Themore customers WesternUnionhas, themorevaluableWestern Union is to its

agents, because WesternUnionisabletodelivermorecustomers to agents,comparedtoitscompetitors.In contrast, Western

Union’s closest competitor isMoneyGram International,which has 200,000 locations(less than half of WesternUnion’s 410,000 locations),and it processes only one-fourth of the total customerdollars that Western Union

does. Its network is weakerbecause it offers its agentsfewercustomerdollars,anditoffers its customers fewerqualitylocations.2

ExampleofaDeterioratingAdvantageA network effect is notalways sustainable. Can youguess which was the first

third-party charge carddeveloped in the UnitedStates? Most of you willanswer American Express,Discover, Visa, orMasterCard, which togetherrepresent the majority ofcurrent spending on creditcards. However, the correctanswerisDinersClub,whichspawnedanewindustrywhenit launched the third-partycharge-card business in the

1950s. It possessed thehighest number of bothmerchants and users; in fact,it was so successful that atone time, American Expresseven considered selling itscharge-card business toDinersClub!3

However, an influx ofcompetitors in the followingdecades relegated DinersClubtoonlyasmallcornerofthemarket.DinersClubrivals

focused successfully onbuilding their networks bysigning up new merchantsand customers. Diners Clubstucktoitstraditionalrootsasa charge card, whereasbankcards that extendedcredit offered more appealand utility to the masses.Competitors seized thisopportunityby increasing thenumber of customers(offering them free cards),

which then allowed them toattract the best merchants. Ifyou had closely monitoredthe numbers of cardholders,merchants, and transactionvolumeascompetitorsbattledDinersClub,youwouldhavebeen able to see thedeteriorationinDinersClub’snetwork, beginning as earlyas a couple of years after itsfirstmajorcompetitorjumpedin.

Other examples ofdeteriorating networks mightinclude social-networkingwebsite MySpace. Althoughitwasthemostpopularsocialnetworkingsite in theUnitedStates, it was quicklysurpassed by late-entrantFacebook.InDecember2008,Facebook had fewer than 60million users, whereasMySpace had close to 80millionusers.Yetonlyayear

later, in December 2009,Facebookhadmore than100million users (a gain of 40million), whereas MySpacehadclose to60millionusers(alossof20million).4

Source#2:BrandLoyaltyA brand can give a businesstremendous advantage overcompetitors when customers

remainloyaltothebrandandwhenabusinesscanchargeapremiumprice for the brand.This often results in pricingpower for the business. Thedegree to which brandstrength will lead to acompetitive advantage variesby the type of product orservice. For example, bathand shower accessories haveless brand loyalty thanbeverages.

Start by asking what thebrand stands for withcustomers. Certain brandnames are synonymous withuser experience—forexample:

Four Seasons Hotels’brand means that thecustomer will receiveunrivaled service. As aresult, it can charge ahigherrateforitshotels.Nordstrom is also well

known for itsunparalleled customerservicesuchasitsreturnpolicy, which letscustomers return anyitematanystore.Starbucks is best knownfor supplying premiumcoffees in an invitingatmosphere.

To build a brand,businesses must continuallystrengthen the brand in the

minds of consumers. Once abusinessstopsinvestinginitsbrand,itislikelythevalueofthe brand will decline. Youcan start to see this whenmanagement begins to cutdevelopment, marketing, andpromotion to save expenses.Thiscausesthebrand’slong-term identity to suffer at theexpense of these short-termsavings.In other situations,

managementwilldiscounttheprice of its products in orderto sell its excess inventory,whichcancause thevalueofa brand to deteriorate in theminds of customers. Forexample, luxury handbagmaker Louis Vuitton is ableto consistently charge ahigher price for its handbagscompared to its competitorGucci because LouisVuittonwill destroy overruns rather

than sell them throughdiscount channels.5 Incontrast, Gucci discounts itsinventory more frequently.Yves Carcelle, chiefexecutive officer (CEO) ofLouis Vuitton, says, “We’renever on sale. All the restdiscount. Us, never. When acustomerinvestsinoneofourproducts,theydon’texpecttosee itdiscounted threeweekslater,sowedon’tdoit.”6

Tommy Hilfiger is anothercompany that suffered whenitdiluteditsbrand.Formanyyears, Tommy Hilfiger hadcrafted an upscale image inits red, white, and blue flagandcrest logo.But thebrandbecame diluted when thecompany made it widelyaccessible to middle-classconsumers (whereasbefore ithad been accessible to thatmarketonlyonanoccasional

basis). This caused it to loseits status as an aspirationalbrand. It also began tomovefrom its traditional preppystyle to a hip-hop image,which helped increase salesfrom $847 million in fiscalyear 1998 to $1.9 billion infiscal 2000 but eventuallyalienated many of itscustomers. The stock pricepeaked on July 1999 at $40per share but dropped to

$16.60 per share by the timethe company was takenprivateonMay10,2006.7

Recently, private-labelproducts (PLs) have provento be an enormous threat topreviously strong nationalbrands in groceries,household goods, and over-the-counter drug segments.According to the PrivateLabel ManufacturersAssociation, “store brands

nowaccountfornearlyoneofevery four itemssold inU.S.supermarkets, drug chains,and mass merchandisers.” Inthe United States and manyother countries, labelingrequirements allow for easycomparison of certain items,such as food and drugs. Thecostofproduction,marketing,and promotion is often lessfor these private-label items,and retailers benefit because

theygethighermargins fromselling them. In some cases,national brands have had tolower prices to staycompetitive.Many PLs are not just

cheaper, lower-qualityversions. With theintroductionofPLsatseveralpricepointsandqualitylevels(especially premium levels),thesemultiple-tieredproductshave gained substantial

market share: In fact, a 2010Nielsenstudyshowedprivatelabel store brands hadcaptured 17 percent of themarket share in the UnitedStates.8 Private labels nowsell more mouthwash anddishwashersoapthanColgateandmorefoodwrapandtrashbags than Clorox (whichmakes Glad).9 However,some products are lessaffected than others. The

same2010Nielsenstudyalsofound that private-labelmarket share ranged from ahighof40percentindairytoless than 1 percent foralcoholicbeverages.

Source#3:PatentsPatents can be a source ofprotection because theylegallyprotecttheproductsorservices of a business fromcompetitorsovera17-to20-

year period. The bestway todeterminewhetherapatentisvaluableis tounderstandif ithasanycommercialvalue,asevidenced by any product orlicensing revenues. Notsurprisingly, drug companieshave extremely valuablepatents:Forexample,Pfizer’sset of patents for Lipitor isthe basis for a quarter of itssales, about $11 billion.Almostallofchipsetdesigner

Qualcomm’s $10.9 billion in2009 revenues are related toits patents on code-divisionmultiple access (CDMA)and3G cell phone networktechnology.10

The easier patents toresearch and understand arethose in the pharmaceuticalindustry, because there is alot of information as to thepotential market size of adrug. The more difficult

patents to evaluate are thosebased on technology. Forexample, TesseraTechnologies has patented atechnology that enablesdevices such as laptops andmobile phones to pack moresilicon inside their products.It is difficult to analyze howmanyofthesedeviceswillbemanufactured in the futureand which ones will employTessera’stechnology.

Although they provideprotection, patents have afinitelife,andyouneedtobecautious not to assign toomuch value to them. PaulBobrowski, dean at theCollege of Business atAuburn University, oncejoked that a patent was asvaluable as his patent leathershoes. David Freedman, areporter for Inc. magazine,explains,“Theproblemisthat

a long period of patentprotection is not usefulbecause a newer technologywilldisplaceit.Therefore,themore innovation there is ormore technological changesthere are in an industry, theless value a patent will haveasasourceofprotection[ofasustainable competitiveadvantage].”11

Source#4:Regulatory

LicensesRegulatory licenses andapprovals can also createsustainable competitiveadvantages by limitingcompetition. For example,WesternUnion benefits fromlawsandrestrictionsdesignedtoinhibitmoneylaundering.Ifthesourceofadvantageis

regulatory, spend your timecloselymonitoring legislative

threats from the entity thatregulates it, whether it is inWashington or in state orlocal government offices.Closely monitor lobbyistswho influence legislation byvisiting the websites ofgroups that either generallysupport or oppose theindustryorbyreadingarticleswritten about what impactnew laws or legislativechangeshaveonanindustry.

First,determinewhetherthelicense or approval isregulated by the state, local,or federal government or acombination.Next,determinewhat types of power eachregulatoryentityexertsonthebusiness, such as the abilityto regulate the price chargedfor goods or services or thenumber of units a businesscan sell. The competitiveadvantage’s strength depends

on how much power theregulatory entity has overpricing. If the regulatoryentity controls the prices abusiness can chargecustomers, then thecompetitive advantage isweaker. Dorsey uses theexampleofautility,whichisregulated in the price it cancharge customers. He thencontrasts this to apharmaceutical company

where the Food and DrugAdministration (FDA)concernsitselfwiththesafetyof drugs it regulates, but itdoes not control the pricesthatabusinesscanchargeforthem.Regional casino Penn

NationalGaming is regulatedby each state in which itoperates. To evaluate thecompetitive threats to PennNationalGaming, youwould

need to watch legislativetrends by state. The statelegislature typically approvesgaming for each state, thenthe licensing of casinos ismonitored by each statethrough gaming boards (suchas the Ohio State RacingCommission, PennsylvaniaGaming Control Board, orMaine Gaming ControlBoard).Theseboardsapprovethe total number of slots or

table games that are allowedwithin a certain geographicalregionofthestate.Theboardalso sets the amount of theslot-winpercentage(whichisthe amount it is allowed towin from customers): Forexample, 6 percent to 10percent of slot handle. Thestate also sets the tax rateongaming revenue that casinoscollect. For example,Maryland leviesa67percent

tax on gaming revenue,whereas Nevada levies a 6.5percent tax. If the statedecides to either reduce theamount of slot-winpercentage or raise the taxrate, this would decrease theprofitabilityofPennNationalGaming.On the other hand,

profitability can increase if astate approves new slots ortable games for existing

casinos,asWestVirginiadidwhen it allowed PennNationalGamingtoaddtablegamestoitscasinothere.Ifastateisconsideringincreasingthe taxrateorallowingmoregambling units, thisinformationisfoundwiththeregulatoryboard.Youneedtocloselymonitor the licensingentitiesinthesestatesforanyproposed changes tounderstand what impact,

either positive or negative,the changes will have onprofitability.Businesses regulated at the

federal level have more riskinonerespect,whichisthatasingle rule change can affectthe entire business. Mostlocally or state-regulatedbusinesseswouldonlyhaveapercentage of businessaffectedbyeachchange.For example, the for-profit

education industry isregulated by the federalgovernment through theU.S.Department of Education(ED). The ED sets thestandards that need to befollowed by this industry. Asinglerulechangecouldhavedisastrous effects on thefuture profitability of theindustry. For example, theED is setting standards thatmust bemet for the students

of a for-profit institution toqualify to receive federalstudent loans, whichrepresents more than 70percent of the revenues ofeach institution. In 2009, theED considered not extendingloans to for-profit colleges ifthey failed to meet thesestandards. These changescould have disastrous effectsforsomefor-profitcolleges.

Source#5:SwitchingCostsWhy would you not buy acheaper product of the samequalityorabetterproductforthesameprice?Theansweristhat there may be anadditional cost associatedwith changing products, or areduction in the benefit youstand to receive. These areoften called switching costs,

like those you incur if youchangecellphoneproviders.The strength level of

switchingcosts isdeterminedby how embedded theproductorserviceiswiththecustomer or the amount oftraining needed to use it.Think about how muchtraining you face whenlearningnewsoftware:Ifyouhave to retrain yourself oryour employees when

changing products, you’veencounteredaswitchingcost.Forexample,Bloomberg,a

high-endprovideroffinancialand trading information, hasembedded its services withcustomers through a lot oftraining, so it does notmakesense for those customers toswitch and invest the time tolearn another product. Thesavings of switching to alower-priced competitor

would be outweighed by theadditionaltrainingtime.Also,because many of itscustomers are traders, thebenefit of switching to a lesscostly service to savemaybeafewthousanddollarsayearis small incomparison to thesize of the transactions theyare making. Finally, there isalso some chance of makingan error as customers learnanynewsystem.

In order to learn if theprotection provided byswitching costs isdeteriorating or improving,youneedtocloselymonitoracompany’s customer-retention rates. For example,Blackboard is a leadingprovider of softwareapplications and services toeducational institutions. Itssoftware enhances thelearning experience by

allowing students to interactwithteachers,classmates,andcourse materials outside ofthe traditional classroomenvironment. Blackboard’sproducts are used daily bystudents, parents, andadministrators, and thesoftware is deeply embeddedwithin a school’s otherinformation systems. Forexample, a professor mayassign digital material on a

class website. Thisembeddedness, or stickiness,is reflected in Blackboard’shighcustomerretentionrates.Atgreaterthan90percentformost of its products,12Blackboard’s customerretentionisroughlyfivetimeslarger than the company’sclosest competitor. If thisretention rate begins to drop,however, this might signalthatBlackboard’scompetitive

advantageiseroding.

Source#6:CostAdvantagesCostadvantages includesuchfactorsaseconomiesofscaleand advantageous locations.The more structural a costadvantage is, the moresustainableitis.Forexample,lowering costs by moving acallcentertoIndiawillhelpa

business, but most of itscompetitors can narrow thisadvantagebydoingthesame.Economies of scale are a

more structural kind ofadvantage.Asabusinesswithfixedcostsgrows,itisabletotake advantage of lower per-unitcosts.Thisway,itisableto charge lowerprices for itsproducts or servicescompared to competitors.This widens the competitive

advantageandmakes itmoresustainable.There are variousways for

a business to createadvantages based oneconomiesofscale,includingincreasing efficiencies byconsolidating a fragmentedindustry.

ObtainingaCostAdvantagethrough

IndustryConsolidationIn large, fragmentedmarkets,especially those that havebecome commoditized, youcanoftenseebusinesseswithlow-cost advantages buildingmarket share. The higher themarket share, the morecustomer choice is limited,which gives the survivingdominant players an

advantage.For example, LabCorp and

Questeachplayedlargepartsin the consolidation of thelaboratorytestingbusiness.Inthe early 1990s, there wereseven or eight national labcompanies that all performedthesametypeoftests.Aslab-test reimbursementsincreasingly fell to health-maintenance organizations(HMOs), the HMOs

demanded lower prices.LabCorp and Quest acquiredother businesses to achieveeconomies of scale, and theycontracted with HMOs toofferlowerpricing.Althoughend-customers could chooseto use other labs, the scalealreadyachievedbyLabCorpand Quest made matchingtheir pricing difficult forcompetitors. Other labsquickly found that their

existing customers didn’twant to pay higher co-paysfor non-contract testing, andthecompetitionfolded.

ObtainingaCostAdvantagethroughaGoodLocationWhenever a business has ageographic location thatcompetitors are unable toeasilyduplicate,thiscangive

a business a cost advantage.Forexample,cementplantsincertain areas of the UnitedStates benefit when housingand public constructionincrease demand locally forcement.Becauseitisdifficultto build new cement plants(“not in my backyard”) andbecause it is generallyinefficient to ship cementlong distances because of itsweight, those cement plants

areabletoundercutthepricesofmostcompetitors.

TheBestKindofSustainableCompetitiveAdvantageIsStructural

Whencustomershavelimitedchoices in the products orservices they can use for

extended periods of time thecompetitive advantage islikely structural. A structuralcompetitiveadvantagecanbearesultofregulation,aprimelocation,orbetterdistributionnetworks.For example, thinkabout a prime piece of realestate in your communitywhere there is easy access,visibility, and location. Thislocationtypicallywillbeableto charge higher rents to

retailers because it is in agood area where morecustomersarelikelytoshop.The best way to identify a

structural competitiveadvantage is to view it fromthe perspective of customerchoice: Does the customerhave limited products orservices to choose from, ordoesthecustomerhavemanychoices?For example, if youarebuyinginfantformulayou

are limited to two mainproducts: Enfamilmanufactured by MeadJohnson and Similacmanufactured by AbbottNutrition. In contrast, whenchoosing a restaurant, youhaveamyriadofchoices.Structural advantages are

typicallythemostsustainableadvantages.Foronething,themoreacompetitiveadvantageis based on structural

characteristics, the less thebusiness depends on suchfactors as managementexecution.Forexample,bondratings firms Moody’s andStandard & Poor’s bothpossess strong structuralcompetitive advantagesbecause the governmentlimits the number of firmsthatcanissueratingsthroughregulation, so they rely lessonhavinggoodmanagement.

In contrast, a restaurant (andretail in general) depends agreat deal on the quality ofmanagement,sotheyhavefarlessofanadvantage.

WhyIt’sHardtoFindBusinesseswith

SustainableCompetitiveAdvantages

For most businesses, acompetitive advantage is notsustainable over an extendedperiod of time. Competitiveadvantages expire. Evenwhenabusinessappearsmostformidable and generates thestrongest financialmetrics, itcanbeonthevergeoffailure.Ifabusinessdoesn’tinnovatesuccessfullyanddefenditself,competitors will always bethere to chip away at the

business.For example, Sony knows

that when it creates a newproduct, it has between oneand two years before otherconsumer-electronicsmanufacturers imitate thatproduct. Therefore,when themanagement team sits downtodecidehowtheyaregoingto price their product, theyprice it at a levelwhere theywill be able to recover their

investment in an 18- to 24-monthperiod.Most advantages are

temporary, such as when abusiness launches a newproductthatissuperiortothecompetition’s product, andmanyadvantagesdeclineovertime.Forexample,microchipmanufacturer Intel used tomake excess profits for longperiods after introducing anewchip.Thereasonforthis

was that, in the past, therewas less competition in chipmaking. Computer makerswere willing to pay apremium to Intel to have thelatest microprocessors inorder to differentiatethemselves. However, asmore competitors haveentered the industry, Intelnowhasasmallerwindowoftime in which to earn ahigher-than-average profit on

anewchip.Itisincreasinglydifficultto

find businesses withcompetitive advantages, forseveralreasons:

Consumersarelessloyalto products or brandnames. Witness howprivate-label productscontinue to take marketshare from brandedproducts.Increased global

competitionhas loweredthe bar for new entrantsin most industries, suchas manufacturing. Forexample, globalcompetition has almostshut downmanufacturing of shoesin the United States,where production fellfrom 121 million shoesin 1999 to only 31millionin2007.13

Technological advanceshave shortened thelifecycle of manycompetitive advantages.Let’s take a closer lookatthisreason.

Competitiveadvantagesarelesssustainablewhentheyareaffected by changes intechnology or if they are inrapidly emerging industries.Changes in technologythreaten a competitive

advantage when they expandcustomer choice, whether byofferingthesameproductforless or by offering greaterbenefit for the same price orless. Here are just a fewexamples:

Book retailer Barnes &Noble’shistoricalabilityto charge premiumprices for books wasdiminished by onlineretailer Amazon.com,

which is able to sellbooks at a lower pricebecauseitdoesnothavethe higher overhead intheformofstoreleases.TheInternethasreducedthe sustainability ofmany competitiveadvantages. Forexample, newspaperslost most of theirclassifiedadvertisersandthe large percentage of

profits they representedto low-cost Internetsites.Other businesses are interminal decline as theirproductsandservicesarebeing replaced by newand improved offeringsfrom competitors thatexceed what they haveto offer. For example,dial-up Internet serviceAmerica Online (AOL)

has been decimated byhigh-speedproviders.

In all of these examples,customer choice improvedduetochangesintechnology,whether because of lowercostsorgreaterbenefits.

BewareofBusinessesthatWereSimplyattheRightPlaceatthe

RightTime

Toooften,investorslookatabusiness’s past success as aresult of a competitiveadvantage,when they shouldbeaskingwhyabusinesshasa competitive advantage andif therearecertainconditionsthat created it. Manybusinesses may simply havebeen in the right place at therighttime.For example, when the

price of computers dropped

and more consumers couldafford personal computers,Dell was able to beat itscompetitors on price becauseit had the lowest coststructure of all computermanufacturers. In contrast,othercomputermanufacturerswere locked into distributionagreements that increased thecost of a computer. Overtime, however, Dell’sadvantage has eroded as

competitorsnowmanufacturecomputersatalowerorequalprice. What many investorsbelieved to be an enduringcompetitive advantage wasnot.

MostInvestmentGainsAreMade

DuringtheDevelopmentPhase,

NotAfter

Asyouarelearningaboutthesource of a competitiveadvantage, it is important toremember that the greatestgains in a stock are usuallymade as a business isdeveloping its competitiveadvantage rather than after italready has developed one.For example, we all knowthat Wal-Mart has acompetitive advantage, butinvestors earned the biggest

stockgainsasWal-Martgrewanddevelopedthisadvantage.Ideally, you want to

identify those businesses thatare in the early stages ofbuilding a competitiveadvantage. It can take yearsand sometimes decades for abusiness to develop itscompetitiveadvantage,and itis difficult to see acompetitive advantagebuilding, because in most

instances, the business islosing money during thattime. For example, onlineretailer Amazon.com lostmoney for eight years whileusing its capital to rapidlyexpanditscustomerbaseanddevelop its markets beforecommitting to more efficientoperations and profit. Thebest way to distinguishwhetherabusinessisbuildinga competitive advantage or

wastingmoney is tomonitorthe number of customers abusiness serves. Theinvestments Amazon.commadeincreasedthenumberofcustomers it served. Incontrast, businesses that failare those that continuallyspend money but do notincrease the number ofcustomerstheyserve.Look for those businesses

thatcontinue topushproduct

or service innovation byinvesting in research anddevelopment (R&D) or thatare wisely spendingmarketing dollars to increaseawareness of their productswith superior valuepropositions or uniqueappeal. For example, Appleremained committed to itsR&D program even afterrevenue dropped by 33percent. Apple increased its

R&Dspendingby13percentin 2001, which increased itsR&Dasapercentageofsalesfrom 5 percent of sales in2000 to 8 percent of sales in2001, as stated in their 200110-K.Duringthistime,manyshareholders questioned whyApple would continue toincrease its expenses, eventhough its revenues weredeclining. Yet because ofthese expenditures, when

Apple introduced the iTunesmusic store in 2003 and theiPod in 2004, the stage wassetforrapidgrowth.Be cautious of those

businesses that only imitateinnovation. For example,Wal-Mart has always hadcutting-edge information-technology (IT) systems forretail. It was one of the firstretailers to invest in barcodescanners to increase

efficiency. (It’s hard toimagine, but barcodescanners were consideredrevolutionary at the time.) Acouple of years later, Kmartadded barcode scanners,which helped Kmart, but bythen, Wal-Mart was alreadyusing the next generation ofIT tools in the form of aprivate satellite network. InITandinotherareas,Kmart’simitationofWal-Martwasn’t

as effective as Wal-Mart’sinnovation, and Kmart wasleftbehind.

WhatIsNotaSustainableCompetitiveAdvantage?

It is important for you todistinguish a business’scompetitive strength from asustainable competitive

advantage. If a business hasgood customer service, aquality product, andknowledgeable workforces,those are all strengths, butthosecanoftenbeduplicated.For example, a business thatreturns its phone callswithinan hour is preferable to onethatreturnscallsthenextday,but a competitor can easilyduplicate this enhancedcustomer service. Some

strengthsaremoredifficulttodevelop than others, such ashaving very knowledgeableemployees, a strongemployee culture, or anefficientproductionprocess.For example, in the for-

profit education industry,there are some advantagesthat are easy to copy andsome that are difficult tocopy,asshowninTable4.1.

Table4.1ComparingCompetitiveAdvantagesinEducation:AreTheyEasyorDifficulttoCopy?CompetitiveAdvantagesthatAreEasytoCopy

CompetitiveAdvantagesthatAreDifficulttoCopy

Quickapprovalofstudent-loanapplications

Accreditation

Abilityofstudentstoworkontheirownschedules

QualityFaculty

Studyfromhome ResourcesEasy-to-navigatewebsite

Qualityofeducation

Therefore, sustainable

advantages include factorsthataredifficulttocopy,suchas accreditation, whereascompetitive strengths includesuch factors as an easy-to-navigatewebsite.

16.Doesthebusinesspossesstheabilityto

raisepriceswithoutlosingcustomers?

The best indicator of acompetitive advantage is abusiness’s ability to increaseprices without losingcustomers. For example, thefollowing companies (andothers, of course) all havepricingpower:

Blood-testing equipmentmakerImmucorLuxury goodsmanufacturer LouisVuittonGlobal financialinformation providersFactSet ResearchSystemsandBloombergSalt producer CompassMineralsInternationalHäagen-Dazs ice cream(ownedbyNestléS.A.)

Häagen-Dazs ice cream isable to sell its products at alargepremiumoveritscostofproduction, thereforedemonstrating pricing power.In contrast, commodity-typebusinesses, such as steelproducers, do not havepricingpower.Inmostcases,these types of businessesmust decrease their prices tospurdemand,andthepriceistypically set by the

production cost rather thanthevalueoftheproducttothepurchaser.

CommonCharacteristicsofFirmswithPricing

PowerBusinesses that have pricingpower typically have a fewcharacteristicsincommon:

They usually have high

customer-retentionrates.Their customers spendonly a small percentageof their budget on thebusiness’s product orservice.Their customers haveprofitable businessmodels.The quality of theproduct is moreimportantthanprice.

Let’s look at each of these

individually.

HighCustomer-RetentionRatesA business with a highrenewal rate on its servicestypically has pricing power.For example, financial-services informationproviderFactSet Research System’sclient-retention rate from2002to2008wasgreaterthan

90 percent.As a result of itshigh client-retention rate,FactSet is able to raise itspriceswhen contracts renew.In contrast, abusiness that isalwaysfightingforcustomerscertainly is in no position toraise prices. Itmust typicallydecreasepricestoattractnewcustomers.

LowPriceSensitivityTo determine how price

sensitive a customer is, findout how much of thecustomer’sbudgetisspentonthe product or service. Thehigher the percentage of thecustomer’sbudgetspentonaproduct or service, the morelikely it is that the customerwillbepricesensitive,whichmay impede the ability of abusiness to raise prices. Forexample, medical laboratorytesting businesses have

pricing power because theircost to the customerrepresents 3 percent ofoverallmedicalspending,yetthey are pivotal todetermining the greatmajority of treatments. Thismakes lab-testcustomers lesspricesensitive.

CustomersHaveProfitableBusiness

ModelsIf customers have plenty ofcash, or their businesses arehighlyprofitable,theywillbeless sensitive topricing.Thisis trueas longas theproductdoesnotrepresentalargepartof their overall budget. Forexample, Bloomberg’scustomers aremostly traders,who have highly profitablebusinesses. The cost of

Bloomberg’s financialterminals represents a smallpercentage of a customer’soverall profits and thereforeprice is not the firstconsideration. If customersgenerate low profits, thenthey are likely to be underpressuretoreducepurchasingcosts, as in the case of aclothingmanufacturer.

High-Quality

ProductsorServicesSometimes the quality of theproduct is more important toa purchaser than the price.For example, PrecisionCastparts is a leadingmanufacturer of high-qualitycastings, forgings, andfasteners. Jet aircraft enginemanufacturers(suchasRolls-Royce) use PrecisionCastparts’ parts to construct

theirengines.Itiscriticalthatthese engines run smoothlyand that components workflawlessly to ensure theengine does not malfunctionwhile an airplane is in flight.Also, many of PrecisionCastparts’ products last fivetimes longer thancompetitors’ products. Thismeansthatbuyersarewillingto pay a premium forPrecision Castparts’ products

because the quality of theproduct matters more to thecustomerthanprice.Similarly, Fastenal is an

industrial parts supplier thatmakes sure it can supply awide range of partsimmediately tomanufacturers.A simple boltdistributed by Fastenalrepresents a smallpercentageof a manufacturer’s budgetbut can be critical to the

operation. Speed and qualityof servicemattermore to thecustomer than price in thiscase, because the cost ofdowntime is significantlyhigher than the price of thebolt toget themanufacturingplantmovingagain.

ArePricingAdvantages

SustainableRather

thanTemporary?Becertainthatpriceincreasesare not just dependent on atemporary condition. Forexample, some commodity-typefirms,suchasdiskdrivemanufacturers, are able toincrease prices on theirproducts when demandexceeds supply, but theseprice increases tend to beshort lived because supply

eventually catches up withdemand. An example wouldbe during the recession in2008 when trucking capacityshrunk significantly due tomany small carriers ceasingoperations.Duetothelimitedcapacity in the market,remaining carriers gainedsomepricingpowerovertheirshippers.Themajority of thetop50carriersincreasedratesby 3 to 9 percent in 2010,

with the flat-bed carriersenjoying the higher end ofthat range.14 This pricingpoweristemporary,however,because prices will drop asnew carriers begin to enterthe market again, expandingcapacity.

WheretoFindPricingPowerInformation

Look for pricing powerinformation in the followingsources:

The MD&A section ofthe10-KHistorical operatingmetricsInvestor presentations,conference calls, and soon

Keep an eye out forimportant pricing powerindicatorssuchas:

Multiple years ofincreasesIncreases that don’t justoffset costs (seen inoperating profit percustomer and operatingincomegrowth)Pricing that is higherthancompetitors

To determine if a businesscan raise prices, begin bylooking at the ManagementDiscussion and Analysis

(MD&A)sectionfoundinthe10-K,andreadmanagement’sexplanations for changes inthegrossprofitmargin.Readat least 5 to 10 years of thissectionofthe10-K.For example, in its 2004

Form 10-K, salt producerCompass MineralsInternational states: “Theincrease in gross profitprimarily reflects the impactof improved prices and

volumes ($8 million and$15.3million,respectively).”Fiveyearslater,inthe2009

10-K, the company states:“Thegrossmarginforthesaltsegment partially offset thedecline in gross margin bycontributing an increase ofapproximately $40 millionduetopriceimprovements.”Compass can raise prices,

anditspecifiestheadditionalrevenues it receives by

increasingitsprices.Next,determineiftheprice

increases are lasting or not.Further reading of Compass’10-K and other documentsreveals that Compass’increases have been lasting,as they have been able toraise prices consistently overthelastfiveyears.Finally, see if these price

increaseshave translated intooperating income growth, or

if they have been used tooffset increasedexpenses.Todo this, compare the grossprofit margin to operating-incomemarginoveraone-tofive-year period. If theoperating-income margin isdroppingas thegrossmarginis increasing, then expensesmay be rising faster thanpriceincreases.Anothermethod to identify

pricing power is to calculate

historical operating profitmetrics. For example,Western Union reports thetotal number of transactionsand operating profit for itsconsumer division in the 10-K.You can divide consumertransactions by the operatingprofit for its consumerdivision to yield a singletrendingnumber representingoperatingprofitperconsumertransaction. In 2003,

operatingprofitperconsumertransaction was $9.44. By2008,thisdecreasedto$6.51.This downward trend inoperatingprofitperconsumertransaction indicates thatpricingpowerisdeclining.Infact,WesternUniondisclosedin its 2009 10-K that it re-invests 1 to 3 percent of itsrevenuesinpricedecreasestoincreasecustomertraffic.Other useful sources for

determining pricing powerare company investorpresentations, conferencecalls,orannualreports.Thesesources may provide otherindicators of pricing power,suchaswhetherabusiness isable to charge more than itscompetitors. For example, inhistoricalannualreports,FourSeasons Hotels disclosed thedaily room-rate premium(known as RevPAR

premium) it achievedcompared to its competitors.Historically, Four Seasons’pricing premium was 50percent greater than itsclosest competitor, RitzCarlton.15

Inmostcases, ifabusinesshas pricing power, it willdisclose it. If the businessdoes not disclose increasingprices, then it is highlyprobable the business does

nothavepricingpower.Lookfor price increases in thecontextofother indicatorsofpricingpower:trendsinprofitper customer, pricing thatdoesn’t just offset increasedcosts,andpriceincreasesthatcan continue for multipleyears.

ExamineWhetherPricingPowerIs

FoundThroughouttheOverallBusinessorOnlyaSegmentof

theBusinessDetermine if the business’spricing power protects all ofits revenues or just apercentage of them. Somebusinesses have pricingpower in certain products orservices, yet not in themajority of the products or

services they offer. Forexample, airlines set theirprices by how muchcompetition they have on acertain route, rather than bydistance. As a result, theyhavepricingpoweroncertainroutes rather than all routes.A plane fare from Austin,Texas, to Corpus Christi,Texas, (200 miles) may bemore than a fare from NewYork to Los Angeles (3,000

miles) because there is morecompetition on the NewYork-to-LosAngelesroute.Ifmoreofanairline’sroutesaresimilar to the New York-to-LosAngelesroute,theairlinehaslessoverallpricingpowerthan it would if more of itsroutes were like Austin-CorpusChristi.

TechnologyCreates

PriceTransparencyTechnological changes haveaffected the ability ofbusinesses to increase prices.The Internet inparticularhashelped create pricetransparency. In the past,somebusinesseswereabletomaintain higher pricingbecause itwasmore difficultfor customers to comparepricing. For example,

consider thechanges inhotelroom price transparency. Inthe past, customers relied ontravel agents or had to callmultiple hotels to comparepricing.Incontrast,theynowuse online travel sites (suchas Expedia and Travelocity)todothesamethinginstantly.Customerscannoweasilyseehotelpricing,andasa result,theyhavebecomemorepricesensitive. This greater

visibility has lowered theroom rates that hotels cancharge.

17.Doesthebusinessoperateinagoodorbad

industry?Investingintherightindustryis important because a large

part of your potential rate ofreturn is often attributable tothe industry you are investedin, as opposed to a specificcompanyyouareinvestedin.As you evaluate an industryasawhole,askhoweasyitisto make money in theindustry.Ifitiseasy,that’sagood industry to be in, andyour chances of makingmoneyinyourinvestmentarebetter.

ToBegin,CalculatetheRangeof

IndustryReturnonInvestedCapital

To begin evaluating theindustry, compare thedistribution of returns oninvested capital (ROIC,which question 26 discussesin more detail, includingshowingyouhowtocalculateit).Ifit’seasytomakemoney

in an industry, you will findthat most companies aredoingwell,andtherewillnotbe a wide range ofdistributionofROIC.If thereis a broad range of ROIC,with some companies doingwell and some doing poorly,this is a tougher industry tobein.For example, the

pharmaceuticalindustryhasaconsistentlyhighROIC,with

returnsrangingfrom13to21percentoverthelastdecade.16The best pharmaceuticalbusinesses are not far fromthe worst in terms of ROIC.In contrast, ROIC for themajor oil companies rangedfrom3to15percentoverthelast decade. This wider andlower range of ROICindicates that it is harder tomake money in thisindustry.17

To get a deeperunderstanding of whether anindustry is good or bad,compare the best companiesto the worst within theindustry. By makingcomparisons between theextremes in an industry, youwillidentifythereasonswhytheindustryisgoodorbadtobe in. This information willalso help you evaluate othercompanies if you decide to

investintheindustry.

AnotherMethodofIndustryAnalysis—

fromImperialCapital’sSteveListerTo give you more in-depthmethods of picking a goodindustry, I present a casestudyoftheindustryresearchmethods of Steve Lister, co-founder of Toronto-based

private equity firm ImperialCapital, who has beenselecting companies fromgood industries for manyyears. Lister’s case studyillustrates several methodsyou can use to understand ifthe industry as a whole is agoodone.Lister’s firm has a solid

track record of identifying,evaluating, and investing insome of the most profitable

industries, such as regionaltelephone-book publishersand refrigerated warehouses.Lister believes that findingthe right industry is whatcounts most. Like many,Lister believes that yourchances of picking a goodinvestmentarebasedmoreonthe industry than on theindividualcompany.Henotesthat ifan industry isgrowing5percentto8percentayear,

even if you do not identifythe best individual company,your performance will stilllikely be good. Furthermore,Lister has discovered thatover time, theprofitabilityofa business will eventuallytrend toward themeanof theindustry, as it is difficult forany business to outperformtheindustryforalongperiodoftime.Lister’s firmhasdeveloped

a scorecard system with 100differentitemsthathelpshimevaluate theeconomicsofanindustry.AsListersays:We score an industry on100 items every time.Thereisalotofjudgmentin terms of how tounderstandthingssuchasthe volatility of customerdemand, profit margins,pricing power, andbarriers to entry. We go

throughalloftheseitemsandratethemandcreateasort of index. Maybe wearewrongon5percentto10 percent of the items,butat theendof theday,itistherelativescorethatmatters. If an industryscores positively on only50 of the 100 items, wewillpasson the industry,but if the industry scoresanywhere from 60 to 75

of the100 items,wewilllookforabusinesswithinthatindustrytoinvestin.Some of the questions on

Imperial Capital’s scorecardinclude:

What drives theindustry?Howdopeople competewithintheindustry?Whatisthelargermacropicture?

What are the industrytrends?What is the averagecash-conversion cyclefortheindustry?What is the industry’sexposure to cyclicalmarkets?Does the industry havethe ability to pass onpriceincreases?What is the volatility ofdemand from

customers?Once analysts at Imperial

Capital narrow down theindustries they will considerinvesting in, they thenresearch the industry moreclosely to understand thetrendsindemandandwhatisdriving demand. Listeridentifies whether the trendsare negative or positive, andwhether they are temporaryorstructural.Thisallowshim

to understand whether thetrendsaresustainable.For example, when Lister

and his team evaluated thehealthcare industry, theystarted by looking at morethan100healthcaresegments,orwhathecallsniches.Theyanalyzed the growth rates,profitability, the number ofbusinesses, andreimbursement risk for eachof these niches. Then they

developed a ranking of eachof the different healthcareniches, based on thisunderlying research. Oncethey narrowed down the listto 12 niches with above-average profitability, theylooked for healthcarepractitioners who could helpthemanswer thequestions intheir scorecard and furthernarrow down the industriesthat they could invest in.

ThesehealthcarepractitionerswereformerorexistingCEOsofbusinesseswhohad“lived,slept, and breathed theindustry for a long time.”AsLister says, “The only wayyou can know where theskeletons are buried in anindustry is to partner withsomeone who knows wherethey are.” To locate theseCEO partners, Lister and histeam go to industry

conferences and use theirestablished network ofindustrycontacts.One business that Lister’s

firm invested in because itmet the majority of ImperialCapital’s criteria (75 out of100)wasAssociatedFreezersCorporation, a refrigeratedwarehousingcompany.Therewere several factors thatattracted Lister and his teamto Associated Freezers,

includingthese:Underlying demandwasstrong. As womenentered the workforce,frozen foods made up alarger part of people’sdiets. Supermarketsshowed evidence of thisincreased demand asthey increased thenumber of frozen foodsaisles.The quality of frozen

foodsimproved.Theoldstyle TV dinner wasreplaced with morepopular choices andhigher-qualityingredients.Price was not theprimary determinant.The customers (frozen-food manufacturers)chose warehouses basedon service, real-timelinks to inventory, good

temperature control,quality, and on-timedelivery,notonprice.There were barriers toentry. Industryregulation forcedrefrigerated warehousesto staff engineersbecause the extremelylarge refrigerationequipment is dangerous.Because of the expenseandexpertiserequiredto

build the refrigeratedwarehouses, entry wasconstrainedbycapital.The financialcharacteristics werestrong. Earnings beforeinterest, taxes,depreciation, andamortization (EBITDA)margins exceeded 36percent once arefrigerated warehousewas built, and the

maintenance capitalexpenditures wereminimal. This allowedinvestors to earn excessfree-cashflows.Finally, the averagecash-conversion cyclewas 120 days, sorefrigerated warehousescould grow withoutusing a lot of borrowedcash.

Lister and his investment

partners were extremelysuccessful in this investmentbecause Lister and his firmhad identified a goodindustry.

18.Howhastheindustryevolvedover

time?

Understanding how anindustry evolved will helpyou evaluate the business inthecontextofitscompetition,its operating environment,and the various other forcesthatshapeit.Whenyoustudyan industry, youwill pickuponfactorsandforces thatarenot as obvious as when youstudy only one business. Tounderstand the industrywell,study its history over a long

period (i.e., more than 10years). Seeing change overtimewillhelpyoupickuponfactors andmajor forces thatare not apparent in only oneperiod.For example, when I was

interested in investing in alarge advertising agency, Istudied not only theindividual agency, but theentireindustry.Ididnotfullyunderstand all the forces that

affected the industry until Isawthemunfoldovertime.Oneofthemainservicesof

anadagency,historically,hasbeen ad placement. Fordecades, adagencies chargedon the basis of billings: Inother words, the agency waspaid a percentage of theamount their clients paid totelevision stations,newspapers, magazines, andso on, to run their ads, so if

an ad campaign for a clientcost $200 million, the adagency’s commission mightbe 10 percent of that, or $20million. Obviously, this wasvery profitable for largeagencies. In fact, theoperating margins for theadvertising industry used toexceed20percent.As the industry

consolidated, companiesleveragedtheirbalancesheets

to acquire other agencies,assuming that those healthymargins would continueindefinitely. Two thingshappened that changed themargins within theadvertising-agency industry.First, companies began torealize that paying apercentage of their totaladvertising bill to theadvertisingagencieswasn’t agood value for them. They

began to see that their salesresults weren’t tied to howmuch they paid, but insteaddepended on several otherfactors, including the qualityof the ad, the research thatwent into it, and the numberof potential customers itreached. Second, with thegrowth of Internetadvertising, companies whowanted mass-market ornational advertising

campaigns were no longerstuck with major televisionnetworks and limited printmediaastheonlyavenuesforreaching customers. Insteadthere were now hundreds ofweb sites whereadvertisements could reach anationwide audience. Massmarkets became fragmentedand the brokering power ofthelargeagenciesdiminishedsignificantly. The large

advertising agencies had tomove to a lower pricingmodel,andoperatingmarginsbegantodecrease.Interestingly, the large

advertising agenciescontinued to acquire otheradvertising agencies. Curiousabout this, I asked managerswhat the benefit of size wasfor an agency during a timewhere markets werebecoming more fragmented.

Themanagementteamsofthelarge agencies explained thattheywerecontinuingtomakeacquisitions becausecustomerswouldbenefitfrombeing able to use a singleagency to run a globalcampaign:Forexample,Nikewouldbeabletorunaglobalcampaign without having tohire 10 separate agencies.Thesemanagersclaimedtheyhad created synergies by

combining agencies: Withmore distribution powerunderoneroof, theybelievedthey would enjoy the benefitof efficiencies on the costside.However, because I had

studied the way that ad-agencyindustryconsolidationhad takenplace in thepast, Iknew that consolidationdidn’tresultinlargecohesiveagencies being able to offer

seamless global advertisingcampaigns; I also knew thatconsolidation didn’t result inefficiencies. In fact, as largeagencies made acquisitions,the acquired agency was notabsorbed; instead it oftencompetedwithotheragenciesin the same umbrella orconglomerate agency. Eachagency within theconglomerate ran its ownprofit and loss statement and

had few incentives to workwithotheragenciesunderthesameroof.Ifollowedupwithadditionalresearchandfoundthattheindustrystilloperatedin a similar fashion. So eventhough acquisitions resultedin increased revenue onpaper, they weren’t going tocreate cost efficiencies orsynergies.Studying the advertising

industry over time allowed

me to conclude that adagency consolidation workeddifferently than consolidationin other industries. Iconcludedthatmarginswouldnot grow in this newenvironment,andIpassedonthe investment. By knowinghow the entire industryevolved,Iwasabletoseethefallacy in management’sclaims of cost synergies andbettercustomerservice,andI

sidesteppedapoorinvestmentopportunity.A great source to help you

understand how an industryhas evolved is the collectionof Standard & Poor’s (S&P)Industry Surveys. S&Ppublishes surveys on manyindustries, including realestate investment trusts(REITs), chemicals,publishing, restaurants, andhomebuilding, toname just a

few.Thereportsaretypicallybrokendownintosectionsonhow the industry operates,industry trends, key industryratios and statistics, and asection titled “How toAnalyze” a particularindustry, such as a REIT.There is also a section onindustry references, whichcan give you valuable leadsfor trade journals, industryassociations, and other

sources. There is acomparative-companyanalysis in the appendix,which will give you usefulcompetitor information and alistofothercompaniesin theindustry. You can accessthese reports through auniversityorlocallibrary.

19.Whatisthe

competitivelandscape,andhowintenseis

thecompetition?You can better understandwhat the competitivelandscapeisforabusinessbyanswering the followingquestions:

Does the business have

limitedcompetition?Does the industrychangeoften?How do the competitorscompete within anindustry, and how couldthatchange?How fiercely dobusinessescompete?What risks does thebusiness face fromsubstituteproducts?Can competition from

low-cost countriesimpactthebusiness?Which competitor setstheindustrystandard?Why have competitorsfailedinanindustry?

Let’s take a closer look ateachofthesequestions.

DoestheBusinessHaveLimitedCompetition?

Competition does notincrease the value of abusiness. Generally, morecompetition means morecustomer choice and lessprofitability. In addition, abusiness with limitedcompetition is easier toanalyzethanonethathaslotsofcompetitors.For example, think about

the competition in asupermarket aisle. There is

limited shelf space on eachaisle that name brands andprivate-label productscompete for. If you areanalyzing a name-brand foodcompany, you can easilyassess how a certain foodbrand is doing against aprivate-label brand or otherbrands by monitoring shelfspace in various nationalsupermarkets. In addition,there are many market-

research organizations thatcan provide you withvaluable informationregarding market share, suchas global information andmeasurement company A.C.Nielsen. In contrast, it is farmore difficult to understandthe competitive position of abusiness such as a check-cashingstore,wheretherearethousands of direct andindirectcompetitors.

To begin your assessment,view theCompetition sectioninthe10-K.Ifabusinesslistsits competitors by name, thecompany has limitedcompetition.Forexample,the2009 10-K for bond-ratingagency Moody’s lists thefollowingcompetitors:

Standard&Poor’sFitchDominion Bond RatingServiceLtd.ofCanada

A.M.BestCompanyInc.Japan Credit RatingAgencyLtd.Rating and InvestmentInformation Inc. ofJapanEgan-Jones RatingsCompanyLACEFinancialCorp.RealpointLLC

In contrast, in suchbusinesses as banking,

homebuilding, or restaurants,the company will not list itscompetition but will simplydisclose that it has manycompetitors.Forexample,the10-K fromJune30,2010 forDollar Financial (a check-cashing business andconsumer loan provider)states:In the United States, ourindustry is highlyfragmented.According to

FinancialServiceCentersof America, Inc., thereare approximately 7,000neighborhood checkcashing stores and,according to publishedequity research estimatesby Stephens Inc., thereare approximately22,000short-termlendingstores.

DoestheIndustry

ChangeOften?If the industry is one that isconstantly changing, then itwillbeevenmoredifficulttoevaluate the competitiveposition of a business. Forexample, if you areevaluating competitorsindividuallyinthetechnologyindustry, by the time youhave analyzed most of thosecompanies, the technology

maychange,whichofcourseopensthedoor toanewcropof competitors you neverconsidered.Therefore, to evaluate

competitors in a fast-changingindustry,viewthemfrom the customerperspective.Youwillneedtolocate and maintain closecontact with customers tounderstand if they areswitching to other products

andservices.For example, when I first

began analyzing the onlinetravel industry,whichwas inits infancy at the time (in2001), I attended severalonline travel-industryconferences (such as ThePhoCusWright Conference)to look for potentialinvestments. I knew thatonline travel was a growingindustry, but I did not know

whichbusinessestoinvestin.Most of the industry players—such as Expedia,Travelocity, andpriceline.com (and manyothersthatnolongerexist)—were in their early stages ofdevelopment. Because theindustry was changing soquickly, I searched forcustomers and travelproviders (i.e., hotels,airlines) who used these

services.Iwantedtofindoutwhichservices theypreferredandwhy.When I first studied

priceline.com, I personallydid not like the businessmodel because customerscould only choose to bid onhotels with a certain starrating, and they could notchoose the specific hotelwheretheywouldbestaying.I thoughtthisbusinessmodel

had limited potential, andmany of its competitorsagreed. However, thecustomers and travelproviderskepttellingmethatbecause priceline.com was adifferentiatedservice,itcouldrepresent a great investment.The travel providers andhotels liked this businessmodel because they did nothave to advertise discountedhotel rates, which could

damagetheirpricingpower.The customers and travel

providers ended up choosingthe best investment in thisindustry: priceline.com hasbeen one of the highest-returningstocks in theonlinetravel industry, increasingfrom$8pershare toward theend of 2000 to more than$400 per share at the end of2010.18 Had I not viewedcompetitors from the

customerperspective,Iwouldhave come to the wrongconclusion as to whichbusiness would be mostsuccessful.

HowDotheCompetitors

CompetewithinanIndustry,andHowCouldThatChange?

Competitionmaybebasedoncapital, service, or price.Determine whether thecompetitive dynamics canchange, and then constructdifferent downside scenariosfor the business based onthosedynamics.Let’slookateach of these factorsindividually:

CompetingoncapitalIf the businesses compete

based on capital, then theadvantage will always residewith the well-fundedcompetitors. For example,BHP Billiton (a globalresources and miningcompany) has an advantageoversmallerminingoperatorsbecause it has more capitalthat it can use to developlarge mines. Competitorswithlesscapitalarelimitedinthe types of mines they can

develop.

CompetingonserviceIf companies compete basedonservice, thecompanywitha stronger, more ingrainedcustomer service culture willhaveanadvantage.Therefore,you should focus onunderstanding the reasonswhy one business has bettercustomerservicethananotherandwhether that canchange.

For example, if a newmanagement team takes overa company that has poorcustomer service and if theymake improvements, theymay be able to gain marketshare from a dominantcompetitor.

CompetingonpriceYouneed todetermine if thecompetitors within anindustry have to constantly

match each other based onprice.Ifso, thebusinessmayhave a difficult timeincreasing its margins orearnings, as increases inmargins will need to comefromcostcutswhichbecomemore and more difficult toachieve.

CompetingbycopyingBe cautious investing inbusinesses whose

managementteamsattempttoreplicate the success of acompetitor’s breakthroughproducts or profitablebusiness lines. Whenevercompetitorsattempttomeetacompetitor head on byentering the same businessline where a competitor hasanadvantage,thereisrisk.For example, Stanley

O’Neal, former head ofMerrillLynch,wasknownto

be obsessed with hiscompetitors and madederivative trading a prioritybecause it was generating somuch profit for hiscompetitors, includingGoldman Sachs. O’Neal’sgoal was to increase profitsthroughtheseexoticproducts;however, he did notunderstandtherisksinvolved,which eventually destroyedMerrillLynch.19,20

In contrast, JohnMcFarland, CEO of electric-motor manufacturer BaldorElectric Company, once toldmehedidnotworryabouthiscompetitors, nor did heattempttotrackthemorcopythem. Instead, he asked hiscustomers which productsthey liked.He explained thatif he spent his time trackingcompetitors, he might betempted to incorporate some

of their changes into hismotor designs, and then laterlearn that the customers didnot value these changes. Itwas better to let customerinput drive his decisionmaking,insteadofcompetitorinput.

HowFiercelyDoBusinessesCompete?Thedegreeofcompetition,or

how fiercely competitorscompete,candependonsuchfactors as whether thecompetitorsareroughlyequalin size or whether theindustry is growing ormature. If competitors arenumerous and roughly equalin size, then it will be anintensely competitiveindustry, such as the check-cashing industry. In theseenvironments, there is

typicallynoindustryleader.In contrast, for industries

with only a few strongplayers controlling themarket, these market leadershold an advantage, simplybecause of their size. Forexample:

Home Depot can offerlower prices on itsproducts to customersbecause it oftenrepresents a large

percentage of the salesforitssuppliers.Philip Morris, maker ofMarlboro cigarettes, isable to get more shelfspace compared to itscompetitors.The Coca-ColaCompany can investmore in advertising toincrease brandawareness.Amazon.com has the

resources to invest inmore efficientdistribution and Webpagedesign.

In growing industries,competition is generally lessfierce.When industrygrowthbegins to slow, competitorsfightformarketshareand,insome instances, will changetheway they compete.Therehave beenmany instances inwhich two large, dominant

competitorshaveenteredintopricewars.For example, when Roger

Enrico became PepsiCo’sCEO in 1996, he started aprice war with The Coca-Cola Company that lasteduntil 1998. As he tried toboost volume and increasemarket share, the price of atwo-liter bottle of Coke orPepsi sold for as little as 59cents, compared to prices of

$1 before the price warbegan.21Insteadofcompetingbased on marketing, Cokeand Pepsi were competingbased on price. When theprice war ended, volumes atboth businesses droppedbecause consumers,accustomed to the lowerprices, decreasedconsumption.Sometimes competitors

become irrational in the way

theycompetewitheachother,evenfollowingstrategies thatlose money in order to gainmarket share. You need todetermine if this is atemporary phenomenon or along-lasting trend. If youidentify a temporary changein the way businesses arecompeting, you can oftenprofit.For example, in 2007,

Blockbuster launched its

Total Access (TA) DVD-by-mail program to competewith its rival Netflix.Blockbuster decided to cutthe price of its program byseveral dollars a month toundercut Netflix’s pricing.Blockbuster quicklyaccumulated more than 2.2million customers, andNetflix lost 50,000 of itssubscribers. The stock priceof Netflix dropped to under

$17 per share, which wasnear its IPOpriceof$15pershare five years earlier, in2002.However, if you had spent

some time reviewingBlockbuster’s financialstatement, you would havelearned that it had a lot ofdebt and that it was losingmoney on its stores. TheTAprogram was also losingmoney because it was

designedtogainmarketshareinstead of generate profits.Youwould have learned thatBlockbuster’s strategy wasnot sustainable and that atsome point, itwould have tostop under-pricing Netflix.WhenBlockbusterwasforcedto raise its prices, it quicklylosttheadvantageithadoverNetflix. Netflix’s stock priceincreased to more than $175per share at the end of 2010

(from$17persharewhentheprice war began), whereasBlockbuster’s stock declinedfrom over $6 per share in2007to$0.16pershareattheendof2010.22

There are also financialmetrics you can monitor tounderstand if an industry isbecoming more competitive.Thiswillalertyouthatfutureearnings may drop,decreasing the value of the

business you are analyzing.Taketotalcostsanddividebythe number of customers,transactions, or anothermetric. Track the resultingratio of operating cost percustomer or operating costper transaction. Is itdecreasing or increasing formostofthecompetitorsintheindustry?Asmarketsbecomemore competitive, costs tendtoincrease.

Forexample, thecustomer-acquisition costs of wirelesstelecom businesses havegradually increased over theyears as more competitorshave entered the market andexisting competitors try toincrease their market share.As a result, many of thesewirelesstelecomcarriershavehad to invest in customersupport, marketing, andincreased commissions to

sign up new customers andretain existing customers.Therefore, if you hadmonitored the customer-acquisition costs forcompetitors in the wirelesstelecom industry, you wouldhave seen that the wirelesstelephone business wasbecomingmorecompetitive.Togetmoreinsightintothe

reasons for differences inprofitability, read articles

abouttheindustry.Searchforarticles using search termssuch as “auto industryprofitability”tolocatearticlesthatarewrittenabouthowtheprofits of an industry orcertain businesses arechangingovertimeand,moreimportant, the reasons forthesechanges.

WhatRisksDoesthe

BusinessFacefromSubstituteProducts?Be careful not to define thecompetition too narrowly byconsidering only directcompetitors. You must alsoconsider the risks fromsubstitute products. Asubstitute product or serviceperformsthesamefunctionasthebusiness’scurrentproductor service but by a different

means. For example, plasticis a substitute for aluminum,and e-mail is a substitute forexpress mail. Sometimes,substitute products can beextremely different from theexisting product or service.For example, for a Father’sDay gift, power tools mayserve as a substitute for anecktie. The threat ofsubstitute products is high ifthey can offer the customer

an attractive price orperformance tradeoff to thecurrent industry product orservice. Here are a fewexamples:

International callingcards suffered whenlow-cost Internet-basedservice Skype enteredthemarket.Advancements in digitalphotography replacedthe duopoly on

traditional film thatKodak and Fuji had.KodakandFujitooktoolong to transition to thenewdigitalmedium andtherefore lost significantmarketshare.

There are certain types ofbusinesses that are currentlyimmunefromthecompetitivethreatsofsubstituteproducts.For example, there are notany cost-effective substitute

productsforcement.Youcanbuild a house with steel, butthis is not cost effectivecomparedtousingcement.Sometypesofproductsand

services are immune fromsubstitute products for longperiodsoftimeandothersforshort periods of time. Forexample, the U.S. PostalService dominated thetransmission of mail fordecades in theUnited States,

bute-mailevolvedtobecomea substitute product.Typically, the more asset-intensive a business is, theless threat it has fromsubstitute products: Forexample, think of airplanemanufacturer Boeing,chemical firm DowChemical, and cementproducer CEMEX. Althoughsubstitutesmaybedevelopedin any industry, these

businesses have longerperiodsofimmunity.

CanCompetitionfromLow-Cost

CountriesImpacttheBusiness?

As economies become moreinterconnected, businessesface more competition fromforeign competitors. Youneed to determine if a

business is threatened byforeign competition.Generally, items that cannotbeshippedlongdistancesarenot subject to foreigncompetition.For example, plastic parts

for automobiles can’t beshipped long distancesbecause they scratch easily,so there is less foreigncompetition. Rock quarriesalso face little or no

competition from foreignbusinesses because it isextremely expensive to shipaggregates overseas. On theother hand, manufacturingfirms where labor is a largecomponent of the productcostfacethreatsfromforeigncompetition.For instance, Pillowtex (a

manufacturer of pillows,comforters, and towels) had$500millioninsalesin1995.

In 1994, the United Statesbegan tophaseoutquotasonimports.Itscompetitorsknewthey would face extremeprice competition fromforeign markets, and theyimmediately began tooutsourcetheirmanufacturingto developing countries.Pillowtex, however, acquiredmore businesses, hoping tocapture a cost advantagethrough economies of scale;

in fact, in its 1998 10-K,Pillowtexreported that ithadspent $240 million on newmachinery at its U.S. plants.By 2003, Pillowtex wasliquidated as foreigncompetitorsdestroyedpricingwithin the industry.23Investors had eight years toexit their investment inPillowtex before it wentbankrupt. They should haveseen thatPillowtexcouldnot

compete with countries withlower-costlabor.

WhichCompetitorSetstheIndustry

Standard?Making comparisons is avaluable tool to help youunderstand the differencesbetweencompetitors.Alwaystrytolocatethebestbusinessintheindustrybyfindingthe

businesses with the highestoperating margins, highestreturnsoncapital,andlowestcash-conversioncycle.Createa spreadsheet comparing thefinancial and operatingmetrics of the variouspubliclytradedcompetitorstohelp guide you. If a businessis a subsidiary of anotherbusiness, you might be ableto get only the revenues andoperatingincomeinformation

for that business in theSegmentssectionofthe10-K.Also,youwill notbeable toget information from privatecompetitors, but you canoften turn to industry tradeassociations, which mightcompile a range of profitmarginsforanindustry.Notethe differences in thefinancial metrics betweencompetitors. You can oftenlearnmore about the reasons

for these differences in theManagement,Discussion,andAnalysis (MD&A) sectionfoundinthe10-K.For example, Table 4.2

compares the net incomemargin of various freightforwarders.

Table4.2ComparisonofNetIncomeMarginforSeveralFreight-ForwardingCompanies

As you can see, UTiWorldwide has historicallyearnedanaveragenetincomemargin of 2 percent since2005.24 By comparison,Expeditors International hasearned net income marginsbetween4and5percentsince

2005.25 By reading theMD&Asectionforboththesecompetitors, you will learnthat the main reason for thedifference in margins is dueto UTi’s historical growth-through-acquisitions model,compared to Expeditor’smore efficient practice ofgrowing organically orbuildingnewofficesfromthegroundup.Youcanconcludethat growing organicallywill

create more value thanacquiring competitors forgrowth within the freight-forwardingindustry.As you learn more about

each competitor’s strengthsand weaknesses, you canbegin to construct an idealbusiness using eachcompetitor’s strengths. Youcan then use this idealbusiness to makecomparisons to help you

understand the differencesbetween thebusinessyouareanalyzing and the idealbusiness. For example, whenmy firm was researching arefinery business, weidentified three factors thatcombine to create the idealrefiningbusiness:

1. First, protectedwholesale and retailmarkets are importantbecause they ensure that

demand for refinedproducts will continue toexceed supply. In a high-demand/low-supplywholesale market, it iseasier to pass along costsand protect margins.Generallyspeaking,intheUnited States, the eastcoast is highlycompetitive. Bycomparison, the westcoasthasmoredemandin

relation to supply. Onereason for this is thatrefineriesinCaliforniaareprotected by stringentenvironmental policiesthatrestrictnewrefineriesbeing built. This meansthatgaspriceswilltendtobe higher on the westcoastcomparedtotheeastcoast.2.Second,thebiggestcostcomponent in producing

gasoline or heating oil orrefined products is thecost of crude oil. Theabilitytoprocessmultipletypes of crude oilgenerally lowers costs.Compare the averageprice paid per barrel ofcrude oil across differentrefineriestoidentifythoserefineries with low crudecosts.3. Third, plant size is

important because thelargertherefiningplantis,themoreitcanspreadoutits fixed costs. Labor ismostly a fixed cost in arefinery because it takesonly a few employees torun the refinery, andgenerally speaking, youneed the same number ofemployees whether theplant is large or small orrunning at minimal or

optimal capacity.Therefore, the larger therefinery, the moreprofitableitwillbe.

Once you have constructedthe ideal refinery, you canthencomparetherefineryyouare evaluating to the idealrefinery and learn where itsstrengthsandweaknesses lie.Forexample,itmayhighlightthat the refinery you areinterested in cannot process

multipletypesofcrudeoil,soyou know that it is at acompetitive disadvantage torefineriesthatcan.

WhyHaveCompetitorsFailedinanIndustry?

Search for articles writtenabout why competitors havefailed in the industry. Youwill gain great insights into

flawed strategies oroperationalmissteps.For example, in 2005, a

refinery owned by BritishPetroleum (BP) exploded,killing 15 workers andinjuring more than 170others.Costcuttingandalaxsafety culture were to blamefor the explosion at TexasCity, according to a reportissued by the ChemicalSafety and Hazard

InvestigationBoard,afederalagency. “I don’t think I’veever seenanything thatbad,”said Carolyn Merritt, formerchairwoman of the board.BritishPetroleumalsohadoilspills fromBP’spipelinesonAlaska’s North Slope, whichcost it billions of dollars inprofits.26

Fast forward a few yearslater, andBPwasonceagaininvolved in an accident, the

largest marine oil spill inhistory at one of its offshoreoil wells in the Gulf ofMexico. Because BP hadcontinually cut costs and didnot comply withenvironmental and safetyregulations, it was only amatter of time until a newaccident occurred. Bystudyingoil-industryfailures,you would have learned thatoneof thebiggest risks toan

oil and gas firm comes fromhavinglaxsafetystandards.

20.Whattypeofrelationshipdoesthebusinesshavewithitssuppliers?

You need to determine the

type of relationship abusiness has with itssuppliers. Does the businesshaveahostilerelationship, inwhich it isconstantly findingways to pay suppliers lowerprices for their goods orservices? Or does it have agood relationship, where ithelps suppliers innovate newproducts and services for thebenefit of the business’scustomers?

Investors often believe thatabusinessneedstoconstantlynegotiate lower prices fromits suppliers in order toincreaseearnings.Theyfailtorecognize that if thesebusinesses continually takeadvantage of their suppliers,the suppliers will eventuallygo out of business. Thebusiness will then need tofindnewsuppliers,disruptingits supply chain, and

ultimately decreasingearnings. Instead, if there istrust between the suppliersand the business, then this isoften a competitive strength,because good supplierrelationships facilitate theflowofgoods.J.C. Penney thinks long

term about its vendors andnegotiates contract terms thatare favorable to both itselfand its suppliers. The Wall

Street Journal quoted DarcieBrossartofJ.C.Penney,“Wedon’t view squeezing ourvendorstoprotectourbottomline as a viable long-termstrategy.”Inthesamearticle,representatives from Macy’sandDillard’sdidnotwant tocommentabouttheirdealingswith vendors.27 It seemslikely that if Macy’s andDillard’s had good vendorrelations, they would have

communicated openly aboutthat, in order to encouragemore suppliers to work withthem.Similarly, dollar-store

retailer 99 Cent Only Storesmaintainsgoodrelationswithits suppliers, becausemanagement believes thismakesforgoodbusiness.Theretailer pays its suppliersquickly and has nevercancelledapurchaseorder in

thehistoryofthecompany.Ittreats suppliers as if theirroles were reversed, and 99Cent Only Stores were theonesdoingthedelivering.Bytreating its suppliers fairly,the retailer is able to build alot of goodwill with itssuppliers. As a result,manufacturers of productsprefer to sell their excessinventory to 99 Cent OnlyStores, rather than to other

retailers. This gives 99 CentOnly Stores a competitiveadvantageandallowsittosellproductsatlowerprices.The following questions

should help you learn moreabout the suppliers of abusiness and whether abusiness has good supplierrelationships.

Does the business havereliable sources ofsupply?

Does the business helpthesuppliersinnovatebyproviding them withcustomerfeedback?Is the businessdependentononlyafewsuppliers?Is the businessdependent oncommodity resources,andtowhatdegree?

DoestheBusiness

HaveReliableSourcesofSupply?

If a business does not havereliable sources of supply,then it will generate morevolatileearnings.Youneedtodetermine how a business iscreating reliable sources ofsupply and the risks to thosesources.One of Nestlé S.A.’s

fastest-growing divisions is

Nespresso, which has grown30 percent annually since2000. The Nespresso systemcombines single-use coffeecapsules with an espressomachine, which makes thespecialty coffee easy toprepare.ThebiggestproblemNestlé S.A. encountered wasin obtaining reliable sourcesofspecializedcoffeesbecausemost coffees are grown bysmall farmers in

impoverished rural areas. Toensure a steady source ofsupply from what was anunreliablesource,NestléS.A.worked with these smallfarmers,providing themwithtools and advice (e.g., onfarming practices, helpingthem obtain pesticides andfertilizers)tohelpthemcreatemoresuccessfulcrops.Astheproductionqualityfromthesesmall farmers improved, this

increased the reliable supplyof specialized coffee beansforNestlé.28

SupplyChainManagement

Supply chain management isthe process of matchingdemand for products withsupply. This includesdetermining the amount ofinventory to carry, handling

product returns, anddistributing products. If youare evaluating a business,such as a fashion or onlineretailer (e.g., Amazon.com),itisimperativethatyoulearnhow it manages its supplychain.Youneedtodetermineif the sources of supply arestable and if the quality isconsistent. For example, inthe late 2000s, there havebeen several prominent toy

recalls related to the safetyand quality of supplierproducts.Ideally, you want to know

how quickly a supply chaincan adapt to changingbusiness conditions. Forexample, what if a supplierruns out of product? Whatdoes the business do? Youcanoftenfindarticleswrittenabout the supply chain of abusinessorinterviewswritten

about supply chainmanagersin trade journals. Forexample,hereareafewtradepublications for operationsand logistics managementprofessionals:

DCVelocityCommercial CarrierJournalSupply&DemandChainExecutiveSupplyChainDigestWorld Trade Logistics

JournalLogisticsTodaySupply ChainManagementReviewLogisticsManagement

There are many articles inthese publications that havebeen written about Li &Fung, Toyota, Starbucks,Nike, and Wal-Mart—all ofwhich have strong supplychains.As you study a business’s

supply chain, consider howefficient it is.Oneway todothis is to calculate inventoryturnover,whichmeasures thenumber of times inventory issoldinayear.Tocalculateit,take cost of goods sold anddivideitbyaverageinventoryfortheyear.For example, from1995 to

2010,Wal-Mart improved itsinventory turns from 5.23times to eight times. This

meant it was able to turn itsinventory over faster.29 Incontrast, the inventory turnsfor its competitor SearsHoldingswentfrom3.2timesin1995to2.9timesin2010,aindicating deterioration intheir inventory-turnover andsupplychaincapabilities.

DoestheBusinessHelptheSuppliers

InnovatebyProvidingThemwithCustomerFeedback?Inthe1990s,GeneralMotors’warranty costs were higherthan its profits. One of thereasons for this is that GMwas more concerned withdriving down its costs thanwith seeking improvementsfromitssuppliers.Incontrast,Chrysler provided customer

feedback to its suppliers tohelp them develop newfeatures that required fewerrepairs and less frequentreplacement.Byseekingnewinnovations through itssupply chain, Chrysler wasable to take market sharefrom GM.30 You can findsuch information simply bysearching for articles that arewritten about supplierrelationships by combining

search terms such as“supplier”and“[thecompanyinwhichyouareinterested].”

IstheBusinessDependentonOnlya

FewSuppliers?You need to determine thepotential risks for a businessif it depends on only a fewsuppliers. If a supplierrepresents more than 10

percent of net sales for abusiness, that company willoftendisclose this risk in the10-K.For example, the 2010

PetSmart 10-K discloses thatsales from its two largestvendors approximated 22.4percentofnetsalesfor2009.You would need to monitorthese two vendors to learnwhether they are vulnerableto supply disruptions. Read

historical articles to learnmore about these twovendors, andmonitor articleswrittenaboutthesebusinessestolearniftheyarehavinganydifficulties.Forexample,onevendor sources most of itsrawmaterials fromChina, soyouwouldneedtounderstandif there is a risk that it willnot be able to obtain thesematerials. Thiswill alert youto the potential risk that the

salesofPetSmartmaydropifit is having difficultyobtaininginventory.

IstheBusinessDependentonCommodity

Resources,andtoWhatDegree?

If a business depends oncertain commodities to

manufacture its products,monitor those commodityprices. This will help you tounderstand whether risingcommodity prices may forcethe business to increaseprices, which can decreaseprofits if a business is notable to pass along priceincreases to customers. Onthe other hand, if the cost ofsuppliesdecreases,abusinesscaneitherearnahigherprofit

margin or decrease prices toincreasesales.You need to follow the

price of the underlyingcommodity closely so youcan determine whetherearnings will increase ordecrease.Forexample,ifyouareanalyzingapparelmakers,thenyoumustmonitorcottonprices to understand if thecosts will increase. If theapparel maker is not able to

pass on these higher costs toits customers, then it willresultinlowerprofits.Those businesses that are

highly dependent oncommodity resources—suchas oil, steel, or chemicals—are difficult to forecastbecause you must assume acertain price for thecommodityinthefuture.Thisincreases the risk that youwill be wrong in your

valuation of the business.Youareessentiallybettingonone direction of the price ofthe commodity for yourinvestmenttoworkout.Somebusinesses will hedge theirexposure to a commodityprice, which can give yougreater visibility, but oftenthesehedgesareshortterm.For example, Southwest

Airlines CEO Gary Kellytalked about how much

commodity prices affectedthe airline industry saying,“Volatility in fuel prices isthe industry’s No. 1challenge.Allyouhavetodoislookbackatthelastdecadeto see what kind of havoc itwreaks on our industry. It isthe single biggest threat toaviation.” When oil pricesincreased to $145 a barrel,airlineswereforcedtogroundhundreds of planes, drop

routes, and cut thousands ofjobs.31

KeyPointstoKeepinMindEvaluatetheBusiness’sCompetitiveAdvantages

The moresustainable

thecompetitiveadvantage,the more abusiness isworthbecause itcan protectitsprofitabilityoveralongerperiod oftime.Competitiveadvantagesadd themostvalue to a

business thathas lots ofreinvestmentopportunitieswithin thatadvantage.Competitiveadvantagesexpire. Evenwhen abusinessappears mostformidableandgeneratesthe strongestfinancialmetrics, it

canbeontheverge offailure.Competitiveadvantagesare lesssustainablewhen theyare affectedby changesintechnologyor if theyarein rapidlyemergingindustries.Changes in

technologythreaten acompetitiveadvantagewhen theyexpandcustomerchoice,whether byoffering thesameproductforlessorbyofferinggreaterbenefits forthe samepriceorless.

The greatestgains in astock areusuallymadeas a businessisdevelopingitscompetitiveadvantagerather thanafter italready hasdevelopedone.Do notconfuse acompetitive

strength or abusiness thatis successfulbecause it isin the rightplace at theright timewithhavingacompetitiveadvantage.

AssesstheBusiness’s

PricingPowerBusinessesthat have

pricingpowertypicallyhave severalcharacteristicsin commonsuch as highcustomer-retentionrates; theircustomersspendasmallpercentageoftheir budgeton thebusiness’sproduct or

service; thecustomersgeneratehighmargins andlots of cashflow; or thequalityoftheproduct ismoreimportant tothe customerthan theprice.One of thebest methodsfordetermining

whether abusiness haspricingpower is tomonitor thereasons forincreases ordecreases inthe grossmargin.If thebusinessdoes notdisclosepriceincreases,then it ishighly

probable thebusinessdoes nothave pricingpower.Priceincreasesaddvalue to thebusinesswhen theyadd tooperatingincome,rather thanjustoffsettingnew

expenses.

ConsidertheHealthoftheIndustryasa

WholeInvesting inthe rightindustry isimportantbecause alarge part ofyourpotential rateof return is

oftenattributableto theindustry youare investedin, asopposed to aspecificcompanyyouare investedin.By makingcomparisonsbetween thebest andworstcompanies in

an industry,you willidentify thereasons whythe industryis good orbadtobein.Theprofitabilityof a businesswilleventuallytrend towardthe mean ofthe industryas it isdifficult for

any businesstooutperformthe industryfor a longperiod oftime.Understandinghow anindustryevolved willhelp youevaluate thebusiness inthe contextof itscompetition,

its operatingenvironment,and variousother forcesthatshapeit.

AssesstheBusiness’sCompetition

Competitiondoes notincrease thevalue of abusiness.Generally,more

competitionmeans morecustomerchoice andlessprofitability.In growingindustries,competitionis generallyless fierce.Whenindustrygrowthbegins toslow,competitors

fight formarket shareand, in someinstances,will changethe way theycompete.If customer-acquisitioncosts areincreasingthen abusiness isfacing morecompetition.Abusinessisnot

threatenedbyforeigncompetitionif itsproductscannot beshipped longdistances,butif labor is alargecomponentof theproduct cost,then thebusiness willface threatsfrom foreign

competition.

EvaluatetheBusiness’sRelationshipwithItsSuppliers

Goodsupplierrelationshipsfacilitate theflow ofgoods. If abusiness

does nothave reliablesources ofsupply, thenit willgeneratemore volatileearnings.If theinventory-turnoverratiois increasingover time,then this isan indicatorthat thebusiness’s

supply chainis becomingmoreefficient.A businesswith adiversifiedsuppliernetwork hasless risk thanonedependentononly a fewsuppliers.Thosebusinessesthat are

highlydependentoncommodityresources—such as oil,steel, orchemicals—are difficultto forecastbecause youmust assumea certainprice for thecommodityinthefuture.

aNote that in 2004, Sears

merged with K-Mart;therefore, later yearsincludeK-Martresults.1.Author’sinterviewwithPatDorsey,March31,2011.2.WesternUnion200910-KandMoneyGramInternational200910-K.3.Evans,DavidS.,andRichardSchmalensee,PayingwithPlastic:TheDigitalRevolutionin

BuyingandBorrowing,2nded.CambridgeMA:MITPress,2005.4.comScoreMediaMetrix(U.S.data).5.Cardona,MercedesM.“AffluentShoppersLiketheirLuxeGoodsCheap.”AdvertisingAge,December1,2003.6.Blackhurst,Chris.“LaBelleMaison.”TheEveningStandard,May25,2010.

7.Standard&Poor’sCapitalIQ.8.“StoreBrandsSurge.”MMR27(2010):115.9.“PrivateLabelontheAttack.”BlackBook—U.S.HouseholdandPersonalProducts,August2009.10.LeVine,Steve.“IBMPilesUpPatents,ButQuantityIsn’tKing,“BusinessWeek,January25,2010.

11.Freedman,David.“Relax.LetYourGuardDown.WhyPatents,Trademarks,andOtherIntellectualPropertyProtectionsareBadforBusiness.”Inc.,August2006,pp.109–111.12.Blackboard200910-K.13.AmericanApparelandFootwearAssociation.ShoeStats,2008.AccessedMay11,2011.

http://www.apparelandfootwear.org14.Wubbe,Eileen.“TSLProfile.”SecuredLender,September2010,pp.39.15.2004FourSeasonsAnnualReportandTimeValueofMoney,LPinterviewswithFourSeasonsmanagement.16.Standard&Poor’sCapitalIQ.17.Ibid.18.Ibid.

19.Steinberg,RichardM.“MerrillLynchFailedatERM,andThenJustFailed.”ComplianceWeek,August2009,pp.42–43.20.Verschoor,CurtisC.“WhoShouldBeBlamedtheMostfortheSubprimeLoanScandal?”StrategicFinance,December2007,pp.11–12.21.Tobin,Edward.“ColaWarsSoldiersMarch

TowardMarketingBattle.”ReutersNews,November22,1999;“CanadianBeverageFirmCottCan’tFindBuyerAmidPricingPressures.”DowJonesOnlineNews,April24,1998.22.Standard&Poor’sCapitalIQ;Steverman,Ben.“NetflixBattlewithBlockbusterGetsUgly.”BusinessWeek,July24,

2007.23.Carroll,PaulB.,andChunkaMui.“7WaystoFailBig:LessonsfromtheMostInexcusableBusinessFailuresofthePast25Years.”HarvardBusinessReview,September2008.24.Standard&Poor’sCapitalIQ.25.Ibid.26.Dalton,Matthew.“RiskstoBPRevivalCenterin

U.S.”WallStreetJournal,January2,2008.27.Talley,Karen.“Retailers,SuppliersTussle.”WallStreetJournal,February11,2009.28.Porter,MichaelE.,andMarkR.Kramer.“CreatingSharedValue”HarvardBusinessReview,January–February2011.29.Standard&Poor’sCapitalIQ.

30.Hoover,Sandra,andSaulBromberger.“SupplyChainChallenges:BuildingRelationships.”HarvardBusinessReview,July2003,p.70.31.Schlangenstein,Mary,andMaryJaneCredeur.“HigherU.S.AirfaresLoomasOilClimbsToward$100.”BloombergNews,December22,2010.

CHAPTER5

MeasuringtheOperatingand

FinancialHealthoftheBusiness

After you’ve assessed the

environment, industry, andcompetitive framework(covered inChapter4) that abusiness is operating in, youwant to focus on evaluatingthe company itself.Essentially, you want tounderstand whether thecompany isoperationallyandfinancially healthy. Thischapterstartsbyshowingyouhow to review a company’sfundamentalsandthenhowto

measure its basicperformance, using operatingmetrics. Operating metricsindicate improvement ordeterioration of the businessandallowyoutocomparethecompany toothercompanies.We’ll look at detailedexamples from a couple ofindustries and then walkthrough the process offiguring out which operatingmetricsmattermost,andhow

to find, track, and analyzethem.As we move beyond basic

operational performance, thischapterwillexploretheotherfactors that affect businessfunction and health. As welookatrisk,inflation,balancesheet issues, and debt, I’llfocus on giving you tools toidentify and evaluate theproblems that are specific tothe business you are

considering investing in. Forexample, as we look atinflation, I’ll show youcharacteristics of businessesthathave less toworryaboutwheninflationrises.Finally, we will look at a

general measure of businessquality by seeing how wellthe business generates areturnon themoney investedin it (ROIC). I’ll show youwhat ROIC is, how to

calculate it, and where itmatters most. Each of thesections in this chapter isdesigned to enhance yourability to recognizeopportunities and avoidinvestment errors as youstudyindividualcompanies.

21.Whatarethe

fundamentalsofthebusiness?

Fundamentals are the basicthings a business must do inorder to be successful: forexample, an express deliverycompanyhastodeliverthingson time; restaurants have toserve good food. Think ofthese as the blocking andtackling functions of thebusiness.

Fundamentalsalsodrivethevalue of the business. Saidanother way, the better acompany executes its mostimportant basic operations,the more valuable it is. Forexample, at a for-profituniversity, it is thequalityofthe academic faculty thatcreates employable students.In turn, employable studentscreate demand for the for-profit university’s services,

which increases the overallvalue of the for-profituniversity. Here’s anotherexample: High employeeproductivity helps SouthwestAirlines succeed, becausethat’showitkeepsfareslow,which increases the value oftheairline.Determine whether the

management teamunderstands what increasesthevalueof thebusinessand

whether that shapes theiractions. If managementdeviatesfromthese,thenitislikelythatprofitswilldecline.Forexample:

Jeff Bezos, founder ofonline retailerAmazon.com, focuseson continuallyenhancing the customerexperiencebydeliveringorders in a timelymanner and offering

more products in orderto enlarge thecompetitiveadvantage.Larry Page and SergeyBrin, founders ofInternet search businessGoogle, focus on“organizing the world’sinformation and makingitaccessible.”Christina Gold, formerCEOofWesternUnion,focused on tying up the

most desirable agents inthe world in long-termcontracts and thendriving traffic to them.Agents aresupermarkets, banks, orretail chains that offerWestern Union’sservices.Robert Silberman, CEOof Strayer Education,focuses on academicquality, which drives

goodstudentoutcomes.Michael Bloomberg,founder of Bloomberg,focused on giving hiscompany’s customers“the information theyneed—no matter whatthe information is—where and when theyneedit,inwhateverformismostappropriate.”

Ineachofthesecases,therearespecificoutcomesyoucan

identify and evaluate tounderstand if the company issuccessfully executing itsfundamental operations. Youcanmeasureandtrackeachofthese: food quality orcustomer satisfaction, rate ofon-time deliveries, employeeproductivity, graduateemployment, or facultyquality. If a fundamental isdeteriorating, then the valueofthebusinesswillaswell.If

a fundamental is steady orimproving, you can havemore confidence in thebusiness’sunderlyingvalue.Watch for those managers

whochase toomany ideasorhave continually changingvision statements. This candistract them from focusingon fundamentals. Beforecompany founder HowardSchultz returned toStarbucksin2008,thecompanypursued

toomanynewideasthatwerenot central to their success.From March 31, 2005, untilthe time Shultz returned,Starbuck’s stock pricedeclined from $26 per shareto $19.86 per share.1 WhenSchultz returned as CEO, herefocusedthecompanyonthemost important projects,canceling the ones that wereless relevant to the corebusiness. Schultz took out

sandwiches that interferedwiththearomaofcoffee,andpulled the plug on productslike Mazagran, a soft drinkthe company made withPepsi.Healsotookoutsomeof the in-store products suchasbooksandCDs.2Starbucksreturned its focus toproviding quality products inan inviting atmosphere, withexceptionalcustomerservice.The stock price increased

from $19.86 per share whenSchultz tookoveronJanuary8, 2008, to $32.48 per shareonJanuary4,2011.3

As an investor, identifyingand tracking fundamentalsputs you in position to morequicklyevaluateabusiness.Ifyou already understand themost critical measures of acompany’soperationalhealth,youwillbebetterequippedtoevaluate unexpected changes

in thebusinessor theoutsideenvironment. Such changesoften present buyingopportunities if they affectthepriceinvestorsarewillingtopay forabusinesswithoutaffecting the fundamentalsofthe business. Being able torecognize deterioratingfundamentals is equallybeneficial, as you can avoidinvestment mistakes. If anegative news announcement

causes the stockpriceofoneof your holdings to drop,always ask, “What impactdoes the announcement haveon the fundamentals of thebusiness?”For example, in the past, I

invested in money-management firm W.P.Stewart.Thefundamentalsofa money-management firminclude acquiring andretaining accounts. Certain

accounts, called stickyaccounts, have more of along-term relationshipwith amoney manager and tend tostickwiththefirmevenwhenthe firm’s funds areunderperforming. Therefore,every time I listened toW.P.Stewart’s conference calls ormonitored news releases, Iwatched for any informationthat might indicate that theiraccounts were no longer

sticky. On one conferencecall,W.P.Stewart’smanagersindicated that a largepercentage of their accountshad shifted to consultant-related accounts. With theseaccounts, an intermediarydetermines whether tocontinue to invest in amoney-management firm.These accounts are lesssticky. I evaluated thisdeteriorating fundamental,

andsoldthestock.Thestockdropped 80 percent over thenext few quarters as theconsultant-related accountswithdrew assets at an evenfaster pace. By recognizingwhich fundamentals werecrucial to the value of thebusiness and by closelymonitoring them, I was ableto avoid an investmentmistake.

22.Whataretheoperatingmetricsofthe

businessthatyouneedtomonitor?The best way to monitorwhether the fundamentals ofa business are improving ordeteriorating is to measureand evaluate the operating

metrics of a business.Operating metrics aremeasuresthathelpyougaugethe true performance of theunderlying business, similartotakingyourbloodpressuretomonitoryourownpersonalhealth.You can begin to usethese metrics to learn aboutthebusiness,andthenasyougainin-depthknowledge,youcan use them to continuallymonitor the health of that

business,whichwillalertyouto potential problems. Youneedtodothefollowing:

Identifythemetricsforaparticularindustry.Research the sources ofmetrics.Monitorthemetricsovertime.Determine if changes inmetrics are lasting ortemporary.Compare the metrics of

the business you areanalyzing to those ofcompetitors and identifythe reasons for thedifferences.

The next sections covereachofthesetopicsindepth.

IdentifytheMetricsforaParticular

IndustryTodeterminewhichoperating

metrics are useful, firstidentify what you are tryingto measure. The type ofmetricyouusewilldependonthe industry or business youare analyzing. Below are afew of the most commonlyused operating metrics inseveralindustries:

Banks use efficiencyratio, return on assets,and average cost offunds.

Real estate usesoccupancy rate, rent persquarefoot,andcostpersquarefoot.Airlines use availableseat miles, load factor,traffic,andcapacity.Retailers use same-storesales, basket size, salesper square foot, andaverageticket.Internet firms useconversion rate and

trafficcounts.Subscription-type firmsuse number ofsubscribers, averagerevenue per subscriber,average cost persubscriber,andcustomerchurn.Creditcardfirmsusenetcharge-offs,delinquencies, andpaymentrates.Hotels use occupancy,

revenue per availableroom (RevPAR), andaverage daily rate(ADR).Gaming businesses useslot-win percentage,table-win percentage,and average daily winpertableperday(WPT).

Followingaremoredetailedexamples of two of themetricslistedthatyoucanuseas models for examining

metrics in many industries.Let’s examine each tounderstand what the metrictellsyou,howitiscalculated,andwhatitslimitationsare.

EfficiencyRatio(UsedbyBanks)Theefficiencyratioisdefinedas the ratio of noninterestexpense to total revenues. Itis used to indicate a bank’s

ability to control its expenselevels. The lower theefficiency ratio, the better abank is at controlling itsexpenses.Smallerbanks tendto have higher efficiencyratios compared to largerbanks, because larger bankscan spread their expensesover more products, andlarger banks tend to generatehigherearningsfromfees.Monitoring this key

banking ratio over anextendedperiodcanhelpyouunderstand the industry ingreater depth. In the early1990s,forexample,aratioof60 percent was considered agoodtargetforbanks.Bythelate 1990s, themost efficientbankshadratiosinthelowtomid 50 percent range.4 Theefficiency ratio reflects afundamental industry change(increase insizeand increase

infees)asbankscontinuedtoconsolidate through the1990s.

Same-StoreSales(UsedinRetail)If you are analyzing a retailbusiness, same-store sales isoneofthemetricsyouwouldlookattogaugethehealthofa retailer. Same-store salesare defined as the year-over-

yearsaleschangesforastorethathasbeenopenatleast12to 18 months. It helps youunderstand if stores aremaintaining their existinglevelofsalesor ifstoresalesare declining. If competitorsalesaregood,buttheretaileryou are studying hasdeclining same-store sales,theretaileryouareanalyzingislosingmarketshare.

ResearchtheSourcesofMetrics

Operating metrics areobtained from a variety ofsources, including theManagement,Discussion,andAnalysis (MD&A) sectionfound in the 10-K or 10-Q;industry primers and guidespublished for investorsanalyzing a certain industry;trade associations; company

press releases; and articleswritten about the business.Let’s look at each of thesesourcesinabitmoredetail.

10-Kand10-QReportsThe 10-K and 10-Q reportsare a great starting point foridentifying the key operatingmetrics of a business. In thebusiness description section,

look for the followinginformation:

NumberoftransactionsNumberofcustomersNumberoflocationsNumberofemployeesTotal square footage ofoperatinglocations

You can then take theseoperating numbers (such asthe number of transactions)and divide by revenues and

costs to calculate metricssuchasthese:

RevenuepertransactionCostpertransactionTransactions perlocation

IndustryPrimersUsefulsourcesforidentifyingthe operating metricstypicallyusedforanindustryare industry primers, such as

these:Reuters OperatingMetricsStandard & Poor’sIndustrySurveysFisher Investmentsguides

Theseareguideswrittenforanalysts who are researchingspecific industries. They areuseful because they explainhistorical trends in operatingmetrics, and provide detail

and additional informationthat helps you understandwhyachangeinametrictookplace.Suppose you were

researching telephonewireless carriers: Standard&Poor’s Industry Surveyexplains thatoneof themostimportant operating metricsfor these businesses isaverage revenue per user(ARPU).5Thereportgoeson

todescribehistoricalchangesinARPU.Forexample,inanatmosphere of heavycompetition for newcustomers, providers offeredprice cuts during the periodfrom 1987 to 1998. Thismade ARPU decline. Thereport also explains whyARPU rose after that, citingdata from the trade groupCTIA—The WirelessAssociation. This data

showed average localmonthly bills rising from$39.88 in June 1998 to$49.57 in June 2009. Theincreasewasdrivenbyhigherusage and data-relatedservices. The report furthernotesthatalthoughrateswentup after 1998, they’ve beenflat since 2003, mainlybecausevoiceusedeclinehasbeenoffsetbytheincreaseindatause.

InternetSearchandBooksA simple Internet search,usingtermssuchas“industrymetrics for [insert name ofindustry]”willhelpyoubeginto identify useful metrics.You can also search formetrics in accountingtextbooks and other bookswrittenaboutanindustry.

TradeAssociationsMany trade associations andtrade journals publishperiodicstatistics in theformofratios.Often, themembersof the trade association willsend in confidential financialand operating reports to thetrade association,which thencompiles them inan industrystudy.For example, the National

American Retail HardwareAssociationpublisheda2007report called the “Cost ofDoing Business Study,”which outlines the averageprofitandthehighestprofitofhardware stores, homecenters, and lumber/buildingmaterial outlets. These typesof surveys are useful whenyou are making comparisonsbecause you can benchmarkthe business you are

evaluatingtotheindustryandalso against the mostprofitable competitor. Manytimes, these reports willoutline the reasons why acertain business within anindustry has greaterprofitability.

MonitorMetricsoverTime

Monitor metrics over an

extended period of time,rather than drawingconclusions from a singleyear. Construct a simplespreadsheet to calculateoperating metrics on aquarterly or annual basis soyou can better understandtrends. Then identify thereasons for changes in thesemetrics period by period byreading the MD&A sectionfound in the 10-Q or 10-K

reports.For example, in the 2009

10-K report for restaurantbusinessCheesecakeFactory,management describes whycomparable sales decreased2.3 percent from the priorfiscalyear2008:We realized effectivemenu price increases ofapproximately1.2percentand0.8percentinthefirstand third quarters of

2009, respectively. Thedecrease in comparablesales for fiscal 2009wasdue to reduced traffic atourrestaurants,whichwebelieve was primarilydriven by themacroeconomic factorsaffecting the restaurantindustryingeneral.Write down all of the

reasons for the changes in aparticularoperatingmetricfor

at least a three- to five-yearperiod. By studying thereasonsbehindthechangesinthe operating metrics, youwill gain deeper insight intowhatfactorshavethegreatestimpact on the value of abusiness.For example, if sales drop,

identify why they aredropping, insteadof focusingon how much they dropped.When you identify which

factors have themost impacton a business, those are theoperatingmetricsyouwanttotrack most closely. Supposethe changes in the cost of aparticular raw materialgreatly affect costs, then youneed to track a relevantmetricforit,suchascostperton.

DetermineifChanges

inMetricsAreLastingorTemporary

Ultimately, you want todetermine whether thechanges in the metrics arelasting or temporary. Forexample, the most commonreasonforgainsinsame-storesales are increased customertraffic and higher pricing. Ifyou discover a decrease in

customer traffic, evaluate ifthis decrease is temporary orlasting.Forexample,extremeweather conditions generallycause a change in retailtraffic. This is a temporary,rather thanpermanent,effect.In contrast, increasedcompetition may be longlasting.

ComparingMetrics

amongCompetitorsYou need to determine thereason for the differences inmetrics among competitors.When comparing operatingmetricsofonebusiness to itscompetitors, make sure bothbusinessesareusingthesamemeasurement and accountingstandards.Forexample,whencomparing same-store salesgrowthoftworetailers,make

sure the same time periodsare used, such as 15 monthsversus12months.If you are comparing two

oil-exploration businesses,and they both use a metricsuch as finding costs perbarrel of oil, make sure theaccounting standards are thesame. (Finding costs reflecttheexpensesofsearchingfornew oil and gas reserves.)There are two very different

methods for calculatingfindingcostsunderGenerallyAccepted AccountingPrinciples (GAAP). Checkthe footnotes of the 10-K tomake sure the accountingmethodsusedtocalculatethemetrics are comparable andadjustthemiftheyarenot.

23.Whatare

thekeyrisksthebusinessfaces?

Businesses face differenttypes, frequencies, and levelsof risk. As an investor, youneed to evaluate how theserisksmayaffect thebusiness.The first place to start is the10-K, in a section titledRiskFactors, where managementdiscloses most of the knownrisks to the operations of the

business. The risk factorssection isbrokenup into twoparts:

1.Thefirstparthighlightsrisks that relate to thebusinessorindustry.2. The second parthighlights risks that relatetothestockprice.

Thefirstsetofrisksismoreuseful because it outlineswhat can go wrong with theoperations of the business,

whereas the second set ofrisks tends to be standardlegal language found in all10-Ks: for example, “thestockpricemayfluctuate.”Mostinvestorsreadthrough

thissectionfairlyquicklyanddo not take the time tounderstand thepotential risksofthebusiness.However,itisimportant for you to spendsometimeinthissectionandinvestigate whether the

business has encountered therisks listed in the past andwhat the consequenceswere.Thiswillhelpyouunderstandhow much impact each riskmayhave.You may also want to

reviewtheriskssectioninthe10-K of direct competitorsand look for risks that thebusiness may not havecovered. Trade associationswill often outline common

risks, and many articles arewritten on how to reducethem. This will help youbuild a comprehensivecollection of risks thebusinessmayencounter.Writedowntheoperational

risksyou find in the10-Korother sources in a report;these operational risks mightinclude:

OvercapacityCommoditization

DeregulationIncreased power amongsuppliersShiftsintechnologyChanges in laws andregulationsProductobsolescencePatentexpirationsDevelopment of newproduct lines where thebusiness has limitedexpertise

The emergence ofcompetitorsBranderosionOverreliance on too fewcustomersLimited geographicdistributionResearch anddevelopmentfailureBusiness-developmentfailureMerger or acquisition

failureAweakproductpipelineAndothers

Spend time carefullyreviewingeachoftheserisks.As you learn about thedifferentrisksabusinessmayencounter, use thisinformation to constructdownside scenarios for yourvaluation of the business.This helps you betterunderstand the threats to the

valueofthebusiness.Identifythose risks that have thegreatest impact on the valueofthebusiness.For example, if five

customers make up 70percentoftherevenuesofthebusiness,andifonecustomerwho represents 20 percent ofsales were to leave, whatimpactwouldthishaveonthefinancials of the business? Ifyou discover that losing the

customer might send thebusiness into bankruptcybecause the business has ahigh debt load, then youmightwanttoavoidinvestinginthatbusiness.You will learn that the

majority of the risks thebusiness will encounter areoutlined in the risk factorssection of the 10-K and thereasons a business will failare also disclosed. For

example,thoseinvestorswhocarefully read the riskssection in global financial-services firm LehmanBrothers’ 10-K avoidedinvesting in the company’sstock because they saw thatthose risks were beingmagnified as the financialcrisis began to unfold. Someinvestors even made moneybysellingthestockshort.Theshort sellers saw events

transpiring such ascounterparties refusing totrade with Lehman, whichincreasedtheirconvictionthatLehman could fail. Thereasons that Lehman failedare disclosed below, whichwerealsodisclosedinthe10-K:

1. The company’s capitalposition was severelyweakened by excessivetradinglosses

2. Counterparties stoppeddealing with Lehman asthey remained defensiveandshifted theiractivitiestomorestablecompetitors3. Lehman’s reputationwasintrouble4. Short-term securedcreditorsdidnothaveanyreason to continue torenew their loans toLehman5. Lehmanwas unable to

sell complex instrumentsbecause they weredifficulttovalue

By carefully studying theriskssection,youwillbeinabetterpositiontoevaluatethedownside in any potentialinvestment and learn moreabout the potential impact ofrisks on the earnings of thebusiness.As you read articles about

the business, look for

examples where the businessor its competitors haveencountered a particular riskbefore.Learnwhat happenedand what the financialimplicationswere.Forexample,whenmyfirm

invested in bond ratings firmMoody’sat less than$20pershare,thestockpricehadjustdropped frommore than $30per share because investorswereworriedaboutthemany

lawsuitsthatwerebeingfiledagainst Moody’s. Most oftheselawsuitswerefromstateattorney general offices andinstitutional investors whoclaimed thatMoody’s causedthem to lose money becausetheyreliedon their ratings tobuy bonds. Many of thesebonds that defaulted wererated AAA, which wasMoody’s highest rating.There were many newspaper

articles written about theselawsuits, and every time thenewspapers announced that anew lawsuit had been filed,thestockpricedropped.However,my firmwas not

as concerned as otherinvestors,because thereweremany past examples ofsimilar lawsuits filed againstMoody’s.Infact,someofthelawsuits even used the samelegal language that was used

inprevioussuits.Inonesuchcase, institutional investorsunsuccessfully suedMoody’sto recover money they lostinvesting in the municipaldebt of Orange County, atthat time the largestmunicipalbankruptcy inU.S.history. We used thisevidence of past legalprecedent to support ourinvestment thesis that thethreat from the lawsuits filed

againstMoody’swasweakerthaninvestorsperceived.

WhenEvaluatingOperationalRisks,AdopttheMentalityofanInsuranceUnderwriter

When thinking through risks,adopt an insuranceunderwriter’s mentality

instead of relying onsubjective measures. If youallow subjective measures topermeate your thinking, thensuch factors as prevalence inthe news might lead you tobelieve that a risk is greaterthan another.Most of us areafraid of risks that are newrather than thosewe’ve livedwithforawhile.For example, when

terrorists attacked the World

Trade Center on September11, the relative newness ofdomestic terrorism decreasedthe prices of many stocks.Investors believed that therewouldbemanymoreterroristattacks and that this was ariskthatmostbusinessesnowfaced.Thankfully, therewerenot any other major acts ofterrorism that resulted in lostlives or damaged properties.Just because an event has

occurred and the mediaconstantly discusses it doesnotmean that the actual riskis greater. Therefore, howmuch people discusssomething is a bad indicatorof actual risk. In fact, themorepeopletalkaboutarisk,themore likely that riskwillbemitigated.In contrast to popular

thinkingaboutrisk,insuranceunderwritersthinkintermsof

frequency (i.e., how often inthe past has the riskhappened?) and severity (i.e.,what is the financial cost?).Therefore, when you areidentifying operational risks,you should identify whethertheyarelow,medium,orhighforfrequencyandseverity.Onevaluablesourcetohelp

you identify the frequencyandseverityofpotentialrisksis insurance manuals written

for insurance underwriters,such as A.M. Best’sUnderwritingGuide.The jobof insurance underwriters istoidentifyalloftherisksinabusiness so that they canproperly price insurancecoverage.Thisguideprovidesdetailed descriptions andunderwriter’schecklistsofallthe key risks involved inrunning nearly 580commercial and industrial

classifications—fromadvertising agencies tobeverage distributors,clothing manufacturers, e-tailers, furniture stores,crushed-stone-miningcompanies, money-lendingbusinesses, wireless phonecarriers, and hundreds ofothertypesofbusinesses.Thelist of risks is thorough, andthe main risks a businessencountersarehighlighted.

HowDoYouMeasureRisk?

Riskdoesnotjustincludetheprobability that somethingmayhappen; inaddition,youhave to consider how severethe outcome might be. Themoreseveretheoutcome,thehigher the risk. For example,the threat of bankruptcy ismuch more severe than thethreatofhavingtopayafine

forviolatingalaw.It is very difficult to

measure risk because youneverknowwhatwillhappenfor sure ahead of time.Morethanoneoutcomecanoccur.Tohelpyouunderstandthe

potential financialimplicationsofacertain risk,look for past evidence. Useappropriate historical data,instead of making subjectiveestimates. Look to other

businesses that haveencountered a similar risk.For example, in Chapter 1,we looked at HeartlandPayment Systems, the credit-card transactions companythat had a security breach.Ahackerwasabletoobtainthecredit card information ofseveral merchants, andHeartlandwasresponsibleforpaying the cost of replacingthese stolen credit cards. A

similar case had settledrecentlyinvolvingretailersTJMaxx and Marshalls, whosecomputer systems were alsohacked.Theseretailerssettledwith the issuing banks toreplace the stolen cards forabout 70 cents per card.Using this information as areference point, you couldmakeabetterestimateof thepotential cost of settling. Ifyoudonothavedataonwhat

the impact will be, then youmight think about reducingthe size of the investment orsellingit.Let’stakealookatanother

example, in this case, whyinvestmentmanager FrançoisRochon did not invest inCanadian oil sands becausehe could not understand thepotential financialimplications of the risksinvolved.

CaseStudy:Investingin

CanadianOilSandsDeemedTooRisky

FrançoisRochon,thefounderof money manager GivernyCapital, outlined to hispartnerstherisksofinvestingin businesses exploiting oilsands in Alberta, Canada, inhis 2008 annual report. Heexplained why he felt these

risks were too great for himbecausethebusinessinvolvedtoomanyunknownvariables:ItisclearthatoilsandsinAlbertarepresentasourceof fabulous wealth. Thereservesareastronomical,and everything seems tobe in place for aprofitable exploitation.But this exploitation isnot as simple asconventional fuel. There

areextremelyhighcapitalrequirements and acomplex procedure totransform the oil sandsinto oil. To produce abarrel of petroleum fromoil sands requires two tofour water barrels, andthe wastemust be storedsomewhere.Thisdisposalof wastewater couldbecome a majorenvironmental problem.

At the end of 2007, theAmerican governmentpassed the EnergyIndependence andSecurityAct. It stipulatesthat federal agenciescannot initial fuelprocurement contractsanymore that are morepolluting thanconventional sources ofoil. Experts estimate thatemissions related to oil

sands are approximately20 percent to 25 percenthigher than conventionalpetroleum sources. Thispoliticalelementisaddedto the increase ofroyalties ordered by thegovernment of Albertalast fall. The growthprospects of this regionare impressive, but thereare numerous possibleunexpectedcircumstances

(including huge relianceonthepriceofcrudeoil).We are monitoring themajor players of thisindustry,butfornow,wejust remain curiousspectators.If Rochon had past

examples of the potentialfinancial impact from theseenvironmental liabilities orother data to support the oilsands investment thesis as

safefromrisk,hemighthavesome basis on which to act.With no data, he decided tostayonthesidelines.Asyouconsidertherisksas

presentedinthe10-Korothersources, think like aninsurance underwriter,making sure that youunderstand both the risk’slikelihood and potentialfinancial cost. Learn moreabout these risks by reading

articles and looking forexamples where the businessor competitors encountered aspecific risk before. Attemptto understand the financialimplications of these risks.Finally, base your evaluationon data and past examples,notnoise.With limitedornodata about a major potentialrisk, consider rejecting theinvestment.

24.Howdoesinflationaffectthebusiness?

Inflation affects mostbusinesses negatively. Mostinvestorsthinkaboutinflationaspricesgoingup.Itisnot.Itis the value of money goingdown. To evaluate the effectof inflation on your holdingsor potential holdings, ask

yourself if the business willbe able to maintain its cashflows in real terms. In otherwords, in order to avoidinflation’s value-destroyingeffects, cash flows mustincrease at the same rate asinflation. Inflation’s biggestthreat to the value of abusiness comes from theinabilityofabusinesstofullypass on cost increases to itscustomers without losing

salesvolume.Ifabusiness isunable to increase prices tooffset theeffectsof inflation,thenitwillfailtomaintainitscash flows in real terms. Abusiness can offset thenegative effects frominflationifit:

Can pass on priceincreases to itscustomers (pricingpower)Hastheabilitytoreduce

itscostsHas low capital-expenditurerequirements andminimal levels of debtonitsbalancesheet

Let’s look at each of thesefactorsinabitmoredetail.

TheAbilitytoPassAlongPriceIncreasesPrice increases allow the

business to offset the effectsof inflation because thebusiness can pass along theincrease in costs. If thebusiness can maintain salesvolume,itscashflowswillbemaintainedinrealdollars.

TheAbilitytoReduceCosts

If a business can reduce itscoststructure,itcanoffsetthe

increased cost of labor andmaterials during aninflationary period. Abusinessthathasahighfixed-cost structure or one thatneeds to constantly reinvestcapital in its assets (forexample,arefinery)willhavea difficult time decreasingcosts to offset the negativeeffects of inflation. Thosebusinesses with variable coststructures (for example,

money-transfer businessWestern Union, wherevariable costs representmorethan 75 percent of thebusiness’s total costs) canmoreeasilyadjusttheircosts.

LowCapital-ExpenditureRequirements

For businesses with largecapitalexpenditures,inflation

increasesthecostofreplacingexisting assets. For example,businesses that are growing,suchas a retailer,may sufferfrom inflationary effectsbecausethecosttobuildnewstoresincreases.Ontheotherhand, businesses that haveinvested capital at a lowercost might benefit in aninflationary environment asthe value of older assetsincreases. For example, an

investorwho built a building10 years ago in a growingarea benefits when newbuildings in the area areconstructed at a higher cost.This causes the value of theolderbuildingtoriseasrentalratesincreaseinthearea.

Long-TermDebtMaturities

The common view is that

businesses with a lot of debtbenefit from inflationaryperiods as the value of thedebt declines. This is true ifthebusinessdoesnothavetorefinance its debt in the nearterm, because inflationgenerallycausesborrowingtobecome more expensive, notless expensive. Lenders, infact, avoidmaking long-termcontracts and are moredemanding on covenants

during inflationary periods.Businesses that have long-term debt maturities orlimited debt on their balancesheetsarethereforeinabetterposition, as they can avoidboth increased interestexpensesandmorerestrictiveloancovenants.

InflationRisksThere are various types of

inflationary risks—such asincreasing costs (includingwage inflation) and risinginterest rates—and you needto develop an understandingofhoweachoftheseinflationriskswill affect eachofyourinvestment holdings. Thiswill prepare you to makeinvestment decisions in aninflationary environment.Let’s take a closer look ateachoftheserisks.

WageInflationBusinesses with a largenumberofemployees,suchasa grocery store, will beaffected by wage inflation.Wage inflation can comefrom a variety of sources,such as an increase in theminimum-wage rate in aparticular state, increases inthecostsofbenefitpackages,or high employee-retention

rates. Whatever the source,risinglaborcostssignificantlyreducefree-cashflow.

RisingInterestRatesMost stocks are negativelyaffected by rising interestrates. In a rising interest-rateenvironment, the price-to-earnings ratios of stockstypically drop. This is whystockshavealways tended toperformbadlyduringperiods

when inflation is rising andcorporate earnings aredeclining. Businesses thatinvest inrealestatewouldbenegatively affected, ascapitalizationratesinarisinginterest ratescenario increasewhich would then decreaseoverall asset values. If abusinesshaslargeamountsofvariable debt (versus fixed-ratedebt), thenrisinginterestrates will also increase

interestexpense.To evaluate the effects of

inflation on potential orcurrent holdings, determinehowwellthebusinesswillbeabletomaintaincashflowsinreal terms inscenarioswherematerial costs, wages, orinterestratesarerising.

25.Isthe

business’sbalancesheet

strongorweak?A strong or weak balancesheet may be the differencebetween your investmentfacinginsolvencyorsimplyabump in the road. A strongbalance sheet will providemanagement with thefinancialflexibilityitneedsto

take advantage ofopportunities during alleconomic periods. Yourprimary goal should be tofigure out if the cash-flowstreamthebusinessgeneratesis predictable enough toassure that debt payments,both on and off the balancesheet,canbemade.Youneeda sufficient margin of safetyto pay the debt over timeshouldcashflowsdecline.

Let’s start by looking at abusiness’s motivation fortakingondebt.

IdentifyingaBusiness’s

MotivationforDebtItisoftenusefultodeterminethe motivation behind abusiness’s debt on thebalance sheet. Did it take ondebt to fund losses, make

acquisitions, pay specialdividends, or enter newproductlines?For example, during the

creditboomin2005to2007,many businesses were takenprivate by private-equityfirms and subsequently takenpublic again. In order torecover more of their equityinvestments in thesebusinessestheyhadjusttakenpublic, the private-equity

firmsforcedthebusinessestoissuedebtandpaylargeone-time dividends. DominosPizza, for example, issued aspecial one-time $13.50-per-share dividend toshareholders. CEO DavidBrandon could provide littlejustification for this action,statingonly,“Webelievethisnew capital structure is theappropriate corporate financedecision for our company.”

This and similar scenariossaddle many businesses withhigh amounts of debt.Management often attemptstojustifyitsactionsbystatingthatthebalancesheetneedsabetter capital structure andneeds leverage to maximizethe value of the business.When you discover abusiness in this situation,realize that you areconsideringpartneringwith a

management team and boardthat may have compromisedthe financial strength of thecompany.6

ConsideringtheAdvantagesofLow

DebtThere are several advantagesto businesses with limitedamounts of debt. Think oflimiteddebtas,say,debtthat

canbepaidback in less thanthree years out of existingcashflows.First,thebusinesshas less risk of enteringbankruptcy, allowing you, asan investor, to sleepbetter atnight. Second, a strongbalance sheet allows thebusiness to be opportunistic.Businesses that have strongbalance sheets are often ableto gain competitive ground,because they are able to

invest in their business inways that their leveragedcompetitors cannot. Forexample, during the creditdownturnthatbeganin2008,those businesses that werebeholden to the creditmarkets were scrambling forcash to pay off debt, whilethose in a stronger positionwereable tobeopportunisticand buy back stock, makeacquisitions,orgrow.

CaseStudyofaCompanythatUsesDebtConservatively:BrookfieldAssetManagement

Global asset managerBrookfield AssetManagement is a greatexample of a firm that usesdebt conservatively.Brookfield strives to finance

itsbusinessonaconservativebasis by financing itsoperations primarily usinglong-term, investment-grade,non-recoursedebt.Mostdebtis secured by specific assets,which ensures that the weakperformance of one asset orbusinessunitwillnothurttherest of the company. Tofurther protect itself,Brookfield will only borrowthe amount that it would

typicallybe able topaybackinonebusinesscycle.Brookfieldalsostaggersthe

maturity of its debtrepaymentssothattheydon’tall come due at the sametime, thus decreasingrefinancing risk. Brookfieldwill typically finance assetsthat generate predictablelong-term cash flows withlong-term fixed-rate debt,instead of variable-rate debt,

inordertoprovidestabilityincashflowsandprotectreturnsin the event of changes ininterest rates. It alsomaintains access to a broadrange of financing markets,such as equity and debtmarkets, so that it canfacilitate access to capitalthroughout the businesscycle. This way, it is notdependent on any particularsegment of the capital

markets to finance itsoperations.7

DeterminingHowMuchaBusinessCan

BorrowYou need to determine howmuch a business canborrow.The capacity to borrowdepends on several factors,suchasprofitability,stability,relative size, asset

composition,andtheindustrypositionofabusiness.Italsodepends on external factors,such as credit-marketconditionsandtrends.Duringdifficult credit environments,banks and other financialinstitutions are less likely tolend money and typicallyimpose more restrictions,suchas lowerdebt-to-incomeratios. During easy-creditenvironments, financial

institutions have looserrequirements, such as higherdebt-to-incomeratios,astheytry to expand the pool ofcreditapplicants.The amount of total debt a

business can put on itsbalance sheetdependson theamount and distribution ofcash flows a businessgeneratesaswellasthevalueof the assets securing thedebt. The more stable the

cashflowsareforabusiness,themoredebtitcantakeon.For example, think about a

utility business, where thecash flows are steady. Thisbusiness can easily handlehigh amounts of debt on itsbalance sheet. Bycomparison,abusinesswithamore cyclical cash flowpattern, such as ahomebuilder, cannot handlehighamountsofdebt.Thisis

because it will have a moredifficult time paying back itsdebt when its cash flowscontract with the businesscycle.

FactoringinOff-BalanceSheetDebt

Tocalculate the total debtofabusiness,youmustfactorinany off-balance sheet debtobligations.Anytimethereis

a contractual obligation thatdoes not show up on thebalancesheet,youaredealingwith off-balance sheet debt.Theseinclude:

LeaseobligationsWarrantiesPurchasecontractsUnfunded pensionliabilitiesAny other contractualobligations

These are typicallydisclosed in the footnotes tothefinancialstatementsunderthe section titledCommitment andContingencies.Retailers,shipoperators, airlines, andmanyother types of businesseshave large contractualobligations that are off-balancesheet.For example, many

businesses rent buildings and

equipment using long-termlease contracts. If these leaseobligations are classified asoperating leases rather thancapital leases, they are notrequiredtobereportedonthebalance sheet andare insteadplaced in the footnotes.However, these requiredrental payments arecontractual obligationssimilar to debt. A good ruleof thumb for estimating a

business’s total leaseobligation(andamethodthatis often used by credit-ratingagencies) is to multiply oneyear’s rental expense byseven. Otherwise, you willhave to discount the futurerentalpaymentstothepresentusingadiscountrate.Anotherexampleofanoff-

balancesheetliabilityiswhena utility is required topurchase a certain amount of

coalperyear at a fixedpriceper ton, or when there is alawsuit that is pending andthe business has estimatedpotential liabilities in theform of damages it will berequiredtopayinthefuture.

UsingRatiostoDeterminea

Company’sAbilitytoPayItsDebts

There are two typesof ratiosyou can use to find out howeasily a companycanpay itsdebts.Oneiscoverageratios,and the other is static ratios.Let’s look at eachindividually.

CoverageRatiosCoverage ratios measure theability of a business to meetfixedobligations.Acoverageratio takes the income

available for paying the totalfixed obligations for a givenyear and divides that by theannual interest expense andfixed charges. There arevarious types of coverageratios:

Earnings before interest,taxes, depreciation andamortization (EBITDA)tointerestexpenseEarnings before interestand taxes (EBIT) to

interestexpenseCash flow fromoperations to interestexpense

For example, if a companygenerates$200millioninpre-tax income and pays $50million in interest expense,thenitsinterestcoverageratiois four times. This is thenumber of times a businesscancoverits interestexpenseout of pre-tax income. A

moreconservativecalculationuses EBIT, which does notadd back depreciationcharges. Many times,depreciation charges equalthe amount needed tomaintain a business’s assets,which is a real cost to thebusiness.Bynotaddingbackdepreciation, you areeffectively accounting forthosemaintenancecosts.When calculating coverage

ratios, it is preferable to usecash flow for the numeratorbecause liabilities must bepaid in cash. Earnings are asofter accounting measureand can be manipulated, sousing cash flow provides amore consistent, dependablemeasure.To interpret coverage

ratios, youmust consider thedistributionandpredictabilityofcashflows.Youcannotuse

one coverage ratio, such asfive times EBITDA tointerest expense, for allbusinesses, and assume it isconservative. The morecyclical the cash flows, thehigher the coverage youwillneed. Healthcare andpharmaceutical companiestypicallyhaveamorenarrowdistribution of cash flowsthan, say, oil and gascompanies. For example, a

conservative coverage ratiofor a healthcare companymight be EBITDA/interestexpenseofeight times,but itmight be 10 times for an oilandgasbusiness.8

StaticRatiosThe next most useful ratiosare static ratios, whichmeasure the ability of abusiness to repay its debtobligations at one point in

time.Theseinclude:Current assets to currentliabilitiesDebttoequityDebttototalassets

UsingRatingAgencies

One simple andstraightforward way tounderstand the degree ofleverage on a business’sbalancesheetistoexamine

theratingsfromfirmssuchas Moody’s, Standard &Poor’s (S&P), and Fitch.You should not rely onthese ratings, but youshould instead use them asa starting point. These arepubliclyavailable,andtheywill help you to gain aquick insight into abusiness’s balance sheet.Rating agencies focus onexamining a debt-issuingcompany’s assets, financialresources, earning power,management, and thespecific provisions of the

debtsecurity.Belowaresamplecoverageand static ratios thatMoody’susestoratedebt:

Table5.1EBITDA/InterestExpenseRatiosCompanyRating

EBITDA/InterestExpenseRanges

AaatoA 17×to8.2×BaatoB 5.1×to1.5×CaatoC 0.3×

Table5.2DebttoEBITDARatiosCompany DebttoEBITDA

Rating RatioAaatoA 0.9×to1.7×BaatoB 2.4×to5×CaatoC 6.3×

J.Tennant,“Moody’sFinancialMetricsKeyRatiosbyRatingandIndustryforGlobalNon-FinancialCorporations,”Moody’sSpecialComment,December2007.

The downside to usingthese ratios is that they onlygive you a snapshot of the

business at a certain point intime. A business can changedramatically from quarter toquarter,sostaticratioscanbemisleading when notanalyzed over a longer timeframe. For example, if youare analyzing a retailer, theratios will fluctuatedepending on the quarter. Inthe first and second quarters,the retailer is stocking up oninventory and may have

greaterdebt,moreassets,andgenerate less earnings. In thefourth quarter, the sameretailer may have less debtandassetsbutgeneratehigherearnings because of holidaysales.

AssessingtheShort-TermFinancialStrengthofaBusiness

You want to get anunderstanding of how liquidthe balance sheet is, whichtells you the amount of timethe business would normallyrequire to convert assets intocash. This will help youassess the ability of abusinesstopayitsshort-termliabilities. Short-termliquidity is extremelyimportant to lenders becauseitistheinabilitytopayshort-

term liabilities that causesmost businesses to enterbankruptcy.The assets on a balance

sheet are organized in orderof their liquidity.Thecurrentassetsarethingssuchascash,accounts receivable, andinventories. Long-term assetsinclude property, plant, andequipment.To determine a business’s

short-term liquidity needs,

evaluate how quickly thecurrent assets on the balancesheetcanbeliquidated.First,startwithcash.

CashSometimes cash is not asliquid as you may think, soyou will need to makeadjustments.Manybusinessesearntheirrevenuesinforeignjurisdictions and keep cashbalancesinthecountrywhere

they earned the revenues, inordertoavoidpayingtaxesinthe United States. If such abusiness were to repatriatethis cash to invest in theUnitedStates,thenyouwouldneed todiscount the cash forthe taxes the business wouldhave to pay. For example, in2009,computermanufacturerDell had the majority of itscash domiciled in foreignjurisdictions. If Dell wanted

to use this cash to buy backitsstockintheUnitedStates,it would have had to paytaxes in the United States atrates as high as 30 percent.Therefore, the cash balanceneedstobeadjustedforthesepotentialtaxes.Youmayalsoneedtomake

adjustments to the cashbalance for the amountneeded to fund operations.For example, children’s

retailer Build-A-BearWorkshophad$60millionofcashonitsbalancesheetasofthe fourth quarter of 2009.However, by the end of thesecond quarter of 2010,Build-A-Bear’s cash balancehad declined to $31 million.This was due to Build-A-Bear’s need to buildinventory during this periodin advance of the busierholiday season. An investor

whoassumedthat$60millionin cash was available to payshort-term obligations wouldhavebeenmaking amistake,due to the fact that Build-A-Bear’scashbalancefluctuatesdue to seasonal working-capital needs. Investorsshould normalize cashamounts to account for thesepatterns.

AccountsReceivable

Next,youneedtounderstandthe quality and liquidity of acompany’s accountsreceivable. This is especiallyimportant for thosebusinesses that selloncredit.You need to calculatereceivables turnover in orderto understand how quickly abusiness is able to collect onits accounts receivable. Thisisthetimeneededtotranslatereceivables into cash. The

receivables turnover iscalculated by dividing netsales by average totalaccounts receivable.Youcanconvert this to thenumberofdays it takes to turnaccountsreceivable into cash bydividing the turnover figureby 365. For example, if ittakes120daysforabusinesstoconvertitsreceivablesintocash,andithadonly30daystopaydownshort-termdebts,

then a business mightpotentially face a short-termliquidity crunch. In otherwords,thebillsarecominginbefore the money is there topaythem!

InventoryUnderstanding how long ittakes to convert inventory tocash will also help youunderstand how quickly abusiness can pay back its

short-termliabilities.Youcancalculate this by dividing thecostofgoodssoldbyaverageinventory.Convert this tothenumber of days it takes toturn inventory into cash bydividing this turnover figureby365.Inventory is an important

asset and inventory turnoverrepresents one of the mainways that a businessgeneratesrevenue.Abusiness

needs to have sufficientinventory because if it runsout of products it will losesales. Having too muchinventory for long periods,however, is not good either.In addition to failing toproduce revenue, a businesswouldhavetopaytostoreit,and it can go bad or becomeobsolete.

AssessingtheLong-

TermLiquidityNeedsofaBusiness

Short-term liquidity is fareasier to evaluate comparedtolong-termliquiditybecauseit is easier to make areasonable projection in theshortrunthanthelongrun.Ifyouareunabletomakelong-term projections (which isoften the case with cyclicalbusinesses), then you will

morethanlikelybeunabletounderstand the long-termfinancial strength of abusiness. As a result, themeasuresusedtoevaluatethelong-termliquidityneedsofabusinessarelessspecific.Theliquidity will depend onwhether the business haspermanent equity capital oruses short-term funds, whichare temporary and thus amoreriskysourceofcapital.

One business that usespermanent equity capitalinsteadofshort-termfundstofinance its business is globalasset manager BrookfieldAsset Management. In 2010,Brookfield was funded by$30 billion of permanentequity capital. CEO BruceFlatt explainedwhy, “This iscapital that does not comedue, has nomargin calls andwhether it trades for less in

the market due to externalfactors has very little effecton the capital base.”9 Overthe years, Brookfield hasbeen strengthening itspermanent equity capital inordertostrengthenitsbalancesheet. For example, in 2001when Brookfield converteddebentures,whicharemid-tolong-termdebt, into commonshares, this added permanentequity toBrookfield’s capital

base. It also strengthened thebalance sheet and eliminatedthe interest cost and risk ofthesedebentures.

DeterminingWhethertheDebt

InterestRateIsFixedorVariable

Determine if the interest rateon the debt is fixed or basedon variable rates, such as

LIBOR plus 5 percent(LIBOR is the LondonInterbankOfferedRate).Youwill find this information inthe financial statementfootnotesunderthenotetitledDebt. If the interest rates arefixed, thenyouwillbebetterable to assess the impact ofdebt financing. If interestrates are variable, you mustallow for the possibility thatinterest ratesmay increaseor

decrease, adding uncertaintytoyourprojections.

DeterminingtheDebt-Maturity

ScheduleRefinancing debt representsrisk for a business. It isimportant for you todetermine when debt iscomingdue.Youcanfindthedateswhendebt isduein the

notes to the financialstatements under the Debtfootnote. For example, abusiness may have issueddebtwhen interest rateswerelow. If interest rates roseduring that period, and thebusiness intends to refinancethedebt insteadofpayitoff,it will have to pay a higherinterest rate which willdecrease the earnings of thebusiness.

Other constraints can alsolimittheavailabilityofcredit.Many businesses in 2008wereunabletorefinancetheirdebt because the creditmarketsdriedup.

EvaluatingLoanCovenants

Tounderstandifabusinessisfinancially strained, evaluateits loan covenants and

determine if the business isnearing the limitsof the loancovenants set by its lenders.Loancovenantsarethetermsof the loan that the lenderrequires, and they serve toprotect the lender. Loancovenants define defaultlimits and legal remediesavailable,whichgivealenderan early start beforebankruptcy so that the lenderstill has time to negotiate a

solution. Most bondindentures and creditagreements restrict corporateactions that would impairliquidity in any way bysettingminimumratiosthatabusinessmaynotexceed.Forexample the covenant mightstate that the current ratio(which is current assetsdivided by current liabilities)cannotbebelow1.1.You can usually find

information on loancovenants in the 10-K reportor other financial filings. Ifthe business is nearing thelimits of its loan covenants,this is an indicator that it isfinancially strained.However, being in goodshape with respect to loancovenants is no guarantee ofsolvency; management issometimesable to stretch thedefinition of covenants to

present a better financialpicturethanreallyexists.

DeterminingWhethertheBusinessHasRecourseor

Non-RecourseDebtThemostbenignformofdebtisnon-recoursedebt,whichisdebt that is secured by aparticularassetandnotbytheoverall business. In a non-

recourse situation, if thebusiness defaults on a loanbackedbyacertainproperty,then it has the right to turnover the property to thelender,withoutfurtherlosses,in exchange for theforgivenessoftheloan.For example, real estate

firm Vornado Realty Trust(among the largest U.S.commercial landlords), wasable to simply turn over its

ownershipofsomeverylargeproperties when it wasunwillingtocontinuetomakedebt payments on anunprofitableventure.Itturnedover its ownership of thesecond-largest furnitureshowroom owner andoperator in the United Statesto the special serviceroverseeing the mortgage.Vornado had $217.8 millionin non-recourse debt

associatedwith thepurchasesof many properties in NorthCarolina, such as theMarketSquare complex, where tensof thousands of buyers cometobuyfromhomefurnishingsmanufacturers andwholesalers. Vornado wasable to walk away from thedebt because it was non-recourse debt, or debt that issecured only by theindividualproperty.10

26.Whatisthereturnon

investedcapitalforthebusiness?Return on invested capital(ROIC) is the profit abusiness generates relative tothe amount of moneyinvested in the business. Itshows you how well a

business is using its assets.The more profit that comesout relative to the amount ofinvestment required, thebetter the business. It iscalculated by taking incomeand dividing by theinvestment used to generatethat income. Here are tworules of thumb regardingROIC:

1. A business with aROIC below 5 percent is

typically considered alow-quality business,unless it is developing acompetitiveadvantage.2. In contrast, a businessthat generates a ROIC inexcess of 10 percent is ahigh-qualitybusiness.

The average ROIC variesfromindustrytoindustryandrangesfromnegativetomorethan 50 percent; here aresome examples of high-end,

mid-range, and low-endROICindustries:

At the high end, withROIC typically greaterthan 20 percent, areindustries such assoftware firms, softdrinks, pharmaceuticals,distilled spirits, luxuryproducts, and medicalinstruments.IndustrieswithROICof10 to20percent include

hotels, packaged foods,grocery stores, drugstores, and bookpublishing.On the low end, withROICfromnegativeto5percent, are industriessuchasairlines.11

WhyIt’sImportantforYoutoCalculate

ROIC

Suppose you are analyzingtwodifferentbusinesses.Thefirst one earns $100,000 innet income from $10millioninsales,andthesecondearns$500,000 innet income from$5million in sales. The firstbusinessgeneratesa1percentnet profit margin, while thesecond business generates a10 percent net profitmargin.At first glance, which onewouldyouprefertoinvestin?

Based on this informationalone, most investors wouldprefer thebusiness that earnsahighernetprofitmargin.However, to better answer

this question, you must takeone more step. You need todetermine what level ofinvestment or assets wererequired to generate theseearnings.Let’s say in the first

business, it takes $1 million

in capital to earn $100,000,andinthesecondbusiness,ittakes$10millionincapitaltoearn$500,000.Thereturnoncapitalof thefirstbusiness is10 percent($100,000/$1,000,000),whilethe second business is 5percent($500,000/$10,000,000).After consideringROIC, youcanseethat the firstbusinessis a higher-quality business

because it requires lesscapital to generate the samelevelofprofits.The reason for this is that

the higher the ROIC, themore a business is able toearn.Sayyoubuyabusinessthathas$100incapitalanditearnsa5percentROIC.Whatare the earnings of thebusiness? $5 is the correctanswer.Nowsaythebusinesscanearnan80percentROIC.

Whatare theearningsof thisbusiness? $80 is the correctanswer. A business with ahighROICwill delivermorewealth to its shareholdersover the long term fromhigher earnings. Ideally, youwant to own a business thatover an extended period oftime can reinvest excessearningsathighROIC.Forexample,atoilandgas

business EOG Resources,

Inc., the ROIC has been 20percent on average since2000 under the stewardshipof CEO Mark Papa. As aresult, the book value pershare increased from $4.12per share on December 31,1999, to $40 per share atDecember 31, 2009. Thiscaused the stock price toincreasefrom$7.75pershareatJanuary1,2000, to$97.77per share at December 31,

2009, a 1,161 percentincrease, not includingdividends that would furtherenhancereturns.Furthermore,the stock price increase wasnot a result of EOG’s stocksimply being bid up underpriceymarket conditions; theprice in this case was drivenup by earnings, as EOGessentially maintained thesameP/Emultipleduringthisentireperiod.12

It is important for you tocalculate ROIC becauseultimately the value of abusiness is based on thereturns a business is able toachieve on its investedcapital. ROIC also turns outto be a fairly good predictorof stock return over the longhaul. In other words, if youpay fair value for the stockand hold it five years, oddsarethatifROICis5percent,

then your return will besimilar.YoumustplaceROICfora

business in context with thepriceyoupayforthestock,asthe price you pay determinesyourrateofreturn.Ifyoupaytoo high a price for a stocksuch as a high multiple ofbookvalue,thenahighROICwill not help you earn asatisfactory return on yourinvestment. You must

remember that ROICcalculations are the returnearned by the business,instead of the return realizedon your stock cost basis.Sinceyourreturnisbasedonwhat you pay for the stock,make sure you can benefitfromhighROICbypayingalowpriceforastock.

Methodsof

CalculatingROICThe basic method forcalculating ROIC is to takeincome and divide by theinvestment used to generatethat income. There are anumber of different ways tocalculate ROIC, and no onemethod is universallyaccepted. You can calculateROICwithgoodwill,withoutgoodwill, using gross assets,

or net assets. You need toadapt the calculation to thetype of business you areanalyzing.Theprosandconsof each method arehighlightedbelow.

TheBasicEquationLet’sfirststartwiththebasicequationforROIC:

Invested capital = totalassets

−excesscash+/− accumulatedamortization anddepreciation+/− goodwill or otherintangibleassets+off-balancesheetitems− non-interest bearingcurrentliabilities

CalculatetheNumerator

First, isolate the earningsfrom the operations of thebusinessbyremovinginterestincome, taxes, and interestexpense:

Remove interest incomefrom cash balancesbecause it is notgenerated by the coreoperations of thebusiness.Exclude taxes becauseyou need to isolate the

effects of differences intax rates, tax loss carry-forwards, or any otherforms of taxmanagement.Excludeinterestexpenseto remove the effects offinancing decisions,which vary acrossbusinesses andindustries.Also considersubtracting non-

recurring items, such asrestructuring andimpairment charges andamortization charges ofintangibles from pre-taxearnings.

CalculatetheDenominatorNext, you need to determinewhich assets should beincluded, what liabilities

shouldbededucted, andhowthe assets should be valuedwhen determining theinvestment base. Ideally, youwant todeterminehowmuchinvestment is needed tooperate the business day today. You will have to makeseveral adjustments beforecalculating the investmentbase, such as removingexcesscash,decidingwhetherto use gross or net assets,

including or excludinggoodwill, removing currentliabilities, and including off-balance sheet assets andliabilities such as accountsreceivable that have beensecuritized, pensionliabilities, and capitalizedoperatingleases.Be sure to use average

amounts for the investmentbaseinsteadofrelyingononespecificquarter.Forexample,

if you are evaluating a retailbusinessandyouuse theendoffirstquarternumbers,thesewill be unusually low as theretailer typically has sold offmost of its inventory. As aresult, the ROIC figures youcalculatewould be unusuallyhighandmisleading.Let’s now review the pros

and cons of adjusting eachline item for the investmentbase:

RemoveExcessCashYou need to remove excesscashthat isnotneededin theoperation of the business soyoucanbetterunderstandtheROIC the core business isgenerating. Excess cash isanycashthatisnotneededtooperate the day-to-dayactivitiesofthebusiness.For example, at discount

retailer 99CentOnly Stores,

ROIC averaged 20 percentfrom1995to1999,butthenitbegan to drop as the cashbalance increased. Manyanalysts were concernedaboutthedropandbelieveditwas due to deterioratingbusiness conditions, when infact, itwasdroppingbecauseof the excess cash on thebalance sheet. By removingexcess cash, you willunderstand the ROIC being

generated by the operationsof the business.This is oftenreferred to as the return onoperational capital. In thecase of 99CentOnlyStores,theROICexcludingcashwasmuch higher than the ROICincluding cash, as shown inTable5.3.

Table5.399CentOnlyStoresReturnonInvestedCapital(ROIC)

Source:TimeValueofMoney,LPinternalresearchandStandard&

Poor’sCapitalIQ.

IncludeProperty,Plant,andEquipmentCostsYou must include thepurchase of fixed assetsnecessary to operate the

business, such as real estate,plant, and equipment. Youneed todeterminewhether touse the gross book value ofthese assets or thedepreciated,netbookvalueoftheseassets:

Gross book value takesthe historical oracquisitioncostofassetswithout deductingaccumulateddepreciation or

amortization.Net book value is thevalue if you removeaccumulateddepreciation. Becausethenetbookvalueofanasset is less each year,this causes ROIC toincrease each year. Thisresultsinalowerrateofreturn during the earlystages of an investmentand higher rates of

return in later stages, astheassetbasedecreases.

Let’slookatanexample.Ifa business is depreciating itsasset base and earning thesameamountofincome,thenROIC will naturally increasebecause the denominator isdecreasing. Take an assetwith a book value of$200,000andassumethatforthe next five years, thebusiness depreciates it by

$30,000 each year. If thebusinessgenerates$10,000inearnings for the next fiveyears, the ROIC wouldincreasefrom6percentattheendofthefirstyear($10,000divided by $200,000 minus$30,000) to 20 percent($10,000dividedby$200,000minus $150,000) by the endof the fifth year. Therefore,the same asset generates anincreasing ROIC as it gets

older. Table 5.4 is a chartshowing these amounts (inthousands).

Table5.4EffectofDepreciationonROIC

To counteract this effect,you might want to considerusing gross assets by adding

back accumulateddepreciation. This way, theinvestment base is notaffected by depreciation orwrite-downsofassets.Most investors do end up

using net book value. Theargument forusingnetassetsratherthangrossassetsisthatdepreciating assets are offsetby maintenance and repaircosts, which rise asequipment gets older, thus

tending to offset thereduction, if any, in theassetbase.

IncludeorExcludeIntangiblesorGoodwillWhen calculating theinvestment base, you maywant to remove goodwill orother intangibles, which arenot assets that the business

must continue to replenish.By removing goodwill, youcan more easily seeimprovements in tangiblereturns. On the other hand,realize that if you excludegoodwill from yourcalculations, itmaymask thefact that management hasoverpaid for acquisitions,making the return on capitalseemhigherthanitreallyis.There are a few situations

where itmight be prudent toinclude goodwill orintangibles,suchaswhenyouare analyzing a mediabusiness that must buytelevision rights. Thesetelevision rights are reflectedon the balance sheet asintangibles but are anecessary investment for thebusinesstooperate.

IncludeOff-Balance-

SheetLiabilitiesYou should add off-balancesheet liabilities to theinvestment base whencalculating ROIC becausethese are contractualobligationsthataresimilartodebt.These liabilities includeoperatingleases,underfundedpension plans, or securitizedaccountsreceivable.

OperatingLeasesAnoperatingleaseistherenta business contractuallyowes,andit’snotincludedonthe balance sheet, whereas acapital lease is shown as anasset and liability on thebalance sheet. You can findoperating leases in the notesto the financial statements,and you can either discountthe future operating lease

obligations using a discountrate or multiply one year’srent by a multiplier rule ofthumb,suchasseven.For example, at CVS

Caremark, a pharmacyservices company, the Notessection of the 2009 10-Ksummarizes significantcontractual obligations. Thetotal obligation for operatingleasesare$26.9billionwhichis significantly higher than

the long-term debt on thebalance sheet which totals$8.8 billion at the end of2009.Thus,off-balancesheetobligations represent a largepercentage of total liabilities.If you use off-balance sheetitems, such as convertingoperatingleasestocapitalizedleases, make sure you maketheproperadjustments to thenumerator. For example, ifyou are adding off-balance

sheet operating leases, youmust add rent expense to thenumerator(toincome)soyouavoiddoublecounting.

UnderfundedPensionPlansAnunderfundedpensionplanis a liability because thebusinessmust use its cash tomake up for the fundingshortfall. For example, at

Raytheon, a defensetechnology business, thefunded status of the pensionplan for 2009, which isshown under the heading of“Net amount recognized onthe balance sheets” was adeficit of $4.6 billion. Youmustincludethisdeficitwhencalculating the totalcontractual obligations of abusiness.

AccountsReceivableAccounts receivable that areremoved from the balancesheet when they aresecuritized and sold to otherinvestorsatadiscountshouldalsobeaddedback.

RemoveNon-Interest-BearingCurrentLiabilitiesRemoveshort-termliabilities,

such as accounts payable,compensation and benefits,other accrued items, advancepayments, unearned income,and non-current deferredincome taxes from theinvestmentbase.Apayableiseffectively an interest-freeloanwhere thebusinessdoesnot have to lay out anymoney and therefore shouldbe removed from theinvestmentbase.

EvaluatingaCompany’sAbilityto

ReinvestExcessEarnings

Avoid jumping to theconclusion that one businessisbetterthananotherbusinessjust because it has a higherROIC. What counts is theability of a business toreinvestitsexcessearningsata high ROIC, which is what

creates future value. Youneed to determine thepercentage of excess cashflows that the business canreinvest and whether theROIC on new investmentswillbethesame.For example, lubricant

manufacturer WD-40generates a high amount offree-cash flows, which it isunable to reinvest in thebusiness. The reason it can’t

reinvest very much capitalback into the business isbecause WD-40 does nothave many growthopportunities. Therefore, thecompany pays out themajorityofitsfree-cashflowsasadividend. If itwereableto instead reinvest theseexcess free-cash flows at itsROICof15percent, thenthevalue of the business wouldincrease significantly due to

theeffectsofcompounding.Contrastthistoglobalasset

manager Brookfield AssetManagement,whichisabletoreinvest the majority of itsexcess cash flows back intoitsbusiness,atROICof10to15 percent. This allowsBrookfield AssetManagement to create morevalue.

HowtoImprove

ROICTobetterunderstandROIC,itis necessary for you tounderstand how a businesscan improve itsROIC.ROICcanbeimprovedby:

1. Using capital moreefficiently, such asmanaginginventorybetteror managing receivablesbetter,or2. Increasing profit

margins, instead ofthrough one-time, non-operating boosts to cashearnings.

A supermarket chain iscontent earning a low netprofit margin, typically 1percent,because it turnsoverits inventory very quickly. Ithas a relatively lowinvestment in assets becausemost of its assets are leased.On the other hand, a capital-

intensive business such as asteel manufacturer has aheavy investment in assets.This heavy investmentcontributes to lower asset-turnover rates. The steelmanufacturer must achieve ahigh net profit margin inorder to offer investors areasonable return on capital.In another example,Goodyearalsohasalowassetturnoverrate.Althoughitsnet

profitmarginsarecomparablewith Whirlpool (both a bitover 5 percent), Goodyear’sROIC is much lower thanWhirlpool’s, mainly becauseit has lower asset turnover.TheROICatWhirlpoolis17percentwhereas theROIC atGoodyearis9.6percent.Herearesomeotherexamples:

A business can bemoreproductivewithitslong-term fixed assets. If a

business can generatemore sales for eachdollarofproperty,plant,and equipment it ownsthen it will be able togenerateahigherROIC.For example, arestaurant that wants toincrease itsROICmightthink about opening forlunch as well as dinner.This allows therestaurant to generate

more sales per dollarinvested in restaurantassets.A business can useonline sales channels toimprove efficiencies ininventory and salescosts, while alsoreaching additionalmarkets. Williams-Sonoma (an upscalehousewares andfurniture retailer) began

as a catalog retailer. By2010, e-commercerepresented 77 percentof direct-to-consumerrevenues and wassignificantly moreprofitable than eitherretail stores or catalogsales. Relative to theretail and catalogbusiness, the e-commerce site forWilliams-Sonoma has a

lower fixed-asset base,higher inventory turns,and a higher operatingincome margin whichcausesittoearnahigherROIC.13

A business can improveitsROIC throughhigherinventory turns (cost ofgoods sold/averageinventory) becauseoperating with higherinventory turns requires

less capital to financethe business. The moreinventory turns, thefaster a business getsback the money it hasspent on inventory. Ineffect, abusinesshas itsmoney invested ininventory for a shorterperiodoftime.A business can collectits accounts receivablefrom customers faster.

For example, winedistributor ConstellationBrands reported, “Lastyear, we really focusedon receivables in theUnited States. We wereactuallyabletobringthenumber of days thatsales are outstanding(DSO) down by fourdays.That’sworthabout$9 million a day. Wethink that’s a permanent

improvement.”14 Bycollectingaccountsmorequickly, ConstellationBrands has less capitalinvested overall,increasingitsROIC.A retailer can be moreselective in the productlines it carries, focusingonthosethatsellquicklyand removing those thatsell slowly. Wal-Martopened smaller stores in

2010, compared to themid-1990s when itopened 200,000-square-foot stores. This changehelped to minimizeinventory levels, andreduce capitalinvestment. Because thesmaller stores werestocked with faster-sellingitems,ratherthana wide assortment ofitems, the change also

improved inventoryturnover. This hashelped Wal-MartincreaseitsROIC.15

A manufacturing firmcan use leanmanufacturing tocut theinventories it needs tostock,or it canmake itssuppliers responsible forstockinginventories.

WhenROICIsLess

UsefulThere are certain instanceswhen calculating ROIC islessuseful, suchaswhen theinvestmentbasedoesnotaddto theearningsofabusiness.This is typically the case inknowledge-based businessessuch as in moneymanagement, informationservices businesses, or othernon-capital-intensive

businesses.Forexample,ifmutualfund

manager T. Rowe Priceincreasesthenumberofdesksand computers at its office,this investment will not addtothereturnsofthebusiness.Therefore, calculating theROICofafirmlikeT.RowePrice is less useful thancalculating the ROIC of afirmthathasahigheramountof invested capital, such as

Praxair, a producer anddistributorofindustrialgases,which builds newmanufacturing plants everyyear tomeet the demands ofitssteelmill,glassfurnace,orchemicalplantcustomers.

DoNotRelyonHistoricalROICWhenMakingForecasts

One common mistakeinvestors make is they relytoo much on the historicalROIC and project itindefinitely into the futurewithout considering thatreturns typically decline overtime or that a business islimited in the amount ofcapital it can redeploy in thebusiness. There have beenvery few businesses that areable to maintain high ROIC

over a long period of time,and those that do often havelimited growth prospects.WhenforecastingROICforabusiness make sure you arenot extrapolating past returnswithout understanding howthosereturnswereearned.Some examples of things

you need to look out for(adjustmentsyouwouldneedtomake)beforeextrapolatingfuture ROIC include the

following:A business may have anew product that haslimited competition thatallows it to earn highROICintheearlyyears.Ifcompetitionenters themarket,youmayneedtoreduce your forecast ofROIC.A retailer may havesaturated its growth inthe best locations and is

now beginning to locatenew retail sites insecondary locations,whichmay not generatethe same returns as theolder locations. In thiscase, you would reduceyour forecast of futureROIC.Increased regulatoryrequirements may forcea business to reinvestcapital in the business

that does not earn areturn,suchaswhen theEnvironmentalProtection Agency(EPA) introduces newregulations. In2002, theEPA required big rigtrucks to emit fewerpollutants. The truckingindustry estimated thatthecosttomeettheEPArequirements added$3,000 to $5,000 to the

costofanengine,whichtypically cost $15,000.16This will decrease theROIC a trucking firmcanearn.

LimitationsofMakingComparisonsWhen you aremakingROICcomparisons betweenbusinesses in the sameindustry, you often need to

make several adjustments tomake meaningfulcomparisons. For example, ifyouarecomparing theROICof two refineries (one that isolder compared to a newerone), the depreciated cost oftheold refinerywillgeneratea higher ROIC than the onewith the new refinery. Thenewer refinery may be moreefficient and operate at alower cost, but you would

havetoadjust theassetvalueof the old refinery forinflation to make ameaningful comparisonbetweenthetwofirms.Differences in accounting

methods also complicate theability to make comparisons.If you are comparing twofirms within the sameindustry, you have to adjustthe accounting statements ofbothbusinesses tomakesure

their accountingmethods areconsistent. For example, youwouldwanttomakesurebothbusinessesareusingthesameinventory-accountingmethod,such as first-in-first-out(FIFO)inventorymethods.When comparing a faster-

growing business to one thatis not growing, you mightfind that the ROIC is higherfor the business that is notgrowing.Thereasonisthatin

a faster-growing business,investments aremoreheavilyweighted to the more recentinvestment projects (such asrecent equipment purchasesor new store openings),leading to higher book-valuedenominators, thus pullingdownROIC.Businesses that constantly

reinvest in their business tobuild an advantage—such asmaintaining their property,

plant, and equipment orinvesting in productdevelopment and marketing—willshowlowerROICthanthose that do not. This canhavetheunfortunateeffectofproducing lower ROIC incases where managers aremaking prudent investmentdecisions and higher ROICwhere managers haveminimized crucialinvestments just to make

short-term earnings lookgood.

KeyPointstoKeepinMindAssesstheBusiness’s

FundamentalsManagersshouldunderstandand have a

laser focuson what iscreatingvalue at thebusiness.Watch outfor managerswithcontinuallychangingvisionstatements ormanagerswho chasetoo manyideas.If a

fundamentalisdeteriorating,then thevalue of thebusiness willas well. If afundamentalis steady orimproving,youcanhavemoreconfidenceinthebusiness’sunderlyingvalue.

UnderstandtheCompany’sOperatingMetricsOperatingmetrics willhelp yougauge thetrueperformanceof theunderlyingbusiness. Bymonitoring

them, theywillalertyouto potentialproblems atthebusiness.

IdentifytheKeyRisksFacingtheBusinessWhenevaluatingrisks it helpsto think likean insurance

underwriter.Think interms offrequency(i.e., howoften in thepast has theriskhappened?)and severity(i.e., what isthe financialcost?)With limitedor no dataabout amajor

potentialrisk,considerrejecting theinvestment.

UnderstandHowInflationAffectstheBusinessYou’re

EvaluatingMostinvestorsthink about

inflation assimplypricesincreasing.That is notaccurate.Inflation isthe value ofmoneydecreasing.To avoidinflation’svalue-destroyingeffects, cashflows mustincrease atthesamerate

as inflation.To do this, abusinessmust be ableto pass onpriceincreases toitscustomers,be able toreduce itscosts, havelow capital-expenditurerequirements,orhavelong-term debt

maturities.Most stocksarenegativelyaffected byrisinginterestrates. In arisinginterest-rateenvironment,the price-to-earningsratios ofstockstypicallydrop.

PayAttentiontoaBusiness’s

DebtBusinesseswith limitedamounts ofdebt,orthosethat can payback totaldebtobligationsin less thanthree yearsout ofexisting cash

flows, makesaferinvestments.A strongbalancesheetprovidesmanagementwith thefinancialflexibility itneeds to takeadvantage ofopportunitiesregardless ofeconomicconditions.A business

that financesits balancesheetconservativelyuses long-term, fixed-rate,investment-grade, andnon-recoursedebt.The amountof total debta businesscanputonitsbalancesheetdepends on

the amountanddistributionof the cashflows abusinessgenerates aswell as thevalue of theassetssecuring thedebt. Themore stablethe cashflows are fora business,the more

debt it cantakeon.

EvaluateaBusiness’sReturnonInvested

Capital(ROIC)Ultimatelythevalueofabusiness isbased on thereturns abusiness is

able toachieve onits investedcapital.A businesswith anROICgreaterthan 10percent isconsidered ahigh-qualitybusiness,whereas onewith lessthan 5percentROIC is a

low-qualitybusiness.Thereason forthis is thatthe higherthe ROIC,the more abusiness isabletoearn.What createsthe mostvalue is theability of abusiness toreinvest itsexcessearnings in

the businessat a highROIC.ROICcanbeimproved byutilizingcapital moreefficiently(such asmanaginginventoryandreceivablesmoreefficiently)or byincreasing

profitmargins.ROIC is lessuseful whentheinvestmentbasedoesnotadd to theearnings of abusiness.There havebeen veryfewbusinessesthat are ableto maintainhigh ROIC

over a longperiod oftime, andthose that dooften havelimitedgrowthprospects.

1.Standard&Poor’sCapitalIQ.2.Wiggins,Jenny.“WhenCoffeeGoesColdPart1.”FinancialTimes,December13,2008;Damian

Whitworth(InterviewwithHowardSchultz),“IWorryAboutEverybody.I’mParanoid.YouHavetoBe.”Times(London),March12,2011.3.Standard&Poor’sCapitalIQ;Ignatius,Adi.“WeHadtoOwntheMistakes.”HarvardBusinessReview,July–August2010.4.Standard&Poor’s

industryreports;Moody’sratingsandfinancialdatabases,asofJuly1,2006.5.Moorman,James.“Telecommunications:Wireless.”S&PIndustrySurveys,January20,2011.6.“Domino’sPizzaCompletesItsRecapitalizationPlanandDeclares$13.50perShareSpecialDividend.”PR

Newswire,April17,2007.7.BrookfieldAssetManagementwebsite.8.Moody’sratingsandfinancialdatabases,asofJuly1,2006.9.Flatt,Bruce.BrookfieldAssetManagementConferenceCall,November7,2008.10.Pruitt,A.D.“CanneryLoanisinDefault—VornadoStoppedMaking

Paymentson$18MillionMortgageontheLandmark.”WallStreetJournal,May12,2010;KrisHudsonandA.D.Pruitt.“‘JingleMail’:DevelopersAreGivingUpOnProperties.”WallStreetJournal,August25,2010.11.Standard&Poor’sCapitalIQ.12.Ibid.13.GoldmanSachs

dotCommerceDayInvestorPresentationbyWilliams-Sonoma,June22,2010.14.ConstellationBrandsatBarclaysCapitalBack-To-SchoolConference,CQFDDisclosure,September10,2009.15.DrugStoreNews,YearbookIssue,April1,2010,pp.26–29.16.Ball,Jeffrey.“TruckFirmsGoonBuyingBinge

toCircumventaNewEPARule.”WallStreetJournal,May28,2002.

CHAPTER6

EvaluatingtheDistributionofEarnings(Cash

Flows)

The future is inherently

unknowable.No one can saywithcertainty that abusinesswillgenerateagivenamountofearningstwoorthreeyearsfrom now, but we canestimate with some certaintywhat the range of earningsmight be. The range (ordistribution) of futureearnings of a particularbusiness is a key factor inhow much investors shouldbewilling topay to invest in

that business. The wider thedistributionoffutureearningsis for a business, the moredifficult it is to value thatbusiness and therefore toknow at what price thebusiness represents anattractive investment.Businesses with recurringrevenue streams or thosesellingconsumerstapleshaveamuch narrower distributionoffutureearnings.

For example, at Procter &Gamble, the range ofoutcomes for the futureearnings isverynarrow:Youwillnotseea50percentdropintheuseofTidedetergentinone quarter. When thedistribution of earnings isnarrow, you can use single-point-estimate valuationmethods, such as earningsyield, free cash-flow yield,and price-to-earnings ratios.

Incontrast, if thedistributionof earnings is wide, as in acyclicalbusiness,youneedtouse other valuation methods,suchasscenarioanalysis.This chapter explores

various factors that will helpyou determine whether thedistributionoffutureearningsandcashflows ismost likelyto be wide or narrow. Tostart, you must firstunderstand whether the

earnings thatwere calculatedunder Generally AcceptedAccounting Principles(GAAP) represent the trueearningsofabusiness.Todothis, you must determine ifmanagement uses liberal orconservative accountingstandards.Solet’sbeginwiththat.

27.Arethe

accountingstandardsthatmanagement

usesconservativeor

liberal?Your ultimate goal indetermining whethermanagement uses liberal or

conservative accountingmethods is to help youdetermine the true operatingearnings of that business. Inmost cases, youwill need tomake adjustments to theaccounting numbers tounderstand how much abusiness actually earns. Thereason for this is that thereare many ways to calculatefinancial numbers underGAAPstandards.

As this book is beingwritten, there are manychanges occurring toaccountingstandardswiththeadoption of InternationalFinancial ReportingStandards (IFRS), such asdisallowingtheuseoflast-in-first-out(LIFO).Eventhoughthere are many changesoccurring, the methodsmanagement can use tomanipulate earnings will

unfortunatelyremain.Here are several ways to

determine whethermanagement is using liberalor conservative accountingstandards.

ReadtheIncome-TaxFootnote

A good place to beginlearning if a business’sreported earnings

approximate its actualearnings is to read theincome-tax footnote found inthecompany’s10-Kreport.Abusiness keeps two sets ofbooks.The first one is basedonGAAPaccountingandtheother is used to calculate theamount of taxes a businessowes to the IRS. The IRSbooks tend to be aconservative benchmark,because in most cases firms

seek to minimize their tax-return income. On the otherhand,management can selectfrom various accountingmethods to calculate GAAPincome. If there is a largedifference between earningsforthesetwosetsofbooks,itwill be captured in theincome-tax footnote. Thefootnote reconciles thedifference between GAAPtaxes on earnings (known as

theincometaxprovision)andtheamountof taxpaid to theIRS(knownascurrenttaxes).In the income tax footnote,

compare the differencesbetween the Income TaxProvision andCurrent Taxesfor at least 5 to 10 years.Calculate how much bookearnings are overstated orunderstated compared tocurrent taxes. Ifyoudiscovera business is reporting

earnings yet is not payingtaxes,thisshouldsetoffsomealarm bells, as businessesrarelycheattheIRS.For example, one business

reported$189millioninaftertax earnings, but it paid theIRS and foreign taxauthorities only $5 million!That suggests a hugedifference in profits reportedto shareholdersversusprofitsreportedtotheIRS.

In comparison, NationalPresto Industries, a companythat makes housewares suchas pressure cookers, wafflemakers, and frying pans,reported that itscurrent taxes(both federal and state)totaled $70.9 million from2007 to 2009 compared to atotal taxprovision (i.e., booktaxes) of $74.8 million overthis same time period. Thismeans that its GAAP

earnings approximate actualcash earnings, indicating thatyouwould not need tomakeadjustments to the financialstatements in order tounderstand what the realearningsofthebusinessare.

CompareCashFlowfromOperationsto

NetIncomeManagement has less

flexibility in manipulatingcash flow from operationsthan it does net incomebecause net income containsa large number of highlysubjectiveestimates.Note the differences

betweennet incomeandcashflowfromoperationsoverthelast one to five years. If netincome closely approximatescash flow from operations,then there is less likelihood

that it is being manipulated.However, if net income isconsistently higher (morethan 30 percent) than cashflow from operations, thismay be a sign thatmanagement is managingearnings.

EvaluatingWhetherManagementManipulates

EarningsOne objective way to gaininsight into the integrity andcharacter of a business’smanagement team is to learnwhether they employconservative or liberalaccounting practices. Acompany’s accounting booksare written by its managers,and the accounting practicestheyemployare, toadegree,

a reflection of the kind ofpeople they are. If theaccountingistoocomplicatedto understand, this may be asignal that management doesnot really want you tounderstand how the businessmakes money or how wellthey are running thecompany.Management can

manipulate earnings inseveral ways. The degree of

manipulation varies fromminor changes to outrightfraudulent transactions.Earnings are most oftenmanipulated to cover updeteriorating earnings withinthe core business. Othertimes, management wants tomeet the quarterlyexpectations of Wall Streetanalysts by shifting earningsfromgoodyears tobadyearsorbyshiftingfutureearnings

tothepresent.Thereareseveralwaysthat

management manipulatesearningsdespitebeingwithinthe technical bounds ofwhatGAAP accounting standardsconsideracceptable.Lookforany(orall!)ofthefollowing:

Improperly inflatingsalesUnder- or over-statingexpensesManipulating

discretionarycostsChanging accountingmethodsUsing restructuringcharges to increasefutureearningsCreating reserves bymanipulatingestimates

Let’stakealookateachofthesemanipulations.

InflatingSales

Managementcanbooka salebefore revenue is actuallyearned by incentivizingcustomers to take moreproduct than they need. Thisismostlikelytohappenwhenthebusinesssellsitsproductsthrough distributors orresellers, when it has a fewlarge customers, or when asales representative needs tohitaquarterlysalesnumber.For example, Telecom

equipment companyRiverstoneNetworks inflatedits sales numbers in 2006 byimproperly recognizingrevenues. In this case,Riverstone had sideagreementswithitscustomerssaying payments toRiverstone were contingentupon resale of Riverstone’sproducts, but Riverstonebooked them as sales eventhough they didn’t actually

receive payment. TheSecurities and ExchangeCommission’s (SEC)complaint against Riverstonecited almost $30 million infraudulent revenues overseveral quarters, withoverstatements ranging from14 percent to more than 20percent of revenue duringeachquarter.1

You can identify methodsused to accelerate revenues

bylookingforlargeincreasesinaccountsreceivablegrowthcompared to sales growth.Whenaccountsreceivablearegrowing faster than salesconsider it a warning sign.Growth rates in sales and inaccountsreceivableshouldberoughly equal. If sales growby 10 percent, then accountsreceivableshouldgrowby10percent.For example, the sales of

contact-lens manufacturerBausch and Lomb grew 12percent in 1992 and 10percent in 1993, whilereceivables grew 35 percentand39percent in thosesameyears. The reason for thedifference was that BauschandLombchangedthewayitaccounted for revenues. Itpreviously recognized saleswhenmadetoendcustomers,but itchanged to recognizing

sales when made todistributors. A sale to adistributor is not the sameasselling to an end customer,becausesellingtodistributorsdoesn’tguaranteethattheendcustomer will actually buythe product, and thedistributor can return anyunsoldgoods.By the end of 1994, the

SEC began a formalinvestigationintoBauschand

Lomb’s accounting practices.The SEC investigatorsconcluded that during 1993,executivesartificiallyboostedthe company’s earnings bywrongly recognizing revenuefrom the sale of contactlenses. This accountingscandal led to an earningsrestatementand thedepartureofexecutives.2

There may be legitimatereasons for differences in

accounts receivable and salesgrowth, although anydiscrepancies should becarefully investigated. Forexample, sometimesreceivables growth exceedssales growth, and this mayhappenforseveralreasons:

First, the disparity ingrowth rates mightreflect a deliberatechange in sales termsdesigned to attract new

customers.For example,instead of requiringpayment within 30 daysof shipment, a businessmight allow customerstopayin45days.Second, it canbedue todeterioratingcreditworthiness amongexisting customers,which would representanotherproblem.Third, a business could

have changed itsfinancial-reportingprocedures, whichdeterminewhensalesarerecognized.

Under-orOver-StatingExpensesManagement sometimesshifts current expenses tolaterperiodsinordertoboostshort-term earnings.

Management can do this bycapitalizing an expense itemover several periods. Thisway, it can deduct theexpense over many years,insteadofallatoncewhen itis incurred. Capitalized costsend up on the balance sheetas assets, which are thenamortized over futureperiods.Commontypesofexpenses

that are capitalized and later

depreciatedinclude:Start-upcostsResearch anddevelopment (R&D)expensesSoftwaredevelopmentMaintenancecostsMarketingCustomer-acquisitioncosts

You can find out if abusiness routinely capitalizes

its costs by reading thefootnotes to the financialstatements.For example, Internet

service provider AmericaOnline(AOL)disclosedinitsfootnotes to the 1994 10-Kthat it was classifyingmarketing costs as balancesheet assets rather thanoperating expenses, namingthem Deferred SubscriberAcquisition Costs. By

capitalizing these expenses,AOLwasabletooverstateitsearningsforseveralyears.Beginning in 2001 and

continuing through May2002, telecom companyWorldCom capitalized morethan $9 billion of ordinaryexpenses inorder tomask itsdeteriorating financialcondition and increase theprice of WorldCom’s stock.OnJuly21,2002,WorldCom

filed for Chapter 11bankruptcyprotectionandonMarch 15, 2005, CEOBernard Ebbers wasconvicted of fraud andsentenced to 25 years inprison.3

ManipulatingDiscretionaryCostsDiscretionary costs includeadvertising, R&D expenses,

andmaintenancecosts.Thesecostscanalsobemanipulatedin order to smooth earnings.Management can curtailspendinginanyoftheseareastomeetanearningsgoal.Thisreduction in expenses maycompromise the long-termviabilityofthebusiness.Youshould monitor theseexpensesonaquarterlybasisand look for any irregularpatterns. If you discover that

in the fourth quarter, R&Dexpenses dropped by amaterial amount compared tothe same quarter a year ago,this may indicate thatmanagement is attempting tosmoothearnings.Manipulating discretionary

expenses is quite common.Professors Campbell Harveyand John Graham at DukeUniversity and ShivaRajgopalat theUniversityof

Washington surveyed 401financial executives at U.S.companies in 2003 askingthemwhatactionstheymighttake to smooth earnings andmeetanalystestimates.Closeto80percentof the financialexecutives surveyedresponded that in order tomeet an earnings goal, theywould reduce spending ondiscretionary items likemaintenance, research, and

advertising.4

ChangingAccountingMethodsLook for changes in theaccounting methods thecompany uses. A businessmust always disclose in afootnote if it changesaccounting methods, and itmust disclose any impact onearnings.

One of the more popularmethods used to deferexpenses is to extend theuseful life of assets in orderto reduce depreciationexpenses. A business mustdisclose in the footnotes tothe financial statementswhether it has extended theuseful life of an asset orchanged depreciationmethods. Also, when thebook value of the asset is

more than the present valueof projected cash flows fromthe asset, some companiessimply write down the valueof the asset. Managementmay be tempted to writedown the value of assetssubstantially during yearswhen earnings are lean. Theeffect of writing down theasset is that depreciation andamortization expenses arealsoreducedforallperiodsin

thefuture,causingearningstoautomatically increaseduringfutureperiods.For example, Waste

Management artificiallyboosted earnings byextending the useful life ofassetsandusinghighresidualvalues. The alleged fraudunraveled in 1997when newinterim CEO Robert Millerordered a review of WasteManagement’s past

accounting practices. WasteManagement issued arestatement of $1.7 billion,which was the largest incorporatehistoryatthattime.Stockholders lost more than$6 billion in market valuewhen, after the restatement,the price of the stock fell by33 percent.5 In its 1997annual report, the companydescribed how it changed tomore conservative

accounting:Effective October 1,1997, the Board ofDirectors approved amanagementrecommendationtorevisethe company’s NorthAmerican collection fleetmanagement policy.Front-end loaderswill bereplaced after 8 years,and rear-end loaders androlloff trucks after 10

years. The previouspolicywasnot to replacefront-end loaders beforethey were aminimum of10 years old and otherheavy collection vehiclesbefore they were aminimumof12yearsold.AlsoeffectiveOctober1,1997, the companyreduced depreciable liveson containers frombetween 15 and 20 years

to 12 years, and ceasedassigningsalvagevalueincomputing depreciationon North Americancollection vehicles orcontainers.

RestructuringChargesorOne-TimeExpensesIf the business is reporting alarge restructuring loss,

management may add extraexpenses in that restructuringcharge in order to decreasefuture expenses. Later,management can reversethese restructuringcharges toincreasefutureearnings.You can find these

reversals in the footnotes tothe financial statements bylooking for liability reserves.Typically, a liability reserveis set up by writing off the

expected cost of therestructuring as an expenseand crediting a restructuringreserve or other accruedliabilities and payablesaccount that is recorded as aliabilityon thebalancesheet.Later, as the costs of therestructuringarepaidincash,the restructuring reserveliability is reduced. Ifmanagement initiallyoverestimates the amount of

the restructuring expense, itcan reverse the liability andaddtheamounttoearnings.For example, when Albert

Dunlap became CEO ofSunbeam in July 1996, hetook several restructuringcharges that reduced netincome from $50 million in1995toalossof$228millionin 1996. By recording suchunusually high restructuringcosts, Sunbeam was able to

move future-year expensesinto its 1996 results. As aresult, by 1997, net incomejumpedto$109million,morethantwotimestheamountofnetincomeSunbeamreportedonly two years earlier in1995.Itwas later discovered that

Dunlap was manipulatingearnings by taking largerestructuringchargesandthenreversing these charges in

lateryears. In2001, theSECsued Dunlap for manyinstancesof fraudandbarredhim fromservingas apubliccompanyexecutive.6

UsingReservesReserves are often called thecookie jar of accountingmanipulation because theyrequire a large degree ofjudgment to estimate. Theterm cookie jar refers to the

ability to artificially storeearningsinthebalancesheet,sothatdishonestmanagementcan draw on them inunprofitable future years andlessen the impact of thenegativetimesonitsfinancialstatements. This is not adesirable occurrence, and theresult can be financialstatements that areintentionally misleading.Management can

overestimate the size of areserveaccount,which it canthenlaterdrawontoincreasefutureearnings.Reservescanbebookedfor:

BaddebtsSalesreturnsInventoryobsolescenceWarrantiesProductliabilityLitigationEnvironmental

contingenciesTo create reserves,

management can take acharge against currentearningsforoneoftheabove-listed reasons. Sometimesmanagement can useunrealistic assumptionswhentheyestimatereservecharges.They can over-reserve ingood times, thencutbackonor even reverse charges inbadtimes.Thisiswhatmakes

the reserve (the cookie jar)such a convenient income-smoothing mechanism formanagement. Look in thefootnotesattheallowancefordoubtful accounts and thencompare the provision fordoubtful accounts to actualcharge-offs. If the provisionaccount estimates increase ordecrease by a materialamount over a three-yearperiod while charge-offs

remain constant, thismay bea sign that management isusing reserves to manipulateearnings.For example, food

distributor Sysco uses aconservative method for itsallowance for doubtfulaccounts. In 2009, thecompanycharged$74millionto costs and expenses(provision for bad-debtexpense). In 2009, it wrote

off $72 million in customeraccounts (charge-offs),netofrecoveries.7 Therefore, itcorrectly matched itsprovision for doubtfulaccounts to actual chargeoffs. You can thereforeassume that Syscoconservatively estimates thecharge-offs. Table 6.1illustrates.

Table6.1Sysco:AllowanceforDoubtfulAccounts

Source:2010Sysco10-K.

On the other hand, KrispyKreme Doughnutsmanipulated earnings byfailing to book adequatereserves for doubtful

accounts. The provision fordoubtful accounts and theactual charge-offs are showninTable6.2.

Table6.2KrispyKreme:AllowanceforDoubtfulAccountsRelatedtoTradeReceivables

Source:2007KrispyKreme10-K.

As you can see in Table6.2,theprovisionfordoubtfulaccountswas$12.7millionin2005, which managementoverstated because actualcharge-offswere$2.6millionin 2005. By over-estimatingthe provision in 2005 and

under-estimating theprovision in 2006 and 2007,the management of KrispyKreme was able to increaseearningsin2006and2007.

28.Doesthebusinessgenerate

revenuesthat

arerecurringorfromone-offtransactions?

Businesses that earn theirrevenues from recurringsources are easier to valuewhen compared to those thatgenerate revenue from one-off transactions. Businessesthat have recurring revenueinclude:

Subscription-basedbusinesses, such as acable televisionbusiness.Razor/razorblade-typebusinessmodels,suchasImmucor, which sellsblood-bank equipmentandconsumablereagentsto be used with theequipment.Franchisors such asChoice Hotels, which

earns license fees onhotel brands such asComfort Inn, RodewayInn,andSleepInn.Servicebusinesses, suchas Fiserv, whichprovides integrated dataprocessing andinformation-management systems tofinancial-servicesproviders and earnsmore than 95 percent of

its revenue fromrecurring servicecontracts.

It is easier to forecast thefuture revenues for thesetypesofbusinessesbecausearecurring revenue business’sstartingbase isn’t zero, but acertain percentage of lastyear’slevelofsales.Supposea business earns $1.00 pershareinrevenueand$0.90isfrom recurring revenue, then

you know that $0.10 is atrisk. Recurring revenueallowsnewsalestoaddtotherevenue base, rather thansimply replace lost revenues.For example, Praxairprovides hydrogen and othergases to industrial clientsunder 15-year contracts,whichproducesanextremelypredictable revenue stream.Every new customer Praxairis able to add then provides

additionalrevenue.Other advantages of

businessesthatearnrecurringrevenuesinclude:

Lessdependenceonnewproducts. A businessdoes not have tocontinually come upwith new products orservices to replace theprior year’s revenues.On the opposite side ofthe spectrum from

recurring-revenuebusinessesare those thatgenerate revenues fromone-off transactions orthose that depend oncontinually selling thesame number ofproducts to maintaintheirsalesfromtheprioryear. These types ofbusinesses range fromconsumer-productsbusinesses, such as

navigation-equipmentmaker Garmin, toequipmentmanufacturers thatsecure large individualcontracts, such asCaterpillar. These typesof businesses depend onorders that come in oneat a time, with noguarantee orpredictability in therevenue stream, and are

therefore more difficulttovalue.Greaterpredictability.Ifthere is a lack ofvisibilityintoabusiness,it is difficult formanagement to knowhow much to invest orhowmuch tobudget forexpenses, whichincreases the odds ofmaking mistakes. Forexample, ifmanagement

makes a mistake in itssales forecast for theyear and budgets itsexpenses to that levelofsales, the business willlikely generate a loss.Therefore, recurringrevenueshelpputalimiton the downsideearningsofthebusiness.

You can typically findinformation on recurringrevenues in the 10-K under

the Management, Discussionand Analysis (MD&A)section. For example, the2010 10-K for hotelfranchisor Choice Hotelsstates, “Our companygenerates revenues, income,and cash flows primarilyfrom initial, relicensing, andcontinuing royalty feesattributable to our franchiseagreements (20-yearagreements on average).”

This indicates that ChoiceHotelsgenerates themajorityof its revenue from recurringsources.

29.Towhatdegreeisthe

businesscyclical,countercyclical,

orrecession-resistant?

Astheeconomyspeedsuporslows down, industries andindividual businesses mayeither go along with theeconomic cycle, go in theopposite direction, or not beaffected at all. There istremendous variation in howbusinesses react to economiccycles. In general, if a

business’s earnings declineduring an economicdownturn, the business isclassified as cyclical. Ifearnings increase during aneconomiccontraction,wecallit countercyclical. It isimportant to determine thedegreetowhichabusiness iscyclical or countercyclicalwhen forecasting earnings.Earningsthatfluctuateupanddownwiththebusinesscycle

aremore difficult to forecastthan earnings that displaygreater stability over theeconomiccycle.For example, it is difficult

to know what the futureeconomics will be for ahomebuilder. Demand forhomes is driven by manymacro-economic factors suchas interest rates, the cost ofmaterials, the employmentsituation (people don’t buy

houses if they are worriedabout losing their jobs), andthe general health of theeconomy.Itisdifficult,ifnotimpossible to forecast howthese multiplemacroeconomic factors willchange and what thecumulative effect onhomebuilderswillbe.Todetermine thedegree to

which a business is cyclicalor countercyclical, you must

first ask which types ofeconomic conditions make iteasierforabusinesstoattractcustomers. If abusinessdoeswell during an expandingeconomyyetdoesnotprosperwhen the economy isshrinking, it is cyclical. Forexample, the followingbusinessesarecyclical:

HouseholdfurnitureApparelAppliances

VacationtravelAutomobilesHomebuildingBig-ticket luxurymanufacturersResidentialconstruction

These are products thatconsumers can deferpurchasingintougheconomictimes.Thelongeraconsumercan defer purchasing theseitems, the more cyclical abusinesswillbe.

Someproductsandservicesare less cyclical. Customersbuy less, but do notcompletelydeferthepurchase—for example, businesses intheseindustries:

AdvertisingMedicalequipmentDrugsPeriodicalsInsurancecarriersDairyproducts

LegalservicesAccountingservicesBakeryproducts

Countercyclical businessesdowellwhentheeconomyiscontracting;forexample:

DiscountretailersPrivate-label products(store brands versusnationally brandedproducts)Medicalcare

While rare, certainindustries operateindependently of theeconomic cycle. In this casetheproductorservicemaybemore of a necessity; forexample:

Tobacco companies,where customers areaddictedtotheproductPipelines carrying oilandgasStudent-housingREITs

FuneralservicesThefollowingsectionstake

acloserlookatindustriesthatare recession resistant. If abusinessisrecessionresistantthen its earnings will not beimpacted as the economyenters a recession, therebymakingiteasiertovalue.

Recession-ResistantBusinesses

A recession-resistantbusiness,whichisrare,isonewhere the earnings of thebusinessarelessaffectedbyacontraction in the generaleconomy. For example,consider the economiccontraction that began in2007. To understand if abusinessisrecessionresistantor resilient, study how itresponded to that economicslowdown. Start by reading

the MD&A section found inthe 10-K. Read about thereasons for changes in thefinancialstatementlineitems,such as sales, so you cangaugetheeffectofrecessions.Read articles written aboutthe business during therecessionaswellashistoricalconference calls. It is highlylikely that analysts andjournalists will be askingcompany management how

their business is respondingto the recession, andmanagement’s answers willyieldmanyinsights.For example, specialty gas

distributor Airgas sells themajority of its products tonon-cyclical and counter-cyclical businesses. Many ofits products are used formaintenance and represent asmallportionofacustomer’stotalcosts.Ifyoulookbackat

previous recessions, Airgasgenerated relatively flatrevenues and earnings beforeinterest, taxes, depreciation,and amortization (EBITDA),indicating that Airgas is arecession-resistant business.In a fourth quarter 2009conference call, COOMichealMolininisaid:25 percent of our salesare the customersimpacted by the more

traditional cyclicality ofindustrial manufacturing,while 30 percent of oursales are the customerswhose growth profilestend to outperformGDP.Another quarter of oursales are the customerswho use our productsprimarily for repair andmaintenance, and thevolumes in that businesstend to stay more stable

than manufacturing. Intoday’s economy, thediversity of our customerbasehashelpedsoftentheimpact of the rapiddecline in U.S.manufacturing.Therefore, by reading a

conference call transcript,you would have learned thatatleast55percentofAirgas’srevenues are recessionresistant.

DegreeofRecessionResistance

The degree to which anindustry or business isaffected by recessionsdependsonseveralfactors:

Theamountof recurringrevenues a businessgenerates (morerecurringrevenuemeanslessvolatilityinearningsandmoreresistance).

The percentage of thecustomer’sbudgetthatisspent on that business’sproduct or service (if asmall percentage of thecustomer’s budget isspent on that business’sproduct or service, thecustomerislesslikelytodrop the product orservice).The percentage of itscustomers that are

exposed to businesscyclesandhowsensitivethey are to these cycles(if a business sells tohomebuilders, thatbusiness will be greatlyaffected by cycles inresidentialconstruction).

PastRecessionsMany industries andbusinesses are labeled as

recession resistant becausethey were able to survive aprevious recession without alarge drop in revenues. Becautious when you see anindustrylabeledas“recessionresistant” because not allrecessions are created equal,and each recession impactsbusinesses in different ways.Besuretounderstandiftherewere complicating factors,such as supply/demand

imbalances in previousrecessions. Such factors canmask the true effects of adownturn.For example, Las Vegas

casinoswereconsideredtoberecession resistant during the1980s and 1990s becausethey had fared better thanother businesses duringprevious recessions. The realreason they did so well wasbecause Las Vegas casino

demand was growing andsupply was limited duringthose years. During therecession in 2007, however,there was an oversupply ofcasinos in the Las Vegasmarket, which caused LasVegas casinos to experiencetheir worst operating resultsever.Be certain to consider

location and context as youevaluate supply and demand.

Regional casinos, forexample, were much lessaffected by the recession in2007, mainly because oflimited supply. In regionalmarkets, the numbers of slotmachinesandtablegamesarestrictly limited by localgaming regulation. As aresult,thesemarketshavelesschanceofbeingoversupplied.Forexample,regionalgamingcompany Penn National

Gaming found that eventhough customers werespending less on their visits,they continued to visit thecasinos at the samefrequency.Bycomparison,inLas Vegas, there was both adropintripfrequenciesandinhow much customers spentduringeachvisit.Theveterinary industryhas

alsobeenlabeledarecession-resistant industry because

spendingonpethealthdidnotdropduringtherecessionthatbegan in 2007. According toan annual industry survey,veterinaryspendingincreased3 percent in 2009 against a2.4 percent drop in GDP.There is evidence thatveterinary spending isbecoming less discretionary,with people more likely todemand higher-quality vetcare and less likely to defer

spending during downturns.However, increased demandhas also been fueled bychanges in pet testing. In thepast, most vets diagnosed ananimal through touch anddirect observation; however,new vets are increasinglytaught to use tests as a toolfordiagnosis.Beforedrawingtheconclusionthatveterinaryspending as a whole isrecession resistant, consider

that recent resistance mayhave been due to increasedtesting.Thisunderlyingtrendmay not fuel demand duringthe next recession so theveterinary industry may notbe as recession resistant asinvestorsbelieveittobe.

30.Towhatdegreedoes

operatingleverageimpacttheearningsofthebusiness?

Operating leverage measurestheimpactofchangesinsaleson earnings. The higher theoperating leverageabusinesspossesses, the more difficultit is to forecast the earnings

ofthebusiness.Forexample,a relatively small error inforecasting sales can bemagnifiedintolargeerrorsinearnings projections. If salesdecrease by 10 percent, thenearningsmay decrease by 30percent. This means thatbusinesses that have highfixed costs typically reporterraticearnings,whichmakesthemmore difficult to value.In contrast, businesses that

havelowfixedcostsandhighvariable costs present lowervolatility in earnings and aresimpler to value. Forexample,a10percentgrowthrate in sales for a variable-cost firm could translate into10 percent growth inearnings. The earnings aretherefore not as volatile as abusiness with high amountsofoperatingleverage.

TypesofBusinesseswithHighOperating

LeverageThe following businessestypically have high operatingleverage:

Businesses that have ahighlaborcomponentBusinesses with highcapital-expenditurerequirementsManufacturerswithhigh

material and productioncostsBusinesses that arerequiredtoinvestalotofmoneyininventory

These types of businessesinclude:

AirlinesAluminummanufacturersAutomanufacturersBondratingfirms

ChemicalmanufacturersGamingbusinessesHotelsMiningcompaniesREITsRetailersSteelmakersSupermarketsThemeparksUniversities

Calculatingthe

DegreeofOperatingLeverage

Businesses have varyingdegreesofoperatingleverage.Some businesses have lowamounts of operatingleverage, such as hotelfranchisorChoiceHotels,andsome have high amounts ofoperating leverage, such as athemepark.To calculate the degree of

operating leverage (i.e., howmuchearningsare influencedby changes in sales), dividethe percentage change inoperating income by thepercentage change in sales.The higher the degree ofoperating leverage, the morevolatile the operating-incomefigure will be relative to agiven change in sales. Forexample, let’s look at twocompanies, Boeing and

ChoiceHotels:Boeing has a highdegree of operatingleverage: For the yearended 2008, Boeingreported in its10-K thatrevenues decreased 8.3percent and operatingincome decreased 33.9percent.By comparison, also in2008, hotel franchisorChoiceHotels in its 10-

K reported revenueincreased 4.3 percent,withacorresponding1.5percent increase inoperatingincome,whichmeans it has a lowerdegree of operatingleverage compared toBoeing.

Let’sexamineonebusinessin more detail to understandwhy it has high operatingleverage.

CaseStudy:WhyThemeParksHaveHighOperating

LeverageA theme park has very highfixed costs and low variablecosts. A theme park requiressignificant capital investmentin terms of land andequipment.Eachyear,aparkhas to make significantinvestments in new

attractions in order to attractmore customers. Fixed costsdo not change with thenumber of customers and alot of these costs are stillincurredevenwhenthethemeparkisclosed.Afterreachinga certain level of attendance,where a theme park achievesits break-even point, everynew customer’s ticketrevenue drops straight to thebottomlinewhichcontributes

to high marginal profit.Therefore, it is in theinterestof a theme park to increaseattendance.Table 6.3 compares the

revenue growth and earningsbefore interest and taxes(EBIT) growth for themeparkSixFlags.

Table6.3RevenueGrowthComparedtoEBITGrowthforSixFlagsThemeParks

Datasource:“SixFlagsEmergesfromBankruptcy,”HedgeWorldNewsvia

Reuters,May3,2010,andStandard&Poor’sCapitalIQ.

This shows how sensitiveearnings are in relation torevenue. High operatingleveragecanmakeacompanyvulnerableontwofronts:

Ifthebusinessfacesany

risk of say, reducedrevenue,asinthecaseofSix Flags, it has theadditional, amplifiedearnings risk thataccompaniesit.If the business has highamounts of debt, thiscombination can bedisastrous.

Be careful if you invest inbusinesses that have highoperating leverage and large

amountsofdebt.Theycangobankrupt quickly, becausesmalldeclines in revenueareamplified into largerdeclinesinearnings,bringingaboutaninability to make interestpayments.To calculate the actual

amount of the degree ofoperating leverage at abusiness, you need tounderstand what the break-even sales are for the

business. This way, you candetermine how acorresponding increase ordecrease in revenue willimpact the operating incomeofabusiness.

CalculatingBreak-EvenSales

Ideally, you would want tounderstand at what level ofsales a business would

generatebreak-evenearnings.Thisway,youwouldbe in abetter position to understandat what level of salesoperating leverage will startto work against the earningsofthebusinessorinitsfavor.Here’s a method used to

calculate break-even sales: Ifa business generates $1millionof sales andhas a30percent gross profit margin(GPM) and incurs $200,000

in fixed costs, it will earn$100,000. Therefore, break-evensaleswouldbe$666,667(Sales × 30 percent =$200,000), assumingeverything else stays equal.Unfortunately, in the realworld, everything else doesnot stay equal, which makesitdifficulttocalculateatwhatlevel of sales a businesswillbreakeven.Further complicating

things, it is difficult tocalculate the exact amountsof fixed and variable costs:Even management hasdifficulty calculating exactamounts. The reason for thisis that most fixed costs aremore flexible than theyappear because equipmentcanbesold,alaborforcecanbe resized, leases can berenegotiated, or certainproduction lines can be shut

down. For example, hotelsover the last decade havebeen able to change theirbreak-even cost foroccupancy. For example,break-even occupancy forhotels declined steadilybetween 1986 and 2000.8 In1986, a hotel had to have anaverage occupancy of 66.4percent to break even. By2000,thisamountchangedtoonly 47.4 percent. Why the

drop? Because hotels shiftedtheirrevenuemixtofocusonhigh-margin room revenues.They cut costs related toaccounting, telephones, andother back-of-the-housestaffing, and they lowereddebt levels. These changesenabledthemtobreakevenifahotelwasonlyhalffull.Instead of calculating an

exact amount for break-evenlevel,youcancalculaterough

estimates for the businessesyou’re considering investingin: After all, a roughapproximation is better thanno approximation. Let’s startbyexamininghowtoidentifyfixedandvariablecostsusingthe 10-K report so you canestimatebreak-evensales.

IdentifyingFixedCosts

A fixed cost is a cost thatdoes not change with thenumber of outputs. Forexample,withastainlesssteelmanufacturer, certainmachinery needs to be keptrunning even if it is notmaking anything. Heatersmust be constantly keptrunningeveniftheplantisn’tmaking steel because if theywere turned off, theequipment would

disintegrate. Also, fans thathandlepollutantsmustalwaysbe kept on because turningthe motors on and off candamage them. These costsremain the samewhether thesteelmillmakesonebatchofsteelor10batches.Ifdemandfor steel drops, these plantsmustcontinuetooperate,andwhen sales drop, thatcontributes to a largedecreaseinearnings.

IdentifyingVariableCostsVariable costs are costs thatchangeindirectproportiontochanges in revenue. If abusiness sells more items,costs increase, and if salesdecrease, then costs willdecrease. The types ofbusinesses with the highestvariablecostsarefranchisors.An example would be real

estate brokerage firmColdwellBanker,whichsellsfranchise rights to use itsbrand. When ColdwellBanker’s franchised brokerssell properties, the companyreceives a fee from the saleproceeds. Coldwell Bankerthen pays for nationaladvertising and marketingfrom the proceeds of sales,and so tends to incur costsonly in relationship to

transactions.To begin learning more

about how to identify fixedand variable expenses andhow to calculate them, twoexamples are presentedbelow.Thefirst isSouthwestAirlines, which has a highfixed-cost structure and lowvariable costs; the second isChoice Hotels, (a franchisorof hotel brands such asComfort Inn,ComfortSuites,

andClarion),whichhas highvariable costs and low fixedcosts. Both examplesillustratehowyoucanusethebalance sheet and incomestatementtohelpyouidentifythe fixed and variableexpenses. Let’s start byreviewingthebalancesheet.

ReviewingtheBalanceSheet

Start by looking at the fixedassetsasapercentageoftotalassets of the business. Abusiness that has a largepercentage of long-termassets compared to totalassets typically has a highfixed-coststructure.At Choice Hotels, total

assets are $340million as ofDecember31,2009.Thetotallong-term assets are $64million,ofwhich$43million

are net property, plant, andequipment, and $21 millionare long-term investments.Total long-termassetsare19percent of total assets,whichimplies that Choice Hotelshasalowleveloffixedcosts.Incontrast,asoftheendof

2009,SouthwestAirlineshadtotal assets of $14.27 billion.Its total long-term assets are$10.39billion,madeupofnetproperty, plant, and

equipment. Total long-termassets are 73 percent of totalassets, which implies thatSouthwestAirlineshasahighleveloffixedcosts.

ReviewingtheIncomeStatementofSouthwestAirlinestoIdentifyFixedandVariableCosts

Next, review the incomestatement and beginwith thetotal selling, general, andadministrative expenses(SG&A). The SG&A sectioniswherethemajorityoffixedcosts are typically found. Towalk you through thisprocess, let’s use the 2009income statement ofSouthwest Airlines as anexample. The breakdown (inmillions) is shown in Table

6.4.

Table6.42009OperatingExpensesofSouthwestAirlinesTotalOperatingExpenseBreakdown

Amount(inmillions)

Salaries,wages,andbenefits $3,468Fuelandoil $3,044Maintenancematerialsandrepairs

$719

Aircraftrentals $186Landingfeesandotherrentals $718Depreciationandamortization $616Otheroperatingexpenses $1,337Totaloperatingexpenses $10,088

Next,usetheMD&Aofthe

10-K to classify whetherexpenses are fixed orvariable. The examplesshown below (in quotationmarks) are from the 2009SouthwestAirlines10-K:

Salaries, wages, andbenefits—Fixed Costs:“Salaries, wages, andbenefits expense perASM (Available SeatMiles) was 9.6 percenthigher than 2008,

primarilydue to thefactthat the Company’sunionized workforce,who make up themajority of itsEmployees, had payscale increases as aresult of increasedseniority, while theCompany’s ASMcapacity declined 5.1percent compared to2008.” In addition, the

notessectionofthe10-Kstates, “Approximately82 percent of theCompany’s Employeesare unionized and arecovered by collectivebargaining agreements.”You can thereforeconclude that most ofthe salaries, wages, andbenefitsarefixed.Fuel and oil—FixedCosts in Short-Term

and Variable Costs inLong-Term: Southweststates that fuel and oilexpense decreased 18percent as the availableseat miles decreased by13.6 percent. Most ofthisdecreasewasdue toa decrease in the pricesof jet fuel.Themajorityof fuel and oil expensesare fixed in the shortterm and variable in the

long term. They arefixed in the short termbecause it would taketime for Southwest toadjust its flights to adecreaseindemand.Maintenance materialsand repairs—MainlyVariable Costs: “Themajority of the increaseinenginecostsrelatedtotheCompany’s 737–700aircraft, which for the

secondhalfof2008andall of 2009 wereaccounted for under anagreement with GEEngines Services, Inc.(GE Engines) thatprovides for enginerepairs to be done on arateperflighthourbasis.Under this engineagreement, which issimilartothe‘power-by-the-hour’ agreement

with GE Engines theCompany has in placeforits737–300and737–500 fleet, payments areprimarilybasedonarateperflighthourbasis.”Inother words, SouthwestAirlines has outsourcedits maintenancematerials and repairs toGeneral Electric, andSouthwest pays GeneralElectric based on the

number of air milesflown:Therefore, this isavariableexpense.Aircraftrentals—FixedCosts: “Aircraft rentalsexpense per ASMincreased 26.7 percentand, on a dollar basis,increased $32 million.”Furthermore, in theNotes to the financialstatements, you’ll seethat total rental expense

for operating leases,both aircraft and other,charged to operations in2009, 2008, and 2007was $596 million, $527million, and $469million, respectively. Inother words, aircraftrentals are fixedexpenses because theyrepresent multi-yearcontractualobligations.Landing fees—Fixed

Costs: “Landing feesand other rentalsincreased$56millionona dollar basis andincreased 14.1 percenton a per-ASM basis,compared to 2008. Themajority of both thedollar increase and per-ASM increase was duetohigherspacerentalsinairports as a result ofhigher rates charged by

those airports for gateand terminal space.”Landing fees can bethought of as anoperating lease.Southwest will pay thesame fee for the gatewhether theplane is fullor not. Assuming astable flight schedule,these costs can beconsideredfixed.Other operating

expenses—FixedCosts:Other operatingexpensesincludeinterestexpense, capitalizedinterest, interest income,and other gains andlosses.Mostofthesearelong-term contractualexpenses and thereforearefixed.

Conclusion:SouthwestAirlines

HasHighOperatingLeverageTo summarize, here are thefixedexpenses forSouthwestAirlines(inmillions):

Salaries, wages, andbenefits where 82percentoftheworkforceis unionized and has acontract($3,468).Aircraft rentals as wellaslandingfeesandother

gate leases ($718 +$186).Other operatingexpenses mainlyrepresenting contractualobligations($1,337).Depreciation andamortization($616).Total fixedexpensesareapproximately$6,325.

Here are the variableexpenses for SouthwestAirlines(inmillions):

Fuel and oil are mainlyvariable expenses($3,044).Maintenance, materials,and repair are variableexpenses which vary bythe number of milesflown($719).Total variable expensesare$3,763.

Therefore the percentage offixed expenses is 63 percent,and variable expenses

approximate 37 percent.Many of these variableexpenses are fixed in theshort run because SouthwestAirlineswouldneedtoadjustits flights to meet lowerdemand. Therefore,approximately two thirds ofSouthwestAirlines’ costs arefixed and one third arevariable,whichmeansifsalesweretodrop,thiswouldhavea disproportionate effect on

the earnings of the businesscompared to a business thathas largely variable costs. Inotherwords, if sales dropped10 percent, then earningscould easily drop by morethan 40 percent. You wouldneed topaya lowerprice forthis business because itsearningsare less stable.Nowlet’s take a look at ChoiceHotels’incomestatementandsee how that compares to

SouthwestAirlines.

ReviewingtheIncomeStatementofChoiceHotelstoIdentifyFixedandVariableCosts

ChoiceHotels is a franchisorthat licenses hotel brandnames such as Comfort Inn,Comfort Suites, Econo

Lodge, and Clarion. As ofDecember 31, 2009, theCompany had franchiseagreements representing6,021 open hotels and 843hotels under construction.Table6.5showsabreakdownof the total operatingexpenses (in thousands)found in the fiscal year2009Choice Hotels 10-K, withexcerpts below (again inquotationmarks).

Table6.52009OperatingExpensesofChoiceHotelsTotalOperatingExpenseBreakdown

Amount(inthousands)

Selling,general,andadministrative

$99,237

Depreciationandamortization

$8,336

Marketingandreservation $305,379Hoteloperations $3,153Totaloperatingexpenses $416,105

Selling, general andadministrative—Mainly Fixed Costs:“The cost to operate thefranchising business is

reflected in SG&Aexpenses on theconsolidated statementsof income. SG&Aexpenses were $99.2million for 2009, adecrease of $19.8million from the 2008total of $119.0 million.The decline in adjustedSG&Acostsfortheyearended December 31,2009,wasprimarilydue

to cost containmentinitiatives as well aslower variable franchisesales compensation.”Also,intheNotestothefinancial statements,there is a section titledContractual obligations,which breaks out thedebt and lease expensesof the business:Operating leaseobligations total $14

million. Advertisingexpense was $81.3million in 2009representing 82 percentofSG&A.Advertisingisa variable cost but youshould probablyconsider it to be a fixedcost as advertising isnecessary to maintainhigh brand awareness.Leasesare$6million in2009, which are a fixed

cost because they arecontractual obligations.AlthoughChoiceHotels’SG&A has somevariable components,you can conclude thatthemajorityofexpensesarefixedcosts.Marketing andreservation—Noincome or loss fromthese expenses, so theybreak even: “The

Company’s franchiseagreements require thepayment of franchisefees, which includemarketing andreservation system fees.The fees, which arebasedonapercentageofthe franchisees’ grossroom revenues, areusedexclusively by theCompany for expensesassociated with

providing franchiseservices such as centralreservation systems,national marketing, andmedia advertising. TheCompany iscontractually obligatedto expend themarketingand reservation fees itcollectsfromfranchiseesin accordance with thefranchise agreements; assuch, no income or loss

to the Company isgenerated.” Thesemarketing andreservation expenses arepassed on to thefranchisees. Thesebreak-even expenses(meaning Choice Hotelsdoesnotmakeaprofitora loss on them) shouldbe considered neitherfixednorvariable.

Conclusion:ChoiceHotelsHasLowOperatingLeverageFixedcostsareclose to$108million,outofatotalof$416million, but $305 million ofthose expenses representareas where Choice does notearn a profit or breaks even.Therefore,thebusinessneedstogeneraterevenueinexcessof $108 million in order to

break even. In 2009,excludingthe$305millioninrevenue it earned frommarketing and reservations,Choice Hotels generatedclose to $250 million inrevenue, which can easilycoverthesefixedexpenses.Ifrevenueswere to drop by 55percent in one year, ChoiceHotels would break even.BecauseChoiceHotels has alow level of operating

leverage, an investor takeslessriskthattheearningswillfluctuate widely whenrevenuesdecline.As a result, investing in

businesseswithlowoperatingleverage results in less riskthan investing in one withhigh operating leverage. Thereason for this is thatbusinesses that have a largepercentage of variableexpensesareabletodecrease

theirexpensesquicklyifsaleschange. Those that have ahigh fixed-cost structure areunable to react quickly to adrop in sales. Therefore theearnings of a business withhigh operating leverage canchangequickly,whichmakesit difficult to forecastearnings. You should alwayspay a lower price for abusiness that has highoperating leverage to give

yourself a sufficient marginofsafety toaccount for theselargefluctuationsinearnings.

31.Howdoesworkingcapitalimpactthecashflowsofthebusiness?

Workingcapital is thecashabusinessusestofunditsday-to-day operations. Forexample,abusinessusescashin order to buy inventory,which it needs to operate. Abusiness then gets paid bycustomers after it sells thisinventory and then uses thatmoney to pay its suppliers.By understanding workingcapital, you will be able toassesswhetherabusinesscan

growbyusingitsowncapital,rather than having to dependonitscustomersandsuppliersto finance the business. Thefaster a business can turn itsinventory and collect itsreceivables and the longer itcan stretch out its payables,the higher the operating cashflow.If it is difficult for you to

understand the working-capital needs of a business,

then it will be difficult foryoutoforecastthecashflowsofabusiness.Toaccount forthis risk, you must pay alowerpriceforthestock.

CalculatingNetWorkingCapital

Working capital is calculatedby subtracting current assetsfrom current liabilities.Current assets are balance-

sheet items such as accountsreceivable and inventory.These are assets that can beturned into cash in less thanone year. Current liabilitiesare balance-sheet items suchas accounts payable andshort-term debt. These areliabilities that are due withinoneyear.Increasesinworkingcapital

areconsideredacashoutfloweven though the capital does

not leave the business. Forexample, an increase ininventory consumes cash,eventhoughthebusinessstillholds the inventory. Thebusinessdoesnothaveaccessto the cash it has invested intheinventoryuntilitsellsthatinventory. As a result, thebusiness cannot use the cashfor other investments. Youcan think of working capitalin terms of opportunity cost

where the business foregoesthe ability to use cashwhenever it has to holdinventory or if customersdelay payment. By bettermanaging working capital,doing such things as sellinginventory more quickly, abusiness is able to free upcash thatwouldotherwisebetiedupininventory.

AmountofWorking

CapitalNeededbyaBusiness

The amount of workingcapital a business needsdepends on the capitalintensity and the speed atwhichabusiness can turn itsinventory into cash. Theshorter the commitment orcycle, thelesscashis tiedupand the more a business canusethecashforotherinternal

purposes.For example, most

restaurantsneedtoretainverylittle cash on hand becausetheir inventories are turnedinto cash very quickly.Service businesses typicallyrequire little or no inventoryand are paid in cash bycustomers before providingthe service. On the otherhand, airplane manufacturerBoeing takesmuch longer to

turnapileofsheetsteelandabunch of electronics into anairplane; therefore, Boeingneedsalotofcashonhandtocover necessary cashdisbursements.

CalculatingaCompany’sAbilitytoGenerateWorkingCapital:UsingtheCashConversion

Cycle(CCC)Theprimarytoolyoucanuseto measure how quickly abusinessisabletoconvertitsinventoryandreceivablesintocash and pay its short-termobligations is the CashConversion Cycle (CCC).The CCC calculates thenumber of days that cash isinvested in inventory andaccounts receivable, and the

extent to which the cashoutflow is covered byaccountspayable.Thefasterabusiness can turn over itsinventory and collect itsreceivables and the longer itcan stretch out its payables,the higher the operating cashflow.Here’stheformula:

Inventory conversionperiod (Days InventoryOutstanding): Average

Inventory/(Total Cost ofGoodsSold/365)Receivables conversionperiod (Days SalesOutstanding): AverageAccountsReceivable/(TotalRevenue/365)Payables conversionperiod (Days PayablesOutstanding): AverageAccounts Payable/(CostofGoodsSold/365)

If you addDIO (days to sellinventory) to DSO (days tocollect receivables), that willtell you the total conversionperiod of inventories. Let’ssay it takes 50 days to sellinventory and 30 days tocollectreceivables.Therefore,you can conclude that itwouldnormally take80days(50+30)tosellinventoryoncredit and to collect thereceivables.

Then, you would subtractthe time that it takes to payback suppliers. For example,if the days payablesoutstanding(DPO)is20days,youwould subtract this from80 days to arrive at the totaltime it takes to convertinventories into cash, or 60days.A business can improve itsCCCinseveralways:

Bysellingitsproductsas

fast as possible (highinventoryturns)By collecting paymentsfrom customers as fastas possible (highreceivablesturns)By paying suppliers asslowly as possible (lowpayableturns)

Table 6.6 lists someexamples of businesses withdifferent cash-conversioncycles. They range from

negative CCC (which meansthatsuppliersare funding thebusiness) to high CCC, suchashomebuilderTollBrothers,which is required to keep alot of land in inventory inordertooperate.

Table6.6CashConversionCycleofDifferentBusinessesFY2009

Source:Standard&Poor’sCapitalIQ.

Company No.ofDays

Apple –48daysSouthwestAirlines –15.4daysWholeFoodsMarket 14daysVerizonCommunications 25daysEnergizerHoldings 151daysAmgen 340daysTiffany 437daysTollBrothers 847days

Calculate the CCC for atleastafive-yearperiodforthebusiness you are analyzing.Youwant to understandwhythe CCC is changing overtime. You can do this byexamining each of the

components that makes upthe CCC—that is, the DIO,DPO,andDSO.For example, Hughes

Communications (abroadband satellite business)improved its cash conversioncyclefrom62daysin2008to39daysin2009.Itdidthisbyencouragingcustomerstousecreditcardstopaytheirbills,which speeded up itscollectionofreceivables.This

had the effect of reducingDSO from 70 days to 65days. In addition, Hughesalsoincreasedthetimeitpaidits suppliers from 48 days in2008 to 67 days in 2009,which further helpedHughesfree up more cash flow.During 2008, the stock priceof Hughes dropped frommorethan$50pershare,toaslow as $9 per share at thebeginning of 2009. As

Hughes’s managementimproved cash flows, thishelpedthestockpricerecoverto$26pershareonDecember31,2009.9

DetermineWhetherChangesinWorking

CapitalAreSustainable

Next, youwant to determineif the improvements or

deterioration in the CCC aresustainableor temporary.Forexample,duringtherecessionthat began in 2007, manybusinesses improved theirworking capital because theywereforcedtofindadditionalcash to finance theiroperations. In the past, theywere less disciplined inmanaging their workingcapital because they did notface financial constraints.

However, many of theseimprovements are temporaryratherthansustainable.If the improvements in

working capital aresustainable, theneverydollarof freed-up working capitalwill boost cash flows.However, if improvementsare temporary, you need toadjust cash flows in order tonormalize them for thesetemporaryimprovements.For

example,mostbusinessescanget away with delayingpayments to suppliers. If thecompany has increased itsDPO (days payableoutstanding) from40days to45days,andyoubelievethatimprovement isn’tsustainable, then you shoulduse40dayswhencalculatingthat company’s CCC. Atsome point, suppliers maydemand stricter payment

terms, so the delay may beonlytemporary.

NegativeWorkingCapital

When a business has morecurrentliabilitiesthancurrentassets, it has negativeworking capital. This meansthe customers and suppliersare financing the business,whichisalessexpensiveway

of funding growth. Forexample, let’ssayyouownaretailbusinessandyouinvest$1millionininventory,anditcosts $1 million to build astore.Now let’s say you canfinance 50 percent of yourinventorybypayingsuppliers90 days later. The upfrontcapitalinvestmentwouldthenbe$1.5million insteadof$2million. Your suppliers areallowing you to delay

payments for yourinvestmentsandgivingyouareadysupplyofcash.A common attribute of

businesses that benefit fromnegative working capital isthat cash flow fromoperations exceeds netincome. Here are twoexamples,from2009:

At online retailerAmazon.com, cash flowfrom operations

exceeded net income by$2.4billion.At online travel websiteExpedia,cashflowfromoperations exceeded netincomeby$377million.

This means thesebusinesses were able togeneratemorecashflowfromoperations than net income.Many times the excess free-cash flows are invested inshort-term investments, such

as cash, which generateinterest income that dropsstraight to the bottom line.These businesses thusgenerate a safer cash-flowstream.

NegativeWorkingCapitalOnlyWorksinYourFavorWhenSalesAreGrowing

You cannot rely on negative

working capital being aconsistent,meaningfulsourceof cash flow, especially ifgrowth isn’t strong. If thebusiness experiences asignificant downturn, eitherdue to a secular decline,demand shocks, or market-sharelosses,thenthebusinessmay face a liquidity strain.When the business stopsgrowing, it is unable to pushout liabilities further into the

future, and the positiveeffects of negative workingcapital will reverse anddecreasethecashflowsofthebusiness. Instead ofcontinuing to pay suppliersout of growing cash flow, ifgrowth slows down, thebusinesswillhave topay thesuppliers out of its existingcashbalance.For instance, in the third

quarter of 2008, Dell

generated negative cash flowfromoperations,which ithasdone only two times since1993.10 At the beginning ofthe third quarter, demand forproductswas stable andDellwas ordering supplies on anormal basis, when midwaythrough the quarter,customers stopped placingorders due to the financialcrisis that was taking place.This meant Dell could no

longer keep pushing out itsaccounts payable balance,and it had to usemore of itscash to pay its payables. Inthe fourth quarter of 2008,this situation reversed itselfas demand stabilized andDell’scustomersreturnedtoamore consistent orderingpattern. Luckily, Dell had asizableamountofcashon itsbalancesheetsoitwasabletofund the shortfall. If a

negative working capitalbusiness does not haveenough cash on the balancesheet, then the business willrun into short-term liquidityproblemsandpotentiallyfacebankruptcy. If you foreseethathappening,thatcompanyis obviously not a goodinvestmentatthattime!

32.Doesthe

businesshavehighorlowcapital-

expenditurerequirements?

Determining the capital-expenditurerequirementsofabusiness will help youunderstand how much free-cashflowthebusinessisable

to generate. If the capital-expenditure requirements arehigh, then the cash flows ofthe business need to becontinually reinvested in thebusiness just to maintainexisting assets. High capitalexpenditures reduce cashflow,whichiswhatthevalueofabusinessisbasedon.For example, a paper

manufacturer often losesmoney due to the cyclical

nature of thebusiness.Whenthe paper manufacturerfinally generates excess cashflow, management mustspend the excess cash flowupgrading its manufacturingplants. Therefore, the cashflowsarecontinuallyrecycledinto the business, whichcauses the value of thebusiness to be stagnant. Onthe other hand, a businesswith low capital-expenditure

requirements (one thatrequires less capital tomaintain its assets) carriesless risk, especially ininflationary environments.Because a business does notneedtocontinuallyrecycleitsexcess cash flow tomaintainits assets, this allows it toreinvest excess cash flow tocreate more value ordistribute these excess cashflowstoshareholders.

Acapital-intensivebusinessis a business that requires alarge amount of capital orassets for every dollar ofsales. Here are someexamples of capital-intensivebusinesses:

SemiconductorsTelecomRetailChemicalsCement

SteelPulpandpaperMaterialsMiningOilandgasThemeparksAirlinesTraditionalmanufacturingcompaniesDistributioncompanies

The ratio of capital

expenditures to salesofmostof these businesses is morethan $0.20 of capital forevery$1inrevenue.Telecombusinesses are some of themost capital-intensivebusinesses because theyrequire, on average, $1 ofcapital for every $1 inrevenue.In contrast, businesses that

are not capital intensiveinclude:

FranchisorsIntermediaries that earncommissions forconnecting buyers andsellersSoftwarebusinesses

These businesses are notcapitalintensivebecausetheydo not require majorinvestments in new facilitiesto grow or maintain theirbusiness. These types ofbusinesses add employees,

instead of physical plants, togrowthebusiness.

CalculateMaintenanceCapital

ExpendituresIt is important for you tocalculate the amount ofmaintenance capitalexpenditures a companyneedstomaintainitsbusinessin order to calculate the

distributable free-cash flowsof a business. Maintenancecapital expenditures are theamount of investmentnecessary to keep thecompany in a steady state:For example, replacing orupgrading administrative orsupport facilities such asbuildings or parking lots.These expenditures typicallydo not earn an excess returnonthecapitalexpended.They

generally help maintaincurrent cash flows, but theydonotincreasecashflows.Many businesses require

largeamountsofmaintenancecapital expenditures to keeptheir equipment operational.For example, an oil refinerymust constantly reinvestcapital to maintain itsbusiness. These types ofbusinessesneedtospendalotof theircapitalupdating their

plants to meet governmentregulations or environmentalstandards, such asOccupational Safety andHealth Administration(OSHA) or U.S.Environmental ProtectionAgency (EPA) regulatorystandards. This capital doesnotearnareturn,althoughinafewinstances,itcanmakeafacilitymoreproductive.Youneed to determine what

percentageofcapitalneedstobe reinvested to meet theseregulatory standards or othernon-discretionary requiredinvestments. By doing this,you will understand theamount of excess cash flowsa business generates, whichwill help you value thebusiness.Some businesses

continually defer capitalexpenditures to maintain

property and equipment, butthatcanincreaseriskbecausethoseassetsmaylosevalueorrequire extremely heavyexpenditures at a later pointin time. For example, if arefinerydoesnotmaintainitsassets, then the refinery willsuffer prolonged periods ofdowntime when the assetsneed to be repaired orreplaced. This will result inlower cash flows from the

business because the refinerywill have to shut down partsof its plant to fix the assetsthatwereneglected.You can find the capital

expendituresofabusinessbyreading the company’s cash-flow statement, and you canfindfurtherexplanationofthebreakdown in the MD&Asection.Somebusinesseswilldifferentiate between capitalexpenditures needed for

growth and capitalexpenditures needed tomaintainabusiness.For example,WholeFoods

Market reported in its 10-Kthat for fiscal year 2010(which ended on September26, 2010) that its capitalexpenditures amounted to$256.8 million, of whichapproximately$171.4millionwas used for new storedevelopment and

approximately $85.4 millionwas spent on remodels andotherpropertyandequipmentexpenditures. However, thisis unusual: Most businessesdo not separate out theamount of capitalexpenditures used for growthand those to maintain thebusiness.Wheneveryouareunableto

calculate the maintenancecapital expenditures, you can

use depreciation as a roughapproximation. It is easier touse depreciation if thebusiness has a low or well-defined growth pattern orsteady state. In other casesyou will have to adjust thedepreciation upward ordownward depending on thetypes of assets a businessmustmaintain.For example, at book

retailer Barnes & Noble, the

depreciationoftheshelvesinthe bookstore is higher thanthe reinvestment needed tomaintain them, thereforeusing depreciation tocalculatemaintenance capitalexpenditures would not beappropriate. In contrast, thechildren’s entertainmentrestaurant Chuck E. Cheeseconstantlyhas to investmorethan its depreciation chargesto refresh its store base.

Those high maintenanceexpenses decrease thedistributable free-cash flowsofthebusiness.For any business you’re

considering investing in, youwill need to determine howlongtheassetswilllastbeforethey need to be replaced.Read the notes to thefinancial statements in thesection where managementdiscloses the breakdown of

property, plant, andequipment into categoriessuch as informationtechnology, property,machinery, equipment,buildings, or land. You canthenfocusonthoseassetsthatneed to be maintained orreplaced (such asmachinery)and exclude those that don’t(such as land) whenestimatingdepreciation.Supposeyou’reconsidering

investing in an airline, youshould know that planes arereplacedevery10to20years.The time to replace an assetdepends on the asset and theage of that asset: Forexample, a plane that isutilized more than anotherwill have to be replacedsooner. As assets age,maintenance capitalexpenditures typicallyincrease. In order to get a

roughestimateoftheaverageage of assets, calculate theratio of net property, plant,and equipment (PP&E) togross property, plant, andequipment(note:Ifabusinessusesaccelerateddepreciation,adjust it to straight-linedepreciation).For instance, in 2009, the

ratio of net assets to grossassets at cement makerCEMEX was 61 percent,

which means that the assetsaregetting close to their halflife.ThismeansthatCEMEXpotentially faces highermaintenance capitalexpenditures in the future toupgrade many of its olderplants. You would thereforeadjustyourestimateoffuturecash flows downward toaccount for these potentialfuture capital outlays. Thecloser the ratio of net assets

to gross assets is to one, themore this means that abusiness will not face highermaintenance capital-expenditure requirements toreplace its existing assets inthefuture.

KeyPointstoKeepinMindWhatYouNeed

toKnowaboutEarningsThe range ordistributionof futureearnings(cashflow)isa key factorindetermininghow muchinvestorsshould bewilling topay for thatbusiness.

The widerthe potentialdistributionof futureearnings is,the moredifficult thebusinessistovalue.

ForBusinessesthatUse

ConservativeAccountingMethods:

Thedifferencebetweencurrent taxes(taxespaidtoIRS) and theincome-taxprovision isless than 10percent.Cash flowsfromoperationscloselyapproximatenetincome.Revenue is

recognizedwhen it isearnedinstead offront-loaded.Items areexpensedquicklyrather thancapitalized.Discretionarycosts are notmanipulatedby cuttingadvertising,research anddevelopment

(R&D), ormaintenanceexpenses inorder tosmoothearnings.Depreciationexpenses arenotartificiallyreduced byextendingtheuseful life ofassets.Restructuringcharges arenot inflated

to lowerfutureexpenses.Reserveaccounts areneitheroverstatednorunderstated.Provisionsfor doubtfulaccounts arecorrectlymatched tocharge-offs.

ForBusinesses

thatUseLiberal

AccountingMethods:

Revenuemay beoverstatedand expensesunderstated.Deterioratingfundamentalsmay bemasked.Low-quality

earningsmaybe derivedfromunsustainablesources suchas:Gains andlosses fromdebtretirementAssetwriteoffsfromcorporaterestructuringsTemporaryreductions in

discretionaryexpendituresforadvertising,R&D, ormaintenanceexpenses

EvaluateaBusiness’sRecurringRevenues

It is easier toforecast thefuture

revenues fora businesswithrecurringrevenuesbecause thestarting baseis a certainpercentageoflast year’slevelofsales,rather thanzero.A businesswithrecurringrevenue does

not have tocontinuallycomeupwithnewproductsorservicestoreplace theprior year’srevenues,andmanagementis able tomore easilybudget itsexpenses.

IdentifyWhethera

BusinessIsCyclical,

Countercyclical,orRecessionResistantEarnings thatdisplaygreaterstability overthe businesscycle areeasier toforecast.These

businessesare alsoeasier tovalue.If customerscan deferpurchasesfora long time,the businesswill be morecyclical thanif customerscan onlydeferpurchasesforashorttime.The degree

to which anindustry orbusiness isaffected byrecessionsdepends onthe amountof recurringrevenues abusinessgenerates,thepercentageofthecustomer’sbudgetthatisspent on that

business’sproduct orservice, andthepercentageofthebusiness’scustomersthat areexposed totheeconomiccycle.When abusiness islabeled asrecessionresistant,

make sure itdid notbenefit fromsupply/demandimbalancesin previousrecessions.

AssessaBusiness’sOperatingLeverageThe moreoperatingleverage a

businesspossesses,the moredifficult it isto forecastthe earningsof thebusinessbecausesmallchanges inrevenue willcause largeswings inearnings.Thosebusinesses

that havehighoperatingleveragetypicallyhave a highlaborcomponent,high capital-expenditurerequirements,highmaterialandproductioncosts, or arerequired toinvestalotof

money ininventory.Businessesthat havehighoperatingleverage andlargeamounts ofdebt have ahigherprobabilityofgoingbankrupt.

IdentifyHowMuchWorking

CapitaltheBusinessHas

The amountof workingcapital abusinessneedsdepends onthe capitalintensity andthe speed atwhich abusiness canturn itsinventoryintocash.

Businessesthat manageworkingcapitalinefficientlyhave lesscash flow toputtowork.Ifimprovementsin workingcapital aresustainable,then everydollar offreed-upworking

capital willboost cashflows.

KnowHowtheBusinessHandlesItsMaintenance

CapitalExpenditures

A businesswith highmaintenancecapital

expenditureshas tocontinuallyreinvest cashflow just tomaintainexistingassets,typicallywithoutmaking anexcess returnon thatinvestment.Wheneveryou areunable to

calculate themaintenancecapitalexpenditures,usedepreciationas a roughapproximation.

1.Taub,Stephen.“SECChargesSixwithInflatingRevenues.”CFO.com,October16,2006.http://www.cfo.com/article.cfm/80474932.Plunkett,LindaM.,and

RobertW.Rouse.“RevenueRecognitionandtheBauschandLombCase.”CPAJournal,September1998;Standard&Poor’sCapitalIQ.3.Badawi,IbrahimM.“GlobalCorporateAccountingFraudsandActionforReforms.”ReviewofBusiness,26,no.2(2005).4.Lahart,Justin.“Corner

OfficeThinksShort-Term.”WallStreetJournal,April14,2004.5.“WasteManagementEx-CEOSaysSECsSuitAgainstExecsIsBiased.”CorporateOfficersandDirectorsLiabilityReporter17,no.17(2002).6.Byrne,JohnA.“ChainsawAlDunlapCutsHisLastDeal.”BusinessWeekOnline,

September6,2002;Sunbeam1996and199710-K.7.Sysco201010-K.8.“Break-evenOccupancyDeclining.”Hotel&MotelManagement,June16,2003.9.Standard&Poor’sCapitalIQ.10.Standard&Poor’sCapitalIQ.

CHAPTER7

AssessingtheQualityof

Management—BackgroundandClassification:

WhoAreThey?

Most investors overlook thehuman aspect of operating abusiness, yet, in most cases,the future success of abusinessisdirectlytiedtothequality of its people. Insteadof focusing on management,many investors spend theirtime determining whether a

business has a competitiveadvantageorifitistradingatalowvaluation,becausetheybelieve that products oroperationalstrengthsarewhatset the most successfulorganizations apart, such asMicrosoft’s ubiquitousWindows operating system.The truth is that, over time,these advantages can beimitated, and if the talentedmanagers who created these

advantages leave thebusiness, then the businesswill struggle to continue toinnovateandcreatevalue.In fact, Microsoft did lose

many talented people whoeithercalled in richor joinednew businesses, such asGoogle. This is one reasonthat Microsoft has createdfewer innovative products.Microsoft’s stock pricepeakedduring the techboom

at$60pershareonDecember29,1999,droppingto$22pershareonlyayear later.Sincethen,ithasappreciatedto$28pershareasofDecember31,2010—not exactly a greatrate of return over a 10-yearperiod.Asanoutsideinvestor,you

cannot know every detail ofwhat’s going on inside abusiness.Thereare toomanyvariables that impact the

futurevaluationofabusiness.You must trust managementto make the right decisions.More important, you mustknow that management canrecover quickly fromsetbacks. In order to trustmanagers, you need to gaininsight into their characterand their ability to execute.This will help you improveyour forecasts for thebusinessgoingforward.

Think about how manygreat businesses of the pasthave faced ruin due tomismanagement—forexample, energy businessEnron. Early on, Enron heldmany high-quality assets,including pipelines. Overtime, managementtransitioned the business intoa trading firm, and Enronspun off or sold these high-quality assets. While Enron

wentbankrupt,manyofthesespin-offs, such as pipelinebusiness Kinder MorganEnergyPartners (operated byhighly capable chiefexecutive officer RichardKinder), went on to becomeextremelysuccessful.Toappreciatehowessential

sound management is to thelong-term success of abusiness, consider that topmanagerstypically:

Are responsible fordesigningthebusiness.Determine the futuregrowth rate of abusiness.Are in charge ofchoosing the rightpeopleandprovidingtheright environment forthese people to performattheirhighestpotential.Determine how toallocate the firm’s

capital.Knowing the type of

management team you arepartneringwithwillhelpyouforecast the future of thebusiness, because the mostlogical predictor for thefuturesuccessofabusinessisits management. A businessdoes not need to have everymanager be an allstar, but atthe very least, the managersin key positions need to be

allstars. Give yourself plentyof time to understand thequality of the managementteamrunningabusiness.ThistopicissoimportantthatI’vedevoted three chapters to it:Chapters7,8,and9.It is best to evaluate a

management team over time.By not rushing intoinvestment decisions and bytaking the time tounderstandamanagement team,youcan

reduce your risk ofmisjudgingthem.Mosterrorsin assessing managers aremade when you try to judgetheir character quickly orwhenyou see onlywhat youwant to see and ignore flawsor warning signs. The morefamiliar you are with howmanagers act under differenttypes of circumstances, thebetteryouare able topredicttheir future actions. Ideally,

you want to understand howmanagers have operated inboth difficult and favorablebusinessenvironments.Your overall strategy

should be to develop aworkingpictureofamanagerand the management team.You can start learning aboutmanagement by gathering allof the historical and currentarticles written about eachmanager.Thesearticlesserve

asatrailofevidenceastothepast accomplishments of themanagementteam,thetypeofpeopletheyare,andhowtheyhave dealt with differenttypes of situations. You cananswer a great number ofquestionsinthisbookjustbyreading articles.You canuseaggregated news archives,suchasDowJonesFactivaorLexisNexis, which archivehistorical articles as far back

as the 1980s frompublications including theWall Street Journal, theFinancial Times, the NewYorkTimes,andvarioustradejournals. Look for articlesthat reveal how the topmanagers run the businessand the type of people theyare. Interviews are especiallyuseful,becausemanagers tellyou a great deal about theirbusiness philosophy or how

theyoperatethebusiness.Useinterviewsourcessuchas theWall Street Transcript or theCharlie Rose show, whichoften feature roundtablediscussion or lengthyinterviews. Pay particularattention to what motivatesthe managers and why theyare where they areprofessionally.Someofthebestsourcesof

informationaretradejournals

andlocalnewspaperswhereabusiness is headquartered.Subjects often reveal moreinformation to industryjournalists thantheywill toanational publication such astheWallStreetJournal.Localjournalists also haveexperience in covering thecompany and may askquestions that reveal deeperinsights. The articles alsotendtobelongerbecausethe

localcompanyisimportanttothe community where it isbased.As you read articles, look

for evidence in four basicareas: passion, honesty,transparency, andcompetence. Look for theability of a manager torecognize and learn frommistakes and also try to seehow quickly they are able torecover from mistakes. Look

for articles that talk abouthow a manager helpsemployees become engagedin the business or keepscustomershappy. If therearenotmanyarticleswritten,youeither have to rely more onothersourcesorsimplyadmitthat you do not have enoughinformation to assess amanager.The questions in Chapters

7, 8, and 9 will help guide

youincollectingtheevidenceyou need to determinewhether a management teamiscompetentandproven.

The first set ofquestions, in Chapter 7,helpsyoulearnaboutthebackground of themanagers and how toclassifythem.ThequestionsinChapter8 help you understandhow the CEO and other

managers manage theirbusiness, which willhelp you determine iftheyarecompetent.ThequestionsinChapter9 help you understandthe personality andcharacter of themanager.

Let’s begin by exploringthe background of themanagement team and howtheyarecompensated.

33.Whattypeofmanagerisleadingthecompany?

It is important to classify thetype of manager you arepartneringwithatabusiness.This way, you will be in abetter position to gaugepotential execution risk. If

you are investing in amanagerwhohasalongtrackrecord (i.e., more than 10years) of successfullymanaging a business, theodds that he or she willcontinue to manage thebusiness successfully are inyour favor. On the otherhand,ifyouareinvestinginanew management team thathas limited experienceserving the customer base of

thebusiness,theoddsarenotin your favor. Here is asimple classification systemyoucanuse:

This is a continuum, fromleft to right; here’s a quickoverview of what eachmeans, followed by a moredetaileddescription:

OO is an owner-operator, typically the

founderofabusiness.LT is a long-tenuredmanageroronewhohasworked in the industryforatleast3to10years.HH is a hired hand, amanagerwhohaslimitedexperience serving thecustomer base of thebusinessandhasworkedat the business for lessthanthreeyears.

Forexample,onthefarleft

sideareowner-operatorssuchas the late Sam Walton,founder ofWal-Mart.On thefar right-hand side are hiredhands who did not have anyprior experience at thebusiness before joining asCEO, such as RobertNardelli, who joined HomeDepot in December 2000from General Electric. Mostmanagers of publicly tradedbusinesses fall into the long-

tenured or hired-handcategory, and these are themost difficult managers toevaluate. Let’s take a closerlook at each type, which isfurtherbrokendownintosub-categoriesshownbelow.

Owner-Operator1(OO1)Theseare the idealmanagerstopartnerwith in abusiness.

An owner-operator is amanager who has genuinepassion for their particularbusiness and is typically thefounder of that business, forexample:

SamWalton, founder ofWal-MartDave and Sherry Gold,co-founders of 99 CentOnlyStoresJoe Mansueto, founderofMorningstar

John Mackey, co-founderofWholeFoodsMarketWarrenBuffett,CEOofBerkshireHathawayFounders of mostfamily-controlledbusinesses

These passionate leadersrun the business for keystakeholders such ascustomers, employees, andshareholders alike, instead of

emphasizingoneconstituencyovertheother.Theytypicallyare paid modestly and havehigh ownership interests inthe business. For example,according to the BerkshireHathaway 2010 proxystatement, Warren Buffettearns $100,000 in salary anddirectlyowns37.1percentofthe stock. These managerstake a long-term perspectivewhen making business

decisions and identify theirpersonal success with thesurvival and growth of theirbusinesses. Much like aparent who will do anythingto save a critically ill child,these CEOs will go to greatlengthstoensurethesurvivaloftheirbusinesses.

Owner-Operator2(OO2)

This is an owner-operatorwho is passionate aboutrunningthebusinessbutisinbetween the two extremes ofbeing completely stakeholderoriented and operating thebusiness for his or her ownpersonal benefit. Thesemanagers typically receivehigher compensationpackages than OO1managers. For example,LeslieWexner,founderofthe

Limited Brands (owner ofVictoria’s Secret), earnedmorethan$10millionintotalcash compensation in 2009,and he owns 17.7 percent ofthebusiness.

Owner-Operator3(OO3)OO3 managers are owner-operators who are passionateabout the business but

primarilyrunthebusinessfortheir own benefit. They donot take shareholder interestsinto consideration and willoften siphon off profits tothemselves throughegregiously largecompensation packages. Youcan usually identify thesetypesofmanagersbyviewingtheRelated-Party-Transactionsection found in thecompany’s proxy statement,

where you might find suchitems as personal use ofcompany aircraft, estateplanning, personal or homesecurity,andrealestatethatisowned by the CEO and thenleasedtothebusiness.For example, in one

business, the company’sfounder receiveda loan fromthe business that bore aninterestrateof1percentoverprime to buy a personal

aircraft. Another CEO wasreimbursed more than $2.6million a year for securityexpenses.BothCEOsofthesefirms could easily afford topay for these luxuries out oftheir own pockets, but theyused the company to pay forthem. You should be carefulinvesting in companies withthese types ofCEOs becausethey typically fail to create alot of value for shareholders

overlongperiods.

Long-Tenured1(LT1)LT1managersare thosewhohave a long tenure at theexisting business. These aremanagers who have beenpromoted from within thebusiness and who haveworkedthereforatleastthreeyears. The biggest risk with

these types of managers isthat sometimes they are thewrong manager for theposition.Perhapstheywereagreat chief financial officer(CFO) or chief operatingofficer (COO), but oncepromotedtoCEO,theyfailtoexecute.For example, when Kevin

Rollins took themanagementreignsfromcompanyfounderMichael Dell and became

CEO of Dell computers in2004,mostinvestorsbelievedthat this would be a smoothtransition, because Rollinshad been Dell’s COO since2001.YetMichaelDell tookback the CEO role in 2007afterRollinsmismanaged thebusiness and inflated Dell’scost structure. In April of2008,Michael Dell spoke toanalysts in Texas andexplained how the company

was going to regroup. Heoutlined the challenges hesaw1:

Declining market share.They had missed beingin the fastest growingpartsoftheindustry.The wrong coststructure,both inCOGS(costofgoods sold)andOpEx (operatingexpenses).Erodedprofitability.The

resultofthecombinationof the wrong coststructure, inefficienciesin the system, andmissedexecution.Toomanypriorities.Thelist of things to do wastoo long and thecompanyneededfocus.Incomplete productcoverage. They were“trying to do too muchwith too limited a

productline.”How could this have

happened? Rollins had madeenormous contributions atDell, including implementingthe negative working capitalbusinessmodelthatDellissowellknownfortoday.Simplyput, Rollins made a greatlieutenant to Michael Dell,buthewasnotequippedtobeCEO of Dell. He was thewrong manager for the

position.

Long-Tenured2(LT2)LT2standsforalong-tenuredmanager who joined fromoutside the business butwhohas worked in the sameindustry. The manager mayhave been recruited from acompetitor or a business thatservesasimilarcustomerset.

Anexampleof this typeofmanagerisFrankJ.Williams,CEO of healthcare researchbusinessTheAdvisoryBoardCompany. He joinedAdvisoryBoardinSeptember2000 as an executive vicepresident(EVP)andhasbeenCEO and a director sinceJune2001.Beforejoiningthebusiness,hewasPresidentofMedAmerica OnCall, aconsultancy for physician

organizations, hospitals, andmanaged-care entities. Inboth businesses, he was inchargeof advisinghealthcarebusinesses on how to runtheir practices, which meanshe had prior experienceserving the same customerbase.

HiredHand1(HH1)An HH1 is a manager whojoined the business from a

related industry.Hired handstendtojumpfromjobtojob.These managers typicallymake short-term decisionsbecause they are notaccountable over the longterm.Mostofthesemanagersare cost cutters rather thanrevenuebuilders.

HiredHand2(HH2)An HH2 is a manager whojoined the business from a

completelyunrelatedindustryand typically has noexperiencewith the customerbase. HH2s have steeplearning curves in the newbusiness.ThinkofCEOssuchas Robert Nardelli, who wasCEO of Home Depot fromDecember 2000 to January2007: Prior to joining HomeDepot, Nardelli worked atGeneralElectric,anindustrialconglomerate.

TheImportanceofManagers’Tenurein

OperatingtheBusiness

As you move down thecontinuum from OO to HH,the less information youwillhave on how amanager willchoose to operate thebusiness.Forexample,ifyouinvest in an HH with alimitedtrackrecordoperating

the business, this increasesyour potential downside riskbecause when a newmanagement team enters abusiness, the company’s pastresults provide less insightinto its futureprospects.Youwill take less risk partneringwith managers who have aproven track record ofrunning a business becauseyou can givemoreweight tothe historical track record.

These establishedmanagement teamsunderstand the intricacies ofrunning the business day todayandmostimportantofall,theyunderstand thecustomerbase. Outsiders typically donot have this depth ofknowledge.It is difficult to findCEOs

who have operated theirbusinesses for a long period.For example, consider these

twostatisticsaccording toananalysis conducted byrecruiting company SpencerStuart for the Wall StreetJournal:

Out of the 500businesses in the S&P500,only28haveCEOswhohaveheldofficeformorethan15years.The typical CEO hasheldthetitleforonly6.6years.

Asconfirmationthattenureimprovesstockholderreturns,considerthis:Ofthe28long-termCEOsabove,25ofthemhad totalshareholders returnsduring their tenures that beattheS&P500index(withtotalshareholder return calculatedas stock price change plusreinvesteddividends).2

34.Whatare

theeffectsonthebusinessofbringinginoutside

management?Many investors will bid upthe stock price of a businesswhen an outside manager orCEO enters the business.These investors believe that

management skills aretransferable and reactpositively when a newmanagement team enters abusiness, especially one thathas beenmismanaged.Theseinvestors think outsidemanagers can instill changesandimproveunderperformingcompanies, because theoutside managers areobjective and not married totheculture.Ifthispersonwas

agreatmanageratTheCoca-Cola Company, the thinkinggoes, then he or she will begreat at operating any otherbusiness. This is similar tosaying that a great valueinvestor would make a greattraderbecausebothareintheinvestment business.Obviously,thesetwostylesofinvestment require differenttypes of expertise andexperience to execute

properly.Investors also often make

the mistake ofunderestimating theimportance of the supportnetworks thesemanagershadat their prior company thathelpedmake them successfulinthefirstplace.Whenthesemanagers then enter a newbusiness, they often run intoproblems because they don’thave that support network,

andmanyfailtoperform.In addition, most of these

managers are great costcuttersbutfailwhenitcomesto growing the business.There are very few caseswhere a manager is good atboth cutting costs andbuilding thebusiness suchasSteveJobs,founderofApple.WhenhereturnedtoApplein1997,Applewasonthebrinkof bankruptcy. Jobswas able

tocutcoststokeepAppleoutof bankruptcy and thenrebuilt its entire product lineandorganization.When you learn that an

outsiderhasjoinedtoleadthebusiness, respond withextreme caution. RHRInternational, a Chicago-headquartered managementconsultant, states that 40percentto60percentofhigh-level corporate executives

brought in from outside thecompany will leave withintwo years. Many haveproblems and leave in just afewmonths.3

A manager with a lot oforganization-specificknowledge is critical togenerating long-term growthat a business, whereas anoutsider needs a significantamount of time to learn thebusiness. Jeffrey Immelt,

CEO of General Electric,said, “You see that the mostsuccessful parts of GE areplaces where leaders havestayed in place a long time.Think of Brian Rowe’s longtenure in aircraft engines.Fouror fivebigdecisionshemade—relying on his deepknowledgeofthatbusiness—wonusmaybeasmanyas50yearsofindustryleadership... the places where we’ve

churned people, likereinsurance, are where youwillfindwe’vefailed.”4

In addition, relative tomanagers who have been atthe business for long periodsof time, outside managershave a more limitedunderstandingofabusiness’sresources and constraints.The risk you take as aninvestor is that instead ofbuilding on an existing

business’s capabilities, theydeviatefromthem.Therefore,a new management teamcreatesunpredictability.There are some industries

where specialized knowledgeof the business is especiallycritical: for example,pharmaceuticals, chemicals,and insurance. It is difficultforanoutsidertosuccessfullymanage these types ofbusinesses, and you should

probably avoid investing inthem if an outsider doesbecomeCEO.For example, it is critical

for the CEO of an insurancefirm to have spent a lot oftimeintheinsuranceindustrybecause there is a longlearning curve in thisindustry.Aninsurancefirmisinsuring against risks thatmay occur in the future, andmanagers who have been in

the industry for a long timehave livedwith thefalloutoftheir mistakes. This helpsthem understand how toproperly underwriteinsurance. Without thisexperience, managers arelikely to make many moremistakes, which you, as ashareholder,willpayfor.Thereareafewcaseswhere

outside managers tend to begood hires: For example,

when a business needs tobreak from past strategies orneeds to cut costs quickly. Ifthe industry changes veryquickly, this will alsoimprove the odds that anoutsidemanagerwillsucceed,but if the industry is stable,then industry knowledge ismore important. Most ofthese new managers tend todo well early on in theirtenure as they cut costs, but

later they start to do badlywhen it comes time to buildthe business. In other words,they are good at doing therapid cost-cutting anddivestment, but when itcomes to building andsustaining long-term growth,theyfail.For example, Al

“Chainsaw”Dunlapcreatedalot of value for his investorsby quickly turning around

andsellingsuchcompaniesasAmerican Can, Lily-Tulip,Crown-Zellerbach, DiamondInternational, ConsolidatedPress Holdings, and ScottPaper.Dunlap’s strategywasslash-for-cash, where hewould take a flounderingbusiness and make itprofitable within a year. HedidthisatScottPaper,whichhad just lost $227million in1993: During his 20 months

atScott,Dunlapincreasedthecompany’s market value by155percent,from$2.9billionto $7.4 billion. Heaccomplished this turnaroundby firing 11,200 employees(which consisted of 70percent of its head-officestaff, 50 percent of itsmanagement, and 20 percentof its blue-collar workers)and by cutting the researchand development (R&D)

budget in half, suspendingcorporate philanthropy, anddeferring plant maintenance.He succeeded with thisstrategy for a few years andwas lauded as a legendaryturnaround artist and a rolemodelformanymanagers.SowhenhebecameCEOof

appliancemaker Sunbeam in1996, the stock pricepromptly rose 60 percent, asinvestors anticipated that

Dunlap would quickly turnaround the fortunes of thebusiness. At that time, thiswas the greatest jumpdue toa CEO change that had everoccurred in thehistoryof theNYSE. Unfortunately, thetechniques he used to turnaroundotherbusinessesinthepast—such as slashingexpenses—worked againsthim at Sunbeam, and thecompanydeclaredbankruptcy

in 2001, two years afterDunlap was dismissed asCEO.Infact,afterallthedustsettled,Dunlaphad to acceptalifetimebanfromservingasan officer or director of anypublic company because theSEC alleged that Dunlapengineered a massiveaccountingfraud.5

When an outside managerenters the business, closelymonitor his or her actions.

The best types of outsidemanagersarethosewhodon’tmake changes quickly andmake an effort to understandthebusinessand itscustomerbase as well as solicit theopinionsofemployeesbeforethey implement majorchanges.Thisway, theygainthe support of the employeeswhom they will need toexecute their plans; just asimportant, they avoid the

problem of under- or over-estimating the capabilities oftheemployees.If instead, themanager joins the businessand starts to make changesimmediately, without gettingbuy-infromtheemployeesorunderstanding theirlimitations, it is likely he orshewill fail, and you shouldavoid investing in thiscompany.

35.Isthemanageralionorahyena?

Another simple way tocategorize management is toclassifymanagementteamsaseither lions or hyenas. Thisidea was created by SengHock Tan, CEO of AegisGroup of Companies, aSingapore-based investment

management organization,who came up with thisclassification while watchingaDiscoverychannelprogramaboutlionsandhyenas.Ashelearned about how lions andhyenasinteractinthewild,hefelt that their behavior wasverysimilar to thatdisplayedbymanagers.6

Ashewatchedtheprogram,he learned both are superpredators and are often in

direct competition with oneanother. However, here’s thedifference between the two.Lions typically hunt togetherinagroup(calledapride),sothat they can go after biggergame, which means morefood for everybody. Insteadof having a single dominantleader, as is commonlybelieved, males have equalstatus, as do females. Incontrast, hyenas group

togetheronlywhenhuntingiseasy:After an easy kill, theydisband.On their own again,they go back to scavengingcarcasses.Statusisextremelyimportant to hyenas, with ahigher rank netting morerespectwithinthetroop.Theydo not build a team underthem except when itimmediately benefits them,and loyalty is weak. If ahyena becomes wounded or

weak,thetroopabandonsthathyena. Interestingly, thehyena recognizes the lion’sstatus: As the hyena’s onlynatural predator, the lioncommands the hyena’srespect.Tan applied these

differences in the animalworld to management styles.Table 7.1 summarizes thecontrasts.

Table7.1ContrastingtheManagementStyleofLionsandHyenas

Source:InterviewwithSengHockTanOctober2010.

LionManager HyenaManagerCommittedtoethicalandmoralvalues

Haslittleinterestinethicsandmorals

Thinkslongtermandmaintainsalong-termfocus

Thinksshortterm

Doesnottakeshortcuts Justwantstowinthegame

Thirstyforknowledgeandlearning

Haslittleinterestinknowledgeandlearning

Supportspartnersandalliances

Asurvivorandanopportunist;works

mostlyaloneTreatsemployeesaspartners

Treatsemployeesasexpenses

Admiresperseverance Admirestactics,resourcefulness,andguile

Tan goes on further toexplainthatalionmanagerisable to build theinfrastructure for a 100-storyskyscraper, whereas a hyenamanagercanconstructonlyafive-story building because itcan be done in less time:Investingandbuildingalong-

term infrastructure taxes thenature of the hyena. Forexample, investing in a teamand sustainable infrastructuretakes a lot of time, which ahyenamanagerdoesnothavethepatiencetodo.Thehyenacontinually enriches himselfby repeating the short cycleof building and selling five-story buildings. Hyenamanagers never build themore valuable 100-story

buildingthatlastslongerthana five-storybuilding.AsTansays, “The hyenamanager istherefore an opportunistictrader, not an all-seasonbuilderofalastingstructure.”Although, the skyscraper

willgeneratehugereturnsforitsinvestorsoverlongperiodsoftime,theflippedfive-storybuilding, although profitableto the lone hyena, willgeneratemore limitedreturns

foroutsideinvestors.Tanexplainsfurther:“How

did Apple catapult from $5billion in marketcapitalizationinearly2003toa market cap of $220billion?”TancontrastsApplewithPalm,whichbroughtoutthe pioneering Palm Pilotproduct.WhywasPalm,witha$90billionmarketcapatitspeak, bought out in 2010 byHewlett-Packard, as Seng

Hock asks, “for a mere $1.2billion?” The difference wasthatApplewasrunbyaLionmanager:SteveJobs.Mostcompetentearly-stage

companies do not cross thechasm to an establishedbusiness because they lackthe lion manager’sinfrastructure—theteamwork,theknow-how,thenecessary institutionalstructures, and the culture.

This is the groundworkneeded to survive and growsustainably, and it is whycompanies run by lionmanagers become multi-baggerinvestments.Asyoulookatthemanager

onapersonal level,alsonotecharacteristics that indicatehowlikelytheyaretobeabletobuildandleadaneffectiveteam. Look for their lioncharacteristics. Does the

manager value people morehighly because of power,influence, or what they cando for them? Or do themanagers considerthemselves to be better thanthose around them? Perhapsthey are extremely nice toyou and your friends, butwhentheydealwithawaiter,forinstance,theyarerude.Inotherwords, they are nice topeople they consider to be

important,butdisrespectfultoothers whom they considerbeneath them. If you areengaged in a conversationwith someone and a higher-status person walks into theroom,doesyourconversationend as they quickly leave tojoin thehigher-statusperson?Thisisahyenacharacteristic.For example, I remember

attending BerkshireHathaway annual meetings

and speaking with many ofthe CEOs who runsubsidiaries of BerkshireHathaway. Often, someoneelse would walk up to themand tell them that someoneimportant, such as anotherCEO, wanted to speak withthem. Even though they didnotknowme, theycontinuedto answer my questions anddidn’tcutmeoff.Incontrast,most of themoneymanagers

I knew well wouldimmediatelywalk awaymid-sentence if someone passedby whom they thought wasmore important. Look formanagersthatdisplaythelioncharacteristic of showingrespect forpeople, regardlessof status. It is a strongpredictor of their ability tocommand the respect ofothers, and an importantleadershipcharacteristic.

Thehyena/lionmetaphor isapowerfultoolforevaluatingmanagers.WhenTanandhisteaminterviewmanagers,oneofthefirstquestionstheyaskthemselves is whether themanager isa lionorahyena.This is an easy-to-use andhighly effective tool, and themental imagery may beextremely useful for quicklysummarizing the character ofamanager.

36.Howdidthemanagerrise

toleadthebusiness?

To understand themanagement team’sbackground, start byconstructing a chronology ofthe careers of the top fivemanagers, using the

biography section found inthe company’s proxystatement. The goal is to getthe details of a manager’scareersoyoucanmapoutthemanager’s professional life.You need to use historicalproxy statements,goingbackat least five to 10 years,becauseinmorerecentproxystatements, earlier jobs arenotemphasized.Youcanthenfill in the gaps of the

manager’s career by readingarticles written about theCEO and the other top fourmanagers over a 10-yearperiod.For example, by using a

combination of historicalproxystatementsandarticles,my firm compiled the careerofLarryYoung,CEOofDr.Pepper Snapple Group,shownhere:2008: RemainsCEOwhenDr.PepperSnapple

GroupspinsfromCadbury

2007: CEO/PresidentofDr.PepperSnappleGroup(Cadbury)

2006: PresidentandCOOofCadburySchweppesBottlingGroup(CadburyacquiresDr.Pepper/SevenUpBottling)

2005: JoinsasPresident/CEOofDr.Pepper/SevenUpBottlingGroupinDallas

2005: LeavesPepsiAmericas2002: EVPofCorporateAffairsfor

PepsiAmericas2000: President/COOcombinedcompanyfor

PepsiAmericas/Whitman1999: COOofPepsiGeneralBottling(operating

companyofWhitman)1998: EVPandCOOofWhitmanandPepsi

GeneralBottling1997: President,PepsiGeneralBottlers—East

EuropeanDivision1996: President,International,PepsiGeneral

Bottling1995: VicePresidentofSalesandMarketing—

International,PepsiGeneralBottling1994: DirectorofSalesandMarketing—

International,PepsiGeneralBottling1989: Director,OnPremiseSales&Marketing

forSpringfieldPepsiGeneralBottling1969: BeginshiscareerwithaPepsifranchise

(PepsiGeneralBottling)asaroutesalesmaninSpringfield,Missouri.

This is a very detailedbiography; in contrast, if wehadusedonlythe2009proxybiography for Larry Young,we would have a morelimitedviewofhiscareer, asshownbelow:

Larry D. Young,President and ChiefExecutive Officer andDirector, age 55, hasserved as our directorsince October 2007. Mr.Young has served as ourPresident and ChiefExecutive Officer (our“CEO”) since October2007. Mr. Young joinedCadbury SchweppesAmericas Beverages as

President and ChiefOperating Officer of theBottling Group segmentand Head of SupplyChain in 2006 after ouracquisition of DrPepper/SevenUpBottlingGroup, Inc.(“DPSUBG”), where hehad been President andChief Executive Officersince May 2005. From1997to2005,Mr.Young

served as President andChief Operating Officerof Pepsi-Cola GeneralBottlers, Inc. andExecutive Vice Presidentof Corporate Affairs atPepsiAmericas,Inc.

By building a chronology ofthe career of amanager, youwill understand how themanagercameupthroughtheranksof thecompaniesheorsheworked for, and you can

better determine whether themanager has a history ofmaking deals, financialengineering, marketing, orcreating new products. Forexample, if they worked forbusinesses owned by privateequityfirmsformostof theircareers,thenthemanagersarelikely to have a short-termmentalityandmayemphasizecutting costs over otherinitiatives.

Askquestionssuchas:Doesthemanagerhaveabackground inoperations,marketing,orfinance?Did the manager jumpfrom job to job, or doeshe/she have a longtenureintheindustry?Why are there gaps inhis or her employmenthistory?

Pay particular attention to

how much interaction themanager has had with bothcustomers and employees.For example, determinewhetherthemanagerhasalotofexperienceinoperatingthebusiness or if the manager’scareerhasbeenlimitedtothecorporate suite. If themanager has been acontroller, treasurer, orCFO,and was then promoted toCEO, then most of that

manager’s time has beenspent in the corporate suite.Incontrast,ifthebackgroundof the manager is VP ofSales, VP of Marketing,COO, and then CEO, thatmanager has had moreinteraction with theoperationsandcustomerbaseofabusiness.

BeAwareofthe

RisksofaManagerwithaNon-OperatingBackground

A related risk you may beexposed to is that managerswho have risen from insidethe corporate suite of thebusiness often do not makegood operators. This isbecause they have lessexperience with the day-to-

day operations of thebusiness. If the managershave spent most of theircareers in the corporateexecutive office, then howwill they know how tooperate the business at thecustomer level? Thesemanagershaveanarrowviewofthebusinessduetothefactthat they have only viewedthe business from oneparticular angle. This traps

many managers into aconstricted way of thinkingaboutthebusiness.Theirpastinteraction with theemployees of the businesswill have beenmore limited,aswell.For example, there is no

doubt that new drugdevelopment has suffered inthe pharmaceutical industryas more of the CEOs wholead these companies are

promoted from within thecorporate suite (such asmanagers who have beenCFOs or General Counsels),or from outside, unrelatedbusinesses instead of CEOswithsciencebackgrounds.Asa result,mostpharmaceuticalfirms have not had manyblockbuster drugs from 2000to 2010 and many currentlyface their patents expiring,without any drugs in the

pipelinetoreplacethem.7

Merck’s greatest stockmarket returns came duringthe time it was managed byRoy Vagelos, who was ascientist (both chemist anddoctor) and worked as headof Merck’s researchdepartment and then CEO,from 1978 to 1994. Vageloschanged the way Merck didresearch by emphasizingscientific discovery. Under

his tenure, he brought inhundreds of new scientistsand modernized Merck’slabs.Healsofocusedonnewproduct categories likecardiovascular treatment. Hesought and found what hetermed “really better peoplewhowanted towork in drugdevelopment.”WhenVagelosled the research department,he increased R&D spendingbyanaverageof17.2percent

a year. Merck focused R&Don cures that were needed,instead of makingquestionableimprovementstoexisting drugs, as mostpharmaceutical firms did.During Vagelos’s tenure, 10major new drugs werelaunched, such as Vasotecand Prinivil for hypertensionand Pepcid for heartburn.When Vagelos retired in1994,Merckhadthebestand

largest marketing staff, andled the pharmaceuticalindustryinsales.However, Vagelos’s

replacement,whowaschosenby the board (and notVagelos), was RaymondGilmartin,who joinedMerckfrom Becton Dickinson, amedical device maker. Hewas an outsider who simplydidnotunderstandthecultureofinnovation.Asaresult,the

talented scientists left thebusiness, andMerck’s abilityto develop new drugssuffereddramatically.8

Similarly, take a look atGeneralMotors.AlexTaylordocumentsthedeclineofGMinhisbookSixty toZero:AnInsideLookattheCollapseofGeneral Motors—and theDetroitAutoIndustry.Taylorwrites that GM’s best yearswerewhenitwasledbysuch

innovators as CEO HarlowCurtice, who led GM from1953 to 1958. Curtice hadstarted out as a bookkeeper,but he gradually became asuper salesman whodeveloped a shrewdunderstanding of how designcreated buzz and sold cars.Under his tenure at Buick,sales doubled. As Taylornotes, “Curtice may havebeen the last GM CEO who

wieldedsomuchpowerinthedesignstudio.”AfterCurtice,GMwas run

by managers who weremainly accountants and whotherefore placed moreemphasis on cutting costs,instead of worrying aboutwhat was coming out of thedesign studio. For example,Fred Donner was anaccountant who directlysucceeded Curtice, and he

spent his entire careeroperating GM from NewYorkCity instead ofDetroit.He seldom visited carfactories,andmostofwhatheknew about the operationswasfromexecutivemeetings,balance sheets, and reports.He was focused on cost-cutting rather than designingcars that sold well. Taylormakes a good case for theidea that GM’s failure took

root during this period asthese cost cutting CEOskicked down the road manyofGM’sproblems.

HowMuchExperienceDoestheManagerHavewiththeCustomerBase?Ifabusiness’ssuccesshingesto a great degree onmanagement’scapabilities,as

it does in restaurant chains,you will typically take lessriskifyouinvestinmanagerswhohavea lotofexperiencewith the customer base.Avoid those who have spentmost of their careers in thecorporate suite or who haveserved customers in adifferenttypeofindustry.Forexample, in2002, Jack

Stahl lefthis jobaspresidentof The Coca-Cola Company

to attempt a turnaround atcosmetics company Revlon.Stahl had been at The Coca-Cola Company for 22 yearsandRevlon’sboardhadgreatfaithinhim,believingthathisdisciplined approach tooperations was just the thingRevlonneeded.Hebroughtinfinancial experts andstatisticians, and reduced thecompany’s debt.Unfortunately, he also

changed the way Revlonmarketed its products. AsRevlon launched newproducts, it lost many of itsold customers. Some of thenew products had higherprices and didn’t use thepowerfulRevlonname.Inthefour years after Stahlassumed control of Revlon,the company sufferedcontinued losses aswell as atwo-thirds decline in

Revlon’s share price. Stahlleft Revlon in 2006.9Although Stahl had done anexcellent job at The Coca-Cola Company, he was ill-equipped to deal with thenuances of running acosmeticscompany.

DoestheManagerHaveExperience

withMost

OperationsoftheBusiness?

Youwanttogetasenseofthemanager’s understanding ofallthedivisionsandfunctionsof the business. Ideally, amanager would haveexperience in multiplepositions.Forexample,TomFolliard,

CEO of used-car retail chainCarMax, joined CarMax in

1993 as a senior buyer andbecame director ofpurchasing in 1994. He waspromoted to VP ofmerchandising in 1996, SVPof store operations in 2000,EVP of store operations in2001,andpresidentandCEOin 2006.10 Therefore, he hasled most of the majordivisions at Carmax, and heunderstands what it takes tooperate each division

effectively. This experiencereduces the risk to investorsthat Folliard will fail toexecute. Even moreimportant, it improves hiscredibility with employeeswithin the company becausehehasmanagedmostoftheirdepartmentsinthepast.

WhatIsthisManager’sPrevious

TrackRecordinOperatingaBusiness?

As you read articles writtenabout a manager, be sure tolearn about their pastaccomplishments or lack ofaccomplishments. Forexample, James Adamsonbecame CEO of retailer K-Mart when it enteredbankruptcy in early 2002.

Previously,hewasamemberof K-Mart’s Board ofDirectors. To determinewhether Adamson had theability to lead K-Mart, youcould have reviewed his pasthistory by reading both theproxystatementandhistoricalarticles. From 1995 to 2001,Adamson was CEO of theAdvantica Restaurant Group,which owned Denny’s. HewasbroughtinwhenDenny’s

faced many lawsuits fordiscriminating against blackcustomers, and hesuccessfully transformedDenny’s public image issuesintoanumber-oneranking inFortune magazine’s “BestCompanies for Minorities”categoryin2000and2001.However, during

Adamson’s tenure atAdvantica, the company lost$98million in 2000 and $89

million in 2001. AfterAdamson assumed control ofK-Mart, he was equallyunsuccessful at returning theretailer to profitability.Adamson’s track record oflosing money should havealerted investors that he wasprobably not the best choicefor leadingK-Mart througharestructuring.11

This wasn’t the first timeK-Mart hadmissed themark

on manager appointments.Before Adamson waspromoted as CEO, K-Marthad brought in CharlesConaway as CEO and Wal-Mart veteranMark Schwartzas CFO. Conaway was pastpresident and COO ofpharmacy retailer CVSCorporation and Schwartzjoined from Wal-Mart (K-Mart’s biggest competitor)where he had worked for 17

years. Many investors wereexcited tohear thatSchwartzhad joined the businessbecause of his experience atWal-Mart. Schwartz mademany bold statements toinvestors on how he wasgoing to tackle Wal-Martheadon.However, Schwartz’s track

recordwasn’t as encouragingas his rhetoric. Had youstudied his resume, you

would have seen that two ofthe companies he ran beforeworking atWal-Mart—homeproducts businessHechinger’s and Big VSupermarkets—had landed inbankruptcy. Two years afterConaway and Schwartzwerebrought in, K-Mart declaredbankruptcy.12,13

WhyWasthe

ManagerPromoted?Youneedtodeterminewhyamanagerwaspromotedtohisor her current position. Forexample, in 2010, Merckpromoted Kenneth Frazier toCEO. Frazier had been withMerck since 1992, and hadserved in several rolesincluding that of GeneralCounsel. He was known fordeveloping the controversial

legal strategy of fightingevery case filed againstMerck’s pain drug Vioxx,rather than settling all thecases jointly inaclassactionlawsuit. This strategy hadhelped save Merck hundredsofmillionsofdollars.14

In fact, Frazier waspromotedtoCEObecausehehelped Merck defend itselffromlawsuits,notbecausehewas successful in helping

Merck develop new drugs.Frazier’s background was inthe corporate suite, and eventhough he was head of theglobal human health division(which is Merck’s largestunit) from 2007 to 2010,Frazier’s experience runningtheoperationsofthebusinesswasmore limited. Therefore,this increases the risk thatFrazierwillfail toexecuteasCEO.

WhatWastheCultureLikeatBusinessesWhereThisManager

WorkedinthePast?You need to understand theculture of the businesseswhere the manager hasworked in the past. Forexample, software andhardware business Oracle is

knownforatake-no-prisonersculturethatisresultsoriented,whereas British Airways isknown for an excessivelybureaucratic culture.15 Thiswill give you tremendousinsight into howhe or she islikely to manage the currentbusiness, especially if themanager worked at the priorbusiness for a long period oftime.Start by reading articles

about the culture of theformer business where themanager worked, as well asarticles about the CEO thismanager worked for. Werethe CEO and the cultureaggressiveandhard-charging,or transparent and authentic?For example, if a managerworked at General Electric(GE), take a look at any ofseveral books and articleswrittenabout“theGEWay.”

The GE Way is taught atGE’s management school: Itinvolves rotating managersthrough many jobs, teachesthemhowtogrowabusinessthrough acquisitions, andteaches productivity andquality-control tools such asSixSigma.When Jim McNerney was

passed over as CEO of GE,hewas immediately recruitedby3M tobeCEO (in2001).

OncehewasCEOof3M,heimmediately began to lookfor acquisitions tomake, andhe instituted money-savingSix Sigma process-management systemscompanywide.16 By readingabout the GE Way, youwould have had a greatinsight into how McNerneywouldlikelymanage3M.

37.Howareseniormanagerscompensated,andhowdidtheygaintheirownershipinterest?

It is important to spend time

reviewing the compensationand ownership interest ofmanagement by viewing theproxy statement. You cangain great insight into thecharacter and motivation ofmanagers by understandinghow they are compensated.Youwanttounderstandifthecompensation packagerewards for long-term orshort-term performance. Forexample,ifaCEOowns$100

million of stock, and he ispaid $100,000 per year, thenhe is more likely to makelong-term decisions. Incontrast, if a CEO gets paid$5 million a year and owns$1 million of stock, then hewilllikelyvaluehisjobmorethan the value of thecompany’sstock.Let’s take a closer look at

different compensationscenarios and what aspects

youshouldpayattentionto.

LookforCEOsWhoHaveLowSalariesandHighStockOwnership

Some of the best long-termperforming stocks have beenrun by CEOs with low cashcompensation and high stockownership. These managersgenerally have a long-term

view. Here are a fewexamples:Robert Kierlin, founder of

Fastenal (a distributor ofindustrial products), and hissuccessor as CEO, WillardOberton. Fastenalconsistently ranks at thebottom of CEOcompensation: For example,Kierlinmade$63,000intotalcash compensation in 2001and owned 5.87 percent of

thebusiness.17Buttakealookat how well the stock hasperformed: The stock pricehas appreciated from $0.32per share on September 1,1987 to $60 per share onDecember31,2010—that’sahugeincrease!18Dave Gold, co-founder of

99 Cent Only Stores, waspaid $62,000 to $180,000 intotal cash compensation (anddid not receive any stock

options or bonuses) when hewas CEO, yet he ownedapproximately 40 percent ofthe business.19 Under histenure, the stock priceincreased from $3.81 pershare at its initial publicoffering (IPO) on May 23,1996, to $15.32 per sharewhen he stepped down asCEOinJanuary2005—again,a huge increase: more than400percent.

Joe Mansueto, founder ofMorningstar,ispaid$100,000in total cash compensationand owns 52 percent ofMorningstar.20 The stockprice has increased from$21per share at its IPO in May2005 to $53 per share inDecember 2010—in otherwords,morethandoubleinalittlemorethanfiveyears.Russel Gerdin, CEO of

trucking firm Heartland

Express,earned$300,000peryear in total cashcompensation, a salary thathasn’t changed since 1986.He also owns 34 percent ofshares and does not receivestockoptions.Thestockpricehas increased from$0.43persharein1986to$16persharein201021—another enormousincrease.

BeWaryof

ManagersWhoHoldStockOptions

One of the most commonways that management iscompensatedisthroughstockoptions,whichgivetheownerthe right to buy shares at aspecific stock price. Theyrepresentapotentialpayofftothemanagerwithnorisk:Thedownsideiszero(ifthestockpricedoesn’tincrease,there’s

no payout to the managers,and if the stock price doesincrease, then they benefit).Investors believe that givingstock option grants tomanagerswillmotivate themto create shareholder value,because it gives them anownership interest in thebusiness.The problem is that stock

options often rewardmanagers for things that they

are not responsible for, suchas broad economic gains orindustry growth. As oneinvestor said: “The argumentthatsomeoneisworthtensofmillions of dollars incompensation per yearbecausehisorhercompany’smarket value went up manytimesissoludicrousthatI’vealways been amazed anyonecan espouse it as fair with astraightface.”

In reality, most stock-option programs rewardmanagers for short-termgains. This is becausemanagers with a lot ofoptions rather than actualshares are prone to adoptWallStreet’sshort-termfocusinorder to increase the stockprice and therefore the valueof their options. They cantake several harmful actionsto drive the price of a stock

up in the near-term to thedetriment of the long-termhealth of the business.Examples would be makingacquisitions to boost short-term earnings or cutting toomanycosts.Theseshort-termdecisions can eventuallycause the value of thebusinesstodeteriorateasonebad decision piles up on topofanother.

BeWaryofCompaniesthat

OfferMega-EquityGrantstoCEOsorOtherManagers

Thehighestpaypackagesaretypically given to managerswho are brought in fromanothercompanyor industry.You need to be cautious ofmanagement compensation

schemes that give out mega-equity grants that are out ofproportion to the CEO’scontribution, such as whenRobert Nardelli was given$30millioninrestrictedstockawards plus $7 million incash when he joined HomeDepot as CEO. Furthermore,afterpullingin$38millionin2006,Nardelliwasalsogivenanastronomical$210millionin severance when he exited

thebusiness.Thiswasmoneythat would otherwise havebenefited shareholders. Thestock price under Nardelli’stenure was $45 per sharewhenhejoined(inDecember2000)and$39persharewhenheleft(onJanuary2,2007).22

When Nardelli landed atChrysler later that year, healso landed another lucrativecompensationpackage.UnderNardelli, 35,000 workers at

Chrysler were laid off andChrysler headed forbankruptcy.Nardellileftafteronly 21 months. In both ofthese instances, Nardelli waspaid not on the performanceof the business, but insteadwaspaidtojointhebusiness.However, large

compensation packages donot always necessarilyindicate that a stock willunderperform. For example,

Larry Ellison, founder andchief executive of softwaremaker Oracle, has been oneof the highest-paid CEOs ofany publicly traded business,earning in excess of $78million in option awardsalonein2009,yetinvestorsinOraclewould havemade 3.5times theirmoney in the last10 years ended 2010.(However, it is still difficultto argue that Ellison needs

additional stock options tomotivatehimtodohisjob,ashe owns 23.4 percent ofOracle, as of August 9,2010.23)

LookforManagersWhoDon’t

MonopolizeStockOptionsbutOfferOptionstoAll

EmployeesYouneed todetermine if thestock option plan of acompany is geared to only afew of the top executiveofficers or if options arewidely distributed amongemployees.Thiswillgiveyouan insight into the characterof senior managers, becauseif they share thewealthwithalloftheiremployeesthrough

awidelydistributedplan,thismeans they care about theiremployees. If, instead, theyonly award themselves alarge option package, thismeans they care more aboutthemselves.For example, in a letter to

shareholders, Richard Reese,former CEO of document-management company IronMountain, explained why hewould not accept any stock

options, saying that hepreferredtousethemtoretaingood people rather thancompensatehimself.To find information on a

company’s stock option-program, look for a table inthe proxy statement that liststhe total number of optionsawarded to the top fiveexecutiveofficers.Addupthetotal number of optionsawarded to the top five

executive officers. Then, inthe 10-K or proxy, find thetotal number of optionsawarded to all employees.Calculate the percentage ofoptions given to the top fiveexecutive officers comparedto all employees. Determineif stock options are widelydistributed or if they areconcentrated within the topgroup.For example, at Whole

FoodsMarket,approximately92 percent of the stockoptions granted under theplan since its inception in1992 have been granted toemployees who are notexecutive officers.24 On theother hand, the managementteam at bond-rating firmMoody’s awarded itself alarge percentage of stockoptionswhen itwas spunofffrom Dun & Bradstreet.

Moody’s 2000 proxystatement shows that CEOJohnRutherfurd received 4.1percentofalloptionsgrantedto employees in the fiscalyear, followed by DonaldNoe, SVP of Global Ratingsand Research, who received3.0 percent. These twoexecutive officers receivedabout thesamepercentageofstockoptionsasallofthetopexecutive officers at Whole

FoodsMarketcombined.Thisshould serve as a warningsignal because it indicatesthat senior managers atMoody’sviewthebusinessasone where they canpersonally benefit withoutsharing those benefits withtheiremployees.

LookforCompensationPlans

thatRewardLong-TermPerformance

In order for a compensationprogram to reward long-termperformance, it must tiecompensation to long-termresults. For example, atExxonMobil, half of anexecutive officer’s restrictedshares vest over five years,and the other half must beheld for 10 years or until

retirement, whichever isgreater. This rewardsmanagement for long-termresults.The ideal compensation

structures are those thataward for long-term value-creation factors, such asoperating income or bookvaluepershare,insteadofthestock price. Determine if thecompensation is tied tovariables that make the

business better, rather thanjustbigger.Forexample:

Expeditors International(a global logisticscompany) bases itsbonuses on operatingincome, and thesebonuses make up themajority of executiveofficercompensation.ReckittBenckiserGroup(a global manufacturerof household and

healthcare products)links performance-basedcompensation for allexecutive officers toeconomicvalueadded.Markel Insurance (aspecialty insurer) usesgrowthinbookvaluepershare over a five-yearmeasurement period tobase its totalcompensationpackage.

Let’s look at each of these

companies’ compensationstructuresinmoredetail.

ExpeditorsInternational’sCompensationSystemExpeditors International tiesits compensation system tooperating profit instead ofstock price by paying its topexecutiveofficersfromapoolof 10 percent of pre-bonus

operating income. Thissystem has been in placesinceExpeditorsInternationalwent public in 1984. Ifoperating incomedrops(as itdid in 2009, when operatingincome dropped 19 percentcompared to 2008), thenincentive compensation alsodrops by the same amount.Furthermore, thecompensation system is alsobased on cumulative

operating income, so if anyoperating losses are incurred,then these losses must berecovered before theexecutive team can earn apercentage of operatingprofits. This gives seniormanagers a longer-termincentive because if theyengage in activities thatincrease short-term profits atthe expense of long-termprofits, thentheywillreceive

a lowerbonusdown the line.This creates a directalignment between corporateperformance and shareholderinterests because thecompensation is directlyproportional to the profitresponsibility of eachmanager.

ReckittBenckiserGroup’s

CompensationSystemReckitt Benckiser Grouplinks performance-basedcompensation for allexecutive officers toeconomic value added,measuring net sales growth,profit after taxes, and networking capital. The long-term incentive programrequiresthatEPShastogrowby30percentoverthreeyears

fortheoptionsandthesharestofullyvest.WhenChairmanPeterHarfwasaskedwhythecompensation plan did notreward for stock priceincreases, he said, “We havestayed away from that[performance tied to totalshareholder return], becauseit can lead to outcomes thatare completely uncoupledfrom the company’sperformance.”25

MarkelInsurance’sCompensationSystemMarkel Insurance chosegrowth in book value pershare over a five-yearmeasurementperiodtoset itscompensationprogramfor itsexecutive officers. Theexecutive officers at Markelbelieve that the primarycreator of value for aninsurancebusinessisitsbook

valuepershare,notthestockprice.Markelusesafive-yearperiod in order to discouragemanagers from takingunnecessaryrisks.There are various other

forms of compensation thatarepositiveindicatorsthatthecompensation package isbased on long-term results,such as restricted stockawards. Stock-ownershiprequirements also align

management interests withthelongterm.

LookforRestrictedStockAwardsbecauseThey

RewardLong-TermValueCreation

Restricted stock awardsreward long-term valuecreation more than stock

options because they oftenare conditioned on suchfactors as longevity orperformance. In otherwords,amanagermustbeemployedby the company for a certainlength of time or must meetspecific performance goals.This is meant to encouragelong-term ownership in thefirm.For example, at Goldman

Sachs, 40 percent of the

restricted stock an employeereceives typically vestsimmediately, but it isn’tdelivered for three years.Therefore, if an employeeleaves, then that employeerisks losing his or herrestrictedshares.Similarly, at insurance

underwriterMarkelInsuranceCompany, restricted stock isgiven to senior managersafter they meet pre-

established performancegoals, which are grantedbased on growth in bookvalue per share, over a five-year period. Markel believesthat by paying a substantialportion of incentivecompensation in restrictedstock units (RSUs), it hasboth the advantage ofincreasing management’sequityownershipandcreatingaretentionincentive,because

the manager must remainemployedby thecompany toreceivethestock.

LookforCompaniesthatRequireStock

OwnershipSome businesses have stock-ownership and retentionguidelines that requiremanagementtoownacertainamount of stock. For

example, the 2009 proxystatement for MarkelInsuranceCorporationstates:The Company places astrongemphasisonequityownership by executiveofficers and othermembers of seniormanagement. The Boardof Directors has adoptedstock ownershipguidelines that requireexecutive officers to

acquire and maintainownership of CommonStockwithavalueatleastequal to five times basesalaryandothermembersof senior management toacquire and maintainownership of CommonStockwithavalueatleastequal to two or threetimes base salary,depending on position.Newly hired or newly

promoted executiveofficers are expected toreach these minimumlevels of ownershipwithinfiveyears.If you find this type of

compensation program in theproxy,thenitislikelythatthemanagementhasan incentiveto perform over the longterm.

OtherValuableInsightsYouCan

GleanfromReadingtheProxyStatement

onHowtheCompensationSystemIsSetUp

The way a compensationsystemisstructuredcangaveyouvaluableinsightsintothecharacter and motivation of

management. Rather thanfocusing on how muchexecutiveofficersarepaid, itis more useful to understandhow an executivecompensation plan isstructured. Start by viewingthe proxy statement sectiontitled CompensationDiscussion and Analysis,where the compensationcommittee of the board ofdirectors communicates how

it sets the compensationpackageforthetopexecutiveofficers and employees. Forexample,anexecutiveofficermightbecompensatedevenifhe or she did not meet theperformance targets. TheformerCEO of Shell, JeroenvandeVeer, received a $1.9million bonus from anincentive program where hefailed to meet theperformance targets set for

threeyears.Runningacrossacompensation arrangementsuch as this would certainlyprovide insight into the typeofmanagement teamyouarethinkingofpartneringwith.26

Incontrast, the2009proxystatement for Morningstarstates:In consideration of hisstatus as our principalshareholder, JoeMansueto believes his

compensationasourchiefexecutive officer shouldbe realized primarilythrough appreciation inthelong-termvalueofourcommon stock.Accordingly, at hisrequest, he doesn’tparticipate in our equityor cash-based incentiveprograms. In addition,sinceresuminghisroleasour chief executive

officer in 2000, hisannual salary has beenfixedat$100,000.You can evaluate

Mansueto’scharacterandthathe manages the business inthe interest of hisshareholders, because herefuses to accept stockoptions.This gives yougreatinsightintohischaracter,andthis is the type of CEO youshouldlookforasalong-term

partner.

BewareofCompaniesthatUse

CompensationConsultants

If acompensationpackage isdetermined by consultantshired by the board ofdirectors,thisshouldserveasa red flag. This kind ofcompensation benchmarking

is usually not about theperformance of the business,but rather a comparison towhat others in the industrymake. However, the peergroups used are often incompletelyunrelatedbusinesslines. You will find that themajority of compensationplans are determined in thisway.For example, in FY 2010,

jewelry retailer Zale hired a

compensationconsultantwhoput together a list of 21companies as a peer group.The consultant included suchcompaniesasAbercrombie&Fitch, American EagleOutfitters, and Children’sPlace, which are specialtyapparel companies, notjewelry retailers. Theconsulting firm then targetedcompensationwithinacertainpercentile range of the peer

group.Forexample,the2009Zale proxy states:“Accordingly, base salariesgenerally were targetedbetween the 25th and 50thpercentile of market, andannual performance-basedbonuses generally weretargetedbetweenthe25thand50thpercentileofmarket.”Two red flags are raised

here:That compensationwasdetermined by comparison to

loosely relatedpeers, and thefact that base compensationdoesnothaveanything todowith the performance of thebusiness.

BewareofCompaniesthatUse

EmploymentContracts

Anotherredflagiswhenyoufindemployment contracts in

the proxy statement thatguaranteethatamanagerwillbe paid a certain amount intotalcashcompensation.Thisguarantee of compensationdoes not directly align theexecutive officers with thelong-term interests of thebusiness.For example, K-Mart

handed out roughly $30million in retention loans(retention loans are given

when the company is failing,but often they are awardedafter a bankruptcy filing) toits25topmanagers,including$5 million to then-CEOChuck Conaway. The loanswere given to entice themanagers to stay at thebusiness. At the same time,however, management wasfiringthousandsofemployeesand cutting the salaries ofother managers. This likely

decreased morale among theemployees at K-Mart, andthese managers wereultimately unsuccessful inturning around the business.Eventually, these executiveofficers were fired by theboard of directors, but theyhad already been givenmillions of dollars incompensation because it wasguaranteed.27

You should always watch

for managers who demandextremelyhigh compensationpackages before joining abusiness or who demandthem to remain at thebusiness. There is a sayingthat people who demand themostup front areusually theoneswho deliver the least atthe back end. This isgenerally true because thosewho receive guaranteedsalaries and bonuses,

regardlessoftheperformanceof the business, do not haveany incentive to create long-termvalue.For example, theCEO and

founder of an energycompanywas awarded a $75million-option package torenew his employmentcontractwiththecompanyforfive years and not pursueother entrepreneurialventures. This is a warning

signal. Why would a CEOdemand to be paid $75million to remain at abusiness he founded? If hewere truly passionate aboutthe business, it is likely theboard of directors would notneed to entice him to stay atthe business with financialincentives. This is just plaincommon sense. Clearly, theinterests of the shareholdersand management were not

aligned.

LookforManagersWhoContinuallyIncreaseTheir

OwnershipInterestintheBusiness

Thebestmanagers topartnerwith are those whocontinually increase or retaintheir ownership in the

business. For example, thefollowing CEOs have soldvery limited quantities oftheircompanies’stockduringtheirtenures:

WarrenBuffett,CEOofBerkshireHathaway;Bruce Flatt, CEO ofBrookfield AssetManagement;Dave and Sherry Gold,founders of 99 CentOnlyStores;and

Henry Singleton, formerCEOofTeledyne.

Singleton, for example,didnotreceiveanyoptionawardsand only sold stock in 1987and 1988 after continuing tobuy it for more than 20years.28BruceFlattwasonceasked what his hobby was,and he responded that itwascollectingsharesofhisstock.All of these businesses havecreated tremendous value for

shareholders over the longterm.Use the proxy statement to

construct a manager’sownership of the stock byviewing the stock ownershipsection over a 5- to 10-yearperiod. Note how the shareswereacquired,either throughdirect purchases or throughoption issuances. Determineif the manager is increasinghis or her ownership interest

in the business rather thandecreasing it. If themanager’s ownership interestisdecliningover time, this isnot a positive sign. Manytimes, managers will claimthey are selling fordiversificationpurposes:Thisis reasonable and certainlybelievable,butrememberthatattheendoftheday,asaleisasale.

38.Havethemanagersbeenbuyingorselling

thestock?It is important to keep upwith the purchases and salesof stock made bymanagement by continuallymonitoring Form 3, 4, and 5filings(whichareSECfilings

relatedtoinsidertrading)andschedule 13-D filings (whichare required for anyone whoacquiresbeneficialownershipof 5 percent or more of apublic company). Insidertransactions signal wheresenior managers reallybelieve their companies aregoing, without the corporatespin. They can also be auseful indicator ofwhether astock will out-perform or

under-perform. In his 1998book Investment Intelligencefrom Insider Trading, NejatSeyhun examined insideractivity from 1975 to 1995and discovered that stocksbought but not sold byinsiders outperformed themarket by 7.5 percent, onaverage, during the 12months that followed theinsiderpurchases.Incontrast,companies with insider

selling underperformed themarketby6.1percent.Youmustbe carefulnot to

jump to conclusions from anexecutive officer who isbuying or selling stockwithout first examining themotivation behind thepurchases or sales andwhether the buying andsellingismaterial tothetotalnet worth of that executiveofficer. For example, insider

purchases have become lessuseful indicators than theywere in the past. Manyexecutive officers havelearned that bybuying stock,theycanincreasethepriceofthe stock, because themediareports these purchases. Youhave tobeaware that the topexecutive officers may beattempting to manipulate thestock.In order to be a useful

signal, the insider buying orselling must be significantcompared to the total networth of the insider—forexample, representing 15percentormoreof their totalownership. Unless you seethese high-convictionpurchases,thenpurchasesandsales are just noise, and youneed to be careful not toregard them as usefulindicators.

For example, one CEObought$100millionworthofstock in 2008, which soundslike a big sum. However,when compared to his totalnet worth, which wasestimated by Forbesmagazine to be $17.3 billionin2008,itrepresentedasmallamount.Hereareacoupleexamples

where insiderpurchaseswereusefulindicators:

A good example of astrong buy signal is theinsiderpurchasesofCarlKirkland, founder ofspecialty retailer ofhome décor Kirkland’s.On March 23, 2006,Kirkland owned 1.3million shares. A fewmonths later, onSeptember10,2008,ina13-D filing, Kirklanddisclosed that he

purchased 3,464,032shares of stock for$6,754,862 (i.e., at anaverage price of $1.95per share) by taking outa loan using an airplanehe owned and hisvacation home ascollateral. The 13-Dfiling listed a businessloan agreement betweenBank of America andKirkland Aviation,

which owned a HawkerBeechcraft B200GT fora loan in the amount of$4million.Healso tookoutaloanintheamountof$3.5million,usinghisAvon, Colorado,vacation home ascollateral.Wheneveryousee a former founderbuying so much stockusing loans to fund hispurchases, this is a

strong buy signal. ThestockpriceofKirkland’sshortlyincreasedinpriceto more than $14 pershareattheendof2010.ThreedaysbeforeJamieDimonjoinedBankOneasCEO,heacquiredtwomillionshares fornearly$60 million, using hisowncapital.Whenaskedwhyhebought somuchstock, he said he felt a

CEOshouldeathisowncooking. This is a clearsignal that you and theCEO are aligned. Thestock price increasedfrom$30persharewhenDimon joined in March2000 to $51 per sharewhen Bank One wasacquiredbyJ.P.MorganonJanuary15,2004.29

ExamplesofGood

SaleIndicatorsIfyouseeseniormanagersorboard members selling a lotof shares, this is not a signalthat you should sell yourstock, but it is a signal thatyou should question theirlong-term faith in thebusiness.Youarelookingforextremes rather than aninsidersellingaportionofhisorherholdings:Afterall,that

managercouldberemodelingahouseorhaveotherreasonsthat have nothing to do withhis or her confidence in thebusiness.Thefollowingareafew examples of usefulwarningsignals:

Ifyouseeastockwhoseprice is continuallydropping, yet insidersare selling, this is awarningsign.In two quarters alone,

nine executives anddirectors of NovatelWireless soldmore thanhalf of their holdings in2007, at prices rangingfrom $17 to more than$20 per share.One yearlater, the stock pricedropped below $10 pershare and traded as lowas $3 per share onDecember1,2008.30

Five board members at

Jones Soda Companydisposedofnearlyalloftheir shares of companystockoverathree-monthperiod in 2007 as thestock price reached $27per share. That year,Jones Soda wasdeveloping into amainstreambrandwithanational distributioncontract, and thecompany had just

announced strong fourthquarter earnings. TheCEO also announcedthat the companywouldbe in 25 percent of theretail market by sellingat stores such as Wal-Mart, Kroger, andSafeway. Shortlythereafter, Jones Sodareleased 2007 first andsecond-quarter earningsthat disappointed

investors, causing thestockpricetodropto$7bytheendof2007.Mostof the directors wereable to sell their sharesat prices ranging from$10pershareto$25pershare, while thosestockholders who keptthe stock suffered adecline in their networth.31

CEO John Hammergren

of McKesson (ahealthcare informationtechnology company)owned4.5millionsharesas of June 1, 2010,including options andrestrictedstockholdings.He sold more than 2.9millionofthesesharesin2010 (64 percent of hisholdings),realizingmorethan $98 million inprofits, according to

SEC filings. Thissignificant reduction inHammergren’sownership should serveas a warning signal toinvestors that he doesnot have long-termconfidence in thebusiness.

DeterminetheMotivationWhen

ManagementPurchasesorSellsCompanyStock

You should also examinefurther the motivation ofstock purchases or sales. Togain full perspective oninsider purchases and sales,read thenotes toForms3,4,and 5, which often disclosethereasonforthepurchaseorsale. If you are unable to

determine the motivationbehindthepurchasesorsales,thenyoudonothaveenoughinformation to draw aconclusion, and you need tobe careful to not makeassumptions. Some of themost common reasons arelisted here and described inmore detail in the followingparagraphs:

10b5–1programsTaxpurposes

MargincallsPersonal reasons, suchas commitments tocharities that need to befunded

ExecutiveOfficersWhoSellSharesundertheTermsofa10b5–1ProgramA 10b5–1 program is set upunder SEC regulation

designed to allow insiders tobuyorsellcompanysharesinan orderly pattern withouthaving to worry aboutallegationsofimproperuseofinsider information. Theplansvary incomplexity,butthey generally specify theamount,price,anddateofthepurchase or sale of a stock.Many investors make themistakeofignoringpurchasesandsalesofstockina10b5–1

programbecausetheybelievethere is an orderly pattern totrading the stock, but theexecutive officers have theabilitytochangethetermsofthe program at any point.Whenever you notesignificant deviations fromthe trading plan, this shouldserveasawarningsignal.For example, the co-

founder of subprimemortgage lender New

Century FinancialCorporation, EdwardGotschall, sold more than$15.4 million in stock fromAugust 2006 to the firstquarter of 2007, just beforethe company disclosedaccounting problems relatedto reserves, and the businesseventually filed forbankruptcy. This sale wasconducted under a 10b5–1planandwasignoredbymost

investors32—but it shouldn’thave been. If investors hadpaidattentiontothehistoricalsales pattern in the 10b5–1program, they would havenoticed that Gotschallchangedthetermsoftheplanto dramatically accelerate hisstocksales.Managersalsosellstockfor

reasons that are unrelated totheir confidence in thebusiness. The following two

examplesrepresenttwoofthemostcommonreasons.

ManagersWhoSellStockforTaxPurposesWhen a manager exercises astock option, it generates ataxliabilityforthedifferencebetween the price the optionwas originally granted andthepricethestockissoldfor.

Therefore, the manager hastwowaystohandlethis.Onewayisforthemanagertosellall or a portion of theexercised stock and use theproceeds to pay the tax. Theotherway is for themanagerto take out a loan, using thestockascollateral, topaythetax, which has the effect ofdeferring the tax. The mainrisktothisisthatifthestockprice drops below a certain

price,themanagerwillfaceamargincall.

ManagersWhoSellStocktoMeetMarginCallsDuring 2008, when the S&P500droppedbymorethan37percent, many managers hadto sell stock to meet margincalls. One of the morenoteworthy sales during this

time was from AubreyMcClendon, co-founder andCEO of Chesapeake EnergyCorporation,whowas forcedto sell 94 percent of hisholdings for $569 million tomeet margin calls whenChesapeake’s stock pricedropped65percent.33

KeyPointstoKeepinMind

Learnaboutthe

BackgroundofSenior

ManagersThe mostlogicalpredictor ofthe futuresuccess of abusiness isitsmanagement.

If you areinvestinginamanagerwhohas a longtrack record(i.e., morethan 10years) ofsuccessfullymanaging abusiness, theodds that heor she willcontinue tomanage thebusinesssuccessfully

are in yourfavor. It’seasier topredict whatmanagerswilldointhefuture if youhave alreadyseen whatthey do inboth difficultandfavorableenvironments.Outsidemanagerswho join thebusiness and

make majorchangesimmediately,without fullyunderstandingthecustomersandsolicitinginput fromtheemployees,are morelikelytofail.You canquicklyjudge severalqualities in

managers byusing thelion/hyenametaphor.Managerswho haverisen frominside thecorporatesuite (e.g.,CFOs andGeneralCounsels)often do notmake goodoperatorsbecause they

have lessexperiencewiththeday-to-dayoperations ofthe business;they have aconstrictedway ofthinking; andtheir pastinteractionwith theemployeesofthe businessislimited.

HowManagersAre

CompensatedIsImportant

Some of thebest long-termperformingstocks arerunbyCEOswith lowcashcompensationand high

stockownership.If a businesshas a widelydistributedstock-optionplan, thisindicates thatmanagerscare aboutemployeesrather thanjustthemselves.The idealcompensationstructuresare

those thatreward forlong-termvaluecreationfactors, suchas operatingincome orbook value,instead ofjustthestockprice (e.g.stockoptions).If acompensationpackage is

determinedbyconsultantshired by theboard ofdirectors,thisshould serveas a warningsignal. Thiskind ofcompensationbenchmarkingisusuallynotabout theperformanceof thebusiness, but

rather acomparisonto whatothers in theindustrymake.People whodemand themostupfrontare usuallytheoneswhodeliver theleast at theback end.Watch forthosemanagers

who demandhighcompensationpackagesbeforeworking atthebusiness.Insidertransactionssignal wheremanagersreallybelievetheircompaniesare going,without thecorporate

spin.

1.Dell,Michael,speakingtoanalystsinRoundRock,Texas,April2,2008.2.Lublin,Joann,andSpencerStuart,“CEOTenure,StockGainsOftenGoHand-in-Hand.”WallStreetJournal,July6,2010.3.Byrnes,Nanette,andDavidKiley.“Hello,YouMustBeGoing.”

BusinessWeek,February12,2007,pp.30–32;“ExecutivesNeedMoreThan90DaystoIntegrate.”BusinessWire,March13,2006.4.InterviewbyThomasStewart,“GrowthasaProcess.”HarvardBusinessReview,June2006.5.Byrne,John.“ChainsawAlCutsHisLastDeal.”BusinessWeekOnline,

September6,2002.6.InterviewwithSengHockTaninMay2010andOctober2010.7.Standard&Poor’sCapitalIQasofendof2000to2009.8.Hawthorne,Fran.TheMerckDruggernaut:TheInsideStoryofaPharmaceuticalGiant.Hoboken,N.J.:Wiley,2003.

9.Foust,Dean.“WhereHeadhuntersFeartoTread”BusinessWeek,September14,2009,pp.42–44.10.CarMax2009ProxyStatement.11.Schwartz,NelsonD.,DorisBurke,andMatthewSchuerman,“Greed-mart.”Fortune,October14,2002.12.Ibid.13.Dixon,Jennifer.“HowKmartFell.”Charleston

Gazette,July14,2002.14.Rockoff,JonathanD.“MerckNamesFrazierasCEO.”WallStreetJournal,December1,2010.15.Foust,Dean.“WhereHeadhuntersFeartoTread.”BusinessWeek,September14,2009,pp.42–44.16.“3MaLabforGrowth?”BusinessWeek,January21,2002,pp.50–51.17.FastenalProxy

Statements,2001to2009.18.Standard&Poor’sCapitalIQ.19.99CentOnlyProxyStatements,1997to2005.20.2009MorningstarProxyStatement.21.2006HeartlandExpressProxyStatementandStandard&Poor’sCapitalIQ.22.Standard&Poor’sCapitalIQ.

23.2010OracleCorporationProxyStatement.24.2010WholeFoodsMarketProxyStatement.25.Dillon,Karen.“TheComingBattleoverExecutivePay.”HarvardBusinessReview,September2009.26.Ibid.27.Schwartz,NelsonD.,DorisBurke,andMatthewSchuerman.“Greed-mart.”

Fortune,October14,2002.28.“TheBrainBehindTeledyne:AGreatAmericanCapitalist.”NewYorkObserver,April7,2003.29.Byrne,HarlanS.“DimonintheRough:ATurnaroundatBankOneWon’tBeQuickUnderItsNewCEO.”Barron’s,April3,2000.30.Standard&Poor’s

CapitalIQ.31.Harris,Craig.“SweetDealforSodaHonchos?”SeattlePost-Intelligencer,August14,2007.32.Searcey,Dionne,andKaraScannell.“SECNowTakesaHardLookatInsiders’‘Regular’Sales.”WallStreetJournal,April4,2007.33.Casselman,Ben.“ChesapeakeCEOSells

Holdings.”WallStreetJournal,October11,2008.

CHAPTER8

AssessingtheQualityof

Management—Competence:

How

ManagementOperatestheBusiness

Inadditiontoresearchingthebackgrounds of seniormanagers,sothatyou’llknowmoreabouttheircareers,howthey were promoted, whatfunctional experience they

have(ordon’thave!),andthecorporate culture of thecompanies they worked atpreviously—all of whichChapter 7 focused on—it’salso helpful to assess howmanagersactuallyoperatethebusiness, which is the focusof this chapter. Here, we’lllook at management styles;strategicplanningandday-to-day operations;organizationalstructures(i.e.,

centralized versusdecentralized);howmanagerstreat their employees andwhether they know how tohire well; whethermanagement knows how tointelligently manage itsexpenses; and whethermanagement isdisciplinedorundisciplined in makingcapitalallocationdecisions.By looking at how

managers actually operate,

you will be better able toassess how competent theyare. Competency matters formany reasons, butoneof themost compelling is that trulycompetentmanagers are ableto quickly adapt to changingenvironments. For example,during the stock marketdownturn in 2008, when theS&P500dropped37percent,my firm strictly maintainedits commitment to investing

in proven and competentmanagement teams. With somuch uncertainty in theeconomy,therewasverylittlevisibility into the futureearnings power of manycompanies. Therefore, wepartnered with managementteams that had the ability toadapt their businesses to thechanging economicenvironment. And weavoided investing in

managementteamsthathadalimited track record runningtheirbusiness.For example, we did not

invest inanonline retailerofdiamonds and fine jewelry,because the founder hadrecently passed the chiefexecutive officer (CEO) titleto the chief financial officer(CFO)(February2008).Eventhough the CFO had been atthe business since 1999, we

could not judge hercompetence in running thebusinessinhernewrole.In contrast, we had strong

conviction in regard to thecompetence and abilities ofthe management team atWhole Foods Market,because that team hadoperated successfullytogether since 2001. Facedwith declining same-storesales,which themanagement

team had never encounteredbefore, managementstrengthened the balancesheet and increased free-cashflow.Another less direct but

substantial benefit ofpartnering with proven andcompetent managementteams is that it frees yourtime to focus on otherinvestment opportunities. Ifyoupartnerwith incompetent

managementteams,youhaveto spend a lot of timemonitoringtheiractions.I once invested in a

business because the stockwas cheap, but I knew themanagement team wassomewhat incompetent. Icontinued to hold the stockbecause I believed it wassubstantially undervalued.Eachtimethebusinessissueda press release, my stomach

churned, as I anticipated badnews.TheCEOnever letmedown and continuallyreported bad results. Thisinvestment failed to createanyvalueformyfund.In contrast, when I have

partnered with competentmanagerssuchasBruceFlatt,CEO of asset-management-holding company BrookfieldAsset Management, I do nothave to scrutinize each

management decision indetail. I know that if the topmanagers make a mistake,they will quickly recognizethemistakeandcorrectit.Byinvesting in proven andcompetent managementteams, you will rarely bedisappointed. This will helpyoumaintainanopportunisticattitude.Now let’s take a look at

questions that will help you

determine if themanagementteamiscompetent.

39.DoestheCEOmanagethe

businesstobenefitall

stakeholders?If you were to ask investors

whether shareholder value ismoreimportantthancustomerservice at a business, mostwouldanswerthatitis.Whatthey fail to consider is thatshareholder value is abyproduct of a business thatkeepsitscustomershappy.Infact, many of the best-performing stocks over thelong term are the ones thatbalance the interests of allstakeholdergroups, including

customers, employees,suppliers, and other businesspartners.ThesebusinessesaremanagedbyCEOswhohavea purpose greater than solelygenerating profits for theirshareholders.In the book Firms of

Endearment, David Wolfe,RajendraSisodia,andJagdishSheth studied 30 companiesthat view success as morethan just maximizing

shareholder returns. Thesecompanies instead try tomaximize value for allstakeholders. Interestingly,these companiesoutperformed the S&P 500over the 10 years that theauthors tracked them. Thecompanies returned anastonishing 1,026 percent for10yearsendingin2006—theS&P 500 returned only 122percent.

It is surprising how fewCEOs manage the businessfor the benefit of allstakeholders. The reason isthat it is harder to do. It iseasier to focus on oneconstituency, such asstockholders, rather thanmany.John Mackey, co-founder

and CEO of Whole FoodsMarket, has coined the termconscious capitalism to

describe businesses designedto benefit all of theirstakeholders, such ascustomers, employees,investors, and suppliers.Instead of subscribing to thetheory that the only purposeof a business is tomaximizeprofits, conscious capitalismproponents believe thatincreasesinshareholdervalueare theby-productofhelpingcustomers, employees, and

vendors reach their highestpotential.Mackeycomparesprofitsto

happiness to illustrate hispoint.Justtryingtobehappydoesn’tusuallywork.Instead,we’rehappydue to ahostofother reasons: a strong senseofpurpose,meaningfulwork,goodfriendsandgoodhealth,loving relationships, and thechance to learn, grow, andhelp others. Like happiness,

profits are also the result ofother things, and aren’tachievedbymakingthemtheprimarygoal of thebusiness.“Long-term profits,” saysMackey, “come from havinga deeper purpose, greatproducts, satisfied customers,happy employees, greatsuppliers, and from taking adegree of responsibility forthe community andenvironment we live in. The

paradoxofprofitsisthat,likehappiness, they are bestachieved by not aimingdirectlyforthem.”1

Some examples ofbusinesses that manage thebusiness for customers andother stakeholders instead ofmaximizingprofitsarebelow:

At Costco, CEO JimSinegal says that bytreatingemployeesfairlyand making sure that

customers receive agoodvalue,shareholderswill benefit over thelonghaul.RobertWilmers,CEOofM&T bank, lived abusiness philosophy thatcould be a primer forsound banking: “Knowyour markets andemployees, watch creditquality relentlessly,don’t gamble with

interest rates, and focuson serving yourcommunity.”2 You willnote that none of thegoals were to increaseshareholder value. EvenWarrenBuffett,CEOofBerkshire Hathaway,heldalong-termstakeinM&T.3 Under Wilmers’tenure, the stockappreciated from lessthan $3 per share when

he joined the bank in1983to$87pershareonDecember 31, 2010,4making it one of thebest-performing bankstocks in the last twodecades. Wilmers didnot focus on the profitsof the bank, but insteadfocused on those thingsthat generated theprofits.David Packard, co-

founder of HewlettPackard, was alsoknown for taking abroader view ofstakeholders. One storydescribesthe37-yearoldPackard in 1949listening to a group ofbusiness leaders whowere apparently focusedsolely on profits.Uncomfortable withtheirviews,Packardtold

them plainly, “Acompany has a greaterresponsibility thanmaking money for itsstockholders!” Ofcourse, Hewlett-Packardwent on to become thepremier technologycompany under PackardandBillHewlett.5

Similarly when RobertSilberman took over asCEO of Strayer

Education in 2001, hesaidhewasnotgoingtofocus on any of themetrics that generallydrive public companyvaluations, such asrevenue growth,operating incomegrowth, and marginexpansion. In aninterview, I asked himwhy he focused onacademic outcomes

insteadofprofits,andhesaid, “It evolved fromlooking at the asset ofthe enterprise. It waspretty clear to me thatthe only thing that wasgoing to drive realsustainable long-termvalue tomyownerswasthe intangible value ofStrayer University. SothenIsatbackandsaid,howdoyouincreasethe

intangible value ofStrayerUniversity?Andtheanswertothatis,youincrease the level oflearningoutcomes.”6

40.Doesthemanagement

teamimproveitsoperationsday-

to-dayordoesituseastrategicplantoconductitsbusiness?

Most investors seek outsuperstar CEOs who canseemingly change thebusiness overnight with awell-planned strategy. Inessence, the investorbelieves

that business transformationis the result of brilliant ideasand clever plans.One reasoninvestors think greatperformance results frombrilliant strategy is that it isoften reported to seem thatway in the popular businessmedia. These stories arepopular for a couple ofreasons: First, they are easytowrite;second,peopleenjoystories about flash and

charisma far more thanstoriesaboutCEOswhogrowtheir business throughcontinuous improvement.These articles oftencontribute to increases in thestock price as investors buyinto thehopesanddreamsofthe charismatic CEO.Investors tend to have shortmemories, and they forgetthatmanyofthesebusinesseseventually derail in dramatic

fashionlateron.Beware of the CEO who

believesthatonestrategyorasingle stroke will transformtheir business. These CEOstypically make bigannouncements, such as theywill take their business fromthe number-three position tonumber one in five years, byrevolutionizing the way theyconduct business, bymakinga transformational

acquisition,orbyleapingintoa hot new market. Theseambitious plans hinge onmakingrapid,sizablemarket-sharegains.For example, Nortel’s

strengths had traditionallybeen in voice transmissionwhen CEO John Rothdecided that he wouldtransformthecompanyintoamuchbiggerdatanetworkingcompany. He did this by

quickly acquiring 19 newbusinessesfrom1997toearly2001. Nortel’s stock pricerose,reachingamarketcapof$277 billion in July of 2000.Bytheendof2001,thestockprice had fallen 90 percentfrom its peak the previousyear. Most of the 19acquisitions were eventuallysold for less than Norteloriginally paid or werewrittenoffentirely.7

A strategic plan is adetailed roadmap to success,such as a five-year plan thatsetsspecifictargetsthatmustbemet.Asaresult,astrategicplancanalsobeaninflexibleplan that outlines how abusiness will operate for thenext 2, 5, or 10 years. If aproject or product does notmeet the goals of the plan,then it is dismissed.Therefore, seizing

opportunitiesbecomeslessofapriorityforthebusiness.Contrary to popular belief,

most successful businessesarebuiltonhundredsofsmalldecisions, instead of on onewell-formulated strategicplan. For example, whenmostsuccessfulentrepreneursstart their business, they donot have a business planstating what their businesswill look like in 2, 5, or 10

years. They instead buildtheir business day by day,focusing on customer needsand letting these customerneeds shape the direction oftheir business. It is thisstream of everyday decisionsover time that accounts forgreatoutcomes,insteadofbigone-time decisions. Thesebusinessesdon’t attemptnewinitiatives until existing onesare thoroughly absorbed by

the employees of thecompany. For example,Apple’s approach is to putevery resource behind just afew products andmake themexceedingly well. Can youevenimagineApplemakingacheap,poorlymadeproduct?Another common theme

among businesses thatimprove day by day is thatthey operate on the premisethat it is best to repeatedly

launch a product or servicewith a limited number of itscustomers so that it can usecustomer reactions andfeedback to modify it. Theyoperateonthepremisethat itisokaytolearnfrommistakesandthatitiscriticaltoobtaincustomer feedback to shapetheirstrategies.For example, Coach

conducts more than 10,000customer interviews every

year before it launches newluxuryhandbagandaccessoryproducts. Based on theinformationitcollects,Coachwill alter the design of theproductordropitemsthattestpoorly.Asaresult,Coachhasadirectlinetothepulseofitscustomersandisabletoavoidnumerous market misfires.Coach believes that themillions of dollars it spendson customer interviews

represent a low-cost form ofinsurance against gettingblindsided by customers’shifting priorities. Instead ofsetting up a strategic plan,Coach lets customer inputshapeitsstrategies.8

You need to determine ifthemanagementteamyouareinvestinginworksonprovinga concept before investing alotofcapital in itorwhetherit prefers to put a lot of

money in all at once hopingfor a big payoff. Proving aconcept does not need to beexpensive.Forexample,ReedHastings, founder of movie-rental-by-mail businessNetflix,mailedhimself aCDin an envelope when he wasdeveloping the business.When the envelope arrivedundamaged, he had spentonly the cost of postage totestoneofthebusiness’skey

operationalrisks.9

Similarly, Tom Perkins,founder of Kleiner Perkins,an early investor incompanies such asbiotechnology businessGenentech, counsels, “First,eliminatetherisk.Then,growthe business.” Perkins wouldnot make any significantfinancial commitments to anew venture until certainrisks were reduced. This

model is commonly used inthe Venture Capital (VC)industry where startups aregiven capital in multiplerounds. After a start-upreaches certain milestones,then the VC investors willinvest more money. Forexample, Genentechoutsourcedalotofitsworktolabsinsteadofinvestinginitsown lab as it developed itsproducts. As Genentech

became more successful andproved its product it theninvestedinitsownlab.10

In contrast, businesses thatrely on strategic plans oftenspend millions of dollars onresearch data compiled byconsultants (instead ofcustomers)overalongperiodof time before they launch aproductorservice.For example, when

MotorolalauncheditsIridium

phone, only 50,000 peoplesubscribed to its servicesinstead of the millions ofsubscribersthatMotorolahadanticipated. Itwasoneof thelargest fiascos in businesshistory, and Iridium declaredbankruptcyin2000.Motorolahad devised a long-termstrategic plan to develop aservice where customerscould make cellular phonecallsfromanywhereonearth.

This technology took morethan10years todevelopandMotorola investedmore than$5 billion in the project tolaunch 66 low-flyingsatellites.Unfortunately, when the

companywasreadytolaunchtheservice,thephoneneededto receive the satellite signalwas the size of a brick andusers had to be outdoors toget reception. Both of these

weremajor stumbling blocksthat Motorola had not fullyconsidered when it wasdeveloping the service.11Motorola had focused somuch on achieving itsstrategicgoalthatitneglectedthe basics of getting goodcustomerfeedbackearlyon.Hereareafewexamplesof

businessesoperatedbyCEOswho do not follow well-formulatedstrategicplansbut

instead improve the businessdaybyday.

Henry Singleton, CEOof Teledyne Inc. fromthe 1960s through the1980s, believed the bestplanwasnoplan.Underhis tenure, Teledyne’sstock compounded atmorethan20percentformore than 20 years. Hebelieved itwas better toapproach an uncertain

world with an openmind. Singleton onceremarked at a Teledyneannual meeting, “. . .we’re subject to atremendous number ofoutside influences, andthevastmajorityofthemcannot be predicted. Somy idea is to stayflexible. I like to steerthe boat each day ratherthanplanaheadwayinto

thefuture.”12

Dave and Sherry Gold,co-founders of 99 CentOnly Stores, started thebusiness in 1982 andgrew it tomore than $1billion in sales in 2005.Dave Gold said, “Thepeople who are makinglong-term projectionsusually do not haveaccountability, andpeopleoftenforgetwhat

theysaidyearsbefore.Ifyou have a strategy forgrowth for thenext5or10years,itgetschangedso much in that timeperiod.Idon’tthinkyoucanplanoutmorethan2years from now. I don’tthink that far ahead. Ifyoudo,youjustgetintodreaming.”13

Thomas Stemberg,founder of office retail

chain Staples, said, “Idon’t get hung up onbusiness plans. I readthem, of course. Butwhatever the plan says,thecompanywillenduplooking different. Whenwe started Staples in1986, for example, ourbusiness planproclaimed we wouldnever deliver. Deliveryadded costs; we figured

we couldn’t afford it.”Today,alargeportionofStaple’s profits arederivedfromitsdeliveryoperations.14

BobGraham,co-founderof AIM ManagementGroup Inc., one of thenation’s largest mutualfund companies said,“When we started AIMManagementGroupInc.,weneverhadaplan.We

followed opportunitiesas theycamealong.Ourplan changed along theway,dependingonwhatopportunities presentedthemselves. We had noideathatwewouldbeinthemoneymarket fundsbusinessorintheequityfunds business, nor didwehave an ideaofhowbigtheywouldget.”15

WhyDoStrategicPlansFail?

When CEOs set a strategicplan, they risk becomingcommitted to it andmay failtoconsiderotheralternatives.In thebook Influence, authorRobert Cialdini writes about“the commitment andconsistency principle.” Aftermaking a commitment ortaking a stand, people are

more willing to agree torequests that are consistentwith their prior commitment.In other words, once youmake a public statement, itmakes it difficult for you tochange your mind. Settingstrategic plans has the sameeffect: A CEO is very likelyto do things to remaincommitted to meeting his orher stated plans because theconsequences of not meeting

them are that the stock goesdown, thereby reducing thevalue of stock options ortarnishing the reputation andcredibilityofthemanagementteam. The management teamthus becomes committed toonly one way of doingbusiness.Strategicplans fail because

they often shut out otheropportunities. When anopportunity comes up and it

does not fit into the strategicplan of a business, then themanagement teamwill likelypass it up. The truth is thatmost management teamsoftenstumbleupon theirbestideas.For example, in the 1990s,

Pfizer stumbled upon one ofitsbest-sellingdrugs,Viagra.Thecompanywasdevelopinga treatment for angina (thepainfulheartconditioncaused

byconstrictingorcloggingofheartarteries),whentheusersof this drug began to reportthat it improved their abilityto have erections. So Pfizermadeaverysmartmoveandrefocused on the newlydiscoveredopportunity.16

Another reason they fail isthat abusinessmay focusonstrategictargetsinsteadofonwhat the customer wants.This is the same as telling a

customer“That’snothowwedo things,” instead of asking“Howdoyouwantitdone?”For example, Fannie Mae

and Freddie Mac boughtbillions of dollars’ worth ofsub-primemortgages. Insteadof focusingon the trueneedsofthecustomers, theyhelpedbanks lend money tocustomers who could notafford the loans. Later, asthese sub-prime mortgages

defaulted, both of thesebusinesses had to be bailedoutbythegovernment.

DoNotConfuseStrategicPlanswithLong-TermPlanningDo not confuse a strategicplan with goals or long-termplanning. You can think oflong-term planning as avision that is always in the

headoftheCEOasheorshebuilds the business. Forexample, aCEOmay have along-termplantobecomethehighest-rated business incustomer satisfaction or tohave the lowest employeeturnoverrateinitsindustry.

Highest-RiskStrategicPlans:SettingFinancial

GoalsThe strategic plans that aremost prone to failure arethose that have an overlynarrow focus, such as thosethat set a financial target.ManyCEOsoftenmakesuchannouncements as “thebusiness will generate $100million in revenues in threeyears” or “wewill sell 1,000units per week by the year

2012.” However, whathappens in most of thesecases is that when the CEOfocusesonaspecificfinancialtarget, they neglect otherareas or take on more risk.Thesingleplanwilldominateall of the activities of thebusiness at the expense ofotherimportantareas.For example, in 2003,

General Motors executiveswore lapel pins and buttons

with the number “29” as areminder of the company’sgoalofobtaininga29percentU.S. market share. To meetthe number that year, GMevenoffered rebatesofup to$5,500 and 0 percent loansover6yearsonsomeoftheircars. Six years later, GM’sU.S.marketsharewasbelow20 percent, and the companywasbankrupt.Why?17

The reason GM failed is

because it focusedonmarketshare, and it had built a costbase structured for at leastthat levelofmarket share. Inotherwords,itwaslockedin.To try to make that number,the company burned throughbillions of dollars, launchingnew models in many marketsegments.By2005,theirU.S.share was at 26 percent—which was the lowest since1925. By 2007, they were

down to 23.7 percent, onlybarely ahead of Toyota.Furthermore, GM’s cashlosses during its high-growthyears had left few cashreserves for years withdeclining car sales, and littleor no cash to deal with thedownturn of 2008 to 2009.By competing in too manymarket segments, and notleaving the segments wherethey couldn’t adapt quickly

enough tomakemoney,GMlostthegambleithadmadetotrytogainmarketsharefromToyota and the other importcompanies.18

Paul Larson, editor ofMorningstar StockInvestor,offersagreatanalogyofwhyit isdangerous tosetspecificfinancial targets: “It’s likeyou’re driving somewhereandyoutellyourselfyouwilldrive to a certain destination

at an average speed of 63mph. Instead, the way youshoulddoitistogoasfastasroadconditionswill allow. Ifyouhaveasetprojection,youmight go too fast and crash,or maybe it is a wide openroadandyoucangunit.”19

When a management teamsetsspecificfinancialgoals,itmay resort to suchactionsasmanaging earnings to meetthose goals ormaking costly

acquisitions. Some examplesof CEOs who have failedaftersettingspecificfinancialtargetsare:

Hugh Grant, CEO ofagriculturalbiotechnology companyMonsanto,oncedeclaredthat his goal was todouble profits withinfive years. Tomeet thisgoal, he needed to shiftthe businesses focus

away fromherbicides toits more profitablebiotech seed business.By 2010, Grantannounced that theywere unlikely to meetsuch a goal and that hewas abandoning thoseplans. Grant laterdeclared, “I’ll tell youfrom the school of hardknocks, I don’t thinkyou’re going to be

seeing us laying outlong-termtargets.”20

In 1976, ContinentalBank was the eighth-largest bank in theUnited States. Thechairman of Continentalannounced thatwithin 5years,thebank’slendingwouldmatch that of theother largest banks. Toreach this goal,Continental shifted its

strategy fromconservative corporatefinancingtoaggressivelypursuing borrowers.Continental did becomethe largest commerciallender in the country,and it became a muchlarger bank, but in theprocess, it made severalcritical mistakes.Continentaltookinmorevolatileforeigndeposits,

loosened lendingcriteria, and sent thewrong message to itsemployees, who relaxeddocumentationstandards.Thebankalsolost its historicallyconservative disciplineand cut its pricing onloans. By 1984,Continental was introuble, and it neededthe largest bailout in

U.S. history up to thattime.21

In the late 1960s, Fordhadbeguntolosemarketshare to its competitorswho weremaking smallfuel-efficient cars. FordCEO Lee Iacoccadecided to challenge hisengineers to produce acar that would cost lessthan $2,000, weighunder 2000 pounds, and

complete it by 1970.Talk about specificgoals: This was atrifecta! The result wasthe Ford Pinto, bestknown as the car thatcould ignite on impact.Not only was the cardesign defective,lawsuits later revealedthatFord’stopmanagersknew that the car couldignite. So committed

wereFord’smanagerstotheir strategic plan thatinstead of fixing thefaulty design, theydecided togoaheadandmanufacture the car.Theyfiguredthecostsofthe lawsuits from thePintofireswouldbelessthan the cost of fixingthedesign.22

41.DotheCEOandCFOissueguidanceregardingearnings?

Guidance is whenmanagement predictsearnings per share or otherbusinessmetricsoverthenextquarter or next year and

shares this information withinvestors, either through apress release or a conferencecall.WallStreetanalyststhentend to fixate on whether abusiness will meet or beatthese quarterly earningsestimates. The majority ofbusinesses that are publiclytraded give guidance. TheNational Investor RelationsInstitute (NIRI) compilesresponses from more than

500 public companiesregarding earnings guidanceandreportsthat60percentofcompaniesprovidedquarterlyearningsguidancein2009.23

Guidancecanhavethemostdamaging effects on abusiness when it begins torepresent the organizationalgoals of the whole business.If meeting guidancerepresents the only goal thebusiness has, then other

valued activities will not beprioritized and are oftenignored. Meeting guidancewill therefore drive theoperations of the business,ratherthantheearningsofthebusinessbeingabyproductofthebusiness’soperations.Forexample, a CEO and CFOwho give guidance may betempted to achievedependable period-to-periodgrowth by masking the

volatility inherent in abusiness. Unfortunately, inthe real world, a businessdoes not grow in a constantfashion. The majority ofbusinesses face a lot ofvolatility that CEOs andCFOscannotmakedisappear.Growth is almost alwayssubject to seasonality,cyclicality, and randomevents.Once a business begins to

set guidance, it may alsoadopta short-termoutlookatthe expense of long-termgrowth. A CEO and CFOmay fear disappointing WallStreetanalystsbecauseiftheydo, their stock priceplummets. If managementfallsshortofaguidancegoal,they may do things that arenotinthebestinterestsofthebusiness to make up thedifference. Once they start

this process, it is difficult tostop it. Then managementbegins to borrow from thefuture in order to sustain thepresent and begins toparticipate in the earningsgame. The game has little todo with running a businessand instead becomes amajordistraction that detaches theCEO and CFO from thefundamentalsofthebusiness.For example, a CEO may

push more products onto itscustomers in order to meetthe current quarter’sguidance. Or the CEO mayrefuse to invest in long-termcapital projects that do notcontribute to profitability intheshortterm.Atsomepoint,it becomes impossible tomanage earnings as usual,and the stockprice falls.TheCEOs and CFOs at suchfailed businesses as Enron,

WorldCom, Tyco, Adelphia,andHealthSouth,whichwerestellarperformers,succumbedto the pressure to meet thenumbers.Enronisacaseinpoint.At

onetime,ithadstrongglobalassetssuchaspipelines,butitthen sought to transform itsbusiness model by becomingamarketmakerofnaturalgasandenergy.AsEnron’sstockprice increased due to the

company’s ability tocontinually exceed itsguidance, it had to seek newavenues for growth andmoved away from its corecompetence toareaswhere ithad no expertise, such asbroadband, water, andweather insurance. As theseoperations began to generatelosses, Enron’s managementbegan to use off-balance-sheetpartnerships inorder to

continue increasing theirearnings per share by takingdebt off of its balance sheet.At its peak in August 2000,Enronhadavaluationof$69billion24—yet it declaredbankruptcyin2002.You need to be cautious

with businesses that issueguidance. Ideally,youshouldlook for managers whopromise only what they canrealistically deliver and do

notbowtoanalysts’demandsfor highly predictableearnings. If management isconstantly worried about itsstock price, then this is anindicator that management isworriedmoreaboutmanagingtheperceptionofthebusinessthan operating the actualbusiness. Instead,management should be clearabout all of the risks anduncertainties involved and

shouldoutlinehowabusinessisprogressingtowardmeetingitslong-termobjective.Somebusinesseshaveeven

stopped issuing quarterlyfinancial targetsbecause theyno longer want to subjectthemselvestotheunnecessarypressure to meet externalgoals. Here are just a fewexamples:

Gillette: At one time,Gillette promised

investors that it wouldgrow its earnings at 15percent to 20 percent.But after it acquiredDuracell in 1996, itbegan to have problemsmeeting this goal.Gillette’s managementbegan to resort to suchactions as channel-stuffing products to itsdistributors in order tomeet its projections.

When James Kilts tookoverasCEOin2001,hequickly dropped thepractice of issuingearnings guidanceentirely.25

Newell, a globalmarketer of consumerproducts:Newellusedtostateinitsannualreportsthat it aimed forearnings-per-share(EPS)growth of 15 percent a

year; however, afterNewell acquiredRubbermaid and itsearnings fell, this linedisappeared from theannualreport.Unilever, a consumergoods company: AsCEO Paul Polmanexplained, “Whatmattered far more thangoals and targets wasconsistent delivery over

time. Anything morespecific only causedtrouble.”

If a business does issueguidance, you need to becareful thatmanagersarenotmanaging earnings. Start bycomparing the quarterly orannual earnings estimates tothe actual earnings per shareofthebusiness.Createachartthatshowstheguidancegivenby management, and count

how many times they beattheir estimates. Ifmanagement is consistentlybeatingitsownestimates,youcan classify thesemanagement teams as“dedicated guiders.” Thisshould serve as a warningsignal,andyoushouldcloselyscrutinize its accounting tounderstand how the businessis consistently beating itsguidance.

42.Isthebusiness

managedinacentralizedordecentralized

way?It is important for you todetermine if topmanagementoperates a business using a

centralized or decentralizedstructure. If it is centralized,thebusinessismanagedusingtop-down hierarchies withrigid reporting structures,whichcreatebureaucracies.Acentralizedmanagementteamoften tells employees exactlywhat tasks to do. Thesebusinesses also have verynarrow decision-makingprocesses, and they mainlyget compliance from their

employees rather thangenuine commitment. Thismay lead employees to notfeel trusted and make themless likely to internalizeresponsibility.Theyareafraidto make mistakes andsometimes they will not dotherightthingbecauseofthatfear.Bureaucratic businesses

also tend to have difficultyrecruiting and retaining

competent employeesbecause competentemployees don’twant to justtake orders withoutunderstanding the reasonsbehind them. Rules andrestrictions cause the mostinnovativepeopletorunfromthebusinessorstarttheirowncompanies.Thismeansthatabusiness’s pipeline of futureleadership will often belimited.

Incontrast,ifabusinesshasa decentralized managementstructure, those employeeswho are closest to thecustomer are empowered tomake decisions. Theseemployees often feel as ifthey are running their ownbusiness.Anaddedbenefit isthatit’smucheasierforfront-line employees to conveyvaluable information abouttheir customers to top

managers.Because it’smucheasierforinformationtoflowup, managers know moreabouttheircustomers.Many of the best-

performing stocks in history—that is, those that havecompounded at rates greaterthan20percentover15years—have used decentralizedoperating structures; forexample,Teledyne,BerkshireHathaway, Penn National

Gaming, ExpeditorsInternational, Fastenal,CapitalCitiesABC, andBedBath & Beyond. One reasonfor their success is that thistype of business attractsindependent thought and adiverse workforce, whichencourages innovation. Thegreatest financial benefit isthat decentralized businesseshave reduced corporateoverhead. For example, Penn

National Gaming, a regionalcasino company, has one ofthe lowest corporateoverheads of any publiclytradedcasino.Let’s take a closer look at

Fastenal (another companywith a decentralizedmanagement structure),whose stock price increasedfrom $0.27 per share onSeptember 1, 1987, to morethan $60 per share on

December 31, 2010. Fastenaldoesn’t operate using strict,top-down corporatehierarchies. Instead, thiscompany treats its branchmanagers more likeindividual store owners,giving them wide latitude indecision making. Companyfounder Robert Kierlinalwaysfelt thatbecausemostcustomer interaction happensat thestore level that itmade

sense to transfer the decisionmaking to that level. Branchmanagers know the customerbest, soFastenal’sstore levelmanagers make decisionsaboutwhatinventorytocarry,and what price to charge fortheir products. In fact, somemanagers negotiate directlywithcorporate suppliers.Thecompensationstructureisalsomatched to the store level,with branch managers

receiving commissions andprofit sharing from theirstores.Similarly, Louis Vuitton

Moët Hennessy’s (LVMH)stock price has increasedmore than 10 times in valuefrom1989to2010,undertheleadership of Chairman andCEO Bernard Arnault.Arnault attributes much ofthissuccesstothecompany’smanagement structure,

stating, “One key element ofmanagement of a group likethis (LVMH has 83,542employees26) isdecentralization. You needthe right team of inspiredmanagers. I want all of mymanagers to take charge oftheirdivisionsasthoughtheywerefamilyenterprises.”27

HowDoYouIdentify

aBusinessThatIsManagedinaCentralizedor

DecentralizedWay?First, determine who has theresponsibility for selectingand hiring employees. Is itthe Human Resources (HR)department or the managerswho the employees will beworking under? If it is thegroup where the employee

will be working, then it isdecentralized,butifallhiringisdonethroughHR,thenitisbureaucratic. Ideally, theresponsibility of selectingemployees should restprimarily with those holdingauthorityoverthedepartmentinwhich there isanopening.Herb Kelleher, founder ofSouthwest Airlines, broughtmodel employees into thehiring process. For example,

pilots made hiringrecommendations for newpilots because they were inthebestposition to judge theabilities of potentialcandidates.28

Second, speak with thecustomersofabusiness.Youneed to determine how thebusiness solves customerissues.Doemployeeshavetoresort to a bureaucraticprocess to resolve customer

issues? Or do they have theauthority to solveacustomerissue without gettingsupervisory approval? Thinkabout how frustrating it iswhen you have to return aproduct to a store and themanager has to approve thereturnor youhave to fill outlotsofpaperwork.Incontrast,Four Seasons Hotelsencourages all of itsemployees to solve problems

themselves, and it rewardsemployees who go beyondthe call of duty in helping ahotelguest.Third, note what the

difference is incompensationamong the top fiveexecutiveofficersbyviewingtheproxystatement.Thiswillhelpyoudetermine whether thebusinessisrunbyatop-downCEO or if it is a flatorganization. For example,

the proxy statement of onebusiness revealed thefollowing:

CEOreceivedasalaryof$2,164,423; the nexthighest paid executivereceived$690,577.CEO’s bonus was $7million; thenexthighestwas$825,000.CEO was also given590,000 stock options,as compared to 90,000

options for the next-highest-paidexecutive.

YoucanclearlyseethattheCEO had a significantlyhighercompensationpackagethan the rest of themanagement team. Thisindicates that the business isbeing run by a top-downCEO.By comparison, the 2009

proxy statement forExpeditors International

shows that CEO Pete Rosereceived total compensationof$4,782,892,andtheother4top executive officers earnedsimilar amounts. Thisindicates that it isprobablyadecentralizedoperation.Fourth, talk to salespeople

who sell products andservices to the business.Salespeople have todeterminewhetherabusinessismanagedinacentralizedor

decentralized way becausethey need to identify theprimary decision maker inorder to make a sale. Forexample, experiencedsalespeople will try todetermine how important jobtitlesareatabusiness.Iftitlesarenotimportant,thenthisisa sign it is decentralized.Salespeople will also look atthe environment of thebusiness they are selling to.

Forexample,theylooktoseeif the cubicles or offices ofthe employees are sterile(centralized) or if they arecustomizedtothetastesoftheemployees of the business(decentralized).

43.Doesmanagementvalueits

employees?MostinvestorsviewtheCEOas the sole person whooperates the business, whilethe employees are viewed ascommodities that can bedownsized at any point.Nothing is further from thetruth.Theprimaryfunctionofamanageristoobtainresultsthroughpeople. If amanageris unable to achieve results

through people, he or she isnot a good manager. Try tounderstandifthemanagementteam values its employeesbecause the only way it willobtain positive results isthroughthesepeople.When employees feel they

arepartnerswiththeirbossina mutual effort, rather thanmerely employees of somebusiness run by managersthey never see, morale will

increase. Furthermore, whenabusinesshasgoodemployeerelations, it typically hasmany other good attributes,such as good customerrelations and the ability toadapt quickly to changingeconomiccircumstances.

GreatEmployeeRelationsCan

TranslateintoHigh

StockReturnsGreat managers know that ifthey treat their employeeswell,employeeswill, in turn,treat their customers well.Some of the highest-performing stocks within theS&P 500 have been run byCEOs who value theiremployees. One of the topperformers is ExpeditorsInternational, whose stock

price has increased 83-fold(up to July 2010) sinceCEOPete Rose took over thefreightforwarderin1988.AsPete Rose once said, “Youtakecareofemployees.Theytake care of customers. Andthat takes care of WallStreet.”29

HCL Technologies CEOVineetNayarinstitutedanewway of thinking aboutemployees and customers at

his company in 2005. In thebook Employees First andCustomers Second: TurningConventional ManagementUpside Down, Nayardiscusses his idea thatemployees create the mostvalue at a company, becausetheyendupknowingthemostabout the customer. Hiscompany, which providesglobalITservices,focusesitseffort on making sure that

employees are able to meetcustomer’s needs. Becauseemployees understand thecustomer’sproblemsandhowtofixthem,Nayarmakessurethat employees have whatthey need, and even makesmanagers accountable toemployees. His results areimpressive: From 2005 to2009, revenues haveincreased by 3.6 times andoperatingprofitsby3.4times.

HCL was one of the fewcompanies that grew duringthe global recessionbeginningin2008,anditalsoincreased revenue by 23.5percentin2009.

ReadArticlesWrittenaboutthe

BusinessAsyoureadarticlesaboutthebusiness, look for specific

situationswherethemanagersdemonstrate they care abouttheir employees. Here are afewexamples:

HowardSchultz,founderof Starbucks: HowardSchultz was asked in a2010 interview aboutdecisions that he hadmade that turned out tobe unpopular withinvestors. Heimmediately brought up

healthcare: Schultzestimated Starbucks hadpaid around $300million in healthcarecosts that year. Manyinvestors wanted him tocut that cost, and oneinstitutional investoreven called him andsuggested he had cover(meaning no one wouldcriticize him) to cuthealthcare costs because

times were tough.Schultz decided not tocut the healthcare plan,saying he’d rather havethe respect of hisemployees.30

RichardGalanti,CFOofCostco: In an interviewduring the recession of2007 to 2009, Galantiwas asked whether heconsidered increasingthe amount that

employees pay forhealthcare from 10percent to a higheramount in order to saveCostco $10 million to$20 million per year.Galanti and the otherCostco managersdeclinedtopassthecostalong to employees,saying that in toughtimes they wanted togive their employees as

muchastheycould.31

Herb Kelleher, CEO ofSouthwest Airlines:When SouthwestAirlineswas founded, itstruggledandwaslosinga lot of money becausethere was inconsistentridership. Founder HerbKelleher faced thedilemma of laying offemployees or selling aplane. Kelleher said,

“We’vealwaystakentheapproachthatemployeescome first. Happy andpleased employees takecare of the customers.And happy customerstakecareofshareholdersby coming back.” SoSouthwest Airlines solda 737 plane andinstituted a “no layoff”policy.32 This policycontributed to the

success of SouthwestAirlines: By 2010,Southwest Airlines wasthe biggest domesticairline in the country,with a marketcapitalization greaterthan the combinedmarket capitalization ofall its domesticcompetitors.

In contrast, if you seemanagement taking big

bonusesatthesametimetheyarecuttingthebenefitsoftheemployees, thisisanobviouswarning signal. No matterhowmuchmanagerssaytheyvalue their employees, theywillhavenocredibility.For example, when

AmericanAirlineswasontheedge of bankruptcy, itsuccessfully negotiated withunions for concessions intheircontracts.Justdaysafter

those negotiations, formerChairman and CEO DonCarty made arrangements toprotect the pension plans ofsenior executives.Carty laterresigned because he had notdisclosedtheseactivities.33

DoestheBusinessHaveGoodorBadEmployeeRelations?Therearemanyquestionsyou

can ask to determine if abusiness has good or bademployeerelations:

Does management treatits employees as assetsorliabilities?Does management talkabout the contributionsoftheiremployees?Does managementbelieve that retainingemployeesiscritical?Does the business

promotefromwithin?Doesmanagement showemployeeshowtheycangetpromoted?Doesthebusinessinvestsignificant resources inemployeetraining?Doesthebusinessattracta great number ofapplicants?Are employees avidlyrecruited from thebusiness?

Are there largedifferences between thebenefits that the topmanagers receive versusemployees?Does management treatemployees with respectwhentheylaythemoff?Doesmanagement listentoitsemployees?Doesthebusinesshaveastrongculture?Does the business have

identifiable, sharedvalues?What is the employee-retentionrate?

Thefollowingsectionstakeacloser lookateachof thesequestions.

DoesManagementTreatItsEmployees

asAssetsorLiabilities?

To answer this, look forarticles and note how themanagers refer to theiremployees. For example,Michael Bloomberg says inhis book Bloomberg byBloomberg,“themainassetisnot our technology, ourdatabases, our proprietarycommunications network, oreven our clients. It is ouremployees. Business mustrecognize employees as

assets.”

DoesManagementTalkabouttheContributionsofTheirEmployees?

Nucor Corporation, a steelmanufacturer,puts thenamesofallofitsemployeesonthecover of its annual report.This gesture is a goodindicator, and another is that

Nucor always shows up onFortune magazine’s list of“Best 100 Companies toWork For.” Good employeerelations have likely helpedNucor become one of thebest-performingstockswithinthesteelindustry.

DoesManagementBelieveThat

RetainingEmployees

IsCritical?Shipping company UPSlearnedthatitwascriticalforittoretainitsdriversbecauseexperienced drivers learnedthe fastest routes and weremore efficient in makingdeliveries.Atonepoint,UPSmanagement discovered thatpartofthereasonforthehighturnover rate for drivers wasthatloadingthetruckswasso

physically demanding. Whenit discovered the problem,UPSpromptlyhiredpart-timeworkers to load packages:This way, the drivers couldconcentrate on their corecompetence, which wasfinding the best routes. As aresult, the turnover rate ofUPS declined. Anytime yousee a management teamfocusingonthewell-beingofits employees so they can

focustheirtimeproductively,thisisagreatsign.34

DoestheBusinessPromotefrom

Within?A business that promotesfrom within has a betterchance of retaining valuableemployees because talentedemployees typically like towork in growing

organizations withopportunities foradvancement.Abusinessthatpromotes from within willhire outsiders only when itneeds to fill a specializedposition.You can obtain thisinformation by interviewingemployeesandaskingthemifmostpositionsare filledwithinternal candidates or if thecompany actively recruitsoutsiders. You can also call

theHRdepartmentandaskifthe company has a policy ofpromoting fromwithin.Mostoften, when a companypromotes fromwithin, itwillhighlight this in investorpresentations found on thecompany website or on itsemploymentwebsites.

DoesManagementShowEmployees

HowTheyCanGetPromoted?

Amanager’sjobistohelphisor her people grow. Greatbusiness leaders havesometimes measured theirown success by the positiveimpactthey’vehadonothers,especially in helpingemployeesreachtheirhighestpotential.Inturn,thisinspiresemployees to do great things

for the manager and thecompany.InthebookFirst,BreakAll

the Rules: What the World’sGreatest Managers DoDifferently, research firmGallup sought ways toincrease employeeengagement. The studyrepresents the largestworldwide effort tounderstand employeeengagement, and was based

on Gallup’s analysis of 10millionworkplaceinterviews.Gallup found there are twoemployeesentimentsthatbestpredict engagement: “myopinion matters—I have avoice” and “somebody herecares about myadvancement.”35

If managers focus onthemselves rather thandeveloping their employees,this will cause employees to

disengage from the business,and themanagerswill fail todevelop a pipeline of futureleadershipatthebusiness.

DoestheBusinessInvestSignificantResourcesin

EmployeeTraining?Ifmanagersarecommittedtoemployee training, this is agreat sign that they have a

long-term orientation. Incontrast,ashort-termorientedmanager considers spendingmoneyontrainingemployeesa waste of money and adiscretionarycost thatcanbeeliminated. Look forexamples where the businessis investing in its employeesthrough training by readingarticles written in tradejournals, such as TrainingMagazine.

For example, Kip Tindell,Chairman and CEO of TheContainerStore,believesthatputting employees first is aprofitable strategy. Hebelieves that one greatemployee has the sameproductivity as three goodemployees. Great people arehard to find and even harderto keep. So when TheContainerStorefindsthem,itpays themwell and spends a

lotofmoneytrainingthem.Infact, the average amount oftime a first-year, full-timeemployee spends in trainingis263hoursversus the retailindustry average of 7 hours.Thisinvestmentinemployeescontributes to low turnover.The average turnover in theretail industry is110percent,whereas at The ContainerStore it has historically beenbelow10percent.This lower

turnoverdecreases costsovertime.36

DoestheBusinessAttractaGreatNumberofApplicants?

Manypeoplehearaboutgoodplaces to work and want towork there. Fortunemagazine and regionalmagazines such as Texas

Monthly publish lists of thebest places to work.Whenever a business makesthe list, it has more jobapplicants.

AreEmployeesAvidlyRecruitedfromtheBusiness?

During the 1980s, the mostactivelyrecruitedmanagersinbanking were at Wells

Fargo.37 Finding a businesswith this characteristic is apositive sign because itmeans the business typicallyhas a strong culture focusedon execution. This does notmean employees would besuccessful at anotherbusiness, but if they areavidlyrecruited,thisisasignthat the business is wellrespected. Talk toheadhunters who work in a

particular industry and askthem what businesses theybelieve are thebest places torecruit employees from andwhy.

AreThereLargeDifferencesbetweentheBenefitsThatthe

TopManagersReceiveversus

Employees?A successful CEO once toldme, “If you are constantlyreminding people at thebottomthattheyarenotatthetop, do you really expectthemtobegunghoaboutthecompany?”

DoesManagementTreatEmployeeswithRespectWhen

TheyLayThemOff?One of the most revealingtimes to observemanagers isduring layoffs.Youwillgaina great deal of insight if youwatch how they lay offemployees.Whenacompanyfiresemployees,doesitdosowith respect, or do securityguardsescortemployeesout?If you learn that securityguards escort employees out,

this is a warning signal thatmanagement really does notcareaboutitsemployees.The best-performing

managers have always toldmethatwhentheyhavetolayoff employees, they treatthemwith respect.OneCEOtold me that he would wantthe former employee to stillfeel close enough to thecompany to remain acompany advocate and

customer. These managersconduct layoffs or firings inan open manner and alwaysdisclose the reasons andrationale behind theirdecisions. They often givefurloughed employeesassistance in finding a newjob. This way, themanagement team is able toinstillasenseofsecurityandconfidence in thoseemployees who are left

behind,helping tokeepmorevaluable employees fromleaving.Incontrasttothisapproach,

youwilloftenseeadegreeofinsincerity by CEOs even asthey announce layoffs. Forexample, one CEO stated,“Loyal and committedemployeesarecritical,”yetatthe same time,hewas layingoffthousands.Lookforthesenegativesignswhenassessing

whether a business has goodemployeerelations.Watch out for those

management teams thatquickly announce layoffs themoment their businessencountersasetback,suchasa temporary drop in demandfor its goods and services.There are many examples ofbusinesses in the financial-services, retail, or real estateindustriesthatquicklylayoff

employees when theyencounter a downturn, but assoon as things start to pickup, they look to re-hire thesame people—often at ahigherpayrate. Instead, lookfor those management teamsthat attempt to hold on totheiremployeesbytakingthefollowingactions:

eliminatingovertime;freezinghiring;offering voluntary

retirementpackages;reducinghours;reducing everyone’ssalary;delayingraises;trimming spending ontraining, travel, ormarketing;cuttingtemporarystaff;delaying capitalinvestments;and using less-busy

employees to balanceworkloads elsewhere inthecompany.

For example, in 2008before Federal Expressresorted to layoffs, itinstituted pay cuts andtemporarily halted retirementcontributions.38 In 2000,under similarly slowingeconomic conditions, FedExFreight also resisted layoffsona largescale.In2003,Pat

Reed,CEOofFedExFreightEast, said they juggled hoursandkept peopleworking.Hecalled the long-term payoff“indescribable,” saying itcreated loyalty and reducedturnover.Anotherbenefit:“Itgives you the ability to hirethebestofthebest.”39

DoesManagementListentoIts

Employees?Managers can learn more bylistening to the conversationsof a few employees than byspending time setting downstrategicvisions.Manyofthebest ideas come fromemployees who are in thefield, so it is critical formanagementtolistentothemand have avenues foremployees to channel

information to headquarters.Forexample, the idea for thePost-it note® developed bythe 3MCompany came froman employee, and theFrappuccino® at Starbuckswas invented by a storemanager.

DoestheBusinessHaveaStrongCulture?

Acultureisanorganization’ssharedvaluesandbeliefs,andit sets the tone for howemployees treat customers. Itisfoundinallbusinessesandvariesfrom“thisisjustajob”mentality to “I love myemployer.” For values andbeliefs to be shared, theymust bemade clear and theymustbemodeled.Acultureistypically built through theexample of the top

management of a business;employees will watch howtopmanagementactsasacueforhowtheyshouldact.An identifiable culturewill

attract employeesmost likelytoagreewiththosevaluesandbeliefs. It also informs newemployees about what isimportant at the company.For example, Whole FoodsMarket’s culture is soimportant to the success of

the company thatmanagement sends existingWhole Foods Marketemployees to work at newstore locations. They do thisnotjusttohelpsetupsystemsor train, but to help newemployees understand whichthings are most important toWhole Foods Market. Theycall this transfer yogurtculture.Oneofthemainadvantages

of a strong company cultureis that a business is able toattract great employees anddoes not need to pay thehighest salaries in order torecruit them. Most talentedemployees will gladlysacrifice pay for the rightwork environment.Furthermore, whenemployees feel like they arepart of something important,they are more loyal to the

business.In contrast, a business

without a strong culturemaybeonewherefailuresarenottolerated or where there is alack of trust amongmanagement and employees.Businesses with weak ornegative cultures may beinwardly focused and oftendonotpossessgoodcustomerservice. Employees are thereto collect a paycheck, and

most employees are notlooking to develop theircareersatthebusiness.For example, HealthSouth

(an owner of rehabilitationcenters) had a hard-chargingculture and was known forweak employee relations.When CEO Richard Scrushyperformedauditsoftherehabcenters,heoftenperformedawhiteglovetestofthepictureframes: After wiping his

finger on a hanging picture,hewouldthenwipehisfingeron the clothing of themanager of the center. Anydust marks resulted in loweraudit scores.40 Even thoughHealthSouth was quicklygrowing and its stock pricewas increasing,management-employee relations would besuspectbasedonlyon thisorsimilaranecdotes.Regardlessof short-termgrowth, aweak

or demeaning culture isusually representative of aweakfirm,anditshouldbeawarningsignaltoinvestors.As you determine whether

ornotabusinesshasastrongculture, look for engagedemployees, because thehappier employees are intheir jobs, themore theywilltypically try to satisfycustomers. The companygrapevine is the swiftest

means of communication, sotapping into it with a fewemployees can net youvaluable information. Thebest way to determine if abusinesshasastrong,healthyculture is to talk with mid-level and lower-levelemployees of a business.These are the people whointerfacewithcustomersmostoften. It is one thing formanagement to say

somethingisimportant,butifthe rest of the companydoesn’tbuy it, it isn’tpartoftheculture.For example, if you could

take the staff from, say,Dunkin Donuts, and plunkthemdowninaStarbucks,doyou think you’d receive thesame level of service? Not achance. The Dunkin Donutsemployees would not havebeen selected and trained to

provide individualizedattention and service: Theentire atmosphere would bedifferent. This differenceshows up in your customerexperience,andisonereasonthat Starbucks is able tocharge a premium for itsproducts.41

Tolearnmoreabouthowaculture is built, I interviewedBob Graham, co-founder ofAIM Management Group,

one of the nation’s largestmutualfundcompanies.AIMgrew from a firm with fiveemployees and no assets in1976toafirmwithmorethan$57 billion in assets undermanagement and a valuationof$1.6billionin1997(whenitmergedwithInvesco).OneofAIM’sgreateststrengthsasit grew into a top assetmanager was its extremelylow employee turnover rate,

which was (and still is) rarefor a business in theinvestment managementindustry.Themainreasonforsuch low employee turnoverwas that AIM was wellknown for having a strongand energized culture. Thisallowed it to attract talentedemployees, and moreimportant, to keep them.Grahamrecalls,“Therewasasense of excitement working

at AIM. It was known as apeople-friendlycompany,andpeoplewanted to comeworkthere. It was fun and peopledidn’tleavebecausetheyhadthe excitement of buildingsomething everybody wasproudof.”This was critical to the

success of AIM and itsgrowth. In the book PeopleAretheProduct:AHistoryofAIM, co-founder Ted Bauer

observed that, “In theinvestment business, peopleare the product. Yourinventory goes down theelevator every night andcomesbackinthemorning.Ifpeople are happy, they workmoreproductively.”42

I asked Graham how AIMwas able to build such astrong culture when othercompanies couldn’t. Grahamsays that inat leastoneway,

they modeled their businessonfriendships.“Tobuildanysuccessful enterprise requirespeople. You attract goodpeople through the culture.Our philosophy from thebeginning was that wewanted the business tooperate in the same way ourfriendships did. The three ofus[BobGraham,GaryCrum,and Ted Bauer] were allfriends, andwe all got along

so well together. In fact, wehiredpeoplewewantedtobefriends with. If we felt wewould not enjoy spendingtime with them outside ofwork,thenwewouldnothirethem. When you hire thesetypesofpeople,abigbenefitisthatwheneveryourunintoinevitable disagreements,theywillalwaysbeamicablyresolved.”As Graham and his co-

founders were building theculture, Graham said theywanted to offer a differenttype of work environmentthatgaveemployeesachanceto be part of a small familyoperation. But they alsowanted employees to haveopportunities. Grahamexplains some of the waysthatAIM’s culture supportedits growth. “We offered amore entrepreneurial

environment. We wantedpeople to have a sense thatthey could control theirdestinies.” Graham creditsTed Bauer with helping todevelopemployees:“Tedwasalways willing to giveyounger people a lot ofresponsibility. This was agreat way to develop peoplebecause they reallyappreciated theresponsibility.”Byconstantly

promoting and giving moreresponsibility, Graham saysthey also avoided becomingstagnant.In addition to offering

entrepreneurial opportunities,AIM attracted employeeswhoappreciatedwhat isnowcalled work-life-balance.Graham says, “We believedthat employees should live abalanced life where familywas important. We expected

employees to have a lifeoutsideofwork.”I also asked Graham how

AIM had managed to avoidthe pitfall of an overlycompetitive culture, whichwas dominant in most WallStreet firms. In other words,what did they do to foster acohesive team environment?He told me they weeded outpeople who were bad applesorwho just didn’t fit inwell

withtheculture.Thismadeitmuch easier on those whostayed. These employeesmade extremely impressivecontributions, and they did ittogether. Graham said, “Wewanted to avoid employeeswhohadtheattitudethattheyneededtobeattheguysittingnext to them. AIM’s culturewasnotcutthroat.Employeesdid notworry aboutwhogotcredit.”

AIM’sbusinessandculturalgrowth shows a cycle ofbenefitsthatwouldbehardtoreproduce. The results werethat AIM was able to attracttalented, entrepreneurialemployees and keep thosesame employees happy bygiving them a healthy workenvironment. In turn, theseentrepreneurial employeeswere the engine that helpedAIM grow, which then

offered more opportunitiesfor others to move up theranks.Look for similar elements

in businesses you evaluate.Whenyoulocateonewiththecultural elements that AIMcultivated—that is, talented,happy, energized managersand employees attractingmore of the same—you havediscovered the foundation ofasuccessfulbusiness.

DoestheBusinessHaveIdentifiable,SharedValues?

The strongest cultures haveshared ideas about what ismost important; these areshared values. For example,senior managers may valuethe long-term benefits oftrainingoverthesavingstheywouldhavefromnottrainingemployees. Similarly, a

business may value havinggreat service and generousreturn policies over thebenefits of reducing itsservice staff or reducing itsrestocking efforts. Managersandleadersplayacentralrolein communicating anddemonstrating what isimportant for the business,andtheyoftenareresponsiblefor how well employeesunderstand and adopt these

values, which create thefoundation for day-to-daydecisions regarding theoperationsofabusiness.To learn how to identify a

business that has stronglyheld and clearly definedvalues, I interviewed LeeValkenaar, Co-Chairman ofthe Board for Whole PlanetFoundation.43 Valkenaar hasbeenatWholeFoodsMarketsince 1987 in various

capacities, includingexecutive vice president(EVP) of Global Support(from 2004 to 2008) andpresident of theMid-AtlanticRegion (from2001 to 2004).He helped build the culturethat Whole Foods Market isso well known for today. InValkenaar’sopinion:When you are explicitabout your company’svalues,itgivesemployees

anopportunitytoidentifywiththosevaluesbecausetheyidentifythosevalueswithin themselves.Whenemployeesseethingsthatresonate withinthemselves, they canalign themselves withthose values. One of themain advantages of abusinessthathasvaluesisthatitcreatesbuy-infromemployees by giving

themaformofownershipin the business, whichincreases the chances ofsuccessfulexecution.Many companies havevalues that are expressedthrough a vision andmission. You need todetermine if these valuesarebakedintothepoliciesand procedures of thebusiness or if [they are]just a statement that

shows up on the wall. Iftheyareincorporatedintothe culture—into thepolicies, procedures, andpractices—that is whenexecution happens.Peoplecanandshouldbeheld accountable forknowing and adhering tothese ‘shared valuepolicies’thesameastheywould an attendancepolicy.

For example, although youmay see it in a missionstatement,mostbusinessesdonot think employeeempowerment is critical.Empowered employees canbe intimidating to somesenior managers, andempowerment also requires asubstantialinvestmentintimeandenergytomakedecisionswith more voices. When abusiness truly considers it

important to empoweremployees, it encouragesthem to speak up. WholeFoods Market has teammeetings everymonth whereemployees are solicited fortheir honest feedback.According to Valkenaar,some of these meetings canbe intense, and sometimesemployees have personalagendas or just want to venttheir personal frustrations.

For some seniormanagers, itis not easy to hear that theemployee does not like thepolicies that have beenimplemented,butit iscriticalfor senior management tolisten.To identify whether a

business really has sharedvalues, you need to ask thefollowingquestions:

Howdovalues showupin the organization? At

Whole Foods Market,one shared value is thatthere should be moreequitable levels of payacross the organization.To implement this,managers establishedsalary caps for the topexecutiveofficers,whichlimit the amount theycanmake,comparedtoafull-time employee.According to the 2010

proxy statement, thecompensation waslimited to 19 times theannual wage for a full-timeteammember.Are the valuesidentifiableandexplicit?Are they found on thecompany website? Startbylookingatthewebsiteof the business in theabout us tab. If there isnothing there that

mentions values ormission, then they arenot a central part of theorganization.Does managementcontinually state them?Reinforcement andpublic recognition bymanagers send amessage about what’simportant. Do theemployees even knowwhat the company

values are? If you wereto walk up to anyemployeeatthebusinessand askwhat the valuesare, would thatemployee be able toanswer this question? Ifnot, then it is highlylikely the company hasnot done a good job ofexpressing what itsvaluesare.Does the company hold

its employeesaccountableforknowingand incorporating thevalues? If a supervisororemployeeviolates thecore values, is thisbehavior tolerated? If abusinessisseriousaboutcommunicating,teaching, and operatingby using shareddefinitions of what’simportant, it won’t look

away if an employeeignores a sharedprinciple.

Let’s say a company, onpaper, makes acommitment to anenvironment of mutualrespect, but employeesdon’t buy in. Then that’snot a shared value.Manycompanieshavevaluesonpaper that say it’simportant to treat people

well, but as Valkenaarnotes,“Ifabusinessisnotproactive in managingassholes, then it isprobably not acting inaccordance with thevalues of theorganization.”Are there costsassociated with thevalues? At Starbucks,healthcare costsrepresent a largeportion

of costs, but offeringgreat benefits is valuedat thecompany,becausethat’showitattractsandretains the kinds ofemployees who keepcustomers happy.Observing directinvestment in somethingis often the onlyway todiscernitsimportancetoacompany.

Finally,Valkenaargivesan

example of a business thathas not baked those valuesinto its culture. He related apublicized story about acompany that encountered aproblem because itmanufactured a product thatsaid,“MadeintheU.S.A.”ontheoutsideoftheproduct,butinside,thelabelstated“MadeinChina.”Visualize thepaththisproductmusthavetaken:Asthebrainchildofacreative

merchandiser, it wound itsway from production to theretail stores. Imagine whatmessage is implicitly sentwhen you brand a productmadeintheUnitedStatesandmanufactureitinChina.Couldthatevenhappenina

company that completelybelieved in domesticsourcing? Also, if thecompany were trulycommitted to open

communication, someonelikely would have voicedconcern even after the itemwas produced. Finally, if thecompany thought thatcustomers deserved to knowexactly what they werebuying, the company wouldlikely have stopped stockingtheproductcompletely.Any company can say it

wants open communicationwith employees, the trust of

its customers or that it buysAmerican, but this exampleshowswhysayingit isn’t thesame as doing it. Valkenaarsees a clear disconnectbetween employees andleadershipthatallowedthistohappen. If the company hadreally incorporated its valuesinto its business, the snafuwould likely have neverhappened,orattheveryleasttheproblemwouldhavebeen

solved long before theproducteverhittheshelves.

WhatIstheEmployee-Retention

Rate?Ifabusinesshasanespeciallygoodemployee-retentionrate,it will often mention this onitswebsite,annualreport,oraplaque. For example, BaldorElectric, an electric-motor

manufacturer,hasaplaqueatits headquarters showing thenames of its employees whohave been with the companyfor more than 10 years andthe date each joined thecompany. Most of theemployeesontheplaquehavebeen at the business for 15years or more. There aremany advantages to a highemployee-retention rate,including reduced hiring

costs, better customerrelations, and higherprofitabilitythancompetitors.For example, even though

Costcopaysitsemployees40percent more (on average)than Sam’s Club (which isowned by Wal-Mart) andgives its employees betterbenefits, Costco’s profit peremployee is much greaterthan its competitor Sam’sClub.Lowemployeeturnover

isoneof thereasonsfor this.WhereasSam’sClubturnoveris 21 percent in theemployees’ first year,Costco’s is only 6 percent.“Payingyouremployeeswellis not only the right thing todo, but it makes for goodbusiness,” says Costco CEOJimSinegal.Hefurtherstatesthat if Costco paid rock-bottom wages, it would getwhat it paid for. “It doesn’t

pay the right dividends. Itdoesn’t keep employeeshappy. Itkeeps them lookingforotherjobs.Plus,managersspend all their time hiringreplacements rather thanrunningyourbusiness.”44

44.Doesthemanagement

teamknowhow

tohirewell?There are few managementdecisions more importantthan those involved in hiringand promoting employees.The number-one job of amanager is to pick the rightpeople and then put them inthe right positions. Inessence, management is theart of getting things donethrough other people. Jack

Welch, former CEO ofGeneral Electric, said, “Myjobisnottoknoweverythingabout each business. It is topick thepeoplewhowill runthe business and to decidehowmuchmoneyBusinessAversus Business B or C gets—andhowtotransferpeople,dollars,andideasacrossthosebusinesses. I don’t get intothehow.”45

Ifthemanagementteamhas

good people it can trust andcount on, then executing theplansofthebusinessbecomeseasier. In turn, talentedemployeeshireother talentedemployees, who strengthenthe entire organization.Therefore, if management isable to hire well, this is agreat indication ofcompetence.You need to determine the

caliberandtenurenotonlyof

top managers, but also thosemanagers in importantoperational roles. Begin byidentifying all of the keymanagers at the business byposition. You may want toconstruct a management-timelinereport, similar to theone shown in Table 8.1 forregional gaming businessPennNationalGaming.

Table8.1PennNationalGaming—Management

Tenurefrom2001to2010

To construct this timeline,use the historical proxystatements to identify the topmanagersof thebusiness.Toidentify other managers notshown on the proxystatement, screen for all oftheForm3,4,and5s,whichyou can find on the SECwebsite.Theseformsmustbefiled promptly, and theydescribe the holdings and

transactions of officers,directors, and beneficialowners.An added benefit of

creating a managementtimeline report is that youwillbeabletonoteifthereisa lot of manager turnover atthe business, which is anegative sign. I have learnedthatoneofthebestindicatorsof a business that isdeteriorating is when the

mostcompetenttopmanagersof a business begin to lookfor other jobs or leave thebusiness. You can use yourtimeline to monitormanagement turnover toalertyouofanypotentialproblemswithinthebusiness.After you have finished

constructingatimelinereport,research the backgrounds ofeach manager by searchingfor press releases and

historical articles found innews aggregation sites, suchas Dow Jones Factiva orLexisNexis. You will oftenfindapressreleaseissuedbythe company describing thebackground of the newmanagement hire. You canthen search for other articlesbycombiningthenameofthemanager with previousemployers. As you readthrough the articles and the

press releases, determinewhether the managers hiredhave the experience andknowledge necessary to dothe job. Pay particularattention to whether theyhave dealt with a similarcustomer base in the past. Ifthe top managers are hiringother managers with a lot ofexperiencewith thecustomerbase, then this is a positivesign; however, if they are

hiringtheirformercolleaguesor other managers who havelimited experience with thecustomer base, this shouldserveasawarningsignal.For example, at IMS

Health, a pharmaceuticalinformation and consultingcompany, CEO DavidThomas hiredmanagers whohad worked at his previousemployer, IBM. These newhires did not have

pharmaceutical knowledgeorexperiencewith thecustomerbase. A sweep of pressreleases and news storieswouldhavealertedyoutothefact that many other IBMersended up at IMS Health,amongthem:

JohnSchultz,IMS’SVPofEuropeanSales (after20yearsatIBM);Bruce Boggs, SVP ofIMS’ U.S. Sales (after

26yearsatIBM);Adeh Al-Saleh,President of IMSEMEA,(after19yearsatIBM);andDavid Carlucci,President/COO (after 25years at IBM). Carluccilater became CEO ofIMSHealth.

The warning signal to ourfirmwasthatitappearedthatthe CEO was hiring his

formercolleagues rather thanhiring managers who weremore qualified or who hadexperience in thepharmaceutical industry. Asone indicator of the successof using this hiring method,notethatthestockpricewhenThomas was appointed in2000 was around $25 pershare. It remained in the $25to $26 per share range asCarluccitookoverasCEOin

2006, and it then dropped to$22 per share when thecompanywastakenprivatein2009.46Inotherwords,overanine-year period, themanagers at IMS Healthfailed to create any marketvalueforshareholders.Incontrast,CaseyHoffman,

founder of supportkids® (achild-support-servicescompany), mainly hiredsingle parents. These

managers understood what itwas like to be in theircustomers’ shoes and livedtheir lives understandingmanyofthesamefrustrationsand difficulties as theircustomers.Thisallowedthemto execute more effectivelythan those who did notunderstandthecustomerbase.Asa result, supportkidsgrewits revenuesatanannual rateof 28 percent during

Hoffman’stenureasCEO.47

HowDoYouDetermineiftheManagerKnowsHowtoPickGood

Employees?A businesswill put the oddsofsucceedinginitsfavorifitrecruits and retainsemployeeswho trulywant to

work there. Employees whoare thoroughly engaged aremorelikelytostaylonger.Onthe other hand, if a businessdoesnothirewell, thenmostofitsemployeeswillrotateinand out of critical roles,reducing productivity for thelong term. Managers whoknow how to hire well aredisciplined, hiring only thoseemployees that fit theircriteria, insteadof just hiring

the best candidates who areavailable at the time.Therefore, watch for thosebusinessesthattaketheirtimeastheyhireemployees.Next, determine if the

employees are coming frombusinesses with similarcultures. For example, if anemployee has spent 20 yearsworking at bureaucraticBritishAirways(BA)andhasbeen hired at a decentralized

business such as PennNational Gaming, then it isless likely to be a goodcultural fit for both thecompany and that employee.If most company hiring isfrom businesses with similarcultures, then the odds arebetter that it will be a goodfit.Managers who hire well

typically hire for a certaincharacter trait, such as

integrity or attitude, ratherthan skills. Issadore Sharp,founder of Four SeasonsHotels, said he hiredemployees for attitude firstand then trained for the rest.“I can teach anyone to be awaiter,” he said, in the bookFourSeasons:TheStoryofaBusiness Philosophy. “Butyoucan’tchangeaningrainedpoor attitude. We look forpeoplewhosay,‘I’dbeproud

to be a doorman.’” HerbKelleher, founder ofSouthwest Airlines, echoedthis sentiment when he said,“You don’t have the time,techniques, or enough drugstochangeattitudes.”48

HowWellIstheBusinessAbleto

ArticulatetheValuesandAttributesofthe

FirmtoAttracttheRightEmployees?

It is critical for a business toattract the right employees.Businesses attract employeesto a degree because of theculturetheyoffer.Employeeswho enjoy and excel incollaborative environmentspick those types ofcompanies, whereas otheremployees may choose to

work in more structuredenvironments. The type ofemployee a business attractsdepends on the type ofbusiness. For example, inretail,youmusthaveastrongcustomer-service culture. Ifyouvisitretailstoresandfindthat the employees are notcustomeroriented,thenthisisaclear indicator that theyarenothiringwell.The only way a business

can hire employeeswhowillbe enthusiastic about theirwork and loyal to thebusiness is by clearlycommunicating the valuesandattributesof thebusinessto potential employees. Thisway, employees can self-selectintothebusinessiftheybelieve that their values andpreferences fit with thebusiness. Some businessesexcel at expressing what

makes them unique. Forexample, at Whole FoodsMarket, potential employeesare told that theywillhaveafour-week trial period ofworking in a team; after thattrial period, two-thirds of theteam must accept theemployee inorder forhimorher to join the companypermanently. Potentialemployees who do not liketeam environmentswillmost

likely not want to go furtherin the interview process.Therefore, potential hires atWhole Foods Market self-selectintothebusiness.Employees who thrive in

clear-cut, well-defined workenvironments do not want towork in uncertainenvironmentswherethereareno hierarchies orpredetermined channels ofcommunication.Forexample,

ExxonMobildoesagoodjobof explaining to employeesthat ithasahighlystructuredenvironment and that it willtake a long time in order foranemployee tobepromoted.It expects its hires to remainat the company for longperiods of time. Employeeswho become frustrated withtheir progressmay leave, butthose who remain are morelikelytomaketheircareersat

thecompany.One typeofemployee isn’t

necessarily better thananother,butthebusinessdoesneed to do a good job ofcommunicating what type offirmitis.Ifyounotethatthebusinesshashighturnoverordisengaged and unproductiveemployees,thenthisisasignit is not clearlycommunicating its values topotentialhires.49

DoTheyHireManagersor

EmployeesWhoAreCandid?

Youwant todetermine if themanager hires employeeswhoarecandidor thosewhoarenotafraidtochallengethetop management team.Candidemployeeswill speakup when they think themanagerispursuingaflawed

strategy, whereas anemployee with a differentpersonality or outlook mayjust assume the managerknows more than theemployees.Candor is, in essence, the

willingness of employees toexpress their real opinions.Perhaps you have been in aformalmeetingwhereanothermanager is making apresentation that you know

will not work, but you waitfortheboss’sresponsebeforeproceeding to question theplan. If the boss approves, itis highly likely you will notspeak up. An open CEOencouragesothers tobeopenand not agree to things thatthey have no intention ofacting on, or consider poorideas. Formality thussuppresses candor, whereasinformality encourages it.

Onewaytolearnifabusinesshires candid employees is tolearn about the type ofworkplace it has. Ask theemployees if the meetingsthey attend are full ofpresentations that areprepackaged, well-orchestrated, or stiff. If themeetings are instead open,employees will probably bemore comfortable providingvaluablefeedback.

For example, at DaVita,which operates dialysistreatment centers, CEO KentThiry encourages employeestobringhimbadnews.Thiryregularly surveys employees,andhemakesitapointtoactquickly on the feedback hereceives. He uses theinformation to avoidmistakes.50

Similarly, Motorola wasrecognizedasagreatbusiness

in the1980swhen itwasrunby CEO Robert Galvin.During that period, the onlywaymanagersgotaheadwasby challenging existingassumptions and notsupporting the status quo.Galvin encouraged hisemployees to tell him thetruthandtochallengehim.Astory often told is that ayoung middle manager onceapproached Galvin and said,

“Bob, I heard that point youmade this morning, and Ithinkyou’redeadwrong.I’mgoing to prove it: I’m goingtoshootyoudown.”Galvin’sresponsetoacompanionwasproud: “That’s how we’veovercomeTexasInstruments’leadinsemiconductors!”51

However,asMotorola’stopmanagement changed, theseemployees no longer feltcomfortablebeingcandid.As

a result, Motorola developedfewer innovations, and itsstock price (even afteraccounting for spin-offs)increased only marginallyover the last 20 years, from1990totheendof2010.52

If the top managers arehiringemployeeswhoarenotencouraged to speak theirminds,itislikelythebusinesswill encounter problemsdown the road, making it a

badinvestment.

WhatTypeofBoardMembersDoestheCEOChoose?

Typically, the CEO plays animportant part in bringingboardmembers in, especiallyif theCEOhas been runningthebusinessforalongperiodof time. Is theCEObringingin cronies, board members

with prestige, politicalfigures, friends, consultants,or lawyers? If they arebringing in, say, politicians,many will lack businessexperience, and thiscouldbean indicator that the CEO isbringing in people becausethey are loyal to him or her.Viewing the types of boardmembers that have come tothe business during theCEO’stenurewillalertyouto

whethertheCEOisusingthebusinessasapersonalvehicleto benefit him- or herself, orif the CEO is running thebusiness with shareholderinterestsinmind.Mostofthelargestfraudsin

corporate history involvedboard members whoseinterests were more clearlyaligned with managementthan shareholders and thebusiness.53Forexample:

Enron’s board wasknown for rubberstamping the company’sdeals. Board membersdidn’t often challengemanagement on thefinancial reports or anyother matters. And whywould they? A boardmember doing sowouldbe risking as much as$380,000 received as anannualboardretainer.

WorldCom, the telecombusiness embroiled inaccounting fraud, had aboard almost entirelyaligned with CEOBernard Ebbers: Mostwere insiders, and eventhose who wereoutsiders had strongpersonal and financialtiestoEbbers.At cable businessAdelphia

CommunicationsCorporation, familymembers made up themajority of the board.The founders ofAdelphia were chargedwith securitiesviolations.Insiders dominatedconglomerate Tyco’sboard. CEO DennisKozlowski’sboardfilled8 of 12 positions with

Tyco employees.Kozlowski wasconvicted of grandlarceny related tounauthorizedcompensation.

Look out for conflicts ofinterests between directorsand the CEO found in theRelated Party section of theproxy statement. Forexample, here’s what youwould have found in

HealthSouth’s proxystatement (HealthSouth’sCEO was involved in acorporate accountingscandal):

A director earning$250,000 annually forseven years as part of aHealthSouth consultingcontract.A director with a$395,000 joint propertyinvestment with

HealthSouth CEOScrushy.A director whosecompanyreceiveda$5.6millionglass installationcontract at a newHealthSouthhospital.A company owned byHealthSouth employees(Scrushy, six directors,and the wife of adirector) that also didbusiness with

HealthSouth. Thecompany,MedCenterDirect, was ahospital-supplycompanythatoperatedonline.

Watchalsofordonationstocharities made by thecompanyonbehalfofcertaindirectors as this often servesasaredflag.Forexample,atEnron:

Dr. John Mendelsohnwasaboardmemberand

member of the auditcommittee: He receivedsubstantial donations forthe cancer researchcenter he directed frombothEnronandKenandLindaLay.Lord John Wakeham,another audit committeemember, was paid$72,000 each year overmany years as anEnronconsultant.

WendyGramm (anotheraudit committeemember) received a$50,000 Enron donationfor the program shedirected at GeorgeMason University, theMercatus CenterRegulatory StudiesProgram.

Thesearepotentialconflictsof interest, and they serve asclearwarningsignals.

45.Doesthemanagementteamfocuson

cuttingunnecessary

costs?Iusedtobelievethatafrugalmanager was a goodmanager.Overtime,Ilearned

that although managers whoare habitually thrifty will beable to recognizeopportunities to lower costs,they may not invest inimportant projects. Frugalityis bad when the companydoesnotspendmoneyforthebenefitofcustomers.Ontheotherhand,reducing

unnecessary costs whilecontinuing to invest in thecore business is good. For

example, if you visited theheadquarters of retailer 99CentOnlyStores,youwouldsee stained carpeting, brokenfile cabinets, folding tablesused as credenzas, and frontpages of newspapersdisplayed as art. Clearly,founders Dave and SherryGold have chosen not tospend money on theheadquarters becausecustomers don’t care what

corporate offices look like.AsDaveGold says, “I don’tmind spendingmoney. I justdon’t like to waste it.”Instead, 99CentOnly Storesinvests in the things thatbenefit the customer,spending money on thestores, and making sure itsbuyers (who find the bestproducts for customers) arewellcompensated:Infact,thecompany pays its buyers

doublewhattheywouldmakeanywhereelse.54

AnotherCEOwhobelievesininvestinginhisbusinessisDavid Zaslav, CEO oftelevision companyDiscovery Communications.Zaslav puts creative leadersrather than a business leaderinchargeofeachchannelandprioritizes brand building,audience building, and greatcontent. His thinking is that

quality content is alwaysgoing to be in demand.Zaslav sees the company astwohalves:“Ontherighthalfis better content, bettershows, better characters:Deadliest Catch and Oprah.The left side is everythingelse.Ifwecantake$2outofthe left side and invest $1or$1.50moreinourcontentandbrands, that gives thetrajectory of our growth a

push.”55

Watch also for the type ofcosts a business cuts. WhenStarbucks CEO HowardSchultzcutcostsduring2009and 2010, he avoided cutsthatwould directly affect thecustomer.Instead,hereducedcosts by eliminating supplychain inefficiencies, waste,and certain parts of thesupport structure. Starbucksalso reducedexpenses,butat

the same time, it keptinvesting in the things thatmattered most: For example,maintaining employeebenefitsandcommittingmoreresources to employeetraining. During 2010,Schultz said that hiscustomer-satisfaction scoresactually rose, reaching theirhighest levels ever because,“Wereinvestedinourpeople,we reinvested in innovation,

and we reinvested in thevaluesofthecompany.”56

Also,thinkaboutthis:Ifthemanagement team iscontinually announcing cost-cutting programs, this is asignthattheyarenotfocusedon continually cuttingunnecessary costs. Thesetypes of businesses are oftenserial restructurers as well.For example, during hisHewlett-Packardtenure(2005

to 2010), CEO Mark Hurdtook $3.2 billion inrestructuring charges and$3.3 billion in write-downsforamortizationof intangibleassets related to acquisitions.This buy-and-restructurestrategy helped HP deliverannualrevenuegrowthof7.5percent and 22 percentgrowth in earnings per shareduring Hurd’s tenure.However, Hurd was

constantly restructuring theworkforce by increasing theuseofcontractmanufacturingand other cost-cuttingmeasures. He also acquiredcompanies (such asElectronic Data Systems,3Com, and Palm) to growmarkets in services,networking, and mobiledevices—acquisitions that,combined with ongoingrestructurings, made “one-

time charges” recurring. Theproblem is that once theselargecostshavebeentakensoquickly, it becomes moredifficult for the business tocut costs further without thequality of the productdeclining.57

46.AretheCEOandCFO

disciplinedinmakingcapitalallocationdecisions?

Capital allocation is themanner in which themanagement teaminvests theexcess free-cash flows thatthe business generates.Management decides when

andwhere these excess free-cashflowsshouldbeinvestedor distributed. There are fiveactionsmanagement can takewithexcessfree-cashflow:

1. Reinvest the capitalback in the business innewprojects.2. Hold cash on thebalancesheet.3.Paydividends.4.Buybackstock.5.Makeacquisitions.

It is difficult to find CEOswho are both good atoperating the business and atallocating capital. The mainreason for this is thatoperating a business andallocating capital are twocompletely different skillsets; being proficient at oneof these functions has nocorrelation to beingcompetentwith theother.Asa group, CEOs possess

varying degrees ofcompetencewhenitcomestocapitalallocation.The best capital allocators

are those who are removedfrom the day-to-dayoperationsof abusiness—forexample, Warren Buffett,CEOofBerkshireHathaway;Peter Carlino, CEO of PennNational Gaming; and BruceFlatt, CEO of BrookfieldAssetManagement. The best

capitalallocatorsdelegatetheday-to-dayoperationstoothermanagerswithinthebusiness;for example, Carlinodelegates the day-to-dayoperations to COO TimWilmott. This allows theseCEOs to see the big pictureand not get bogged down inthedetails.One of the best capital

allocatorsincorporatehistorywas Henry Singleton,

longtime CEO of Teledyne,who cofounded the businessin 1960 and served as CEOuntil 1986. In John Train’sbook The Money Masters,Warren Buffett reported thathebelieves “HenrySingletonhas the best operating andcapital-deployment record inAmerican business.” WhenTeledyne’s stockwas tradingat extremely high prices inthe1960s,Singletonusedthe

high-pricedstockascurrencyto make acquisitions.Singleton made more than130 acquisitions of small,high-margin manufacturingand technology businessesthat operated in defensibleniches managed by strongmanagement.Whentheprice-to-earnings ratio of Teledynefell sharply starting in the1970s, he repurchased stock.Between 1972 and 1984, he

reduced the share count bymore than 90 percent. Herepurchased stock for as lowas $6 per share in 1972,whichby1987tradedatmorethan$400pershare.58

The best way to determineif managers are good atallocatingcapitalistoreviewtheir historical decisions,whethertheyarebuyingbackstock or making newinvestments.Youcanidentify

a good capital allocator bylooking for examples wheretheyaredisciplined.For example, in a fourth

quarter 2008 conference call,Penn National Gaming CEOPeter Carlino discussed whythe company did not build ahotel next to its successfulcasino site in Hobbs, NewMexico. A hotel would helpthecasinogeneratemorecashflow as it would encourage

visitors to stay overnight.Carlino said that preliminaryestimates to construct thehotel came in at $30million,yet he felt that it would notmakesensetobuildthehoteluntil the construction costscameincloserto$20million.This$10milliondifferenceisnot a large amount,considering Penn NationalGaming generatedmore than$300 million in distributable

free-cash flow in 2009.59Even though a hotel wouldadd to cash flows, Carlinodemonstrated that he isdisciplined inwaiting for theright deal before proceedingwithanycapitalinvestments.In contrast, themajority of

CEOs would probably buildthe hotel and hope that theextra cash flows fromovernight visitors wouldmake up the $10 million

difference. But Carlino’scapital discipline has helpedPenn National Gamingbecome one of the greatestcompounding stocks in thelast15years,compoundingatmorethan27percentfromitsMay 1994 initial publicoffering (IPO) to its stockprice at the end of 2010 ofmorethan$27pershare.60

47.DotheCEOandCFObuybackstockopportunistically?Earningspershareisthemostimportant measure indetermining what a share ofstockinthebusinessisworth.Because stock repurchasesdecreasethenumberofshares

outstanding, they have theeffect of increasing earningsper share. If the stock isundervalued, these stockrepurchases can addmaterially to thevalueof thebusiness. The timing ofbuybacks will depend on thevalue of the stock, on howmuch cash the business has,andhowmuchcash it needs.Management may decide tobuybackstockasaone-time

act, or you may seemanagement lay outpredetermined amounts eachyear that it plans to use forbuybacks.There are a couple of

common motivations behindstockrepurchases:

Management maybelieve the stock isundervalued, so it takesadvantage of theopportunity to

potentiallyaddvalue.Management may wantto offset dilution fromissuingstockoptions.

Let’s review the tworeasonsforbuybacksinmoredetail.

AddingValueByBuyingBackStockOpportunistically

By making buybacks when

the stock is undervalued,management can materiallyadd to the value of thebusiness. For example, if abusiness is worth $50 pershare and management buys10percentofthestockat$25per share, then managementhas automatically increasedthe value of the business to$52.50 per share ($25 pershare multiplied by 10percent equals $2.50 per

shareplus$50pershare).Ifitinstead pays $100 per share,then it is reducingshareholder value.The lowerthepriceitpaysforthestock,the more value managementwillcreateforshareholders.The best way to determine

if the management team isopportunistic in its stockrepurchases is to examine itshistory. Western Union, forexample, generates a lot of

excess free-cash flow, sostock buybacks make sense.When Western Union wasspun off from First DataCorporation in 2006,management announced itwould invest $1 billion peryear in stock buybacks. In2008, when the stock wastrading atmore than $23 pershare, Western Unionrepurchased $1.3 billion instock. However, as the stock

price declined to below $14per share in 2009,management pulled back,saying the recession hadlimited its ability torepurchase shares, and that itwould only repurchase $400million in stock.With stablecash flows and a strongbalancesheet,WesternUnionhadmorethanenoughcashtobuy the stock. Instead,as thestock price increased,

Western Union beganrepurchasing stock,announcing itwas reinstatingitsplantobuyback$1billionin stock each year.Althoughconservingcash is important,in this case, it wasunwarranted given the strongcash flows, and clearlyillustrated that WesternUnion’s management teamwas not opportunistic in itsstockrepurchases.61

An example of a businesswhosemanagement teamhasmade many opportunisticpurchases in the past isAutoZone, an automotive-parts retailer. AutoZone’searnings per share (EPS)grewatarateof15.7percentfromAugust 2002 toAugust2010, while its net incomegrewatarateof6.23percentover the same period. Themainreasonforthedifference

was due to the sharerepurchases that AutoZonemade, which reduced thenumberofsharesoutstandingfrom 104.4 million shares to48.5 million, or by 53percent.62 The sharerepurchases have clearlyadded value: EPS grew 15.7percent during the eight-yearperiod. Had AutoZone notbought back any stock, thenthe EPS would have grown

only 6.23 percent, whichwould have resulted in alowerstockprice.Table 8.2 examines further

how AutoZone’s stockrepurchaseshaveaddedvalueovereightyears(withAugustasyearend).

Table8.2AutoZoneStock’sRepurchasingHistory,from2002to2010

Source:AutoZone10K2002to2010

August25yearend,BasicEPSdataisCapitalIQ

Youcanuseasimilartablewhen you are assessingwhether a management teamhas added value through

stock repurchases. Theamountandnumberofsharesrepurchased are found in the10-K in a separate sectiontitledStockRepurchases.Similarly, when a business

issuesnewshares (e.g., stockoptions), it destroys value.Forexample,GeneralMotorsreported a 4.82 percentgrowth rate in net incomefrom1985to1995.However,itsEPSover the sameperiod

grewatanannualrateofonly2.68 percent because GMincreased the number ofsharesoutstandingduringthattime.63

OffsettingOptionsDilution

When determining whetherthe stock repurchases addvalue, disregard thoserepurchases made to offset

options dilution. Mostinvestors don’t think ofrepurchasing issued optionsas capital allocation, but thisis an area that managementcontrols, and it is anotherform of capital allocation.You can create a table thatincludes the number of stockoptionsissuedinagivenyearcompared to the number ofsharesboughtbackinordertounderstand what percentage

ofstockbuybacksareusedtooffsetoptionsdilution. In the10-K, there isa section titledStock Plans, where you canfind the total number ofoptionsthatareissuedbythebusiness. Table 8.3 is anexampleforMicrosoft.

Table8.3MicrosoftOptionIssuanceandBuybacks

64

Asyoucansee fromTable8.3, the amount of stockbuybacks to offset optionsdilution averages 25 percent,leaving 75 percent ofrepurchasestopotentiallyaddvalue. When evaluating howeffectively management is

using buybacks, use thispercentage rather than all therepurchases.

KeyPointstoKeepinMind

The best-performingbusinessesoverthelongterm, asmeasured byshareholderreturns, are

managed byCEOs whohave apurposegreater thansolelygeneratingprofits.Mostsuccessfulbusinessesare built onhundreds ofsmalldecisions,instead of onone well-

formulatedstrategicplan.Goodmanagementteams workon proving aconceptbeforeinvesting alotofcapital.They are notlikely to puta lot ofmoney in allat oncehoping for a

bigpayoff.The strategicplansthataremost proneto failure arethose thathave anoverlynarrowfocus, suchas those thatset afinancialtarget (e.g.guidance).Businessesthat are

decentralizedattractindependentthoughtandadiverseworkforce,whichencouragesinnovation.Many of thebest-performingstocks inhistory—thatis, those thathavecompounded

at ratesgreater than20 percentover15years—have useddecentralizedoperatingstructures.When abusiness hasgoodemployeerelations, ittypically hasmany othergoodattributes,

such as goodcustomerrelations andthe ability toadaptquicklyto changingeconomiccircumstances.If managersarecommitted toemployeetraining, thisis a greatsignthattheyhave a long-term

orientation.Avoidinvesting inthosemanagementteams thatquicklyannouncelayoffs themomenttheirbusinessencounters asetback.If a businessculture isadmired andrespected,

the businessis able toattract greatemployees.Fewmanagementdecisions areas importantas selectingthe rightpeople forthe rightpositions.Good hiringindicatessoundjudgment.

The bestcapitalallocatorsarethose whoare removedfromtheday-to-dayoperations ofabusiness.

1.Mackey,John.“ConsciousCapitalism:CreatingaNewParadigmforBusiness.”InMichaelStrong,ed.,Bethethe

Solution:HowEntrepreneursandConsciousCapitalistsCanSolveAlltheWorldsProblems,Hoboken,N.J.:2009.2.Horowitz,Jed.“Buffalo’sFirstEmpire:EnigmaticProfitMachineSeries:5.”AmericanBanker,September14,1993.3.Davenport,Todd.“Wilmers:ProfitabilityPlus

CommunityInvolvement.”AmericanBanker,December1,2005,pp.22–27.4.Standard&Poor’sCapitalIQ.5.Collins,Jim.“The10GreatestCEOsofAllTime.”Fortune,July21,2003.6.Author’sinterviewwithRobertSilberman,Austin,Texas,May19,2010.

7.Standard&Poor’sCapitalIQ;Fuller,Joseph,andMichaelC.Jensen.“JustSayNotoWallStreet:PuttingaStoptotheEarningsGame.”JournalofAppliedCorporateFinance22(2010):59–63.8.Slywotzky,AdrianJ.,andJohnDrzik.“CounteringtheBiggestRiskofAll.”HarvardBusinessReview,April2005,p.86.

9.Gilbert,ClarkG.,andMatthewJ.Eyring.“BeatingtheOddsWhenYouLaunchaNewVenture.”HarvardBusinessReview,May2010.10.Perkins,Tom.ValleyBoy,TheEducationofTomPerkins.NewYork:PenguinGroup,2007.11.Markels,Alex.“TheSkyReallyIsFalling.”U.S.NewsandWorldReport,November8,2004.

12.“TheBrainBehindTeledyne:AGreatAmericanCapitalist.”NewYorkObserver,April72003;HenrySingletonataTeledyneannualmeeting.13.Author’sinterviewwithDaveandSherryGoldinMay2010.14.Stemberg,Thomas.“TreatPeopleRightandTheyWillEatNailsforYou,andOtherLessonsI

LearnedBuildingStaplesintoaGiantCompany.”Inc.,January2007.15.BobGrahaminterviewbyMichaelShearnandMattDreith,April8,2011.16.Langreth,Robert,andAndreaPetersen,“Drugs:StampedeIsOnforImpotencePill.”WallStreetJournal,April20,1998.17.Guilford,Dave.“GMGivesUponShareGain.”

AutomotiveNews,November17,2003;generalpresscoverageofGMfortheperiod;BusinessMonitorInternational.“MarketOverview.”U.S.AutosReport,2008–2010.18.More,Roger.“HowGeneralMotorsLostItsFocus—andItsWay.”IveyBusinessJournal73,no.3(2009).19.Author’sinterviewwith

PaulLarsoninNovember2010.20.Frean,Alexandra.“Monsantohopesthegrasswillbegreenerwithnewcropofproducts.”FinancialTimes,January8,2010.21.Bennett,RobertA.“ContinentalIllinoisChallenge.”NewYorkTimes,August2,1982;“AggressiveBankingPaysOffatContinentalIllinois

Corp.”WallStreetJournal,October15,1981;Bennett,RobertA.“ShapingChicago’sTopBank”NewYorkTimes,September28,1981;Singer,Mark.FunnyMoney.Boston:Mariner,2004;Rowe,JamesL.,Jr,“RecordBailoutforContinentalBankLaunched.”WashingtonPost,May18,1984.22.Bonamici,Kate.“Ford

DecidestoLetthePintoExplode.”Fortune,June27,2005;Halpern,Paul.“TheCorvair,thePintoandCorporateBehavior.”PolicyStudiesReview1,no.3(1982):540–545.23.NIRI(NationalInvestorRelationsInstitute).GuidancePracticesandPreferences-2009,May2009(“2009NIRISurvey”);GuidancePracticesand

PreferencesSurvey-2008,May2008(“2008NIRISurvey”);2007EarningsGuidancePracticesSurveyResults,July2007(“2007NIRISurvey”).http://www.niri.org.24.Standard&Poor’sCapitalIQ.25.Schroeder,Alice.“PleaseHoldforMisterBuffett.”BusinessWeek,March8,2010.

26.December2010LVMHAnnualReport.27.Adams,Susan,andHannahElliott.“MasteroftheBrand,BernardArnault.”Forbes,November22,2010.28.Livingston,Sandra.“BeingDifferentHelpsMakeCarrieraSuccess.”ClevelandPlainDealer,February21,1993.29.Lublin,Joann.“CEO

Tenure,StockGainsOftenGoHand-in-Hand.”WallStreetJournal,July6,2010.30.Ignatius,“Mistakes.”31.“CompanyInterview-RichardGalanti.”WallStreetTranscript.March22,2010,pp.49–51.32.Vinnedge,Mary.“FromtheCornerOffice—HerbKelleher:BeatingtheBigBoysatTheirOwnGame.”SuccessMagazine,October

3,2008.33.Pacelle,Mitchell.“DespiteLawsuits,EnronBonusesHaven’tBeenReturned.”WallStreetJournal,November3,2003.34.Nunes,Paul,andTimBreene,“ReinventYourBusinessBeforeIt’sTooLate.”HarvardBusinessReview,January–February2011.35.Wagner,Rodd,and

JamesHarter.The12ElementsofGreatManaging.NewYork:GallupPress,2006.36.Tindell,Kip(CEOofContainerStore),Lectureat2ndAnnualInternationalConferenceonConsciousCapitalism,May2009;CaseyShilling(VPofMarketingCommunications)ContainerStore,April6,2011.

37.Buffett,Warren.LettertoShareholdersofBerkshireHathaway,Inc.,1990.38.Dade,Corey,andCariTuna.“FedExJoinsOtherFirmsCuttingPay,Retirement.”WallStreetJournal,December19,2008.39.Schulz,JohnD.“A‘ClearOpportunity.’”TrafficWorld,December8,2003.

40.Burke,Monty.“BacktoLife.”Forbes,January20,2002.41.Cawood,Scott.“CompanyCulture:TheIntangiblePathwaytoProfitability.”EmploymentRelationsToday,Winter2008.42.Herskowitz,Mickey,andIvyMcLemore.PeopleAreTheProduct,AHistoryofAIM.Houston:AIM

Funds,2000.43.AuthorinterviewwithLeeValkenar,March2011.44.Sisodia,Raj,JagSheth,andDavidWolfe.FirmsofEndearment.UpperSaddleRiver,NJ:WhartonSchoolPublishing,2007,pp.33–34.45.Hymowitz,Carol,andMattMurray.“Management—BossTalk:RaisesandPraiseorOuttheDoor—

HowGE’sChiefRatesandSpursHisEmployees.”WallStreetJournal,Easternedition,June21,1999.46.Standard&Poor’sCapitalIQ.47.InterviewwithCaseyHoffmanDecember2010.48.HerbKelleher,speakingattheUniversityofTexasatAustin,October19,2006.49.Erickson,TamaraJ.,andLyndaGratton,“WhatIt

MeanstoWorkHere.”HarvardBusinessReview,March2007.50.O’Toole,Jim.“What’sNeededNext:ACultureofCandor.”HarvardBusinessReview,June2009.51.Ibid.52.Ibid.53.MuchoftheinfoonboardalignmentandboardconflictsofinterestisdrawnfromMarianneM.Jennings,

“PreventingOrganizationalEthicalCollapse”GovernmentAccountantsJournal53,no.1.(2004).54.Holt,NancyD.“Workspaces.”WallStreetJournal,October15,2003.55.Edgecliffe-Johnson,Andrew.“TheBiggestBeatofNon-fictionTelevisionEyesaGlobalPrize.”FinancialTimes,January10,2011.

56.Ignatius,“Mistakes.”57.Jones,StevenD.“IntheMoney:Hurd’sH-PGrew,ButChargesPrunedEarnings.”DowJonesNewsService,August10,2010.58.“TheBrainBehindTeledyne:AGreatAmericanCapitalist.”NewYorkObserver,April7,2003.59.TimeValueofMoney,LPfreecashflowestimate.

60.Standard&Poor’sCapitalIQ.61.WesternUnion10Kreports,2007to2009.62.Standard&Poor’sCapitalIQandAutoZone10-Kreports,2002to2010.63.GeneralMotors10-Kreports,1985to1995.64.Microsoft10-Kreports,2009to2010.

CHAPTER9

AssessingtheQualityof

Management—Positiveand

NegativeTraits

In Chapter 8, we looked athow management operatesthe business; this chaptershows you how to evaluatethe positive and negativetraits of the managersthemselves. Many investorsrely on the personality,education, and technicalknowledge of a managementteam to assess whether theyare capable of leading abusiness.Theseareimportant

qualities, but there are farmore important qualities. Ifyouaregoingtoinvestforthelongtermwithamanagementteam, you’d also better thinkabout the character andvalues of the people on thatteam.Forexample:

Is managementpassionate aboutoperatingthebusiness?Does the manager haveintegrity?

Would managers fudgeaccounting numbers tomeetguidance?Do managers haveenough humility toacknowledge when theyhavemadeamistake?

As you begin to evaluatethe character of a manager,lookforapatternofbehaviorthat can help you forecastfuture behavior. When itcomes to people, the best

predictoroffuturebehaviorispast behavior. You want toget an overall sense of whatthemanager is like. In orderto do this, look at what themanagers have accomplishedin the past and moreimportant, how he or sheaccomplished them.Published interviews areamong the best sources forreal insight, as are in-deptharticles written about the

manager.As you are readingand forming an opinion of amanager, make sure you’regetting more than just quickquotes or a few annotatedquotes. If the majority ofanswers are captured, it’s amuch stronger piece ofevidence, and it reduces thelikelihood that certaincomments were taken out ofcontext.A manager’s habits and

values are among the mostimportant factors thatdetermine whether he or shewill be a success or a failurein the long term. Thequestions in this chapterwillhelpyou to identify the traitsthat are common to the best-performingmanagers, so thatyoucan investwith them forthelongterm.

48.DoestheCEOlovethemoneyorthebusiness?

Most investors spend toomuch time trying todetermine whethermanagement has the rightfinancial-incentive structureto create shareholder value

rather than examining if themanager has passion for thebusiness.External incentives,suchasa largecompensationpackage, will never be aspowerful as internalmotivation.Passionmotivatesmore than money. WarrenBuffett, chief executiveofficer (CEO) of BerkshireHathaway, firmly believesthis:Whenhewasaskedhowhe determines which

managers to partner with, hesaid,“...thebiggestquestionIaskmyself is‘Dotheylovethemoneyordotheylovethebusiness?’”1

WhyIsPassionImportant?

Passion is a necessaryingredient for long-termsuccess in business or anyprofession. If you have ever

askedtheadviceofsuccessfulbusinesspeople on how tobecome successful, the mostcommonadviceyouprobablyreceivedwasthatyouneededtofindsomethingyoulovetodo and then do it. By doingwhat you love and gettingvery good at it, you’ll behappier, society will likelyreward you, and the moneywill eventually follow. Theyprobably counseled you to

not go after a job for themoney, and in fact, mostpeople who have made a lotof money didn’t make thattheir primary goal. Forexample, when entrepreneurscreate a business, they areusually following somepassion. They do not say tothemselves, “Iwant to be anentrepreneur” and then lookfor a business to start oracquire.

The same rule of successapplies to public companyCEOsandothermanagers: Iftheyarenotpassionateaboutthe business they aremanaging, theywill likelydoa poor job managing thebusiness over the long term.SteveJobs,founderofApple,said it plainly in acommencement address toStanford University studentsin2005,“Theonlywaytodo

great work is to love whatyoudo. If youhaven’t foundit yet, keep looking. Don’tsettle.”The act of building a

business over a number ofyears is slow and can beboring at times. How canCEOsbeeffectiveif theyarenot genuinely interested inwhat they are doing? CEOsand other managers who arepassionate about their

businesses throw themselvesinto their work, constantlylearnfromtheirmistakes,andthey find opportunities andsolutions to problems thatothers do not see. Passionturnsintotenacity,whichisanecessary ingredient forsuccess because the rewardsareoftenfarintothefuture.

HowDoYouIdentify

Passion?You can identify passion byanswering the followingquestions:

Is the business a careeror just a job for themanager?Would the CEO refuseto sell the business, nomatterwhattheprice?Isthemanagerinterestedin money or motivated

bymoney?Does themanager focuson appearances insteadofthebusiness?What type ofphilanthropic endeavorsis themanager involvedin?Are the managerslifelong learners whofocus on continuousimprovement?

IstheBusinessaCareerorJustaJobfortheManager?

Start by asking whether thebusiness is a career or a jobfor the manager. When youreview the backgrounds ofmanagers (which you canfindintheproxystatementorarticles written about themanagers), determinewhether they have remained

in the same industry for alongperiodoftimeoriftheyjump from industry toindustry. If they haveremainedinthesameindustryforalongperiodoftime,thenthe odds are they enjoy theirwork. Look at previouspositions to understand ifthere is consistency or apatterninwhattheydo.For example, the founders

of child-care provider Bright

Horizons have always beenpassionate about helpingchildren have the best startpossible to their lives. Theyfigured that millions of U.S.parentswantedandneededtowork but could not affordhigh-quality child care. Theydecided to fill this needwithBright Horizons. A quickcheck of the founders’backgrounds tells you thatthis husband-and-wife team

also served as co-countrydirectors in Sudan for SavetheChildren before foundingthe company. Because theirbackgroundwaspreviouslyinhelping children, it wasobvious that they werepursuingtheirpassions.2

WouldtheCEORefusetoSellthe

Business,NoMatter

WhatthePrice?If someone else offered tobuy the business from theCEO, how would that CEOrespond? A truly passionateCEOwould say the businessis not for sale and woulddecline these overtures. Incontrast, most CEOs wouldsell if the price was right.What if youwere offered $1billion for a business

generating an estimated $50million in revenues? Wouldyou sell it because it was anextremelyhighoffer?Thiswasthesituationfaced

byMarkZuckerberg,founderof online social networkFacebook, in 2006 when hewas courted by managersfrom Viacom, Yahoo, andothers to buy his company.Zuckerberg continuallyresisted their offers and

realized that he did notwantto sell the business. He saidhewasnotgrowingFacebooksolelyforthemoneyandthatno amount of money wouldbuy his business.3 What ismost interesting is notwhether Zuckerberg made agood decision or not butrather that such a youngperson (who was only in hisearly 20s) was so passionateabout his business that he

would not sell it for $1billion,or$10billionforthatmatter.4Zuckerbergpreferstohave tight creative andfinancial control of thebusiness and wants to playthegamehisway.Themoneyis secondary.Zuckerberg hasbeen quoted as saying, “Weare engaged in somethinggreater than getting rich.”This is true passion. Fastforward to 2011 and

Facebook is valued between$60billionand$75billion.5

IstheManagerInterestedInMoneyorMotivatedBy

Money?How do you determine if amanager is interested inmoney rather than motivatedby money? You simply lookat their spending habits and

how they live. Passionateleaders make little time forother activities or hobbies,and have few outward signsofwealth.Theyarenarrowlyfocused on the business athand. In contrast, somemanagers seek socialapproval by having bighomes and nice belongings.The difference between thetwo is that one manager isinterested in money and the

other type is generallymotivated by money. Peoplewho are interested in moneytend to be conservative intheir spending habits,whereas managers who aremotivated by money tend tohaveliberalspendinghabits.For example, Warren

Buffett’s personal spendinghabits have remained thesame,whilehisnetworthhasincreased enormously

through the years. Similarly,Dave and Sherry Gold,founders of dollar storeretailer 99CentOnly Stores,have lived in the samehomesince 1963 and Dave drivesan olderToyota Prius.WhenIaskedSherryGoldwhy,sheanswered, “We hadeverything we wanted thatwas achievable throughmoney.”6 Money serves as ascore, and it does not

significantly change theirpersonallifestyles.While spending and

lifestyle can be an indicatorofmotivation, it isn’t alwaysdefinitive. Some high-performing CEOs live in bigmansions, such as LeslieWexner, founder of retailerthe Limited (owner ofVictoria’s Secret). He mayhave liberal spending habits,buthismotivationforrunning

thebusinessismorethanjustmaking money. Study themanagers in-depth tounderstandthesourceoftheirmotivation.TobeginstudyingaCEO’s

lifestyle,startbycompilingaset of articles that focus onthe CEO, using a news-archiving service such asDow Jones Factiva. Forexample, there were manyarticleswrittenaboutStephen

Hilbert, CEO of insurancefirmConseco,andhis larger-than-life lifestyle. Articlesabout Hilbert reported lavishparties in his 23,000-square-foot mansion in Carmel,Indiana.Hishomeincludedafull-size replica of IndianaUniversity’s Assembly Hall,and he and his friends woreHoosier uniforms when theyplayed basketball. Mostinvestorsignoredhispersonal

lifestyle because the stockprice rose 46 percent a year,compounded, from 1988 to1998.However,theseaspectsofHilbert’spersonal lifestyleshould have been warningsignalsbecausetheyindicatedhe was motivated by moneyrather than just interested inmoney.7

What happened to thecompany? On December 17,2002, Conseco filed for

bankruptcy, and the highreturns investors hadpreviouslyearnedwerewipedoutcompletely.If you cannot find articles

writtenaboutthelifestyleofamanager,youcanlookupthevalue of their homes, whichwill give you a glimpse intohow they live. Ownership ofcertain assets such asresidential real estate isgenerally fairly transparent.

Youcancheckforresidentialrealestateat thecountylevelwhere themanager lives.Forexample, in Austin, Texas,you can searchwww.traviscad.org, which isthe website for the localtaxing jurisdiction. You canusually search for propertiesby the name of the person.First, find outwhich city themanager lives in and thendetermine the name of the

county and the taxingjurisdiction. In most cases,the county will list theownership of propertiesonlineandyoucanseethetaxvalueof thehomeaswell asitssize.For example, suppose

you’re interested in learningmore aboutWarren Buffett’slifestyle. A simple onlinesearch will tell you that thetax assessor for Omaha is in

DouglasCounty.Youthengoto the Douglas County taxassessor website, and enter“Warren E. Buffett.” On thesite, it lists that WarrenBuffett owns a 1921 homesittingonthreequartersofanacre of land, with 5,830square feet with fivebedrooms, and a handballcourt, valued at $660,200 in2010.If you want to try a more

comprehensive real estatesearch, there are publicrecords companies that havecombined many of the localpublic records into nationaldatabases, allowing you tosearch for holdings acrossdifferent counties and states.Thiswouldyield informationon second homes, vacationhomes, and so on. Keep inmind that these propertiesmay be held in the CEO’s

name or in the name of aspouseorbusinessentity.

DoestheManagerFocuson

AppearancesInsteadoftheBusiness?

Managers who are trulypassionate about theirbusiness have less time foroutside social engagements.SteveJobs,founderofApple,

did not spend his moneylavishlywhen hewas one ofthe richest people in theworld,andheclaimedtohavelittletimeforasociallife.Hewas on a mission to makecomputers as common askitchen appliances, which atthe time, was dismissed ashype.It is important to look for

distractions managers haveoutside of the business. The

biographyfoundintheproxystatement is a great startingpointbecauseitliststheotheractivities of the top fiveexecutives, suchas sittingonthe boards of other publiccompanies and non-profitaffiliations.Youwanttogaina basic understanding as towhether they are devoting alarge amountof their time tootheractivities.Dotheysitonsocially prestigious boards in

their community? If so, howmuch involvement does theorganization require? Try togain insight into whatmotivatedthemanagertojointhe board: Was it for socialprestige,orwasitbecauseheor she is truly interested inthemissionofthenon-profit?And keep in mind that justbecause a manager isdedicated to great causes,such as the community,

diversity, or other sociallyresponsible goals, this doesnot necessarily translate intogoodethics.Forexample:

Ken Lay,whowas thenthe Chairman of Enron,donated $1.1 million in1999 to endow theKennethL.LayChairinEconomics at theUniversity of Missouri-Columbia.Laywaslaterconvicted of conspiracy

and fraud after Enronfailed.Alfred Taubman gavesignificant gifts to theUniversity of Michiganin Ann Arbor, andbuildingsnamedforhiminclude the TaubmanMedical Library andTaubman Health CareCenter. There is even aschool within theuniversity named for

him, the TaubmanCollege of Architecture& Urban Planning. Yethe spent a year in jailafter being convicted in2001 for price fixing atauctionhouseSotheby’s.Dennis Kozlowski, theformer CEO ofconglomerate TycoInternational, donatedmillions to Seton HallUniversity, and its

Stillman School ofBusiness was housed inan academic buildingnamed for Kozlowski.Yethewasconvictedoflooting Tyco of $600million.8

Many times, you can inferthe motivation of managersbythenumberoflargesocialor charity events they attend.Forexample,whenIsearchedfor information about the

CEO at a large Texas oilbusiness, all the articleswritten about him related tohis attendance at high-profilesocial events. I could notunderstandhowhemadetimefortheactualbusiness!Ilaterinterviewed him and askedhim why he had so muchavailabletimetoattendallofthesesocialfunctions,andheansweredthathehadcapablepeople running the

organization. Although thisseems like a rational answer,hisabsencehurtthebusiness,the stock price fell, and hewas eventually fired by hisboardofdirectors.

WhatTypeofPhilanthropic

EndeavorsIstheManagerInvolved

In?

Philanthropy can be a greatwindow into the character ofa manager. There is aconsiderable amount ofpublic disclosure inphilanthropy. You want todetermine what managerscare about. Are they seekingsocial acceptance in theircommunity? Or are theygenuinely passionate aboutthe charities they give to? Inthecaseofphilanthropy, it is

a warning signal if themanagerisoverlyinvolvedinsocial scene philanthropy—that is, the kind that’s moreabout the social recognitionthan the charity itself. Thisindicates that the manager isexternally motivated andtends to seek acceptance ofthose who are in high socialstanding. Many times, thesemanagers will directcorporate assets to support

their social climbing. Whenyou see a businesscontributing money to themost elite social functions,then it is likely that themanager is using thecorporationtoimprovehisorher social standing in thecommunity. These types ofdonations typically do notpertain to the company butare instead used for socialleverage.

To counter a commonassumption thatphilanthropists always havethe greater good at heart,considerafewexamples:

All of Enron’s keyofficers were activephilanthropists, with agreat number ofnonprofit organizationsin the Houston areabenefiting from theircontributions.

WorldCom and BernieEbberswerewellknownas donors to charitiesand universities inMississippi, and wererespected in thecommunity.Adelphia, once one ofthe biggest cabletelevision companies inthe United States, usedto sponsor Christmaspageantsandflewcancer

patients to healthfacilitiesfortreatment.

Yetallofthesebusinessesarenow defunct and many oftheir executive officers haveservedjailtime.Whatcanyoureallytellby

studying a manager’scharitable giving orphilanthropic patterns?Wherecanyoufindhowandhow much a business orperson donates? Look for

articlesaboutgiftsinsomeofthe news stories you readabout your company ormanagement. Most corporateand personal giving is directand isn’t reported in anyuniform way, though somegiving may be through afoundation.If themanagerorcompany has created afoundation, you should beable to scan the foundation’stax return because it is a

public record. You canrequestitfromtheIRSorjustcheck an online provider,such asGuideStar. Look forForm 990, which will detailwhich groups received gifts,the location and the amountof the gifts, future giftcommitments the foundationhas made, and contributornames and amounts.Companies will publicizesome of this on their

websites, but not all of it.Look atmore than a year ortwo,andyoucanseewhatthegeneral pattern and focus oftheirgivingis.Someotherwaystoturnup

additional informationinclude checking websitesand regional newspapers byadding the CEO’s spouse toyour search. You can alsocheck publications andwebsitesofnon-profitswhere

youknowtheCEOservesonthe board or giving lists orhonor rolls of their almamater or universities withwhich they are affiliated.Therearealsocompaniesthatcollectandcumulatedonationrecords that have been madepublicatonetimeoranother.All thesecanofferaglimpseintothesocialprioritiesofthemanageryouareevaluating.

AretheManagersLifelongLearnersWhoFocusonContinuous

Improvement?Lifelong learners aremanagers who are neversatisfied and continually findwaystoimprovethewaytheyrun a business. This drivecomes from their passion for

the business. It is extremelyimportant formanagement toconstantly improve,especially if a business hasbeen successful for a longperiod of time. Look formanagerswhoregardsuccessas a base from which theycontinue to grow, rather thanasafinalaccomplishment.For example, Michael

Bloomberg, eponymousfounder of the financial

information and mediacompany, wrote, “We’ve gotto improve just to stay even.EachofusatBloomberghasto enhance his or her skills.Every element of all ourproductsmustbe improved. .. Most companies neverupgrade until they areforced.”9

The opposite of those whoimprove are those who arecomplacent. Complacent

managers tend to thinkeverything is okay and oftenlackpassionfor thebusiness.Theyaresatisfied,sometimesindifferent, and usually fallinto mediocrity as a result.Theyoftenremaininvestedinthe way they have donebusiness in the past, such aswhenEastmanKodakrefusedto acknowledge the threat toits film business from digitalphotographyinthe1990s.

Another example ismobilephone manufacturer Nokia,which was one of the mostsuccessful Europeancompanies:Infact,in1998,itwas the world’s biggestmobile phone manufacturer.Nokiawas able to get to thetop of the industry quickly,but once there, it becamecomplacent.NokiaCEOOlli-Pekka Kallasvuo tended tofocusonhangingontomarket

share insteadofcreatingnewproducts. He ignored thetrend of mobile phonesmerging with computingwhen Apple introduced theiPhone in January 2007, andhe continued to focus onmaking cellphones that wereabout calling people insteadof about checking e-mail,getting directions, orchecking the weather. Afterthe introduction of the

iPhone, Nokia’s stock pricefell49percent,andKallasvuowas eventually replaced asCEO.10

49.Canyouidentifyamomentof

integrityforthe

manager?Basically, if CEOs haveintegrity, they are honest.They don’t say something toa group of people justbecausethat’swhatthegroupwants tohear.Whenyouaskaquestion,theytellyouwhatthey really think. In contrast,if a CEO often says, “We’llgo in thisdirection,”butactsdifferently,becautious.Ifthe

CEOsetscertainstandardsofbehavior or expectations ofperformance, yet violatesthem personally, then youshould perceive that themanagerlacksintegrity.How can you learn if the

CEO has integrity? Oneindicator is consistencybetween what they say andwhat they do. For example,Warren Buffett, CEO ofBerkshireHathaway,saysthe

same things over and overagain,andhefollowsthroughin his actions. In contrast,politicians are typically notconsistentinwhattheysayordo, which is why so manypeople are suspicious ofthem. They often say onething in order to get electedandthendoanother.Another way to observe

consistency in behavior is tosee how people act under

different circumstances. Younever truly know someone’scharacteruntilyouhaveseenit tested by stress, adversity,or a crisis, because a crisisproduces extremes inbehavior. A billionaireChinese entrepreneur oncetoldme thathewouldnotdobusinesswithapersonunlesshehadseenthemencounteramoment of integrity, whichheexplainedas“howyouact

whenyouareconfrontedwitha crisis or an ethicalsituation.”Hethensaidthatifit took him 20 years to waitforapersontoencounterthismoment of integrity, he wasmore than willing to wait inorder to do business withthem.Hehadahard-and-fastrulethathasservedhimwell,and he was rarelydisappointed by his businesspartners.

One of the best ways todeterminewhetheramanagerhas integrity is to identify amoment where he or shefacedadifficultsituationandsee what action he or shetook. If you are unable toidentify a moment ofdemonstrated integrity, thenyou are taking the risk thatyou do not know how thatperson will act when facedwithadifficultsituation.You

maywant towait to increasethe amount you invest untilafter you have seenmanagementencountersuchamoment.There are many examples

(manyalreadycoveredinthisbook) of CEOs who havepresented false resultsthrough accounting fraud.These CEOs are oftenconcernedwith losing accessto new capital, defaulting on

loan covenants, or they maybe worried about how WallStreet views them. SuchCEOs typically fail toconsider the broaderimplications of their actions.You want to know if themanager you are evaluatingwill follow the right pathwhen faced with adversescenarios.For example, I once

attendedanannualmeetingof

abankinTexas.Themorningbeforethemeetingbegan,thebank put out a news releaseannouncing ithad finalizedadealwithaTexasbillionaire,wherebyhewouldgive thema large capital infusion thatdiluted existing stockholders.Our firm believed this dealwas detrimental to existingstockholders, but Iwanted toverify this with companymanagement at the meeting.

The annual meeting lastedhalf an hour, and when itcame time for the CEO totake questions from theaudience, I raised my hand.Within moments, the CEOstepped down from thepodiumanddeclared that themeeting had ended.Surprised, I walked over tothe CEO and again tried toask him a question, but hesaid thathehad toattend the

board meeting. I recognizedmost of the board members,who were still socializing intheroom.Inthatmoment,theCEO had failed todemonstrate integrity. Inother circumstances, I hadhad a more favorableassessment of this CEObecause he was typicallystraightforward withinformation,but in this smallact,hedemonstratedalackof

integrity.Thisparticularbankeventuallywentbankruptduetoaggressivelending.In contrast, when I was

researching the backgroundof Dave Gold, co-founder ofretailer99CentOnlyStores,Iwassearchingforarticlesthatwould give me insight intohis character. I ran across anarticle that described howGoldhadadmittedtomakinga mistake in purchasing a

business for 99 Cent OnlyStores. Instead ofwriting offthisinvestment(asmostotherCEOs would have), Goldacquired it back from thecompany with his personalfunds—in the amount of $34million,no less!—whichwastwice what his company hadpaid for it previously. I hadneverheardofaCEObuyingback a mistake in order tobenefit shareholders,

especially at two times theprice. I felt I had a deepinsight into Gold and knewthis was the type of CEO Iwanted topartnerwith,and Imade an investment in thebusinesswhenthestockpricefell.11

The most difficult time toassess a manager is duringnormaltimes.Yougainmoreinsight into managementwhen conditions are adverse

than you do whencircumstances are ideal. Asyou read historical articleswritten about the business orSECfilings,begintoidentifythose periods when thebusiness encountered adifficult situation, such as aneconomic downturn, productrecall, negative mediacoverage that was inaccurateor overblown, or a lawsuit.Read articles, press releases,

and transcripts of quarterlyconference calls that werewritten during this time, andnote how the managementteam responded to thesedifficultsituations. Ifyouareassessing a manager withlimitedtenureatthebusiness,review articles andconference call transcripts atthe prior business. Did themanager disclose moreinformation to shareholders,

ordidthemanagerclamup?For example, during the

recession thatbegan in2007,some managers disclosedmore information so theirshareholders could betterunderstand the operations ofthe business and what themanagement teamwas doingto cope with the difficulteconomic situation, whereasothers did not want todisclose information, citing a

lack of visibility as thereason. This was a weakexcuse, however, becausemanagers do not need toforecast the future, but theydoneed todisclosehowtheyare reacting to a difficultsituation. You need todetermine how a managerresponds to a difficultsituation and then evaluatethe action they took. Werethey calm and intentional in

dealing with a negativesituation, or were theyreactive instead? Ideally,youshould seek to partner withthose managers who solveproblemsforthelongterm.There are a few ways that

management typicallyresponds to difficultsituations; identifying whichactions these managers takewillhelpyoudecidewhetherthey are an ideal partner or

not.Some managers allowcurrent adversity tooverwhelm themcompletely. In this typeof situation,management is trying toevadetheproblemratherthan confront it. Forexample, when BearStearns was nearingbankruptcy, then-CEOJames Cayne could be

found playing golf orplaying in bridgetournaments.Heignoredthe risks the firm wasfacing.12

Some managers attemptto blame the problemson others or on eventsbeyond their control. Inthis scenario, you willtypically see heavilylawyered press releasesor releases carefully

crafted by publicrelations firms. Themanagers will makestatements that they areassessing, reviewing, oranalyzing a problem.Theseare indicators thatsenior managers are notacting—which is whattheyshouldbedoing.Some managers strikeback quickly withoutthinking things through

and often end up goingin the wrong direction.These are the managerswhoannouncelayoffsinorder to quickly cutcosts the moment theirbusinessfacesdistress.Some managers aredetermined to get overtheirsetbacksbutdonotsolve the problem;instead, they apply aquick remedy, which

only solves the problemin the short run. Forexample,aretailerIwasanalyzing discoveredthat the reason some ofits sales had droppedwas that it did not haveenoughshoppingcartsinthe stores. Themanagement teamquickly sent in newshopping carts but thenfailed to follow up later

when the supply wasdepleted again, so ofcourse the retailer founditself in the samesituation a few monthslater.The best managers arethose who quickly andopenly communicatehow they are thinkingabout the problem andoutline how they aregoing tosolve it.Again,

youarelookingforthosestories where managersactedwith integrity. Forexample, RobertSilberman, CEO ofStrayer Education,disclosed that new-student enrollments haddropped 20 percent inthe2010winterterm,thelargest drop thatSilberman had seen inhis 10-year tenure as

CEO. Even thoughSilberman did not knowtheexactreasonsforthedrop, he reported thisnegative news toshareholdersthemomenthe had the information,and then he held aspecial conference callfirst thing the nextmorning to answershareholder questions.He gave shareholders as

much information as hecould, and he explainedhow he was reacting toit.Similarly, on the day ofthe2001terroristattackson the World TradeCenter, Bruce Flatt,then-CEO of BrookfieldProperties, had to dealwith several kinds ofproblems. The mediawas circulating false

reports thatBrookfield’sfour office buildingsnext to theWorldTradeCenter were not stableand about to collapse,even though engineershad already concludedthey were structurallysound. Flatt hired a carto take him fromBrookfield’sheadquarters in Torontoto Manhattan (because

no planes were flyingthat day after theattacks), and hesurveyed the four officetowers Brookfieldowned. After seeing thebuildings himself andconfirming withengineers that theyweresound, Flatt was betterable tomakecorrectionswith themediaandgivegood information to

tenants. He immediatelyhad truckloads ofplywood sent in, and hewas the first landlord tostart repairs in LowerManhattan. He thenpromised tenants theycould return in eightweeks.13 Flatt said, “Wefelt it was important toreturntothepremisesassoon as possible. It wasacalculatedrisk,butwe

needed to evaluate thesituation, makedecisions, and help ourtenants.” Flatt deliveredon his promise, andwithin eight weeks, thetenants were able toreturntotheiroffices.14

50.Aremanagersclear

andconsistentintheir

communicationsandactionswithstakeholders?

The best management teamsare clear and consistent intheir communications withcustomers, employees,suppliers, and shareholders.

They communicate things astheyareanddonotattempttomanipulatetheinformation.Youwillfindthatthemore

transparent management isabout the business, the moreaccountable they are. Incontrast, whenever managersmake something complex,they may be concealing risktaking or bad judgment.Incomplete disclosure alsomakes it difficult for you to

assess the competence of themanagers.Although thismaybe good for the manager,reducinghisorherchancesofbeing replaced, it obviouslymakesyourevaluationof thebusinessmoredifficult.The following sections

describe a fewwaysyoucan(and should!) determinewhethermanagement is clearand consistent in itscommunications.

ReadtheCompany’sAnnualReport

ShareholderLetterYoucanstart learninghowaCEO communicates withshareholders by readingshareholder letterswritten bythe CEO. By reading themsequentially, rather thanreading only one shareholderletter, you will gain greaterinsightsintotheCEOandthe

business.Youarelookingforletters where the CEOcommunicates clearly abouthow the business isperforming; these lettersshoulddescribeandexplain:

What is important attheirbusiness.What is driving theirdecisions.The issues they haveencountered.The metrics that are

important tomonitor thehealthofthebusiness.How the CEO plans toresolve issues faced bythebusiness:Thisisoneof the most importantpieces of information tolookfor.

If, instead, the shareholderletter looks like it has beenwritten by a public relationsfirm or is a carbon copy ofthe information disclosed in

theManagement,Discussion,and Analysis section(MD&A) found in the 10-K,then it is likely the CEO isnot interested in givinginvestors insight intohowheorsheisthinking.For example, if you read a

shareholder letter written byWarren Buffett, CEO ofBerkshire Hathaway, youmight note how easy it is tounderstand what he writes

andhowauthenticheisinhiscommunications. WhenBuffettwrites,hesaysexactlywhathemeans.In contrast, in The Coca-

ColaCompany’s2003annualshareholder letter report,former CEO Douglas Daftwrote,“Iampleasedtoreportthat our Company earned arecord $1.77 per share in2003.” This good news wascoming just after the

company had announced a$197millioncharge,withthestock down 20 percent sinceDaft had been named CEO.Daft thenwent on to explainthat this was a “particularlychallenging businessenvironment”—in otherwords, blaming the outsideenvironment for the results.Daft retired from The Coca-Cola Company shortlythereafter.

ReadConferenceCallTranscripts

Once you feel you have agood understanding of thebusiness, read transcriptsfrom themost recent aswellashistoricalconferencecalls.Theseareagreatinformationsource because if you do nothave access to themanagement team, this is thebest place to see how they

communicate.Youcanobtainclear insight into howmanagement thinks and actsby reading these conferencecalltranscripts.Watch how managers

addressbusinessissuesintheconference call. There isalmost always a recent issuethebusinesshasencountered,and most questions aredirected toward such recentissues. Are the managers

open and honest in theircommunications? Or do theyattempt to avoid the issue?Monitorhowmanyquestionsgo unanswered. Note if themanagers use excuses, suchassayingthattheinformationis proprietary. Manymanagement teams will usethe excuse that they cannotshare information withshareholders for competitivereasons.This is anextremely

usefulindicator:Ihavefoundthat if the strategy of thebusiness is based more onhiding information fromcompetitors rather thanoutperforming competitors, itis far less likely that thebusiness will have long-termsuccess. If the unansweredquestions have to do withspecific financial guidance,thisisokay.Youinsteadwantto monitor how many

unanswered questions thereare about things that arespecific to thebusiness, suchas marketing, historicalmergers or acquisitions,personnel, or legal issues.Most of the time, this is notproprietary information, andthemanagershouldbeabletoanswer these questions or atleast tell you how they arethinkingabouttheissues.For example, during a

conferencecallonNovember4, 2004, with a diversifiedmedia company that ownsradiostations,aninstitutionalanalyst asked if managementhad near-term plans forformat changes at its radiostations. Managementrespondedbysaying,“. . .wedon’t disclose any formatchanges that we mightemploy inour radiodivision.I’m sure you understand.” In

fact, this is not proprietaryand is one of the mostimportant components of aradio company. Ifmanagementdoesnotwanttoanswer questions about themost important part of itsbusiness, investors shouldview management’s actionsasawarningsignal.In many cases, you will

find that the managersrespond to questions, rather

than answer them. In otherwords, they will respond tothequestionwithastatementthat has nothing to do withthequestion,butitmakesthemanager look as if he or sheisansweringthequestion.Forexample,oneCEOwas

askedwhythemarginsofthebusinesshaddropped,andhewent into a long discussiononhowtheworldwasquicklychangingaroundhimandsaid

that the economy wasuncertain. The CEO couldhave at least explained thatmargins dropped because thecost of materials hadincreased,whichwastherealreasonforthedrop.The first part of the call is

usuallyfilledwiththeCEOorCFO reading from a scriptthat has been prepared inadvance.Alotoftimeontheconference call is spent on

this part, and I sometimesthink that management doesthis in order to limit thequestion-and-answerperiod.For that reason, I prefer to

invest in businesses such asPenn National Gaming,which skips the script andjumps straight into questionswitha fewpreparedremarks.Peter Carlino, CEO of PennNationalGaming,says“Ifindmost ofmy shareholders can

read,soIbelieveit isbest tospend more time answeringquestions than reading ascript that is found on thecompany website.” Over theyears, managers have startedto remove these scriptedsessions from theirconference calls to allowmoretimeforshareholderstoask questions. This is anextremely positive signbecause it indicates that

managers want to addressshareholder questions orconcerns. They understandthat shareholders receive themostvaluable insightsduringtheunscriptedformat.For example, in an August

2010 conference call,clothing retailer UrbanOutfitters announced that itwould release a detailedmanagement commentary sothatitsearningscallcouldbe

more focused. Similarly, inJuly 2010, disk drivemanufacturer Seagate andbiopharmaceutical companyGilead Sciences bothannounced that they wouldstart reducing the time spentwith prepared remarks onconference calls, insteadposting those a couple ofhours before the call soinvestorswould have time toabsorb the information and

formulate questions. Theseare all positive signals thatmanagement is open withshareholders.The following sections

discuss some questions youcan ask to better understandhow managers communicatewithstockholders,customers,employees, and suppliers:How do the managerscommunicate whenconfronted with adversity?

And does management onlyemphasizegoodnewsintheircommunications?

HowDotheManagers

CommunicateWhenConfrontedwith

Adversity?The best managers to investindonotmakeexcusesas to

why they cannotcommunicatewithcustomers,shareholders, employees, orsuppliers when they areconfronted with adversity.Instead, they communicateopenly when the economy isin disarray or competitivepressures are high. Incontrast, the worst managerstopartnerwitharethosewhoengage in face-savingbehavior when confronted

with problems. They usuallyturntoheavilylawyerednewsreleases that do not addressthe issues, and they dancearound the informationinsteadofbeingforthcoming.When Howard Schultz,

founder of Starbucks,returned to the company inJanuary 2008, he found thatproblems both inside andoutside the company werecausing sales to decline.

Upon returning, Schultzpromptly stood up to his180,000 employees and theirfamiliesandadmitted thathehad failed them. He toldthem, “Your leadership hasfailedyou,andeventhoughIwasn’t CEO, I have beenaroundasChairman.Ishouldhave known more. I amresponsible.” Schultz saidthatoncehedidthis,itwasapowerfulturningpointforhis

company because the burdenwasoffhisshoulders,andhecould nowmove forward. Inan interview, he said, “Youhave to be honest andauthenticandnothide.Ithinkthe leader today has todemonstrate bothtransparency andvulnerability, and with thatcomes truthfulness andhumility and obviously theabilitytoinstillconfidencein

people,andnotthroughsometop-down hierarchicalapproach.”15

DoesManagementOnlyEmphasize

GoodNewsinTheirCommunications?

You need to determine whatinformation managementemphasizes. For example, inthe 10-K, there is a section

titled “Selected FinancialData.” This is a pro-formastatement that condenses theincomestatementandbalancesheet. This is wheremanagement highlightscertainfinancialitemsitfindsimportant, such as earningsbefore interest, taxes,depreciation, andamortization (EBITDA)adjusted for some type ofcharge.Thissectionmaygive

you some insight intomanagement regarding whatitreportsanddoesn’treport.For example, Internet

company InfoSpace, one ofthe few profitable dot-coms(according to its pro-formastatement) during 2000,reported that it had earned$46 million in pro-formaprofits during that year.Naveen Jain, then CEO, wastouting the stock on CNN’s

financial network in late2000, proclaiming, “Ourwireless business is on fire!”The truthwas that byGAAPstandards (instead of pro-forma), InfoSpace lost $282millionin2000.ButtheCEOwas emphasizing pro-formatargets, which did notrealisticallyrepresentthetrueearnings of the business.Eventually,InfoSpace’sstockcratered,andadollarinvested

at its peak price was worthonlythreecentsby2005.16

The following sectionsdiscusssomequestionstoaskyourselfasyoueitherlistentoorreadwhatamanagersays:

Is the manager easy tolistento?Do you learn from themanager?Does the manager usecorporatespeak?Does the manager use

doublespeak?

IstheManagerEasytoListento?

Chris Lozano, who was anintern atmy firm, attended alecture at the University ofTexas at Austin with talksgiven by two entrepreneurs.Onewasthefoundingpartnerof a venture capital firm andthe other was the founder of

Southwest Airlines, HerbKelleher.ItwasaninterestingcontrastaccordingtoLozano,who said the venturecapitalist was talking to theaudience, whereas Kelleherwas engaged in aconversation with theaudience. Lozano said,“When I listened to theventurecapitalist, I felt like Iwas having a boxing matchwith him.” If you find it

difficulttolistentomanagersor readwhat theywrite, thenitislikelyawarningsignal.

DoyouLearnfromtheManager?

After you’ve read or listenedto what managers say, askyourself if you are learningmore effectiveways to run abusiness from them. Forexample, when I was

analyzing retailer 99 CentOnly Stores, I learned a lotabout the retail businessthrough both Dave andSherry Gold, the founders.Their teachingsenhancedmyunderstanding of thefundamentals of running asuccessful retailbusiness.Onthe other hand, if you findyourself wanting to teach amanagementteamhowtorunitsbusiness,thisisprobablya

signal that you have run intoan incompetent managementteam.

DoestheManagerUseCorporate

Speak?Manymanagersusecorporatespeak or make genericstatements. You may oftenfind yourself running twoconversationsinyourheadas

you try to discern what theymean.Askyourself,“Dotheyuse a lot of corporate jargonsuch as theword strategic orthought leadership”?17 Thismay indicate that thesemanagers do not trulyunderstand theirbusinessandare more concerned withshowing others how smarttheyare.Whenmanagersusecorporate jargon, it may bethat they are more interested

in self-promotion than inclearly explaining toshareholders how thebusinessisoperating.

DoestheManagerUseDoubleSpeak?

Double speak is whensomeone says contradictorythings, such as “We don’ttime themarket, but wewillcontinue to hold cash until

after the middle of the year,when things might getbetter.”For example, the CEO of

Reuters, Tom Glocer, oncesaidthisinastatementtothecompany:“Aboveallelse,weacknowledged things wouldbe tough in 2005, but weconfidently set a budget thatshows Reuters growing ourrevenues for the first time infour years.” Reuters then

added that itwas not issuingrevenue guidance in thememo, which had beenreleased to staff earlier thatweek. The statement said,“This statement is notmeanttoimplythatrevenueswillbepositive for2005asawhole.The 2005 budget is not yetcomplete, and no revenueguidance has been issued for2005.”18

Here’s another example:

GriffinMining,azincminer,disclosed on February 21,2006, that “operating costswere higher than envisageddue to inevitable initialteething problems incommissioning the plant.”19Thekeyquestionyou shouldask is, if the teethingproblems were inevitable,why weren’t they in thebudget?Andanotherexample:Ata

conference on October 3,2001, Joseph Nacchio, CEOof Qwest Communications,statedthatinsteadoftryingtoconvince the audience thatQwest was doing well, hewould “just let the numbersspeak for themselves onOctober 31.” When October31came,thecompanymissedexpectations, and Nacchiostated, “Some of you willrecall that at a recent

conference I said the resultswill speak for themselves.The reality is, they do notspeak clearly for themselveswithout some interpretation,given the current economicconditions and the effects ofmerger and other one-timecharges.” Nacchio quit inJune 2002 amid an SECprobeintoallegedaccountingmanipulation.20

51.Doesmanagement

thinkindependentlyandremainunswayedbywhatothersintheirindustry

aredoing?One of the toughestchallengesamanagerfacesisto look at all of the profitsthat competitors are earningand not be tempted to copythatsuccess.Sometimestheseprofits may be earned fromunsustainablesources.Forexample,JamieDimon,

CEOof J.P.Morgan,didnotfollow his reckless

competitors as they chasedpoor-quality mortgage-backedsecuritiesinsearchofhigherfees.Atthetime,mostofJ.P.Morgan’sshareholderscomplained that Dimon wasbeing too conservative andthat he was passing up thechance to make millions ofdollars in profits. However,when the financial crisis of2009 put some of hiscompetitors out of business,

DimonwasoneoffewCEOswhomanagedtobothweatherthe storm and strengthen hisbusiness during this time ofdistress.Shareholders will often

attempttoinfluencemanagersto maximize short-termprofits. The best managersalways maintain a long-termfocus,whichmeans that theyare often building for yearsbefore they see concrete

results.Forexample,in2009,JeffBezos, founderofonlineretailer Amazon.com, talkedabout the way that someinvestors congratulateAmazon.comon success in asingle reporting period. “Ialwaystellpeople,ifwehaveagoodquarter,it’sbecauseofthe work we did three, four,and five years ago. It’s notbecause we did a good jobthisquarter.”21

Another example of long-termthinkingishowHowardSchultz runs Starbucks. Formany years, investors havesaid that Starbucks shouldundo its company-ownedstores and franchise theminstead, because this wouldsignificantly increase theamountoffree-cashflowthatStarbuckscouldgenerate andwould improve the return oncapital.Althoughit isagood

argument economically,Schultz has continuallyrefused to franchiseStarbuck’sstores.Hebelievesthat this act would fracturethe customer-service cultureof the company, which iscentral toStarbuck’ssuccess.He is thereforemanaging thebusiness for its long-terminterests and hasdemonstrated the ability tothinkindependently.22

Another way to determineif managers thinkindependentlyistoseeiftheycontinually benchmarkthemselves against theircompetitors or if they try tocopy the past success ofcompetitors. It is difficult tocopysomeoneelse’ssuccess,and when a business tries tocopywhatitbelievesmakesacompetitor successful, itmaybe a sign that the

management team does nothave a sound plan for thebusiness.For example, during the

techboomof1998to2000,Iremember people trying tocome up with tech-basedconcepts that would makethem rich. Most of thesepeople did not think aboutmeeting customer needs;instead, they were trying tocopy the success of others.

Morerecently,investorshavestarted hedge funds in hopesof hitting it big. What theyfail to realize is thatmanyofthe billionaire hedge fundmanagers today did notexplicitly set out to createlarge funds. It was anunintended consequence ofbeingattherightplaceattheright time, which issomething that cannot befabricated.

Similarly, when a LasVegas casino had a greatdegree of success luringJapanese gamblers to itsbaccarat room, competitorstried to copy what theythoughtwasthereasonforthesuccess: They spent millionsofdollarsbuilding largerandmore elaborate baccaratrooms and offered moreservices to lure theseJapanese gamblers. For a

short while, the Japanesegamblers visited the rivalcasinos,buttheyalwayscameback to the original casino.Thecompetitorsbecameevenmorefrustratedandcontinuedto invest millions more,without any success. Thereason that particular casinowas successful is that themanager took the time tolearnthelanguageandcultureof these Japanese gamblers.

Hewasinthebestpositiontounderstand how they thoughtand what they wanted. Therival casino businesses couldnot duplicate this becausethey had only copied whatthey could see. This shouldhave served as a warningsignal that the rival casinosdidnot have a soundplanoftheir own focusing on whattheydidbest.Therefore,lookout for those businesses that

are announcing similarproducts or services justbecause their competitorshavebeensuccessful.

52.IstheCEOself-promoting?Youneed tobecarefulaboutinvestinginbusinessesrunbyCEOswhoareself-promotingor those with larger-than-life

personalities.TheseareCEOswho are often popularized inthe media and consistentlyshow up on businessmagazinecoversbecausetheyare announcing headline-grabbing growth projectionsor transformational news.These CEOs makethemselves the brand ratherthanthebusiness.You can identify these

CEOs easily because they

brag about theiraccomplishments and areoften well-rehearsed,articulate,andenthusiastic.Inotherwords, they focus on agreat pitch. They also areusually:

Flamboyant.Havelotsofcharisma.Engage in aggressivesalesmanship.Tend to command thecenterofattention.

Takeoverdiscussions.Have an attitude thatthey are smarter thaneverybodyelse.

Most of the time, these traitsmaskunderlyingissues.Most corporate boards

choose these strong-willed,egotistical CEOs becausethey believe that this type ofCEO will be able to meetdifficult challenges.However, although these

CEOs are good at sellingthemselves, they often bringmanyproblems to a businessbecause they spend aninordinate amount of timemanaging to Wall Street’sexpectations, at the expenseof the company’s day-to-daybusiness.Another way to identify

these types of CEOs is tomonitorhowmuch time theyspend attending investor

conferences that aresponsoredbyWallStreetsell-side research firms topromote their businesses.Look on the website of thebusiness in the investorrelationssection,andidentifyhowmanyWallStreeteventsthe CEO, chief financialofficer (CFO), or othermanagers are attending. Ifthey are present more thantwo to four times permonth,

then you are likely dealingwithapromotionalCEOwhois trying to increase thecompany’sstockprice.As always, there are

exceptions for CEOspromotingthebusiness.Ifthebusiness is dependent onWall Street to finance itsexpansion, then it isnecessarytogenerateinvestorinterest. Many businessesissuedebtorequitytoexpand

their business or foracquisitions. For example, ifthey are attending high-yieldconferences to generateinvestor interest in a debtoffering, then this is anecessary function for themanagement team. Instead,watchoutforthoseCEOsthataretoutingthestockandwhodo not need Wall Street tofinancetheirbusinesses.Other ways CEOs can

promote their stock is byspendingalotoftimetalkingwith TV outlets and otherpress. If you see CEOs whoareconstantlyinthefinancialpress, then it is highly likelythey are just there to bringattention to their companies’stock. Be cautious of CEOswhofocussolelyonthestockprice. Most investors believethis is a good sign, but it isnot.

For example, intelecommunicationscompanyWorldCom’s 1998 annualreport, CEO Bernard Ebbersbragged about a 132 percentincreaseinincomeanda137percent increase in stockprice, and he promised tocontinuebothtrends.In1997,Ebbers told a reporter, “Ourgoal is not to capturemarketshareorbeglobal.OurgoalistobetheNo.1stockonWall

Street.”23 This statementaloneshouldhavecausedyoutosellyourstock.Ebberswasusing his company’s highstock price to make multipleacquisitions, such astelecommunicationscompanyMCI; in fact, he made morethan 75 acquisitions. Howprominent did WorldCombecome? WorldComeventually (and famously)went bankrupt, and Ebbers

was convicted of fraud andconspiracy related toaccountingfraud.

SomeoftheBest-PerformingCEOsAreUnknownandDoNotPromote

Some of the best CEOs arecollegial, team oriented, andsoftspoken,andtheyareabletogaintheconfidenceoftheir

employees. In fact, manyCEOswhohavecompiledthegreatest long-term records ofcreatingwealth are relativelyunknown and don’t self-promote, such as Yun Jong-Yong, who was CEO ofSouth Korea’s SamsungElectronics from 1996 to2008. Yun transformedSamsung from a maker ofcommoditized memory chipsand other commoditized

products to a company thatdesigned innovative digitalproducts, such as cutting-edge cell phones. Theoppositeoftheself-promoter,Yunrefusedmanyinterviews.Instead, he let the resultsspeak for themselves asSamsung Electronics gained$127 billion in market valueunderhistenure.24

The management teams ofsome of the best-

compounding stocks from2000to2010spendverylittletimemeetingwithWallStreet—for example, Four SeasonsHotels, Strayer Education,Whole Foods Market,Morningstar, and ExpeditorsInternational. Instead ofsimplymeetingwith analystseachquarter,themanagementteams at ExpeditorsInternationalandMorningstarask shareholders to email or

writetheirquestions,andthenthey answer these questionsinapubliclyreleasedform8-Ksoall the shareholderscanread their responses. IssadoreSharp, founder of FourSeasons Hotels, did nottypically meet with analystsandwas not available on thequarterly conference call. Ionce tracked him down at ahotel and asked him why hedid not meet with analysts,

and he said that he wouldrather spend time with hisemployees. He said, “I canspend an hour with you andyoumightownmystockforayearand thensell it,or Icanuse that time with thehousekeepingstaffwhocouldpotentially stay at thisbusiness for more than 20years.”

KeyPointstoKeepinMind

When itcomes topeople, thebestpredictorof futurebehavior ispastbehavior.Passionmotivatesmore thanmoney.

You gainmore insightintomanagementwhenconditionsare adversethan you dowhencircumstancesareideal.The bestmanagers toinvest withare thosewho quicklyand openly

communicatehow they arethinkingaboutproblemsandoutline howthey aregoing tosolve them.Theycommunicatethings asthey are anddo notattempt tomanipulateinformation.

The moretransparentmanagementis about thebusiness, themoreaccountablethey are. Incontrast,whenevermanagersmakesomethingcomplex,they may beconcealingrisktakingor

badjudgment.CEOs thatfocus ontheir stockprice aren’tfocused ontheirbusiness.Some of thebest CEOsare collegial,teamoriented, andsoftspoken.

1.Varchaver,Nicholas.

“BuffettGoestoWharton.”CNNMoney.May2,2008.http://money.cnn.com.2.“TheBestAdviceIEverGot.”LindaMason,ChairmanandFounderBrightHorizonsFamilySolutions,interviewedbyDaisyWademanDowling,HarvardBusinessReview,September2008.3.Tapscott,Don.“ChangingtheWorld,OneFriendata

Time.”GlobeandMail,July3,2010.4.Vascellaro,Jessica.“FacebookCEOinNoRushto‘Friend’WallStreet.”WallStreetJournal,March4,2010.5.Efrati,Amir,andPui-WingTam.“FacebookShareClamorHeatsUp.”WallStreetJournal,March17,2011.6.InterviewwithDaveand

SherryGold,May2010.7.Sparks,Debra.“Conseco’sMorningAfter.”BusinessWeek,June5,2000.8.Porter,Jane,andAlinaDizik.“MakeThat‘Dr.Chainsaw,’”BusinessWeek,September11,2007.9.Bloomberg,Michael.BloombergbyBloomberg.UpperSaddleRiver,NJ:JohnWileyandSons,2001,pp.62–64.

10.Lynn,Matthew.“TheFallenKingofFinland.”BusinessWeek,September20–26,2010.11.Coffey,Brendan.“EveryPennyCounts;SellingEverythingfor99CentsMadeDaveGoldRich.”Forbes,September30,2002.12.Kelly,Kate.“BearCEO’sHandlingofCrisisRaisesIssues.”WallStreet

Journal,November1,2007.13.McNish,Jacquie.“BrookfieldBeginstoRebuild:FirmMendsitsOfficeTowers,Reputation.”GlobeandMail,September24,2001.14.Daly,John.“TheToughestSOBsinBusiness.”GlobeandMail,January31,2003.15.Ignatius,“Mistakes.”16.“Dot-comjob:As

InfoSpaceStockCollapses,InsidersCashOut.”SeattleTimes,KnightRidder/TribuneBusinessNews,March7,2005.17.Rittenhouse,L.J.DoBusinesswithPeopleYouCanTrust:BalancingProfitsandPrinciples.NewYork:andBeyondCommunications,2002.18.“ReutersSharesRiseonUpbeatRevenue

Statement.”ReutersNews,October8,2004.19.Larsen,PeterThal.“GriffinMining.”FinancialTimes,February21,2006.20.Howell,Martin.PredatorsandProfits:100+WaysforInvestorstoProtectTheirNestEggs.UpperSaddleRiver,NJ:PrenticeHall,2003,pp.44–45.21.Lyons,Daniel.“The

Interviews:Books(JeffBezos).”Newsweek,December28,2009.22.Ignatius,“Mistakes.”23.Barrett,Amy,andPeterElstrom.“MakingWorldComLiveUptoItsName.”BusinessWeek,July14,1997.24.Hansen,MortenT.,HerminiaIbarra,andUrsPeyer.“TheBest-PerformingCEOsinthe

World.”HarvardBusinessReview,January–February2010.

CHAPTER10

EvaluatingGrowth

Opportunities

Businesses that are growingprofitably create a lot of

value.Themainadvantageofinvesting in a growingbusiness is that you canreceive the benefits of tax-deferred compounding. Thisisduetothefactthatyoucanholdontothestockforalongperiodoftimewithouthavingto sell it. This advantage hasformed the basis of successformanylong-terminvestors,mostnotablyWarrenBuffett.Growth does carry many

risks. There is uncertaintyabout any company’s future,but when you purchasegrowing companies, you aregenerally paying for futuregrowthaswellascurrentcashflow and profitability. Thisrequires you to determinewhethergrowthcancontinue,for how long, and at whatrate.This chapter is intended to

help you reduce the

uncertainty of investing inbusinesses that are growing.Let’sbeginbylookingathowacompanyisgrowing.

53.Doesthebusinessgrow

throughmergersandacquisitions

(M&A),ordoesitgrow

organically?Youcananswerthisquestionby viewing the cash flowstatement found in the 10-K.IntheInvestingsectionofthecashflowstatement,thereisasubsectiontitledAcquisitions.Calculate the percentage ofcash flow from operations

spent on acquisitions for thelast5to10years.Dependingon the percentage spent onacquisitions, a business canbe classified along acontinuum of growth styles.On one end would be thosebusinesses that groworganically.On theotherendwould be serial acquirers.Selective acquirers belongsomewhereinthemiddle.Forexample, compare the

followingcompanies:For-profit educationbusiness StrayerEducation has not madeanyacquisitions,buthasbeen growing steadilyfor many years.Businesses that groworganically are typicallynot paying a premiumprice to acquireadditional customers.They also don’t have to

worry about spendingtheir time integrating anew business and itsemployees into theirownoperations.Medtronic, a medical-device manufacturer,made acquisitions in2002, 2008, and 2009and is considered aselective acquirer.Selective acquirerstypicallyarenotgrowing

to achieve scale, butmake purchases toexpand their existingproduct lines. This waythey do not have tospend valuable timeattempting to gainexpertiseinnewareas.Stericycle, a medical-disposal business, is aserial acquirer thatregularlyspendsfrom30percentto150percentof

its cash flow fromoperations onacquisitions each year.The potential risks to aserial acquirer arepaying too much for abusiness or putting toomuch debt on thebalancesheet.

These are the three basicways that management cangrow the business, and eachcanbesuccessful.Butthereis

decidedly more riskassociated with acquisitions,includingtakingontoomuchdebt, overpaying for anacquisition, or difficultyintegrating the targetcompany.

MakeSureYouPlaceGrowthinContextto

RevenuesYou must always place

growth in context to theexisting revenues of abusiness. Many managementteams will highlight thegrowth of a certain division,such as one that is growing50 percent a year, yet thatdivisionmayrepresentonly1percent of the company’stotalrevenues.Therefore,thishigh growth rate will notmaterially increase theintrinsic value of the

business.

54.Whatisthemanagement

team’smotivationtogrowthebusiness?

There is often pressure on

management teams to growtheir business, because top-line growth can increase thestockprice.Thispressurecancause senior managers tomake mistakes, especially ifthe growth of the corebusiness slowsand they seekgrowth by launching newinitiatives or by makingacquisitions in unrelatedbusinesslines.Manyofthesenewventuresandacquisitions

may fail, and managementwill spend valuable timeselling or closing them. Youshould become especiallyconcerned whenevermanagement launches newgrowth initiatives outside ofits core business, whichincreases the probability thatmanagementisabouttomakeamistake.For example, when Jack

Greenberg became the fourth

CEOofMcDonald’sin1999,growth atMcDonald’s beganto slow as internationalmarkets matured andconcernsabout fatty foods inthe United States hurtconsumption. Greenbergannounced that he wouldfocus on improving the corebusiness, but at the sametime, he would pursue newplatforms for growth byacquiring other restaurant

businesses such as Chipotle,the Mexican food restaurantchain. The result of thisgrowth initiative was that in2001,McDonald’sannounceda quarterly loss for the firsttime in its history. With thecore business stilldeteriorating, Greenbergresigned.DuringGreenberg’stenure, the stock pricedropped from $45 per sharewhen he joined the business

inMay1999to$15pershareonDecember31,2002,whenheannouncedhisretirement.1

McDonald’s thenannounced that JamesCantalupo,whohad spent28years at McDonald’s, wouldbecome CEO. Cantalupo’sfirst announcement was thatMcDonald’swastryingtodotoomany things, andhe soldor closed most of the prioracquisitions that were made

under Greenberg’s tenure.The stock price has sinceincreased from$15per shareat the end of 2002 to morethan $70 per share onDecember 31, 2010, asMcDonald’s has renewed itsfocusonitscorebusiness.2

55.Hashistoricalgrowth

beenprofitableandwillitcontinue?

In order for growth to addvaluetoabusiness,itmustbeprofitable.Growthoften failstotranslateintoprofits.For example, the solar

energy industry is growingquickly,butasof2009,solarpanels that are made of

silicone produce energy at amuch higher cost thanconventional methods.Therefore, even though theindustry is growing, it is notgrowingprofitably.Similarly,whentheInternet

industry first evolved, it alsogrew extremely rapidly, yetmost of the businesses werenot profitable. It wasextremely difficult to predictwhichbusinesseswouldcome

outwinners.To evaluate whether

historical growth has beenprofitable,comparegrossandoperating income margins tounit growth over a three- tofive-year period. As thenumber of units soldincreases, do the gross andoperating profit marginsremain the same, or do theyincreaseordecrease?Forexample,asthenumber

of transactions increased atmoney transfer businessWestern Union, the grossprofitmargin decreased from46.9 percent in 2005 to 43.4percent in 2009. In addition,the operating income margindecreased from 31.8 percentin 2005 to 25.2 percent in2009.3

Then, compare operatingincome growth to unitgrowth,againoverathree-to

five-year period. Theoperating profit pertransaction atWesternUniondecreased from $9.44 pertransaction in 2003 to $6.51per transaction in 2008. ForWestern Union, you canconclude that the growth intransactionsoverthelastfiveyearshasbeenlessprofitable,and you need to determinewhether this is a trend thatwillcontinue.

56.Whatarethefuturegrowth

prospectsforthebusiness?

Beginbyreadingthebusinessdescription section and theManagement,Discussion andAnalysis (MD&A) sectionfound in the 10-K, where

management often discussesthe growth opportunities forthebusiness.For example, let’s look at

the 2010 MD&A section ofthe 10-K for IntuitiveSurgical,whichmanufacturesthe da Vinci™ SurgicalSystems, which provideminimally invasivealternatives to complexsurgical procedures. In the10-K, Intuitive Surgical’s

management discloses thatthe installedbaseofdaVinciSurgical Systems has grownfrom 795 systems as of theendof2007to1,395systemsas of the end of 2009.Clearly, the business isgrowing quickly and couldrepresent a great investmentopportunity. If, instead, yousaw the installed basegrowingfrom795systemsto800 systems, then this may

indicate that the businesslacksfuturegrowthprospects,and you should pay a lowerpriceforthestock.As Strayer’s CEO Robert

Silbermansays,“Whatmakesabusinessattractiveisnottherateitcangrowinanysingleyear,butthenumberofyearsitcangrowatanyrate.”4Thedestiny of any fast-growingbusiness is to experience agrowth rate that slows down

atsomepoint.Therefore,youneed to determine how longgrowth can be sustained. Tostart, you must ask if thebusiness model can bereplicatedbroadly,orifitcanbe replicated in only certaingeographiclocations.For example, hotel

franchisor ChoiceHotels canlicense its Comfort Inn hotelbrand throughout the entireUnited States or beyond. A

clothing manufacturer, suchas Polo Ralph Lauren, hassimilarpotential.Be careful when forming

your future growthexpectations from the pastsuccesses of the business.Remember,you do not profitfromyesterday’s growth. Forexample, if you learn thatdoughnut maker KrispyKreme is successful sellingdoughnuts in display cases

found in Exxon gas stations,do not assume that strategywill work in all Exxon gasstations. The danger lies intakingoneinstanceofsuccessandprojectingit.Thingsmaychange: For example, morecompetition may enter themarket,orKrispyKrememaybegin to cannibalize its ownsalesasitbeginstoopennewlocations near Exxon gasstations.

Sometimes, it is easy todetermine the future growthprospects of a business. Forexample, let’s take a look atBuild-A-Bear,thenichemall-based retailer that lets kidsbuild their own stuffedanimal. From 2004 to 2009,the management team statedinthecompany’s10-Kthatitbelieved it could open storesin 350 locations, primarilymalls, in North America. At

the end of 2009, Build-A-Bearhadalreadyopened291stores,soitsgrowthprospectswere limited. Future growthwould have to come fromincreases in sales at existingstores or growth through itsfranchise business. Build-A-Bear was near its saturationpoint in terms of possiblelocations that met itsrequirements, indicatinggrowth from new stores

wouldbemarginalatbest.In other cases, it is more

difficult to discern the futuregrowth prospects of abusiness. In the case ofhomebuilders, forexample, itis not easy to forecast futuredemand, interest rates, andsupply cost increases. Youwould need to have a handleon all those elements beforeyoucouldforecastgrowthforabusinessinthisindustry.

Tounderstandthesourceofearnings growth, compare itto another relevant metric atthe business. For example,the earnings of a railroadbusiness may be increasing,but if revenue ton-miles(basically a calculation oftotal cargo weight timesnumber of miles shipped) isnot increasing, this wouldimply thereareother sourcesof earnings growth. Place

earnings growth next to thespecificmetric of a business,as shown in Table 10.1, forrailroad company NorfolkSouthern.5

Table10.1ComparisonofOperatingMetrictoEPS

In this case, we arecomparing revenue ton-miles

to earnings per share (EPS).You can generally see fromTable 10.1 that as revenueton-miles drop, sodoesEPS.If instead, EPS increasedwhen revenue ton-milesdecreased, then this mightindicate that the business isresorting toother thingssuchas cost cutting to increaseEPS. These are lesssustainable sources ofearningsgrowth.

To forecast potentialgrowth, youmust understandifthereareseculartrendsthatwill help a business prosperbyfuelingdemand.Youmustalso know if the businessinvests in innovation todevelop new products orservices.A growing businessis one that expands itscustomer base or sells moretoexistingcustomers.

IstheBusinessGrowingBecauseofSecularTrends?

Secular growth trends aresustained trends driven bydemographic or socialchanges. These demographicor social changes can createan extended period ofdemand for products orservices. For example, thinkof the growth in the number

of women entering theworkforce: From 1948 to2000, women grew from 29percent of the workforce in1948 to about 50 percent by2000.6 This was a socialchange, and it drove thesecular trends of womenpurchasing more workplaceclothing, the growth inpopularity of frozen foods(because there was limitedtime to cook a meal), and

other social changes causedby women having lessavailabletime.Be certain to distinguish

between this kind of long-termgrowthandshorter-termcyclicalchanges.Theseshort-term changes are also calledbusinesscyclechanges: theseare the ups and downs thatare associated with growthand contraction in the widereconomy. The earnings of a

cyclical business, such as asteel manufacturer, areespecially sensitive tobusiness cycles, and changewith swings in the economy.(Non-cyclical businessesdon’ttendtogoupanddownwiththeeconomy.)Ifabusinessbenefitsfroma

secular growth trend, itsgrowth is longer lasting thana single business cycle.Secular growth continues

through a business cycle. Infact, earnings-per-share ofbusinesses riding seculargrowthtrendstendtopeakateach succeeding majorbusinesscycle.Also, be careful to

distinguish rising commodityprices from secular growthtrends. For example, an oiland gas firm may showrevenue growth due to therise in the price of oil rather

than an increase in theamount of products sold.Study the price of theunderlyingcommodityfortheindustryoverat least threetofive years in order todetermine the percentage ofrevenue increases ordecreases that are comingfrom changes in commodityprices versus changes in unitgrowth.To better understand

investing in growingbusinesses, I studied theinvestorswhohavebeenmostsuccessful at identifyingimportant trends early on.RonBaron,founderofBaronFunds, has been verysuccessful at recognizingandprofiting from the earlyidentification of seculartrends. Baron has been anearly investor in manysuccessful businesses,

including nursing homeoperator Manor Care; casinoWynn Resorts; for-profiteducation providers DeVryand Strayer Education;staffing company RobertHalf; and online diamondretailer Blue Nile. What isparticularlyimpressiveisthathe not only invested in thesebusinesses in their infancy,buthecontinuedtoholdthesestocks over long periods of

time—infact, fordecades, inseveral instances. Hediscovered most of thesebusinesses long before theybegan their extended growthphase.Hewasabletoidentifymost of these businessesbecause they were run byentrepreneurswhohadaclearvisionfortheopportunitiesoftheir businesses, whereasskeptics did not seeopportunity. As Baron often

says, “We invest in peoplenotjustbuildings.”For example, Baron

invested early on with MarkVadon,founderofBlueNile.Vadonbelieved thatnotonlywould wholesale diamonddistributors place theirinventory on his online retailsite, but also that consumerswould purchase these high-end products online. Otherinvestors were skeptical, but

asVadonbypassedtraditionalretail channels and decreasedthe price consumers paid,BlueNilebecamepartof thefirst wave of successfulInternetretailers.To identify secular growth

trends,Baronaskswhetheranindustry is one where yourchildrenorgrandchildrenwillwork, or if it is one whereyourparentsandgrandparentsworked. His firm looks for

those industries that arepositioned tohave strong jobgrowthoverthenext5,10,or20 years, and then his firmsearches for the bestcompaniesinthoseindustries.Today,hisfirmisinvestingininnovativebusinessesthatareaddressing the biggestchallenges on the horizon,such as battery-poweredtransportation and alternativeenergy.

Other examples of seculargrowthtrendsinclude:

The shift in advertisingdollars from traditionalmedia (such as cableTV) to online channelshas helped fuel thegrowthofInternetsearchbusinessGoogle.Anincreasingnumberofyoung professionals aredeferring havingchildren and instead

purchasing pets, whichbenefits businesses thatsell products foranimals, such as petstore retailers PetSmartandPETCO.More than ever, peopleneedacollegedegree toget good jobs. This hasbenefited for-profiteducation providers,such as StrayerEducation and Apollo

Group.You need to identify and

measure the secular growthtrendsthatpotentiallysupportthegrowthof thebusiness inwhich you are consideringinvesting. Begin byresearching the underlyingtrends supporting seculargrowth. Try to draw specificinsights rather than focusingonbroad themes such as “anaging baby boomer

population will fuel thedemand for nursing homes.”For example, if a businesssells to 20- to 25-year-oldmales, then you wouldresearch this group tounderstand how they thinkand shop. There are varioussourcesyoucanturnto,suchastheresearchproductsfrom:

Market research firmsEuromonitororMintelPolling firmsHarris and

MaritzWebsites such astrendwatching.comRegional demographicsources such as ESRIBusiness InformationSolutionsMagazines such asAdvertisingAge

You can view MarketResearchWorld’s website tolocate substantial summariesof these kinds of reports and

other studies conducted byleading market researchfirms.Forexample, inWho’sBuying Groceries from theWho’sBuyingseries,youwillfind such information as thefact that household spendingon tea rose 28 percentbetween2000and2005.Youcan also get a breakdown ofthe buying patterns of eachdifferent age group: people25–34yearsoldspent$16.44

on tea in 2005,while people35 to 44 years old spent$28.08.7 Most of thesesources extrapolateinformationfromgovernmentdata: For instance, the teacalculationsarebasedondatafrom the Bureau of LaborStatistics ConsumerExpenditureSurvey.Any business school’s

library will give you currentlinks to market research and

demographicscontentsites.

InnovationA growth business mustalways look fornewways tosupplement its growth. Forexample, eight years after itsDOS operating system cameout, Microsoft supplementedthat growth by introducingWindows Office, which in2009 accounted for 40

percentofitsearnings.8

IsInnovationaManagementPriority?

Monitor management’scommitment toResearch andDevelopment (R&D) byobserving R&D expensesover time. Calculate thepercentage of sales spent onR&Dexpenses.

For example, IDEXXLaboratories (a leadingprovider of veterinary testingand diagnostic products) hasspentmore than 6 percent ofits revenues on R&D since1992, to improve its existingproducts and develop newones. From 2007 to 2009,IDEXXinvestedcloseto$70millioninR&D—whichis12times more than its nearestcompetitor and nearly seven

times more than all of itscompetitors combined. Thisenables the business tocontinually improve thequality of its veterinarydiagnosticsandtocontinuallywiden its competitiveadvantage. In fact, IDEXXcontrolsmorethan65percentofitsmarket,andit’snowthelargest global player in thereferencelabmarket.9

AreR&DEffortsSuccessful?

Just because a businessspends a large percentage ofrevenue on R&D does notmean that it will createsuccessful products. ClaytonChristensen, a professor atHarvard who has studiedinnovation extensively,reminds us of two rathersubtle things about R&D

spending. First, mostinnovation starts out in thewrong direction: Therefore,spendingmoremoneyupfrontcan mean more wastedmoney. Second,breakthroughstendtohappenwhen resources are mostscarce. Christensen estimatesthat 93 percent of ultimatelysuccessful innovationsactuallystartoutinthewrongdirection:

The probability thatyou’llgetitrightthefirsttime out of the gate isvery low.So, ifyougivepeople a lot ofmoney, itgives them the privilegeof pursuing the wrongstrategy for a very longtime.10

So, rather than just lookingat how much is spent, youwill need to evaluate howsuccessful past R&D

investments have been. Thebest way to do this is tocalculate the percentage ofsales that come from newinnovations. For example,Graco, apumpmanufacturer,spends3percent to4percentof its revenues annually onR&D expenses. It strives togenerate 30 percent of itsannual sales from productsintroduced in the previousthree years, and comes very

close to achieving thosegoals: In 2007, 2008, and2009, Graco generated 21percent, 26 percent, and 26percentof its sales fromnewproducts.11

Medical device makerMedtronic has spent anaverage of 10 percent of itssales dollars on R&Dprogramssince1990,12whichis comparable to most of itscompetitors that spend

between 8 percent and 12percent of their sales dollarsonR&Dprograms.However,the company’s success increating new medicalproducts differs markedly.For example, Medtronic hasconsistently controlled closeto 50 percent of the cardiacpacemaker market byconstantly investing in newtechnologies and being thefirst to market with new

products.Asaresult,mostofMedtronic’scompetitorshavenot been able to takemarketshare away. Medtronic hasalso spent a large portion ofits historical R&D onemerging technologies inneuromodulation, diabetes,and spinal products. Theinvestments made from themiddle to late1990s in thesethree areas have increasedMedtronic’s revenue from

theseareasfrom25percentoftotal sales in FY 2000 to 40percent in FY 2010, and hasgiven Medtronic a dominantmarketpositioninthesethreeareas.Medtronic’sbone-graftproduct, for example,dominates the spinal market.Clearly, Medtronic has asuccessfulR&Dpipeline thatleads to new products.13 Byexamining the percentage ofsales generated by new

products and services, youcan understand whethermanagement has successfullyinvestedinR&D.

DoestheBusinessGrowByDevelopingTransformationalProductsandServices?

It is extremely difficult to

project demand for newproducts.Themaindifficultyis that you have no existingpattern to extrapolate from.Even if you have very earlysales data, it is common tounder-orover-estimateit.Asyou do attempt to estimatedemand for new products,keep in mind that most newproductlaunchesfail.InnovatorssuchasAppleor

Google are the toughest

businesses to forecast,because their products andservices are transformative.These businesses came todominatetheirindustriesveryquickly. Because thesebusinesses created entirelynew markets, there was noprecedenttouseasabasisforareasonableforecast.For example, it was

difficultformostinvestorstoestimatewhatthefuturesales

of the Apple iPhone wouldbe.Bytheendof2010,Applehad sold nearly 90 millioniPhones according to bothApple andGartner Research.Apple also sold more thanthree million iPad tablets inlessthanthreemonths,whichis the fastest consumerelectronics product in historyto reach the $1 billionrevenue mark. Most WallStreet forecasts were

substantiallylower.To further illustrate the

forecasting problem, evenNintendo failed to anticipatethesuccessofitsowngamingconsole Wii in November2006, which created productshortages. So how can youevaluate whether thesecompanies are worthinvesting in,when so little isknown about thetransformative products

they’recomingoutwith?First,youcansurveytarget

customers, by calling upfriendswho use the productsor finding message boardswhere customers discuss theproduct to understand whatthey think about the newproduct or service. Be sureyou survey them after theyhave tried out the product orservice for at least threemonthsorso.Hadyoutalked

with early iPhone or Wiipurchasers, you would haveheard extremely positiveresponses.WhentheWiifirstcame out, I spoke with 15parents of teenage kids Iknewthroughoutthecountry.I asked them if their kidswere requesting the Wii andwhether their kids’ friendswere buying them too. I alsointerviewed salespeople atfive different electronics

stores located in Austin,Texas, where the productswere sold to ask them if theproducts were selling well.The answers were consistentthattheWiiwasahitproductand would likely generateincreased sales at Nintendo,making it a potentially goodinvestmentopportunity.

UsingMarketShare

FigurestoExtrapolatea

Company’sPotentialGrowth

To evaluate a company’sgrowth prospects, manyanalysts and industryassociations make someestimate of the total size ofthe market and thendetermine the targetcompany’s percentage of it.

They then determine if abusiness has substantialgrowthprospectsbasedonitsmarketshare.Todo this,startbyreading

thesectionofthe10-KreporttitledIndustryorMarketSize.The management team willoften disclose the size of themarket and its share of themarketinthissection.For example, Immucor, a

blood testing-instrument

maker, estimated in its 10-Kreport (dated May 31, 2010)that the worldwide bloodbanking reagent andinstrument market generates$1.2 billion in sales eachyear. Immucor’s sales at thattime were $329 million,indicating that Immucor had27 percent share of themarket. This indicates thatImmucor has plenty ofopportunities to grow and

increaseitsearningsinfutureyears, which potentiallymakes it a good investmentopportunity.However, you also need to

becautiousaboutacceptingatface value the market shareestimatesthatareprovidedbythe management team orindustry associations. It isalways best to assume thatbusinesses have an incentivetoreportamarketsizethatis

larger than it really is.Instead, figure out howmarket share figures arecalculated. Read howcompetitors estimate the sizeof the market and whetherthey are using the sameyardstick and the samemarketdefinition.In the case of mature

markets, there are severalthings to be aware of. First,make sure the market size

hasn’t magically expanded.Readatleast5to10yearsof10-Ks to understand if abusinesshaschangedthewayit calculates its market shareor defines its market. Forexample, one business-services company that hadeffectively saturated theuniverse of large businesscustomers began to includemid-sized businesses as partof its potential market size,

even though these smallerbusinesses had less incentiveto buy and use thiscompany’sproduct.In another example, I

noticed that a medical wastebusiness that I followedreported less market shareone year, even as it hadgrown to be the dominantU.S. medical waste disposalcompany. As the companyhad expanded into

international markets, itbegan to report a smallernumber that reflected itsglobal market share, and bydoing so, they showedsignificantly moreopportunity for growth. Newmarkets, however, aredifferent markets, and mustbe evaluated separately interms of potential to growrevenues and in terms ofpotentialprofits.

Youalsowanttowatchoutfor shrinking effectivemarkets,whichmay increasethe market share ofincumbents. For example,Darling International is thelargest U.S. renderingcompany,which collects andprocesses animal by-productsto create the ingredients forthings like soap, chemicals,and rubber. When my firmcalculated Darling’s market

share, we noted that itincreased every year. Whatwe found was the effectivemarket size was shrinking.There was just as muchrendering going on, but assmaller ranches andslaughterhouses were boughtby larger companies (whichdo their own rendering in-house), there were simplyfewersmalloperationsleft tochoose between Darling

International and itscompetitors. DarlingInternational was increasingitsmarketshare,butitdidsowithin a shrinking marketwithfewertotalcustomers.Youalsoneedtowatchout

for overlapping segments,distribution, and geography.For example, when my firmwas analyzing the marketshare size ofWesternUnion,there were several

confounding factors in play.Afterfindingseveraldifferentestimates and measures ofhow much money actuallycrosses international borders,my firm looked in depth atthe sources of the estimates:We compared informationfrom national banks, U.S.government agencies, theInternationalMonetary Fund,theWorldBank, think tanks,and scholarly studies. We

discovered thatunderreporting in thisindustry is a predictablenorm, making it difficult toestimate the true size of themarket.Inonecase,whatfirstappeared tobean increase inoverallmarketsizeturnedoutto be a change in the wayWestern Union’s own datawas incorporated into thenational estimate. In otherwords, nothing had changed,

but because the new marketsize estimateswerebigger, itappeared Western Union’smarket share had shrunk—which might have ledinvestors to avoid WesternUnion. Yet the maincomplicating factor is thelargeblackmarketformoneytransfer, or the informalsegment.Wenowthinkoftheinformal segment as anothercompetitor, and note that

Western Union’s growthoften comes from takingmarket share from thissegment.

WatchforSignsThatGrowthIsSlowing

There are many signs that abusiness’s growth may beslowing,includingthese:

Targeting a newcustomerbase.

Attemptingtochangeitsbusinessmodel.Paying out a largerpercentage of itsearningsintheformofadividend.

Let’s look at each of thesesignsinmoredetail.

Whenabusinesstargetsanewcustomerbase

When a business begins totarget a new customer base,this is often a tell-tale signthat its core business isstartingtoslow.Forexample,Apollo Group, a for-profituniversity, piloted a newprogram in 2004 to target anew customer when thegrowth of its core business,the University of Phoenix,began to slow. It created anational online community

college named Axia Collegeto target students seekingassociatesdegrees. Insteadofserving its core customer ofworking adults in their late20s to early 30s who seekbachelor degrees, Axiatargeted students who were18 to 23 years old.15 By theend of 2010, Axia collegestudents represented nearly50percentofthetotalstudentpopulationatApolloGroup.

However,eventhoughAxiahas been a fast-growingdivision of Apollo Group,AxiagenerateslessprofitsforApollo Group than theUniversity of Phoenixbecause the students at Axiarepresenthalfthecredithourscompared to bachelor-degreestudents.Furthermore,Apollohad lower receivablescollection rates from Axiastudents. The increase in

receivables from associate-level students constituted themajority of the bad-debtexpense at Apollo. This isbecauseAxiastudentstendtodropoutatahigherrate thanthe traditional bachelorstudents.16FromAugust2005toAugust2010,theoperatingmargin dropped from 31percent to 27.9 percent.17Therefore, even thoughApollo Group has been able

to offset some of its slowinggrowth with growth from anew customer base, this newcustomer base contributessubstantially less to profitsthan its traditional corecustomer.

WhenabusinesschangesitscorebusinessmodelAnother way to recognize if

growth is slowing is when abusiness begins to change itscore business model. Forexample, computermanufacturer Dell has beenchanging its business modelfrom manufacturingcomputers to providingcomputer services. Dell hasmade several acquisitions inthis area, such as its $3.9billion purchase of PerotSystems. This new business

strategy indicates that Dell’score business of sellingcomputer hardware isdeclining.

WhenabusinessbeginspayingouthigherdividendsAnothersignalabusinesshaslimited growth prospects is ahigh dividend-payout ratio,suchaswhenabusinesspays

out more than 30 percent ofits earnings in the form of adividend.Youcancalculateadividend-payout ratio bytakingthedividendspaidbyabusiness and dividing thatnumberbytheearningsofthebusiness.For example, chocolate

maker Hershey Companypaid out 50 percent of itsearningsindividendsin2010,whichisatypicalpayoutratio

for businesses in theconsumer staples industry.Reynolds American, acigarette manufacturer, paidout more than 75 percent ofits earnings in 2010 andincreased its payout to morethan80percentofearningsin2011. Clearly, the growthprospects of both of thesebusinesses are not as high asthey were in the past, andbothcompanies’management

teams believe they do notneed to reinvest the earningsbackintothebusiness.

BewareofPayingTooHighaPricefor

GrowthA growth company usuallyhas a premium price-to-earnings ratio (P/E) attachedtoit.Thereasonisthatwheninvestors expect growth in

earnings, they are willing topaymore,whichincreasestheP/E. For example, youmightbuyabusinessthattradesataP/E ratio of 20 times thatearns$1pershare.Ifitisableto double its earnings in thenext year, then you areeffectively only paying 10timesnextyear’searnings.Avoid paying a high

multiple for a business,because if expected earnings

growthslows, thestockpricewill drop. For example, thestockpriceof Internet searchbusiness Google was flatfrom October 2007 toOctober 2010, even thoughearnings per share (EPS)grew from $13.50 per shareto$25pershareduringthosethree years. Themain reasonthestockpricestayedflatwasthatinvestorswereconcernedthatgrowthwasslowing,and

theywere unwilling to pay ahigher price for slowedgrowth.InGoogle’scase,theP/Emultipledroppedfrom45times to 21 times during thisperiod.18 Now that GoogletradesatalowerP/Emultipleit may be a good investmentopportunity,especially ifyoubelieve that Google cancontinue to grow its EPS athistoricalrates.Ifyoubelievethat Google’s EPS will not

grow in the next severalyears,thenyouneedtopayalowerP/Emultiple.On the other hand, if you

pay a high price, and thebusinesscontinuestogrowitsearnings at a rapid rate, thenthe growth will eventuallybail you out.When my firmfirst began buying grocerWhole Foods Market, wepaid 20 times adjusted EPSfor our initial purchases, at

$40 per share. We believedthat the high growth rate ofWhole Foods Market wouldincrease the earnings of thebusiness and we wereeffectively paying a lowermultipleforthebusiness.Forthe next two years, theearningsgrowthsloweddownasweenteredtherecessionin2007 and the stock pricedecreasedtoaslowas$8pershare. The earnings then

resumed their historicalgrowth rate and the stockprice rose to more than $50persharebytheendof2010.Even though it was delayed,theearningsgrowthmadeupforthehighpricewepaidforourinitialpurchases.

IstheManagementTeamThatWasResponsiblefor

HistoricalGrowthStillLeadingthe

Business?If a business has grown formanyyears,itisimportanttomake sure that themanagement team that wasresponsibleforthatgrowthisstill intact. When forecastinggrowth, some investorsmakethemistake of assuming thatthebusinessisgeneratingthe

growth regardless of themanagement team. If themanagement teamchanges inamaterialway,thenthereisarisk in extrapolating frompast growth. For example, inthe case of Apple, investorsare clearly interested inexactly who is running thecompany, and concern aboutSteve Job’s health directlyaffectsthepriceofthestock.

57.Isthemanagementteamgrowingthebusinesstooquicklyoratasteadypace?

Investors often mistake fast-growing businesses for goodinvestments. In fact,

businesses growing tooquicklyareamongtheriskiestinvestments, because thegrowth is not controlled.Furthermore, a business orindustry that has steep ratherthan gradual growthcharacteristics attracts morecompetition, which can alsodrivedownprofitability.You need to determine if

the management team isfollowing a disciplined or

undisciplined growthstrategy. A high rate ofgrowth does not guaranteeprofitability, especially if themanagement team followsanundisciplined growthstrategy. If the company isgrowinginadisciplinedway,then the management teamwill be able to control thegrowth, creating more value.The following sectionsdescribe indicators you can

use to determine whether abusiness is growing in adisciplinedmanner or if it isgrowingtooquickly.

IstheBusinessGrowingwithinIts

Means?Businessesthatusetheirowncash to grow have moresustainable growth comparedto those that finance growth

by issuing debt or equity.First, internally generatedcashflowisacheapersourceof capital compared to debtand equity. Second, abusinessisnotexposedtothevagaries of the capitalmarkets, such as when thedebt markets froze up in2008. You can estimate howquickly a business can growusing internal funds bycalculatingthelengthoftime

abusiness’scashistiedupinworkingcapital.To do this, calculate the

cash-conversion cycle (CCC)for the business. The CCCmeasures the length of timemoneyistiedupinabusinessbefore that money is finallyreturnedwhencustomerspayfor the products. It iscalculated by adding andsubtractingthefollowing:

Thenumberofdaysthat

inventory is outstanding(DIO)Plus thenumberofdaysthatsalesareoutstanding(DSO)Minus the number ofdays that payables areoutstanding(DPO)

The lower the number ofdays in theCCC, thefasterabusiness can redeploy itsinternal free cash flows intogrowthbecauselesscapitalis

tiedupininventoryorcapitalequipment.For example, homebuilders

have to continually borrowmoneybecausetheytypicallydo not have cash on hand togrow their business becausetheir CCC cycles range from200to400days.Ontheotherhand, a software businesstypically has a CCC of 10days, which allows it tocollect and fund a large part

of its growth with internalfree-cash flow.Asa result, asoftware business has lowerriskbecauseitcanfinanceitsgrowth internally and is notdependentonoutside sourcesof capital to grow itsbusiness.Warren Eisenberg and

Leonard Feinstein, thefounders of housewaresretailer BedBath&Beyond,had a golden rule that they

would never use debt tofinancetheirexpansion.Theywouldonlyopenanewstorewhen they had the capital todo it. As a result, during thefirst decade, growth wasslow: The company startedwith one store in 1971 andgrew to 37 stores in 1992,when Bed Bath & Beyondwentpublic.Bytheendoftheninthyearaftergoingpublic,the store count increased 10-

fold without the use of debt,and the market valueincreased20-fold.19

IstheBusinessGrowingatthe

ExpenseofShort-TermEarnings?

When a business is growing,expenses typically grow at afaster rate than revenues,which negatively impacts

short-term earnings. Forexample, when a cablebusiness first enters a newmarket, it has to make largefront-end investments toinstall the cable. Most ofthese expenditures are madebefore the cable company isable to sign up subscribersand generate revenue. As aresult, in the first couple ofyears, depreciation andinterest expenses represent a

high percentage of revenues,and the businesswill operateat a loss. However, as thecable business addssubscribers, by the third orfifth year, the profit marginsbegin to increase, and cashflows turn positive.Therefore,whenabusinessisgrowing,itmaymaskthetrueunderlyingfree-cashflowsofthebusiness.For example,WholeFoods

Market invested themajorityof its discretionary free-cashflow in new store openings.These expenditures in newstoresmaskedthestrongfree-cash flows thatWholeFoodsMarket’s core business wasgenerating. As a result, itappeared that Whole FoodsMarketwas tradingat ahighprice-to-earnings multiple,when effectively, it wastrading at a lower multiple.

When new store openingsslowed, the high free-cashflows were revealed. Forexample, in September 2008,cash flow from operationswas $335 million; one yearlater, in September 2009,when new store openingsslowed, cash flow fromoperations had increased to$587million.When evaluating the

earnings of a growing

business, you need todetermine if themanagementteamisinvestingforthelong-term at the expense of short-termearnings.Todothis,youmust understand whenprofitability is reached withnew investments. Forexample,atStrayerEducation(the for-profit university forworking adults), a newcampus reaches profitabilitybytheendofthesecondyear.

Therefore, investments innew campusesmade in 2010will not be profitable until2013. By understanding howlongittakesaninvestmenttobecome profitable, you willknow that the start-up lossesfrom new campuses willnegatively impact earningsfor a two- to three-yearperiod,andyoucanadjusttheearnings. As the base ofcampuses that are profitable

grows larger and larger, thestart-up losses from newcampuses have less effect onearnings. For example, in2003, Strayer opened threenew campuses on a base of14, so these new campuseshad a greater impact on theearnings of the business thanwhen it opened 11 newcampusesoffabaseof60.Therefore,when evaluating

abusinessthatisgrowingyou

needtoadjusttheearningsofthe business to account forthe impact of higher short-term expenses in order tocalculate the true earnings ofabusiness.

IstheBusinessGrowingwithintheLimitsofItsHuman

Capital?How fast a business grows

canbe limitedbyhow fast itcan add employees. Ifrevenuesgrowatarateof30percentormoreayear,andabusiness needs to grow thenumber of employees at thesame rate, a business wouldhave to double its employeecount every 2.5 years. Notonlywouldthebusinesshaveto retain existing employees,butitwouldalsoneedtohireand train new employees.

Thiscancreatemanyrisks.Itis therefore critical for abusiness to grow at a ratewhere it does not outstrip itsability to hire qualifiedemployees.Spirit Airlines was known

for offering low fares in theFloridamarket,offeringfaresas low as $9 one-way. Spiritgrewquickly,addingasmanyas13destinationsinoneyear.Unfortunately, Spirit also

grew beyond the capacity ofits employee base, withcustomers complaining thatSpirit lacked enough peopleto staff its ticket counters,reservations, and customer-servicecenters.Atonepoint,Spirit had more complaintsthananyotherairline. In thiscase, the customers were, ofcourse, right. If you checkedU.S. Department ofTransportation data from

2006andcomparedemployeecountstonumbersofaircraft,you would see that Spirit’slow-fare competitors had 77employees per aircraft,whereas Spirit had only 61employees per aircraft.Clearly, Spirit Airlinesattempted to grow tooquickly,withoutmaking sureithadthepersonneltogrow.20

It is critical for a businessto have enough talented

employees to execute itsgrowth strategies. Thisprovides a strong foundationfor the growth and makes itmore sustainable. At StrayerEducation, the number ofcampuses that it opens islimited by the number ofleadership teams it hasinternallythatcanstaff them.Strayer does not rely onhiring outsiders to grow;instead, Strayer promotes

from within. It looks at itsinternal staff and determineswhich people have theleadership skills to take onhigher-level assignments.Oncemanagementfiguresouthowmanyleadersithas,thenit determines the number ofcampuses it shouldopen inagiven year.21 This strategyfrustratesmanyinvestorswhobelievethatStrayercangrowata fasterpace;nevertheless,

this strategy ensures thesustainability of Strayer’sgrowth.

DoestheBusinessHavetheProperInfrastructureto

Grow?You can think about acorporate infrastructure as allthe things that are necessaryto support the growth of

adding new employees,increasing inventory, orbuildingnew sites.There arefourbroad typesofcorporateinfrastructure that supportgrowth:

1. The finance areamanages the flow ofmoney throughaccounting, treasury, tax,and regulatorydepartments.2. The operations area

controls the sales,distribution systems, callcenter, ordering systems,manufacturing facilities,legal, communications,policy and planning,administration, projectmanagement, and healthand safety. For example,if a retail store is havingdifficulty obtaininginventory, it will contactpeople within the

operationsarea.3. Human resourceshandles recruiting,payroll, and benefits foremployees.4.Technology handles allof the informationtechnology for thebusiness, such asnetworking andcomputingsystems.

In 1987, airline companyUSAir bought Pacific

Southwest Air for $385millioninorder toexpanditsroutes to the West coast.Shortly thereafter, USAirbought Piedmont for $1.6billion,which tripled thesizeof USAir. After acquiringboth businesses, USAirlearned that its informationsystems could not handle theincreased traffic that camefrom acquiring Piedmont.Computers broke down

regularly, customer servicesuffered, and even flightcrewswere scheduled on thewrong days. USAir hadclearlyoutgrownitscorporateinfrastructure. This causedprofitabilityatUSAirtodropfrom6to7percentagepointshigher than the industryaverage before themerger to2.6pointsbelow the industryaverageafterthemerger.22Soif you were considering

investing in an airline in the1980s, you should probablyhave passed on USAirbecause it was growingbeyonditsinfrastructure.

IstheBusinessFindingtheRight

Locations?The best management teamsin the retail industry expandtheir store base

opportunistically rather thansettingaspecificgoaltoopena certain number of storeswithin a certain amount oftime. When the managementteamfollowsanopportunisticstrategy, management waitsfortherightlocation,suchasa corner on a busyintersection, instead ofinstructing its real estatedepartment to find a certainnumberoflocationsinacity.

In contrast, when amanagement team sets aspecific goal of finding acertain number of locations,therealestatedepartmentwilllook for locations that areavailable instead of lookingfor ideal locations. Byfollowing this strategy, themanagement team is creatingproblemsbecauseafewyearsdown the road, the companymayhave todevote timeand

significant expenses toclosing unproductivelocations. This is equivalentto taking two steps forwardandonestepbackward.Tilman Fertitta, Chairman

and founder of restaurantchainLandry’s,confirms thisidea:“You need to grow, butyou can’t grow at such apacethatyoustarthavingsecondary locations. And

that is what everybodyseems to do.” Landry’sonceopened40 locationsfor restaurant chain Joe’sCrab Shack in a singleyear, and later sold thechain. Fertitta admits, “Ifyou look at theperformance of those 40stores, [they represented].. .theworstyearofanyopenings.”23

Organic grocer Whole

FoodsMarket also follows adisciplined store-openingstrategy by not opening astore until it finds an ideallocation.Forexample,ittookWhole Foods Market 10years to find a suitable sitefor its first store in SanFrancisco, California. As aresultofitscarefulexpansionstrategy, Whole FoodsMarket has not closed anystoresthatithasopenedsince

itwasfounded.JimSud,VicePresident of StoreDevelopmentatWholeFoodsMarket, summed up thecompany’s strategy during afourth quarter 2010conferencecall:We’re not going to justsign stores to hit somekindofgrowthnumberorsome kind of percentageor some kind of target.We’re going to sign

stores if we find goodlocations that we thinkaregoing todelivergoodreturns on capital for us.And we’re not going todoitartificiallyjusttohitsomekindofexpectation.Now it’s a question ofreally finding locationsthat meet our very strictcriteria. We’re still veryproud of the fact that inour 30-plus year history,

we’ve never had a storethatwe opened ourselvesever fail. Sowe’re reallydetermined to keep thattrackrecordalive.

KeyPointstoKeepinMind

The mainadvantage ofinvestinginagrowingbusiness is

that you canreceive thebenefits oftax-deferredcompounding.What makesa businessattractive isnottherateitcan grow inany singleyear, but thenumber ofyears it cangrow at anyrate.Businesses

that use theirown cash togrow havemoresustainablegrowthcompared tothose thatfinancegrowth byissuing debtorequity.Businessesthat groworganicallycarry lessrisk than

those thatdepend onacquisitionsin order togrow.Beconcernedwhenmanagementis underpressure togrow. Signsof pressureincludelaunchingnewinitiatives

and buyingbusinessesoutsideofthecompany’sarea ofexpertise.Growth ismoresustainable ifit issupported byinnovationsor secularindustrytrends. Tohelp youidentify

seculargrowth,thinkabout theindustry’sjob-growthpotential.Ask yourselfif theindustry isone whereyourchildrenorgrandchildrenwillwork.You need tobe carefulwhen

forming yourfuturegrowthexpectationsfromthepastsuccess ofthe business.Remember,you do notprofit fromyesterday’sgrowth.Avoidpayingahighmultipleforagrowingbusiness,because if

expectedearningsgrowthslows, thestock pricewilldrop.You canidentify abusinesswhosegrowth isslowing bylearning ifthe businessis targeting anewcustomer

base,changing itsbusinessmodel, orpaying out alargerpercentageofits earningsin the formof adividend.Growingbusinesseshave highershort-termexpenses:Adjust

earningsaccordinglyto get a truepicture ofunderlyingearnings.

1.StandardandPoor’sCapitalIQ.2.Ibid.3.Ibid.4.StrayerEducationAnnualReport2009,RobertSilberman.

5.NorfolkSouthern2009AnnualReport.6.Toossi,Mitra.“ACenturyofChange:theU.S.LaborForce,1950–2050.”MonthlyLaborReview,May2002.AccessedMay11,2011.http://www.bls.gov/opub/mlr/7.“Tea.”Who’sBuyingGroceries,5thed.,Ithaca,NY;NewStrategistPublications,Inc.2007.

8.Copeland,Michael,withSethWeintraub,“Google’sNextAct.”Fortune,August16,2010.9.Standard&Poor’sCapitalIQ;IDEXX10-Kreports,2006to2009.10.Mangelsdorf,MarthaE.InterviewwithClaytonM.Christensenin“GoodDaysforDisruptors.”MITSloanManagementReview50(2009):67–70.

11.Graco200910-K.12.Standard&Poor’sCapitalIQ.13.Medtronic10-Kreports,1992to2010.14.MoneyGramInternational2007AnalystDayTranscript-Final,FairDisclosureWire,March7,2007;Ersek,Hikmet(WesternUnionCEO),CreditSuisseGroupTechnologyConference

Transcript,FairDisclosureWire,December1,2010.15.Q42006ApolloEarningsConferenceCall,October18,2006;Standard&Poor’sCapitalIQ.16.March29,2010ApolloGroupConferenceCall,FairDisclosureWire.17.Standard&Poor’sCapitalIQ.18.Ibid.19.Standard&Poor’s

CapitalIQ;GivernyCapital’sFrancoisRochon;BedBath&Beyond10-Kreports,1995to2001.20.Stieghorst,Tom.“Cheapfares,ShortStaffMeanLongDelaysforSpiritAirlines.”SouthFloridaSun-Sentinal,September30,2007.21.StrayerAnnualReports,from2001to2009.22.Carroll,PaulB.,and

ChunkaMui.“7WaystoFailBig:LessonsfromtheMostInexcusableBusinessFailuresofthePast25Years.”HarvardBusinessReview,September2008.23.Ruggless,Ron.“HavingWordswithTilmanFertitta,ChairmanandFounder,Landry’sInc.”Nation’sRestaurantNews,October25,2010,p.42.

CHAPTER11

EvaluatingMergers&Acquisitions

In the quest for greatergrowth and profits, many

management teams seemergers and acquisitions(M&A) as a surefire way toexpand their businessempires. And they are oftenwilling to pay any price tosecure a short-term victory.M&A activity can representserious risks to a businessbecause poorly executed orundisciplined M&A hasproventobeoneofthefastestways a business can destroy

value.Asaninvestor,howdoyou evaluate whether acompany’s M&A activitiesare creating or destroyingvalue?One way of evaluating

M&A activity is tounderstand the motivation ofmanagement: Why is seniormanagementmergingwithoracquiring another company?Another is to evaluatewhether past acquisitions

were successful by using alist of seven questions(discussed in this chapter) togain insight intomanagement’s rationale formaking acquisitions. Thiswayyoucanforecastwhetherfuture M&A decisions willadd value to the business—and therefore, whether thatbusiness is a worthwhileinvestmentforyou.

58.HowdoesmanagementmakeM&Adecisions?

It is critical to understandhow management makesmerger and acquisitiondecisions.ToddGreen,seniormanaging director ofinvestment management firm

FirstManhattan,suggestsitisfrequently as important tounderstand how acquisitiondecisionsaremadeas it is tounderstand why they aremade. Green saysunderstanding howmanagement thinks aboutacquisitionsisoneofthefewconcretewaysforinvestorstoreduce uncertainty inassessing a company’schancesofsuccess.

Greenbelievesthat,withsomany variables in trying topredict where a company isgoing to be five years fromnow (such as where theeconomy is going to be,where future interest rateswill be, andwhat input costswill be) the one tangiblefactor where you candecrease the uncertainty inthe process is inunderstanding how a

management team thinksabout acquisitions. In otherwords, what were theythinking: What did they seeaspotentialbenefits?Green learned thisvaluable

lesson at one of the firstmeetings he attended afterjoining First Manhattan in1981 out of ColumbiaBusiness School. Themeeting was with the chiefexecutive officer (CEO) and

chief financial officer (CFO)of a newspaper publishingand TV broadcastingbusiness. There were 15people gathered around aconferencetable,readytoaskquestions.Greenhaddonehishomework on the companyandwas eager to learnmore.Art Zankel, senior partner atFirstManhattan,proceededtoquestion management aboutanearlieracquisitionthatwas

relativelysmall.Zankelspentan hour and a half askingmanagementaboutthemerits,prospects,costs,andtherisksof theacquisition.Greenwassurprised that Zankel did notspend any time talking aboutthe publishing business,whichrepresentedthebulkofthevalueofthecompany.After the meeting, Green

asked Zankel why he wouldspend an hour and a half

asking about such a smallacquisition. Zankel said, “Ifyou can understand therationalebehinda$30millionacquisition today, you’llprobably be in a betterposition to predict orunderstand the rationalebehind a $300 millionacquisition they make nextyear or a $3 billionacquisition that they makefive years from now.” This

taught Green that one of themost important parts of theresearch process is to putoneself in the shoes of thepeoplemakingtheacquisitionor capital-allocationdecisions. By understandingtheir thinking in the past, hecould evaluate how theymightactinthefuture.Green used this lesson to

evaluateanewCEOofoneofhis core holdings. As Green

gottoknowthenewCEO,hewas able to understand howthe CEO thought aboutacquisitions. TheCEO had ahistory of extensive M&AactivityandGreenunderstoodthatthecompanyhewasnowinvestedinwasgoingtobealot bigger in five years,mainly as a result of newacquisitions. Because heunderstood the CEO’sthinking and rationale

regardingtheprospects,costs,and risks associated withacquiring new companies,Green believed theseacquisitions had a highprobability of failure, so hesoldthatcompany’sstock.1

WhatIstheMotivationBehindanAcquisition?

By understanding the

motivation behind anacquisition, you can oftenidentify problems inmanagement’s process orthinking. There are twocommon motives or reasonsbehindanacquisition.The first is simply to

increase the size of thebusiness.Often,youwillfindmanagement teams with bigegos who want to be incharge of a larger business.

As they consider growing,CEOs and CFOs oftenbecome enamored with theacquisition process itself.These CEOs and CFOs maybeboredoroutoftouchwiththe day-to-day detailsinvolved in running theirbusiness. They may beinsulated, spending most oftheir time in corporateoffices. These CEOs andCFOs often hire investment

bankers to find acquisitiontargetsandwillthendriftintomaking acquisitions inunrelated business lines.Once begun, the process ofbuying a business is difficultfor them to stop as theybecome caught up in theexcitementofsomethingnew.Forexample,assurprisingasit may sound, the Coca-ColaCompany once went so farafield as to buy a shrimp

farm.Gilletteonceboughtanoil business. These types ofacquisitionsgenerallydestroyshareholder value becausethey tend to distractmanagement from the corebusiness. Later on,management often diveststhesesamebusinessesforlessthantheyboughtthemfor.Sometimes, of course, it

makes sense to grow thebusinessthroughacquisitions.

It is often easier and amoreeffective use of thecompany’s time to gain alarge set of customers byacquiring an entire businessrather than acquiringcustomers one at a time.There is usually less risk inthis strategy if themanagement team isacquiring a customer basethat is similar to its existingone.

The second reasonmanagement claims to makeacquisitions is when theybelieve they can improve theoperations of the acquiredbusiness. Management oftenbelieves that it can improvetheoperationsoftheacquiredbusiness through synergies,which are supposed to workby making both companiesmoreefficienttogether.Thereare typically two main types

ofsynergies:Revenue synergiesinclude cross selling tothe combined firm’scustomers, potentialaccess to new markets,or increased pricingpower due to reducedcompetition.Cost synergies includeimprovements inmargins by making theacquired firm more

efficient; reduction ofduplicate costs such ascorporate overhead;reduction inprocurementcostsduetoincreasedbuyingpower;and tax benefits. Costsynergies are usuallyeasier to realize whencompared to revenuesynergies.

For example, here’s howCaterpillar disclosed its

motivation behind acquiringBucyrus,amining-equipmentcompany:The acquisition is basedon Caterpillar’s keystrategic imperative toexpand its leadership inthe mining equipmentindustry, and positionsCaterpillar to capitalizeon the robust long-termoutlook for commoditiesdriven by the trend of

rapidgrowth inemergingmarkets which areimproving infrastructure,rapidly developing urbanareas, and industrializingtheir economies. Adrivingmotivationforthetransaction isCaterpillar’s estimate ofmorethan$400millioninannual synergiesbeginning in 2015derived from the

combined financialstrength andcomplementary productofferingsofthecombinedmining-equipmentbusinesses.2

As promising as it sounds,whenyouhearmanagersutterthe word synergy when theymake an acquisition, youshouldbeextremelyskepticalthat the cost savings orrevenue increases they

promise will materialize.There are many examples ofsynergies that have failed tomaterialize, such as whenUnited Airlines acquiredHertz car rental and WestinHotels in the 1980s. Theseacquisitions were based onthe idea that United wouldcross-sellairlines,rentalcars,and hotels to travelcustomers. The intendedrevenue synergies of cross-

selling never materializedhowever, because mostcustomers chose their hotelbased on convenience, notbecauseitwasofferedaspartofapackage.Synergy estimates typically

growduringboommarketsasthe acquiring companyforecastshigherrevenuesdueto cross-selling or increasedcost reductions. Many times,synergy is invoked when

management wants torationalize a higher price towin a deal. The problem isthat it is far easier to putnumbers on a spreadsheetthan it is to actually realizethesecostsavingsor revenueopportunities in the realworld.For example, when

amusement park businessCedar Fair acquiredParamount Parks in 2006 for

$1.24 billion, it paid 10.6times trailing 12 months’earnings before interest,taxes, depreciation, andamortization (EBITDA),which seemed high. CedarFair justified this highmultiple by citing that it hadidentified $20 to $30millionin synergies that wouldmaterialize from the deal.These synergies woulddecreasethemultiplepaidfor

Paramount Parks from 10.6times to 8.5 times EBITDA.ByFebruary2009,duringhisQ4earningscall,CedarFair’sCFO told investors that $16millioninimpairmentchargeswere entirely due to theacquisition of ParamountParks. By February 2010,CEO Dick Kinzel was againtelling investors during hisQ4 earnings call that theperformance of “certain

acquired parks” would resultin impairment charges. Hesaid that though Paramountwas cash-flow positive, theperformance of Paramountandotheracquiredparkswas“below expectation.” Thesynergies managementthought it could achieveturned out to be much moredifficult to realize in the realworld.3

Synergiesareleastlikelyto

materialize when the twomerged businesses servedifferent customers or are inunrelatedareas.Forexample,in 1999, disability insurersUnumandProvidentmerged.Unum operated in the groupinsurance market, andProvident served individuals.Executivesofbothcompaniesthought that each company’ssalespeoplewould be able tosell theother’sproducts, thus

creating synergies.Unfortunately, after the twocompanies merged, thesalespeople from eachorganization did not want tocollaborate on cross-selling.The merger also had theunintended consequence ofincreasing prices for bothgroup and individualcustomers, which causedcustomers to move tocompetitors. Unum

eventually undid the mergerand exited the individualmarket in 2007. From thedate of the merger (in 1999)to2007,thestockpriceofthemerged entities dropped byhalf.4Some businesses combine

manysmallbusinesses in thesame industry into a largerone,whichisknownasaroll-up. The reason managementteams engage in roll-ups is

they believe they can cutduplicate overhead costs,increase purchasing powerwith suppliers, lower debtinterest costs, and combineadvertising. However, mostroll-ups in industries such asfuneral homes, medicalpractices, auto dealerships,food-service companies, andwaste-disposal businesseshavefailedtocreatevalueforinvestors,andmanythatused

lotsofdebtwentbankrupt.For example, Loewen

Group is a Canadian funeralhome company thatconsolidated many funeralhomes during the 1970s and1980s. During this time, thestock price of Loewen wasbidupbyinvestors,duetoitsconstantly increasingearnings. By 1989, Loewenowned 131 funeral homes,and in 1990, it acquired an

additional130funeralhomes.AsLoewenbegantostrugglewith its earnings, investorsbegan to realize that thesynergies that Loewen hadbaseditsacquisitionbingeonwere not being realized. Forexample, Loewen found thatcustomers did not value thename of a national brand;instead, most customerschose a funeral home basedon referrals and previous

experience. As a result,Loewenkeptthenamesofitslocalfuneralhomes.TheonlyefficienciesrealizedwerethatLoewencouldcutsomecostsfrom embalming andacquiring hearses, butapparently, this was notenoughofabenefit:In1999,Loewenfiledforbankruptcy.5

Of course, some synergiesdo materialize. The commonelement in these is that the

customer base is the same,such as when Kraft acquiredGeneral Foods. Anotherexample is Pool Corporation(Pool), a distributor of poolsupplies. Pool realized thatpool contractors were notwell served by plumbing orbuilding-productsdistributors. Pool recognizedthat customers valued localservice and more important,the availability of supplies.

Rather than pursuing astrategyofrollingupallfirmsin the pool-supplies-distribution business, Poolinstead focused onstrengthening its marketpositioncitybycitythroughacombination of focusedacquisitions and organicgrowth.Pool’ssuccesscanbeattributed to the fact that itfocused on building strongmarket share in each of the

local markets where itoperated, which gave itpricing power. In 1990, Poolhadeightsalescentersandby2010,Poolhadgrownto291sales centers according to its201010-K.

59.Havepastacquisitionsbeen

successful?

Most M&As fail. A few ofthereasonsareasfollows:

Acquisition candidatesare not always availableat good prices; as aresult, managementtypically overpays foracquisitions.Mostbusinesses that arefor sale are not verygood, and an acquirertypicallyendsupbuyinglotsofproblems.

Cultural differencesbetween businessesresultinthedefectionofvaluableemployees.

There are seven ways toevaluate whether anacquisition has beensuccessful. The followingsections look at these (andother)factorsinmoredetail.

DoAcquisitionsFit

intotheCoreCompetenciesofthe

Business?When a business acquiresanother business, the oddsthat it will be a successfulacquisition improve if it isdonewithinthesameindustry—such as when Hewlett-Packard (H-P) boughtCompaq(bothwerecomputermanufacturers)in2002.After

the acquisition wasannounced, H-P’smanagement set an objectiveto realize $2.4 billion in costreductions in one year afterthe merger. They exceededthis objective by achieving$3.7 billion in annualizedsavings within a year of themerger.Incontrast,wheneveramanagement team acquiresanotherbusinessoutsideofitscore competencies, it risks

becoming distracted as itattempts to understand theacquired business and beginstoneglect itscoreoperations.Thingssuchasimprovingthecustomer experience in thecore business get placed onthe back burner and instead,time is spent on integratingthe acquisition. Furthermore,if the management teambeginstorunintoproblemsatthe acquiredbusiness, itmay

not have the internalresourcestosolvethem.Forexample, in1997,John

Mackey, the co-founder ofWhole Foods Market,acquired a catalog vitaminbusiness, which he thoughtwould fit in with WholeFoodsMarket. But when thevitaminbusiness encounteredproblems, Whole FoodsMarket did not have anyonewho knew how to fix those

problems.ThelessonMackeylearned was that WholeFoods Market’s corecompetence was in retailsales. The company’smanagement team did notknowwhat todoorhave thepeople resources to solveproblems stemming fromcatalogsales.Inotherwords,it wasn’t just the type ofproductthatwasimportanttothesuccessoftheacquisition;

the method of distributionand sales was also critical.Eventually, the vitaminbusinesswasliquidated.6

When you see a businessmake an acquisition outsideof itscorebusiness, thismaybe a signal that theprofitability or sales of theoriginal business aredeclining or maturing. Othertimes,managementegosmaybe involved. For example, at

one time,energygiantEnroncontrolled large portions ofthe gas and electricitymarkets in theUnited States.Then it began to expandoutsideofitscorebusinessbyattempting to corner themarket on broadbandcapacity; Enron evenattempted to become theworld’s largest watercompany. Enron lost billionsof dollars on these ventures,

and the company began tomanipulate its accountingnumbers to shield theselosses, eventually filing forbankruptcy in 2001. Enronmaybeanextremecautionarytale of a company acquiringotherbusinessesoutsideofitscore competency, but it’s agreat example to keep inmind when you’reconsidering investing incompaniesthatarestartingto

doso.

DoestheManagementTeam

IntimatelyUnderstandtheBusinessItIsAcquiring?

Companies that acquirerelatedbusinesses—oratleastbusinesses that the

management team knowshow to manage—are morelikelytobesuccessfulintheirM&Astrategiesandthereforebetter potential investments.For example, Danaher is aconglomerate that has grownmainly through acquisitions,acquiringuptoonebusinessamonth throughout its history.The company owns a varietyof industrial businesses thatmake dental-surgery

implements, hand tools,testinginstruments,andothermedical and diagnosticequipment. Over the last 20years(upto2010),Danaher’sstockhasreturned25percentannually. Danaher issuccessful at acquiringbusinesses because they areabletoreducemanypotentialrisks. They do this bybecoming intimately familiarwith the operations of the

businesses they are about toacquire. For example, beforeDanaher began to acquiremedical-technologybusinesses, its managementteam studied the industry forabout threeyears,conductingmore than 400 customerinterviews, as well asnumerous interviews withindustry experts andcompetitors.7

To further reduce risk,

Danaher executives tourplantsandsearchforwaystoimprove the performance ofthe target company beforethey acquire that company.Theyestimatehowmuchtheycan improve the profitmargins of the firm byimplementing what they callthe “Danaher BusinessSystem,” which is a set ofmanagement tools used toidentifypotentialefficiencies.

This system requires that allemployees,fromthejanitortothe CEO, find ways toimprovethewaythatworkisdone.8

In most of its acquisitions,Danaher leaves the existingmanagement in place andprovidesthemwithincentivesto improve performance inthe form of stock andbonuses.Asaresultoftakingits time to understand an

industry before making anacquisition and by learninghow it can potentiallyimprove a business beforeacquiring it, Danaher hasbeen successful atacquisitions.Cisco follows a similar

strategy by routinelydevelopingproducts in-housebefore acquiring anothercompany. Cisco attempts toanswer the question of

whether it is cheaper todevelop a product itself or ifit is better to acquire anotherbusiness. This way, thecompany develops theadvantage of understandinghow a productworks and anin-depth understanding ofwhether it can compete withthe products of a potentialacquisitioncandidate.9

DoestheBusiness

RetainItsCustomersAfteranAcquisition?One of the best ways toassesswhether anacquisitionissuccessfulistomonitortheretention rate of customersafter an acquisition. If abusiness is able to retain themajority of customers threeyears after an acquisition,then this is a positiveindicator that it is making

goodacquisitions.Some industries simply

have better customerretention regardless ofownership change. Medical-disposal businesses, forexamplehavehighcustomer-retention rates. Stericycle, amedical-disposal company,successfully retains itscustomers after buyinganother company. Contrastthis to an advertising agency

where, on average, customercontracts come up forrenewal every two years andthere is high customerturnover. If an advertisingagency acquires anotheragency, take intoconsideration that customersmaynotrenewtheircontractswith the acquired agency.This increases the likelihoodthat the acquisition may failas the earnings of the

acquired agency decrease,duetocustomerdefections.

DoestheBusinessRetainItsEmployeesAfteranAcquisition?Acquisitions often destroy acompany culture. When abusiness acquires anotherbusiness, it typically tries tostandardize the acquiredbusiness, which can damage

the entrepreneurial spirit oftheacquiredbusiness,makingit lessvaluable.Forexample,when Lehman Brothersbought money-managementfirm Neuberger Berman, itstifled the culture, andmanyofthetalentedassetmanagersleft thebusiness to start theirown firms. The departure ofmanyoftheseassetmanagerscontributed to valuedestructionatLehman.

Attempt to understand theattitude thatmanagement hastoward the employees of theacquired business. Forexample, Whole FoodsMarket always respects thepeople who work for thecompaniesitacquires.Infact,Whole Foods Market oftenpromotes some of theemployees from the acquiredbusinesstocreateaclimateoftrust.There isnot an attitude

of arrogance on the part ofthe acquirer, which oftencauses the most talentedemployees of an acquiredfirmtoleave.Cisco learned the

importance of retainingtalented employees afteracquiring StrataCom. Aftertheacquisition,Ciscotriedtospeed up sales and ended uplosing not just sales but 30percent of the employees as

well. Since its firstacquisitionin1993,Ciscohasacquired almost 150companiesandhasdevelopeda set of principles andpractices that make theacquisitions successful: Buysmall, buy early in theproduct’slifecycle,andmostimportant, put the peopleyou’re acquiring aboveeverything else. Since 2002,more than 90 percent of the

employeesacquiredbyCiscohave stayed with thecompany.When Cisco buys a

business today, it largelyleaves the practices of theacquired businesses in placein order to retain employees.To transfer its values to theacquired business, it uses amentoring system, in whichCisco managers supportmanagers at the newly

acquired company.10 Earlyon, Cisco communicatesopenlywiththeemployeesofthe acquired firm and givesthem essential informationabout its plans for thebusiness. This givesemployees ownership in theprocess rather than creatinguncertainty and a lot ofupdated resumes asemployees look for otherjobs. Ned Hooper, vice

president of businessdevelopment at Cisco saysthey structure the acquisitionto retain people through thisadjustmentperiod.After that,they can look at Ciscodifferently. “For us, thepeopleare thestrategicasset....Weneedtheexpertise.”11

In 1999 when Ciscoacquired Cerent Corporation(a maker of opticalnetworkinggear),Ciscomade

sureitsemployeeswerereadyto contribute from day one.Employees arriving at workon the morning that Ciscotookoverthecompanyfoundnewbusinesscardsandbonusplanswaiting for them.Theyalso found their new healthplan information and readyaccess to Cisco’s computersystem. In the first sixmonths, Cisco lost only 4 of400 Cerent employees.12

Look for acquirers whocommunicatewithemployeesearlysotheyarenotworryingabout their jobs and caninstead focus on sales andcustomersatisfaction.Cisco’sLinksys acquisition

illustrates why it’s importantto retain talent for the long-term.WhenCiscoboughtthehome and small-businessrouter company in 2003 for$550 million, it wanted to

keep the same people whohad created the Linksysrouter.Cisco thought that themarket had billion-dollarpotential, but that potentialexisted in marketing futureversions of the router thatonly its creators hadenvisioned. The product’sfuturewas in the employees’heads,sotospeak.Watchforthose businesses that retainemployees after an

acquisition as this is often agood sign that themanagement team is makingagoodacquisition.13

DoesManagementHaveDisciplineorIsthereaRiskThat

TheyWillOverpay?Management teams, evengood ones, usually overpayfor acquisitions. This

represents a huge source ofrisk for you as an investor.For example, in October of2007, online auction houseeBay admitted it overpaidwhen it acquired the Internetphone services companySkype Technologies for $2.6billion in 2005, and took a$1.4billionwrite-down.Thiswrite-down represented 53percent of the total EBITDAgeneratedbyeBayin2007.

Companies overpaybecause quite simply, theydon’t know the real value ofthe target company. Theyoften think they do, whichadds to their problem. Theseller, of course, is morelikely toknow the truevalueandisunlikelytostrikeadealon less-than-favorable terms.Here’s one more reason thatvaluation is difficult—excitement. Acquisitions are

veryexcitingandoftencausemanagerstoloseobjectivity.It is often difficult to

discern whether a businesshas paid a reasonable price.Alsoaddingtotheproblemofevaluating the price paid isthe fact that it can take atleast three to five years todetermine if an acquisitionhas been successful. Johnson& Johnson’s managementoften did post-mortem

analyses of its M&As afterthree years. Former CEORalphLarsensaidinhis2000annual report that they alsomade it a point to weed outacquiredcompanies:While the Companyactively seeks business-building M&As ofcompanies and productlines, we also have inplace a process tocontinuallyevaluatethose

businessesthatareunder-performing, or which nolonger meet our growthobjectives and would bebetter off in someoneelse’s hands. Over thepast 10 years, forexample, we havedivested21businessesorproductlines.There are certain situations

where an acquirer is morelikely to overpay for an

acquisition:If there are a lot ofcompetitors bidding, inan auction-typesituation, withinvestment bank pitchbooks, then the pricewill likely be high. Onthe other hand, if thesellercaresaboutwhoitsells to, then this is agood sign because pricebecomes a secondary

consideration. Forexample, BerkshireHathaway has been ableto purchase manybusinessesatgoodpricesbecause the sellerswantto sell to BerkshireHathaway CEO WarrenBuffett. Bill Child,founder of furnitureretailerR.C.Willey,soldhisbusinesstoBerkshireHathaway on May 29,

1995,for$175millioninstock.Childsaid,“WhenI have spoken tostudents and businesspeople, Ihave told themthat if they ever have achance to associatewithor be a partner withWarren Buffett, to do itand do it fast. Itwill bethebestdecisionofyourlife.”14

The management team

of a business may fearthat a competitor ismakingnewinroadsintoits core business orcreating a new marketfor its customers. Forexample, because toymanufacturer Mattelfeared that the softwareand games made by theLearning Companythreateneditsbusiness,itacquired the company—

and almost wentbankrupt as a result ofthis acquisition. WhenMattel acquired theLearning Company(May 1999) it wassuffering from a declineinitscorebusinesseventhough the toy industrywas growing in the lowsingledigits.Mattelwasnotkeepingpace.Mattelacquired the Learning

Company to transformthe business intosomething beyond a toycompany and to spurgrowth. Management atthe time publicly statedthattheywantedtogrowMattel’s revenue by 10percent a year. Mattelended up selling theLearning Company for$27millionattheendof2000, even though it

paid $3.6 billion toacquire it a year and ahalfearlier.BythattimeMattel had replaced theCEO who bought theLearningCompany. Thenew CEO, when askedwhy they’d sold for solittle said, “Because thatwas thebestofferat thetime and it was losingabout$1millionadayincash.Weneeded tostop

thebleeding.”15

The largerand themoreambitious the deal, thegreater the risk thatmanagement willoverpay. You canrecognize these dealswhen management usesthe words“transformational” or“game changing” todescribe the merger oracquisition. Steve Case,

founderandformerchiefexecutive officer andchairman of AmericaOnline (AOL), stated,“Now that the AOLTimeWarnermergerhasclosed, we have a newcompany for a newworld—one poised tosparkatransformationofthe media andcommunicationslandscape—connecting,

informing, andentertaining people ininnovativewaysthatwillenrich their lives.”16Case further explained,“Theseunmatchedassetsposition AOL TimeWarner to speed thedevelopment of theinteractive medium andcapitalize on suchtransformationalopportunities as digital

music, interactivetelevisionandbroadbandInternet services.”17Shortlyafterthemerger,the share price of AOLTime Warner dropped90percentfromitspeakvalue.18

If the business ishealthy, it will usuallybe able to attract higheroffers. On the otherhand,ifthebusinessisa

damaged property, ittypically sells for alower price. The saleprice of the LearningCompany illustrates asmuch. Its sales hadcontinued to fallthroughout the time itwasheldbyMattel.Acquisitionsmadewhenmarkets are down tendtobeatlowerpricesthanthose made when

marketsareup.In2009,after the United Statesentered a recession,hotel properties weresold at low prices.According to LodgingEconometrics, thePortsmouth, NewHampshire, hotel-research firm, theaverage selling price fora hotel room was$58,190 in 2009, which

increased 86 percent to$107,988 one year later.Those businesses thatbought hotel propertiesin 2009 paid a lowerprice than those whoacquired hotelcompaniesin2010.19

Successfulacquirershaveadisciplined acquisitionstrategy. For example, hereare just a few successfulacquirers: Brookfield Asset

Management; Penn NationalGaming;Cisco;Danaher;andBerkshire Hathaway. TheCEOsofthesebusinessesarewilling to walk away from adeal if they believe they areabouttopaytoomuch.For example, at Penn

NationalGaming,CEOPeterCarlino did not get into abidding war with investorCarl Icahn to buy theunfinished Fountainbleau

Resort in LasVegas becausehe felt he would be payingtoo much if he offered ahigher price.AsCarlino said(during a quarterlyconferencecall), “Wehitourlimit of where we wanted togo and then walked away.Buyingpropertiesatfullpriceat high multiples is liketreading water. Why use thefirepower of our balancesheet on opportunities that

will not really increaseshareholdervalue?”Similarly, Bruce Flatt at

Brookfield AssetManagement often walksaway from deals, even afterinvesting significant amountsof time in them. When agroupledbyinvestmentbankMorganStanleybid$3billionto buy the famous London-based office developmentfirm Canary Wharf, Flatt

offered a rival bid. As thebidding continued, Flattwalked away from the dealwhen shareholders demandedan estimated $20 millionmore in cash (a relativelysmall amount compared tothedealsize).20

When you are readinghistorical articles about abusiness or archivedconference calls, look forthose examples where the

management team walkedawayfromcertainacquisitiontargets due to price or otherfactors. This is a positiveindicator that they aredisciplinedacquirers.

EvaluatingthePricePaid

Write down how muchmanagement paid for anacquisition and note whether

itusedcashorissuedstockordebt. What is the multiplepaidforthebusiness,suchasthe enterprise value toearnings before interest andtaxes (EBIT), EBITDA, andfree cash flow? If thebusiness is paying a highmultiple, such as more than10 times EBITDA, thenmanagement expects theEBITDA to grow in thefuture.Thelowerthemultiple

paid for abusiness, themoreroom management has tomake mistakes in its futureprojections of the acquiredbusiness. The followingexample illustrates how youwould go about determiningwhether management paid agoodpriceforabusiness.Overthelast10years,Penn

NationalGamingacquiredsixcasino businesses thatgenerated a combined

EBITDAof $454million fora going-in multiple of 7.2times EBITDA, which waslower than the averageindustrymultiple competitorswerepayingof8.6timesoverthe same time period. TodetermineifPennpaidagoodprice for all of thesebusinesses, you’d need tounderstand if the EBITDAincreased or decreased overthe10-yearperiod.For2010,

the EBITDA of these sixbusinesses is now slightlyabove $454 million, whichmeans themultiple thatPennpaid on the transactions isstill 7.2 times excludingmaintenance anddevelopment capitalexpenditures. This indicatesthat it not only paid a goodprice, but thatPennhasbeenable to successfully managethese casinos. On the other

hand, most of the casinosacquired by Penn’scompetitors have seenEBITDA decrease by 10percent to 40 percent overthis same time period.Because most of thesecasinos were acquired at an8.6 times going-in multiple,theyeffectivelypaidahighermultiple because EBITDAdropped, which means theyare not successful acquirers.

This speaks to Penn’s abilityto identify, accurately price,and operate casinos moreefficiently than theircompetitors.21

When Western Union, amoney-transfer business,acquiredCustomHouse(May2009), an internationalmoney-transfer company forbusinesses, it paid $370million in cash. CustomHouse at the time was

generating $100 million inrevenues. Western Unionpaid a multiple of close tofour times sales. This pricemakes itdifficult forCustomHouse to yield a high cash-on-cash return on investmentfor Western Union. In orderfor Western Union togenerate a 10 percent rate ofreturn on this investment inthe next five years, theintrinsic value of Custom

Housewouldneedtoincreaseto$600million,whichmeansCustomHousewouldneedtogenerate approximately $40to $60 million in profits bythe end of the fifth year.Considering that revenues in2009 are currently at $100million this would not be aneasy task. At this price,Western Union is betting onthe potential that it will beable to significantly increase

CustomHouse’scashflows.Whatistheenterprisevalue

to book value paid for thebusiness? If a business ispaying a premium to bookvalue for an acquisition, thisisanexpensivewaytogrow.It is easier for a business toearn a decent return on bookvalueifitisnotpayingahighmultiple of book at the start.Forexample,Targetbuildsallofitsstoresdenovo(i.e.,from

the ground up) and thereforebuildsstoresatbookvalue.Ifinstead, Target were topurchase other retailers at ahigh multiple of book value—forexample, ifTargetpaidtwo times book value—thenit would earn a lower returnonitsinvestment.To further illustrate this

concept, consider thisexample: If a stock has abook value of $100 and a

market value of $100 and itearns a 12 percent return onbook, then you would get a12 percent rate of return onyour purchase. In contrast, ifyou bought a stock at 150percent of book value and itearned 12 percent, then youwouldbereceivingonlyan8percent rate of return. Basedon valuation alone, whichstockwouldyouratherbuy?

HowIstheAcquisitionFinanced?

You need to determine howthe acquisition is financed,which will give you aninsight into therisk toleranceof the management team. Ingeneral, there are four waysan acquisition is financed: Abusinesscanissuedebt,itcanuse the cash on its balance

sheet, it can issue equity, orsome combination of allthree. Let’s look at each ofthese financing methods inmoredetail.

UsingCashtoFinanceAcquisitionsIf an acquisition is financedusing cash on the balancesheet, then management ishighly conservative. Most of

the acquisitions that WarrenBuffett, CEO of BerkshireHathaway, has made are incash. These conservativeacquisitions have contributedto the excess returns thatBerkshire Hathaway hasdeliveredtoitsshareholders.

UsingDebttoFinanceAcquisitionsIn contrast, if amanagement

teamuses debt to finance anacquisition,becautiousthatitdoes not take on too muchdebt. Closely monitor debtcoverage ratios and modelvarious scenarios of how thedebtmightconstrict the free-cash flows of the business.For example, create ascenario modeling whatwould happen if revenues atthe combined firm droppedby 10 percent to 40 percent.

Determine at what level offree-cash flows it would bedifficult for the business tomakedebtrepayments.For example, for many

years, CEMEX, a cementmanufacturer based inMexico, used its strong free-cash flows to issue debt toacquire other cementbusinesses around the world.CEMEX then slashedexpenses and improved the

operations of the acquiredcement business, whichgenerated even more free-cash flows. CEMEX thenusedtheseincreasedfree-cashflowstoissueadditionaldebtto make more acquisitions.Each time CEMEX acquireda business, Wall Streetanalysts questioned whetherCEMEX had taken on toomuch debt. However,CEMEX continually proved

these skeptics wrong andcontinued to increase thefree-cash flows of theacquired business and paydownthedebt.Thisstrategyworkedfor20

years,untilCEMEXacquiredRinker, anAustraliancementcompany, in 2007.When thereal estate industry collapsedin 2008, that collapsecompressed CEMEX’s free-cash flows, and CEMEX

found it difficult topaybackthedebtthatwascomingduefrom the Rinker acquisition.As a result, in less than 18months—fromJune11,2007to November 17, 2008—CEMEX’s stock pricedropped from$39.25 to only$4pershare.22Inotherwords,the stock price was almostone-tenth its price a yearearlier, because investorsfeared that CEMEX would

notbeablerefinancethedebt.Eventually, CEMEX was

able to refinance a largeportion of the debt comingdue, but it was forced toaccept a higher interest rateandmoreonerousterms.Thishas impaired the free-cashflows of CEMEX. Eventhough CEMEX willprobably survive and evenprosper, a lot of shareholdervalue was destroyed by a

debt-fueled acquisitionstrategy.

UsingStocktoFinanceAcquisitionsFinally, if a business uses itsstock to make acquisitions,make sure the stock is notundervalued, as theacquisitionwould then dilutethe ownership interest of theacquiring business’s owners.

When a business pays toomuch, it effectivelyredistributes wealth fromitself to the shareholders ofthe acquired business.Therefore, you mustdeterminewhatpercentageofthebusinessisbeinggivenuptomaketheacquisition.For example,whenWarren

Buffett was on the board ofthe Coca-Cola Company, hedid not let Coca-Cola’s

management buy QuakerOats (owner of Gatorade)because “Giving up 10.5percent of the Coca-ColaCompany for Quaker Oatswas just too much for whatwe would get.” Buffettestimated that Gatoradewouldhave increasedCoke’sworldwide case sales lessthan2percent,whilesaddlingCoke with Quakers Oat’sslow-growthfoodbusiness.23

If the business can use itsovervalued stock to makeacquisitions, it favors theacquiring shareholders. Forexample, many banks havebeen able to create value byusing their high stock prices,suchastwotimesbookvalue,to buy banks priced atsubstantial discounts to bookvalue,suchas0.5timesbookvalue.

KeyPointstoKeepinMind

Understandinghowandwhymanagementmakesacquisitionsis one of thefew concreteways forinvestors toreduceuncertaintyinassessingacompany’s

chances ofsuccess.Aspromisingas it sounds,when youhearmanagersutter thewordsynergywhen theymake anacquisition,you shouldbe extremelyskeptical thatthe costsavings or

revenueincreasesthey promisewillmaterialize.Acquisitionsare mostlikely to failwhenthetwomergedbusinessesservedifferentcustomers orare inunrelatedareas.

Amanagementteamislikelyto overpayfor anacquisitionorbuy abusiness thatisnotagoodoperationalfit under thefollowingcircumstances:

Thebusinessusesits

ownundervaluedstocktomaketheacquisition,Thetargetbusinessissoldinanauction-likesituation,

Managementusesdebttofinancetheacquisition,orManagementpaysapremiumEBITDAmultiple,suchas10

timesormore,orapremiumtobookvalue(twotimesormore).

Managementis likely tomake asuccessful

acquisitionif:

Managementhasahistoryofmakingsuccessfulacquisitionsandhasshowndisciplinebywalkingaway

fromdealsinthepast,Theacquisitionfitsintothecorecompetencyofthebusiness,Managementintimately

understandsthebusinesstheyareacquiring,Thecustomersandemployeesremainattheacquiredbusiness,Thebusiness

acquiredisboughtatadistressedprice,andManagementusesovervaluedstockorcashtofinancethe

acquisition.

1.Author’sinterviewwithToddGreen,May28,2010.2.Caterpillarpressrelease,November15,2010.3.MacFadyen,Ken.“ASynergyRunup?”MergersandAcquisitionsReport,May10,2010,p.37.4.CarrollandMui,“7WaystoFailBig.”5.CarrollandMui,“7Ways

toFailBig.”6.WithpermissionfromJohnMackey.7.DanaherConferenceCall,FairDisclosureWire,December11,2003.8.Hindo,Brian.“ADynamoCalledDanaher.”BusinessWeek,February19,2007.9.“Mergers—TheCiscoSystem,SecretsofUSComputerGiant’sSuccess.”

StrategicDirection,Vol.20No.7,2004,pp.25–27.10.Ibid.11.Ewers,Justin.“Cisco’sConnections.”U.S.News&WorldReport,June26,2006,pp.49–53.12.Ibid.13.Ibid.14.Benedict,Jeff.HowtoBuildaBusinessWarrenBuffettWouldBuy:TheR.C.WilleyStory.SaltLakeCity,

UT:ShadowMountain,2009.15.MattelatBancofAmericaSecurities33rdAnnualInvestmentConference,(RobertEckert,CEOofMattel),September17,2003,FairDisclosureWire,September17,2003.16.Case,Stephen.“ThinkingAhead.”ExecutiveExcellence,June2001,p.8.

17.“AmericaOnlineandTimeWarnerCompleteMergertoCreateAOLTimeWarner.”BusinessWire,January11,2001.18.Standard&Poor’sCapitalIQ.19.Stoessel,Eric.“HotelSalesareHopping.”NationalRealEstateInvestor.November-December2010,p.15.20.Marr,Garry.

“BrookfieldSaidSettoRe-openO&YBid:‘Pennies’ReportedtobeStandinginWayofaDeal.”FinancialPost,August25,2005.21.Kontomerkos,Mario(CorporateVicePresidentofFinanceatPennNationalGaming)indiscussionwiththeauthor,February2011.22.Standard&Poor’sCapitalIQ.23.Eig,Jonathan.“Behind

theCokeBoard’sRefusaltoLetCEODaftBuyQuakerOats.”WallStreetJournal,November30,2000.

APPENDIXA

BuildingaHuman

IntelligenceNetwork

After you have reviewed all

of the publicly availableinformation from articles,SEC filings, and industrysources, you may still haveunansweredquestions.Thisisthe time to go out andinterview people who areinvolvedwiththebusinessona day-to-day basis. Doing sowill help you fill in the gapsand give you an in-depthview of a business. Forexample, if the success of

your investment ispredicatedonthebusinessovercomingaspecific obstacle, interviewsources that have directexperienceorhavedealtwiththat particular business firsthand. Cross check anyassumptions you are makingabout the business withpeople who have industryknowledge. This will giveyou greater confidence inyour assumptions and

ultimately help you correctlyvaluethebusiness.A friend once heard an

analystpresentwhatappearedtobeawell-thought-outcasefor investing in chip-makerAdvanced Micro Devices(AMD), which the analystbelieved was undervalued.The analyst told investors inthe audience that AMD hadjust developed a newtechnology thatwas going to

give it an immediateadvantage over its maincompetitor, Intel. Whenquestioned at the conferenceabout which computermanufacturers would beincludingthenewtechnologyin their products, the analysthad only a blank stare—hedidn’t know the answer. Myfriend, who knew thecomputerindustrywell,knewthat it takes as long as 24

months for manufacturers toincorporate new chips intotheir products. From thatpoint, my friend knew thatthe analyst really didn’tunderstand the business, andhis investmentrecommendation was notcredible.Thisisaperfectexampleof

why it is important to speakwith those who have first-hand industry knowledge

whenever you make aninvestment, especially if youaremakinglargeassumptionsabout a business, as thisanalyst did. It is easy to sitdown in front of a computerand dream up variousscenarios for a business, butyou need to develop anunderstanding of how abusiness works from thosewho have experienceoperating or dealing with a

business.Youmustmakeitapriority to speakwith peoplewho are involved with thebusiness on a day-to-daybasis. This Appendixdescribes how to locate avariety of sources youmighttalk to for information, howbest to approach them toensure you’ll get theinformation you’re lookingfor,andhowtoproperlytakenotes so you’ll have the

information to go back to inthefuture.

EvaluatingInformationSources

First, you must distinguishwhether you are seekinginformation from a primarysourceorasecondarysource.

Primary sources are thosewho have first-handknowledge about a business,such as management,employees, suppliers, orcompetitors. Secondarysources are those whointerpret information from avariety of sources, such asstock analysts or journalists.The problemwith relying onsecondarysourcesis thatyoumay not know what

information theyareusing toformtheirinsights.Theymaysimplybevoicinganopinionwith no factual data tosupport it. There is nothingwrongwithconsidering theseopinions, in fact, secondarysources of information canoften be a great source ofcontrary information toinvestigate further. Themistake usually lies inacceptingandfollowingother

people’s opinions or advicewithout investigating thesupportingevidence.

HowtoLocateHumanSourcesThere are many types ofpeople who can providevaluable information andinsightabout thecompany inwhich you’re considering

investing. Try to talk to thecompany’s customers,journalists who cover theindustry, people at industryconferences, other industryinsiders or associates,professors and deans ofbusiness schools locatednearthe company you’reresearching, and evenheadhunters. The followingparagraphselaborate.

TalktoCustomersEarlyinmycareer,oneofthefirst businesses that Iresearched was NielsenMedia Research, the TV-ratings company. This wasand continues to be amonopoly business. Nielsenhad been recently spun-offfrom Dun & Bradstreet, andthe stock price had droppeddue to the threat of a new

competing ratings business,SRI Research, whomNielsen’s customers werefunding.In order to better

understand this threat and tounderstand the stability ofNielsen’s business, Iinterviewed more than 80percent of Nielsen’scustomers. I wanted to findout if SRI Research posed aserious risk. I contacted

managersinchargeofsellingadvertising time at thesestations.Many of the 100 orso sources that I spoke withmanaged advertising forseveral stations in a regionalmarket.Nielsenmeasured 54cable and network channels(e.g., Fox, CBS, and NBC),located in 44 major markets(and each market had anaverage of five to six TVstations).

The interviewprocess tookme over six months, as Ispent about 30 minutes eachday contacting these sources.Every time I interviewed acustomer, I asked who thecustomerthoughtwasagoodsource for me to contact.They toldme the same thingover and over: “call NormanHecht.”Hecht ran a researchfirm that helped Nielsen’scustomers get fairer ratings,

and at one time, he ranNielsen’sprimarycompetitor,Arbitron. When I firstcontactedHecht,hewasmorethanhappytotalktome,andin a one-hour conversation,he summarized everything Ihad learned frominterviewing 80 percent ofNielsen’s customers. Whyhad I spent so much timeinterviewing so manycustomers when Hecht

summarizedmy research andconclusions in an hour? Theonly benefit derived frominterviewing so manycustomers was that I knewthat Hecht was a crediblesource.Inowinterviewand talk to

a variety of sources in orderto identify who the bestsources are in an industry. Iam looking for the NormanHechtoftheindustryorthose

who are well connected andknow a lot of people in theindustry. Ideally, yoursource’s livelihood dependson knowing what ishappening at that company,and your source will havedone business with thecompany over a long periodof time. It is in the self-interest of those sources tostay abreast of valuableinformation.

TalktoJournalistsWhoCoverthe

IndustryJournalists have a vestedinterest in seeking goodinformation.Asyoubegin toreadarticlesaboutabusiness,youmaynotice thatmanyofthese articles are written bythesamejournalists.Youcanresearch the background ofthe journalist to learn how

long he or she has beenreporting about the industry.Look for those journalistswhohavebeenreportingonacertain industry for severalyears. Contact thesejournalistsandask themwhothey believe are the bestsources to talk to in anindustry or, better yet, howthey identify the goodsources.

GotoIndustryConferences

An industry conferencebrings together an entireindustry under one roof, andit is an excellent way tounderstand the competitivelandscapewithinan industry.You’ll be able to watchpresentationsfromarangeofprofessional perspectives,from CEOs to industry

journalists. Find industryconferences where thebusiness is exhibiting. Youcan often find thisinformationonthewebsiteofthebusiness.For example, if you are

studying the televisionindustry, then attending theNational Association ofTelevision ProgramExecutives (NATPE)conference will give you

valuable insights becausemost attendees are involvedin the creating, developing,and distributing of televisionprogramming. You can walkfromboothtoboothtalkingtorepresentatives from eachcompany, asking them whytheir product or service isbetter than competitors. Youwill very quickly understandtheprosandconsofaproductand service by doing this. It

wouldtakeyoualongtimetoobtain this informationotherwise,butyoucandothisinafewdaysbyattendingtheconference.Inmyvisitstoconferences,

I also like to watch how topmanagement and employeesinteract.Howcomfortablearethe employees when the topmanagers are around? Dotheychange theirbehavior? Ilike to ask the employees at

theboothswhathoteltheyarestayingat andwhathotel themanagersarestayingat.Ifthemanagers are staying at aluxuryhotelsuchastheFourSeasons and the employeesarestayingatabudgetmotel,this may mean that thebusiness does not value itsemployees, or at least thatmanagement sees itself asdifferent or above thefrontlineemployees.

OtherIndustryInsidersorAssociatesYou should also search fortangential sources, not justcustomers, competitors,employees, and suppliers.Think of other industryinsidersorassociates,suchasthose people concerned withmanufacturing data, tradingdata, or people who operatesocial and professional

centers. For example, whenmy firm was analyzingWestern Union, we spokewith individualswhoworkedattheWorldBankwhosejobwastocollectremittancedata(when migrant workers sendmoney home, it is called aremittance). We wanted tounderstand if WesternUnion’sgrowthpotentialwashighorlowbasedonexistingdataandwhethertheexisting

data underreported the truesize of the market. Peoplewho work closely with thedata were able to give usmore detail about marketestimates.For example, we learned

that Banco de Mexico, whoreports its figures tointernational groups and theU.S. government, gatheredmuch of its data fromWestern Union itself.

Because they onlyaccumulateddata froma fewcommercialsources,weknewthe market size was largerthanestimated.Thisledustolearn more about how thelargermarketfunctioned,andeventually gave us greaterinsight into how remittanceswork. It also helped usunderstand that WesternUnion had more marketgrowth opportunity than was

firstapparent.

TalktoProfessorsatNearbyBusiness

SchoolsAnother great tangentialsource is college professorsand deans of the businessschool in the area where thebusiness is located, becausethey probably interact withthe local business in some

capacity. Also, many priorstudents of these professorsmay be working at thebusiness. What is thereputation of the business inthe community? Is it a goodplace to work? Does theuniversitywantitsstudentstowork there? For example, Isold an investment in onecompanyafterI learnedfroma university dean that thecompany’smanagementteam

took advantage of itscustomers and that manyformer students complainedaboutanunethicalculture.

TalktoHeadhuntersTalk to headhunters whowork in a particular industryandaskthemwhatbusinessesthey believe are the bestplaces to recruitmanagementfrom and why. Headhunters

are an extremely valuableresource because their job isto find skilled managementfor a business. You can findheadhunters by locating thelocal office of the largerrecruiting firms where thebusiness is located. Forexample, if a business islocated in Atlanta, Georgia,youwould search forarticlesthat listed the top 10headhuntersinAtlanta.Then,

you can begin to look forindividuals in these firms orthose who are cited inarticles.

HowtoContactHumanSources—andGetthe

InformationYou

WantOne way to start buildingyour human intelligencenetwork is to contact thosesources that are quoted inarticles written about abusiness or industry. One ofthe hardest things to do is topick up a phone and callsomeoneyouhavenevermet.It is called the cold-caller’scurse. The stress you feel is

produced by a fear ofrejection. However, becausethese people have alreadyspokentothepress,theywilllikely speakwith you,whichwill increaseyourconfidencein reaching out to othersources. This does not meanthat you should talk only toreadily available sources, butit is a strong start in locatingand contacting the bestsources.

Trytolearnasmuchasyoucanaboutyoursourcesbeforespeakingwiththem,andthenwrite a letter referencing thearticle where they werequoted. Ask if they can giveyou a couple of minutes oftheirtimetofurtherelaborateon their comments. In theletter,letthemknowwhyyouarecallingthemandhowyouwill use the information theygive you. Sending a letter,

instead of an e-mail, willstand out, and you willdramatically improve yourchances of speaking with asource.Also, offer to share your

conclusions from yourresearch. This serves twopurposes: First, it gives youan opening to maintain aregularcontactwithasource;second, you will engendergoodwill. Be sure to keep in

contact with your mostvaluable sources regularly sothatyouarenot calling themout of the blue when youneed them most. You willfindthatitistedioustobeginthisprocess,butthemoreyoudo it, the more momentumyouwillbuild,andtheeasieritwillbecome.Whenyoucontactasource,

your goal is to getinformationonwhythingsare

happening. The bestquestionsarebroadquestionsrather than direct questions.For example, a directquestion is, “What time isit?”becauseyouget justoneanswer: “It is 8:00 pm.” Incontrast, a broad question is,“How do you think thisbusiness compares to itscompetitors, from thecustomers’ point of view?”Youwill find thatoneof the

biggest benefits to askingbroad questions is that youwilluncovermanythingsthatyou did not know about thebusinessandeven things thatyoudidn’trealizeyouneededtoknow.At the end of the

conversation,askyoursourcewho else you should betalking to or who areconsidered some of themostknowledgeable sources in an

industry.Youshouldalsotellyoursourcesthatyouwillnotquote them in any researchreports and that you willprotecttheiridentities,evenifthey give you permission toquotethem.Thereshouldnotbe any risks for your sourceto talk to you, and it isimportantthatyoubuildtrustwiththem.Don’tdespair ifasource is

unwillingtospeakwithyou.I

have found that sources whoare less willing to speak aretheworst sourcesanyway,asthey are often less engaged.People who are open tospeaking with you aregenerally passionate abouttheir subject area, and theywill talk at great lengthsabout it to others who showgenuine interest in theirknowledge. The morepassionate the person, the

more open he or she usuallyistosharinginformation.

CreateaDatabaseof

YourInterviewsforFutureReference

Be sure to record all the

details from yourconversationswithout addingyour own commentary orideas aboutwhat you thinkasource meant. If you areunsure, note this. This wayyouwillnot fall into the trapof rationalizing the answersof your source with yourassumptions. Remember,great investors see things asthey are, rather than as theywant them to be. You also

want to note whether yoursourceisstatingassumptions,atheory,afact,aquestion,anidea, or a related point. Donot be in a hurry to write asummary of yourconversation,andwritedownall responses. This way, youcan create a collection ofinterviews that you can turntolater.Manyoftheanswersyou receive from yourinterviews will seem

innocuous or unimportant,but this information can bevaluablelater.Write a brief synopsis

describing your source. Wasthis person friendly,passionate, and engaged? Ordid he or she answerquestionsquicklyandwanttogetyouoffthephone?Ifyouinclude this information inyour notes, it may help toprovide a context for the

source’scomments.You will find that by

piecing together a greatnumber of ordinaryobservations,youendupwithunexpected and meaningfulinsights. As you interviewmore and more people, youwill start to see patterns thathelp you understand thelargerpicture.Youwant to cultivate your

sources and stay in contact

with them at least two tothree times a year. Themainadvantage of staying incontact with your sources isthat you can turn to themwhenever there is a negativenews report that causes thestockpricetodrop.Thesearethepeoplewhocanhelpyouinterpret the true severity ofthe news. These sources canalso alert you to negativedevelopmentsandinformyou

of changes in the business.Myfirminvestedalotoftimeover many years identifyingreliable people in theindustries we were investedin.Wehave learned that youneed to do in-depthwork onidentifying sources andestablishing their credibilityin advance, because it isdifficult, ifnot impossible, todo this in a short period oftime.

Knowingwecouldspeaktocredible, reliable people paidoff forus.When thepriceofour investment holdingssuddenly dropped during theeconomic downturn in 2008,rather than relying onnewspapers and othersecondary sources forinformation, we called ourcustomer, supplier, andmanagement contacts tobetter understand what was

goingonatthebusinesslevelateachofourholdings.Afterspeaking with these sources,we learned that things werenot as bad as the moresensational news reportssuggested. This helped myfirm maintain rationality andbe opportunistic, becausemost general news storieswere reporting that the U.S.economy was potentiallyheadedintoadepression.

APPENDIXB

HowtoInterviewtheManagement

Team

I regard interviewingmanagersas somethingofan

art, and I admire those whodoitwell.Whenyouthinkofthe best interviews you haveread or watched, you mayremember how you weredrawn into the conversation.Partofwhatdrewyouinwasprobably the fact that theinterviewhad,at somepoint,turned into an engaged andmeaningful conversation. Attheir best, managementinterviews can provide deep

personal insight into howmanagersthink.If you have an opportunity

tomeetwithmembersof themanagement team, use yourtimelearninghowtheygottowhere they are and askwhatlessonstheylearnedalongtheway. This will put mostmanagers at ease, as you aretalking about their favoritesubject:themselves!Youwillalsofindthattheanswersyou

receive are more revealing,and you will gain betterinsight into their character.Most Wall Street analystsdon’t ask these questions, sothe manager’s responses arelesslikelytobescripted.The conversation youwant

to have will be focused onmanagement’s view of howthe business is run. Askquestionsthatareopen-endedratherthanclosed-ended:

An open-ended questionis, “How did you makethe decision to hire thesenior vice-president ofdevelopment?”Thistypeof question requires adetailed, conversationalanswer.Aclosed-endedquestionis, “What is the tax ratefor this quarter?” Thistype of question can beanswered with only a

one-wordanswer,whichwon’t reveal anythingabout how a managerthinks or makesdecisions.

Asinterviewer,yourjobistolisten, and then continue toask questions to clarify whatamanagerissaying.Do not ask hypothetical

questions, such as, “Whatwould you do if you wereconfronted with a certain

problem?” The answers tothese questions do not yieldmany insights because whatmanagersthinktheywilldoisoftendifferentthanwhattheywillactually do. Instead, askquestions that will help youlearnhowthemanagerthinksand how he or she plans toexecute.

AskOpen-

EndedQuestionsThe following are a fewopen-ended questions youmight ask (in no particularsequence). You should focuson the questions that youthink will be most revealingtoyou:

Why did you join thebusiness?Howdid you rise at thebusiness?

What skills made youchief executive officer(CEO)?WhatdoyoubelievethejoboftheCEOis?Whatdoyouwant tobeknownfor?How do you measurewhether you aresuccessful?Ifyouweresittingdownwith some potentiallong-term investors,

what two or threereasons would you givethem to take a look atthebusinessatthistime?Isthereapossibilitythisbusiness is going to betwo to four times asbigas it is today, five, orseven years down theroad?If you were a privatebusiness, how wouldyouoperatedifferently?

What do you like aboutworkinghere?Who are your currentand past mentors, andwhat impact did theyhaveonyourlife?Whatcharacter traitsareneededforyourjob?What character traits doyou look for in asuccessor?Whatthreethingswouldyou do to destroy the

business as quickly aspossible? Give yourselfaone-yeartimeframe.What typeofpeopleareyoulookingtohire?Howdoyoufindqualitycandidates?Howareyoudevelopingfutureleaders?What is the culture youare trying to instill atyourbusiness?Ifweweremeetingthree

years from today, whatwould need to havehappened during thattime for you to feelhappy about yourprogress?Howdoyoukeepthebigpicture in perspectiveand not get too boggeddown in the everydaydetails?What factors do youconsider before you

expand into a newmarket?What are the biggestopportunities thebusinesshas?How many people doyou need to hire togrow?How do you stay closetoyourcustomers?What type ofinformationdoyouneedonaweeklybasis?

Ifyouwereawayforoneyear, which key metricswouldbest tellyouhowthebusinesswasdoing?Why can’t other peopledowhatyouaredoing?

BeAwareoftheDangerofFace-

to-Face

AssessmentsofManagers

Most investors overestimatetheir ability to judge amanagementteambasedonaface-to-face meeting. Theybelieve they have the abilityto judge a person’s characterby looking him or her in theeye or watching bodylanguage.However, there aremany problems associated

with relying on your gutinstincts.First, you may be unduly

influenced by the personalityor personal beliefs of themanager. We all like peoplewhoare likeus,andwe tendtodislikepeoplewhoarenotlikeusorwhodon’tshareourbeliefs. Perhaps the CEOdoes not have the samepoliticalviewsasyoudo,andyou therefore dismiss his or

her ability. We alloverestimate our abilities toberational,andhowmuchwelike someone often affectsourjudgment.Another stumblingblock is

looking at the world throughyour own perspective ratherthan through the otherperson’s perspective. Let’ssay you are a hedge fundmanager who likes to pushyoursubordinatestowork20

hour days, 6 days a week.What types of managementteams do you think you willadmire? You will admirethose businesses that pushtheiremployeestoworklonghours. The problem is thatthis type of culture may notworkatcertainbusinesses(ormany businesses, for thatmatter).Second,managerswilltend

to share with you the things

they think you want to hear.You might sit down with aCEO and listen to whatappears to be a well-laid-outplan to create value thatincreases your confidence inthe business. There may beother negative elements thatyou don’t hear about, and infact, the plan may failmiserably. Part of this is justhuman nature or optimismand not that the managers

intendtodeceiveyou.Addingtothisproblemisthefactthatmany managers are simplyoverconfident in their ownabilities.A third error in assessing

management is ignoringsituation and context. Weoften attribute behavior to aperson’scharacterratherthanto the situation or context.For example, if a person isgoing through a divorce, this

situation may make theperson appear to be unstableeven though he or she maynot be thatway on a normalbasis.Fourth, we all have

different backgrounds andexperiences, which affecthowweassesspeople.Ifyouhavespentmostofyourtimein an office, it is likely youwill resonatewith amanagerwho has worked in the

corporate suite his or herwholelifeinsteadofonewhospendstimeinthefield.Fifth,ourabilitytoevaluate

people is affected by thecompanywekeep.Themoreweassociatewithpeoplewithgoodcharacter,theeasieritisforustorecognizethosewhodo not possess goodcharacter.Earlyinmycareer,I mixed closely with somepeoplewith serious character

flaws. I found myselfconstantly making excusesfor them. I would say thingssuch as, “I know they havecertain flaws, but I amlearning a lot from them.”Over time, I began to spendlesstimewiththesepeopleinboth my business andpersonallife.Ifoundthatmyability to make distinctionsquicklyimproved.ThemoreIassociated with good people,

the quicker I was able toidentify those who hadserious character flaws thatmightaffecttheirbusiness.

APPENDIXC

YourInvestmentChecklist

UnderstandingtheBusiness—TheBasics

DoIwanttospendalotof time learning about

thisbusiness?HowwouldyouevaluatethisbusinessifyouweretobecomeitsCEO?Can you describe howthebusinessoperates, inyourownwords?How does the businessmakemoney?How has the businessevolvedovertime?In what foreignmarketsdoes the business

operate,andwhataretherisks of operating inthesecountries?

UnderstandingtheBusiness—fromtheCustomerPerspective

Who is the corecustomer of thebusiness?Is the customer baseconcentrated ordiversified?Is it easy or difficult to

convince customers tobuy the products orservices?What is the customerretention rate for thebusiness?What are the signs abusiness is customeroriented?What pain does thebusinessalleviateforthecustomer?To what degree is the

customer dependent onthe products or servicesfromthebusiness?If the businessdisappeared tomorrow,what impact would thishave on the customerbase?

EvaluatingtheStrengthsandWeaknessesofaBusinessandIndustry

Doesthebusinesshaveasustainable competitive

advantageandwhatisitssource?Does the businesspossess the ability toraise prices withoutlosingcustomers?Does the businessoperateinagoodorbadindustry?How has the industryevolvedovertime?What is the competitivelandscape, and how

intense is thecompetition?What type ofrelationship does thebusiness have with itssuppliers?

MeasuringtheOperatingandFinancialHealthoftheBusiness

What are thefundamentals of thebusiness?What are the operating

metrics of the businessthat you need tomonitor?What are the key risksthebusinessfaces?How does inflationaffectthebusiness?Isthebusiness’sbalancesheetstrongorweak?What is the return oninvested capital for thebusiness?

EvaluatingtheDistribution

ofEarnings(CashFlows)Are the accountingstandards thatmanagement usesconservativeorliberal?Does the businessgenerate revenues thatare recurring or fromone-offtransactions?To what degree is thebusiness cyclical,countercyclical, orrecession-resistant?

To what degree doesoperating leverageimpact the earnings ofthebusiness?How does workingcapital impact the cashflowsofthebusiness?Does the business havehigh or low capital-expenditurerequirements?

AssessingtheQualityofManagement—Background

andClassification:WhoAreThey?

Whattypeofmanagerisleadingthecompany?What are the effects onthe business of bringinginoutsidemanagement?Is themanager a lionorahyena?How did the managerrisetoleadthebusiness?How are seniormanagers compensated,

and how did they gaintheirownershipinterest?Have themanagersbeenbuying or selling thestock?

AssessingtheQualityofManagement—Competence:HowManagementOperatestheBusiness

Does the CEO managethe business to benefitallstakeholders?

Does the managementteam improve itsoperationsday-to-dayordoes it use a strategicplan to conduct itsbusiness?Do the CEO and CFOissueguidanceregardingearnings?Is the businessmanagedin a centralized ordecentralizedway?Doesmanagement value

itsemployees?Does the managementteam know how to hirewell?Does the managementteam focus on cuttingunnecessarycosts?Are the CEO and CFOdisciplined in makingcapital-allocationdecisions?Do the CEO and CFObuy back stock

opportunistically?AssessingtheQualityofManagement—PositiveandNegativeTraits

Does the CEO love themoneyorthebusiness?Can you identify amoment of integrity forthemanager?Are managers clear andconsistent in theircommunications andactions with

stakeholders?Does management thinkindependently andremain unswayed bywhat others in theirindustryaredoing?Is the CEO self-promoting?

EvaluatingGrowthOpportunities

Does the business growthrough mergers andacquisitions, or does it

groworganically?Whatisthemanagementteam’s motivation togrowthebusiness?Has historical growthbeen profitable and willitcontinue?What are the futuregrowthprospects for thebusiness?Is themanagement teamgrowingthebusinesstooquickly or at a steady

pace?EvaluatingMergers&Acquisitions

How does managementmakeM&Adecisions?Have past acquisitionsbeensuccessful?

AbouttheAuthorMichael Shearn foundedTimeValueofMoney,LP,aprivate investment firm, in1996 to devote his attentionto selecting and researchingstocks and privateinvestments.He launched theCompoundMoneyFund,LP,a concentratedvalue fund, in

2007. Michael serves on theInvestment Committee ofSouthwestern University,which oversees the school’s$270millionendowment.Heis also a member of theAdvisory Board for theUniversity of Texas MBAInvestment Fund. Shearngraduated fromSouthwesternUniversity,asmallliberalartscollege in Georgetown,Texas, with a B.A. in

Business,magna cum laude,with an emphasis inAccountingandFinance.

Index

10-Kreports10-Qreports10b5-1program99CentOnlyStoresA.C.Nielsenaccounting methods,changingaccountingstandardsaccountsreceivable

acquired business,understandingacquisitionscorecompetenciesandcustomerretentionemployeeretentionevaluatingpricepaidfinancinghistoryofmotivationforriskofoverpayment

Adamson,James

AdelphiaCommunicationsadvantageexpandingstructural

adversity, communicationduringAIG. See AmericanInternationalGroupAIM Management Group,Inc.airlines,metricsforAkamaiTechnologies

alertservicesAlfredDunhillAmazon.comAmericaOnlineAmericanAirlinesAmerican CustomerSatisfactionIndex(ASCI)American InternationalGroup(AIG)AmericanWoodmarkAnthropologieApolloGroup

appearances,businessversusAppleapplicantsASCI. See AmericanCustomerSatisfactionIndexassociatesAutoZonebalancesheetBaldorElectricCompanyBankOnebanks,metricsforBarnes&Noble

Baron,RonBarron’sBauer,TedBauschandLombBedBath&Beyondbenefits, managers versusemployeesBerkshireHathawayBestBuyBezos,JeffBlockbusterBloomberg

Bloomberg,MichaelBML Capital Management,LLCboardmembers,selectingBobrowski,PaulborrowinglimitsBrabeck,PeterbrandloyaltyBrazilbreak-evensalesBrightHorizonsBrin,Sergey

Bristol-MyersSquibbBrookfield AssetManagementBrossart,Darciebubbles,spottingBuffett,WarrenBuild-A-BearWorkshopbusinessculturebusinessgrowthduetoseculartrendsdue to transformationalproducts

mergers and acquisitionsversusorganicmotivationforspeedof

businessmodelsbusinesspressbusinessappearancesversusdescribingoperationsevaluatingevolutionimpactoncustomerbase

learningaboutmakingmoneysellingversuslovingthemoney

C.H.RobinsonWorldwideCabela’sCanadianoilsandsCantalupo,Jackcapitalallocationdecisionscapital-expenditurerequirementscapital,competingon

Carcelle,YvesCarlino,PeterCartierCarty,DonCase,Stevecashcashconversioncyclecashflowsfrom operations, comparedtonetincomeimpact of working capitalon

cash,financingacquisitionsCaterpillarCCC. See cash conversioncycleCEMEXcentralized management,decentralizedversusChambers,Johnchiefexecutiveofficersalaryself-promoting

Child,Bill

ChinaChoiceHotelsbalancesheetof

Christensen,ClaytonCialdini,RobertCiscoclosed-endedquestionsCoachTheCoca-ColaCompanycommodityresourcescommunications,consistentCompagnie Financiére

RichemontSAcomparisons,limitationsonCompass MineralsInternationalcompensationconsultantscompensation plans, long-termperformanceandcompensationsystem,setupcompensation,managementcompetitionamountoffiercenessof

intensityofcompetitiveadvantagedeterioratingexpandingfindingbusinesswithsourcesof

competitive landscape,understandingcompetitorscompetitors,failureofconcentratedcustomerbaseconferencecall

consciouscapitalismConsecoconservative accountingstandardsContinentalBankcontinuousimprovementcontracts,employmentcopying,competingoncorebusinessmodel,changestocore competencies,acquisitionsand

corecustomercostadvantagescostsynergiesCostcoWholesalecostscuttingunnecessaryidentifyingreducing

countercyclicalCountryRiskReportscountryrisksCoverGirl

coverageratioscreditcardfirms,metricsforcriteriaasinvestmentfilterchecklist

culture,businesscurrencyriskscurrentliabilitiesCustomHousecustomerbasebusiness’impactonmanagerexperiencewith

customerperspectivecustomerresearchcustomerretentionacquisitionsand

customer-orientation,signsofcustomer-retentionratescustomerscoreeaseofpurchaseforeign market tastedifferencesmanagementclosenesswith

paincyclicalDaft,DouglasDarlingInternationaldatabase,ofinterviewsDaVitadebt-maturityscheduledebtabilitytopayadvantagesoflowfinancingacquisitionsinterestrate

maturitymotivationforoff-balancesheetrecourse versus non-recourseusingconservatively

decentralized management,centralizedversusDellDell,Michaeldependenceonnewproductsdeterioratingadvantage

development phase,investmentgainsandDimon,JamieDiscoveryCommunicationsdiscretionary costs,manipulatingdissenters,hiringdiversifiedcustomerbasedividends,increasingDollarFinancialDorsey,PatDunlap,Albert

E&P. See exploration andproductionearnings before interest andtaxes(EBIT)earningsguidance,issuingearningsmanipulation bymanagementoperating leverage impacton

EastmanKodakeBay

Ebbers,BernardEBIT. See earnings beforeinterestandtaxesefficiencyratioEisenberg,WarrenEllison,Larryemerging markets,managementforemployeerelationsstockreturnsand

employeeretentionacquisitionsand

employee training, investinginEmployees First andCustomers Second: TurningConventional ManagementUpsideDownemployeesasassetsorliabilitiesattractingchoosingcontributionsasdissenters

recruitedbycompetitorsvaluedbymanagement

employmentcontractsEnrico,RogerEnronequitygrants,tomanagementevaluatingabusinessevolutionofabusinessofparticularindustry

excessearnings,reinvestingExpeditorsInternational

expenses,misstatingface-to-faceassessmentsFactSetResearchSystemsfads,trendsversusFannieMaeFastenalFCF.SeefreecashflowFederalExpressFeinstein,LeonardFertitta,Tilmanfiltercriteriaas

valuationasfinanceareafinancialgoals,settingfinancialstrength,short-termFinancialTimesfinancingacquisitionsFirmsofEndearmentFirstDataCorporationFirstManhattanFiservfixedcostsChoiceHotels

identifyingSouthwestAirlines

Flatt,BruceForbesforcedsellingFordforeignearnings,riskstoforeignmarketscustomertastedifferenceslengthofoperationsinFortuneFourSeasonsHotels

FourSeasons:TheStoryofaBusinessPhilosophyFrazier,KennethFreddieMacfreecashflow(FCF)Freedman,DavidFujifundamentalsGAAP. See generallyaccepted accountingprinciplesgains,timingof

Galanti,RichardGalvin,Robertgaming businesses, metricsforGeneralElectricGeneralMotorsgenerally acceptedaccountingprinciplesstockscreensandtaxesand

Gerdin,RusselGileadSciences

GilletteGivernyCapitalGold,ChristinaGold,DaveGold,SherryGoldmanSachsgoodnews,emphasizinggoods,highqualityGoogleGraham,BobGraham,JohnGrant,Hugh

Green,ToddGreenberg,Jackgrowthhistoricalhumancapitalandinfrastructureformarketshareandpayingforprospectsrevenuesversusslowingspeedof

Grusky,BobGucciguidance,issuingHäagen-DazsHammergren,JohnHarvey,CampbellHastings,ReedHCLTechnologiesheadhuntersHealthSouthHeartlandExpressHeartlandPaymentSystems

hedge,naturalHersheyCorporationHewlettPackardHilbert,Stephenhiredhandmanagerhiring,bymanagementhistoricalgrowthhistoryofacquisitionsofparticularindustry

Hoffman,Caseyholdings,tracking

HomeDepothotels,metricsforHughesCommunicationshumancapital,growthandhumanresourcescontacting

Hurd,MarkhyenasIacocca,Leeideas,inventoryofIFRS. See InternationalFinancial Reporting

StandardsImmelt,JeffreyImmucorImperialCapitalIMSHealthInc.(magazine)income-taxfootnoteindependent thinking,managersindustryanalysisindustryconferencesindustry consolidation, cost

advantagesviaindustryinsidersindustryprimersindustrystandard,settingIndustrySurveysindustrychangeevaluatingasawholehistoryofmetricsforaspecific

inflationrisksinflation,effectof

infrastructure,growthandinitial public offerings(IPOs),researchinginnovationinsider purchases, asindicatorsintegrity,managerandinterestratesondebtrising

International FinancialReportingStandards(IFRS)

internetfirms,metricsforinternetsearchinterviews,databaseofIntuitinventoryinvesting opportunities,creatinginvestmentbubbles,spottinginvestment gains,developmentphaseandinvestmentideas,filteringInvestment Intelligence from

InsiderTradinginvestment managers,followinginvestmentportfolio,existinginvestments,trackinginvestorpessimistiPhoneIPO. See initial publicofferingIronMountainJ.C.PenneyJ.D.PowerandAssociates

J.P.MorganJobs,SteveJohnson&JohnsonJonesSodaCompanyJong-Yong,YunKelleher,HerbkeyrisksKierlin,RobertKinder Morgan EnergyPartnersKinzel,DickKirkland,Carl

KleinerPerkinsKodakKozlowski,DennisKrispyKremeDoughnutsLandry’sLandstarSystemLay,Kennethlayoffs,employeetreatmentLBO.SeeleveragedbuyoutLearningCompanylearning,timespentLehmanBrothers

Leonard,BradLester,Howardleveragedbuyout(LBO)liberalaccountingstandardslifelonglearners,managersasLincolnElectricLing,Jameslionsliquidity needs, assessinglong-termLister,SteveThe Little Book that Builds

WealthLizClaiborneloancovenants,evaluatinglocationcostadvantagesvia

LoewenGrouplong-tenuredmanagerlong-term performance,compensationplansandlong-term planning, strategicplansversusLouisVuittonMoëtHennessy

(LVMH)low-cost countries,competitionfromLTVLVMH. See Louis VuittonMoëtHennessyM&A. See mergers andacquisitionsM&TbankMackey,JohnMacy’smaintenance capital

expendituresManagement Discussion &Analysis(MD&A)managementstylemanagement team, length ofservicemanagementtenuremanagementbuyingorsellingstockclosenesswithcustomersforemergingmarketslifestyle

managerbackgroundasnon-operatorcareerversusjobface-to-faceassessmentspromotionhistoryreasonsforpromotiontypesofmanipulationcostsearnings

Mansueto,Joemargincalls,sellingstockfor

MarkelInsurancemarket share, potentialgrowthofMarshallsmaterialsindustryMattelMaxFactorMcDonald’sMcFarland,JohnMcKessonMcKinney,JosephMcNealy,Scott

McNerney,JimMD&A. See ManagementDiscussion&AnalysisMeadJohnsonmedia,stocksandMedtronicMerckmergers and acquisitions(M&A)decisionsabout

MerrillLynchmetrics

comparinglastingmonitoringsourcesof

MicrosoftTheMoneyMastersmoneyasmotivatormakingversuslovingthebusiness

MonsantoMontblanc

Morningstarmotivationforacquisitionstocktransactions

MotorolaNardelli,RobertnaturalhedgeNayar,VineetnegativeworkingcapitalNestlénet income, cash flow fromoperationscomparedto

net working capital,calculatingNetflixnetworkeconomicsNewMountainnew-lowlistsNewellnewslettersNielsenMediaResearchNintendoWiiNoe,DonaldNokia

non-operatorasmanagernon-recourse debt, versusrecourseNordstromNortelNovatelWirelessO’Neal,StanleyOberton,Willardoff-balancesheetdebtone-off transactions, versusrecurringone-timeexpenses

open-endedquestionsoperatingleasesoperatingleveragecalculatingdegreeofimpactonearningsthemeparksand

operatingmetricsoperatingstructuresdecentralizedidentifying

operational improvements,strategic plan versus day-to-

daychangesoperationalrisksevaluating

operationsandlogisticsoperationsareaoperationsdescribingmanagerexperiencewith

Oracleoutside management, effectonbusinessoverpaymentrisk

owner-operatorownership interest,managementincreasingPaccarPackard,DavidPage,Larrypain,customerpassionidentifying

patentsPennNationalGamingpensionplans

People Are the Product: AHistoryofAIMPepsiCoPerkins,Tompersonalinterviewsperspective,customer’spessimism,investorPfizerphilanthropyPhilipMorrisPhoenix,UniversityofPifzer

PillowtexPLs. See private-labelproductspotential growth,extrapolating through marketsharePP&E. See property, plantandequipmentPraxairpredictabilitypriceimprovementspriceincreases,passingalong

pricepaid,evaluatingpricesensitivityprice transparency,technologyandpricecompetingonraising

pricing advantages,sustainabilityofpricingpowercharacteristicsoffindinginformationabout

sourceofprivate-labelproducts(PLs)proactiveProcter&Gambleproductscustomerdependencyonpurchasing

professorsprofitgrowth,revenuegrowthandpromotionsinternal

reasonsformanager’sroutesto

property, plant, andequipment(PP&E)proxy statement,compensationsystemandpurchasing,easeofQuakerOatsQualcommqualityquestionsR.C.Willey

raising prices, effect oncustomersRajgopal,Shivaratingagenciesratios,debtandrealestate,metricsforrecessionresistantrecessions,historicalReckittBenckiserGrouprecommendations,stocksrecourse debt, versus non-recourse

recurring transactions, versusone-offReed,PatReese,Richardregulatorylicensesresearchanddevelopmentresearch,customerreserves,usingrestructuringchargesretailers,metricsforretentionrate,customerreturn on invested capital

(ROIC)calculatinghistoricalimprovingofanindustryusefulnessof

revenuegrowth,profitgrowthandrevenuesynergiesrevenuesgrowthversustransactionsgenerating

RevlonRHRInternationalrightplace,righttimeriskscountrycurrencyforeignearningsforeignmarketsinflationmeasuringoverpayment

RitzCarlton

RiverstoneNetworksRochon,FrançoisROIC.See returnon investedcapitalRollins,KevinRose,PeteRoth,JohnRutherford,Johnsalary, stock ownershipversussale indicators, managementactivityas

sales,inflatingsame-storesalesSamsungElectronicsSchwartz,Markschedule13-DSchultz,HowardScrushy,RichardSeagatesecular trends, businessgrowthduetoselling,forcedservice,competingon

servicescustomerdependencyonhighqualitypurchasing

Seyhun,Nejatsharedvaluesshareholderlettershares,trackingabusinessviaSharpe,IsaadoreShellSheth,Jagdishshort-term earnings, growth

andSilberman,RobertSinegal,JimSingleton,HarrySisodia,RajendraSkypeTechnologiesslowinggrowthSOE. See state-ownedenterprisesSonkin,Paulsourcesevaluatinginterview

locatingofsupplies

SouthwestAirlinesbalancesheetof

speedofgrowthSpiritAirlinesspreadsheet, trackinginvestmentsviaStahl,Jackstakeholders,benefittingStaplesStarbucks

state-owned enterprises(SOE)staticratiosStemberg,ThomasStericyclestickyaccountsstockawards,restrictedstock options dilution,offsettingstockoptionsemployeesmanagersand

stockownershiprequiredsalaryversus

stock returns, employeerelationsandstockscreens,usingstockbuyingbackfinancingacquisitionswithmanagement buying orsellingtransactionmotivation

strategicplansfailureoflong-termplanningversussettingfinancialgoals

StrayerEducationstructuraladvantagesubscription-type firms,metricsforsubstitute products, risksfromSunMicrosystemsSunbeam

suppliersdependenceoninnovationbyrelationshipwith

supplies,sourcesofsupplychainmanagementsustainable competitiveadvantagefindingbusinesswithstructural

switchingcostssynergy

SyscoTan,SengHockTaubman,Alfredtaxpurposes,sellingstockfortaxes, generally acceptedaccounting principles versusIRStechnologypricetransparencyand

TescoTEV. See total enterprisevalue

theme parks, operatingleverageThiry,KentThomas,DavidTimeWarnertime,spentlearningTJMaxxTommyHilfigertotalenterprisevalue(TEV)trackrecord,manager’stradeassociationstradejournals

Train,Johntrends,fadsversusTycoTylerCorporationunderstanding, of acquiredbusinessUnileverUniversityofPhoenixUrbanOutfittersUSAirUTIWorldwideValkenaar,Lee

valuation,asinvestmentfiltervaluecreation,long-termValueLinevalues,businessVanCleef&ArpelsvariablecostsChoiceHotelsidentifyingSouthwestAirlines

VCAAntechVeer,JeroenvandeViagra

VolkswagenAGW.P.StewartwageinflationWal-MartWallStreetJournalWalton,SamWasteManagementWelch,JackWesternUnionWholeFoodsMarketWilliams-SonomaWilliams,FrankJ.

Wilmers,RobertWolfe,Davidworkingcapitalgeneratingimpactoncashflowsneedsnegativesustainabilityofchanges

WorldComYoung,LarryZaslav,David