March 2017 – Bates Creek Consulting

The Better Way to Define Growth vs Value

I often read arguments about which is better, investing in growth or value stocks. Unfortunately much of what is written on the subject is simply wrong. By definition, value stocks have low market to book ratios and growth stocks often have high market to book ratios.

However, there isn’t a lot of difference in the sales growth rates between growth and value because sales growth isn’t what defines them.

The defining factor is in their return on invested capital (see here by Jiang Koller 2007). The process is simple, firms with great opportunities to invest at above average rates of return (high ROIC), receive capital, invest and grow. So why don’t growth companies have more sales growth than value companies? Because many high ROIC firms don’t have attractive places to invest capital and many low ROIC firms don’t need outside capital to continue to grow.

Bennett Stewart in his book “The Quest for Value” defined firms into three basic categories, X firms had returns near the cost of capital, Y firms had returns above the cost of capital but had limited options for investing capital, Z firms also had returns above the cost of capital but had many options for investing capital and grew quickly. Stewart also said there were X-minus firms that didn’t earn the cost of capital and pre-Z firms that grew quickly on outside capital with the thought they’d have a Z level of ROIC later. I like this approach to classifying firms – it is clearer about the status of the business and adds clarity to strategy.

	Return on Capital	Opportunities
X-Minus	Below Cost	N/A
X	Near Cost	N/A
Y	Above Cost	Limited
Pre-Z	Below Cost	Many
Z	Above Cost	Many

X and X-minus, Low ROIC

Firms with returns equal to the cost of capital (and even less than the cost of capital) or “X and X-minus“ can still have sales growth, but they won’t get the high valuations (market to book ratio) of the high ROIC firms. These firms grow because they retain earnings, which even if low, they can reinvest in the company. With low interest rates, firms can borrow to continue to grow. A CFO I once met said that as long as he could borrow at 4% and invest at 7% he was going to continue. The market cost of capital is higher than the bank cost of capital and consequently the firms stock price took a nose dive (although the bankers LOVED him).

Theoretically the right choice for these firms would be to return capital to the investors so that it could be invested at higher rates of return. However, CEO’s and CFO’s rarely think that they should return capital, and it is often the board or an activist that pushes the issue. This is the agency problem, where management and shareholders aren’t always on the same page. Management incentive programs have to be carefully drawn to balance growth and return to shareholders. Too much on sales or profit growth, then the capital becomes “stuck” in low performing investments. Too much on return to shareholders and the management team underinvests and damages the firm long term.

X and X-minus firms shouldn’t grow, but they do by retaining cash and investing in projects that generate weak returns.

“Y” Firms – High ROIC, Constrained by Operations

Most firms with good ROICs that are constrained by other the factors are called Y” firms by Stewart. The firms have good returns on capital but are limited in how fast they can invest. My rule of thumb on retailers was that sustained unit growth rates above 25% always and everywhere resulted in a blowout. Over a 15 year period every retailer who grew at this rate, blew up. Eventually the growth retailer I was with that grew at over 25% a year for 7 years blew up too. The causes of the blow ups vary, but usually it was a lack of talented staff, poor controls or the firm continued to grow after returns declined. All problems that could be foreseen.

Growing at 25% a year for a retailer means opening a lot of new locations, and you need to locate, hire and train a staff. Growing during a downturn when good talent was being laid off helped ease some of the hiring pressure. Although central office and distribution staff grew at a fraction of the sales growth rate, every year staff count would need to grow at 15% or better to keep up.

Growing fast also stresses controls. Ebay used to reorganize 3-4 times a year because as the company grows, the management challenges, controls and processes have to be updated. Nothing is static. What you could get by with at $100m in sales won’t work at $200m in sales.

If you are successful managing the growth, the best markets will eventually be addressed and you reach the point of diminishing returns where further investment turns the above average returns to average returns. (See here for a recent discussion of this same phenomena by Fisher, Gaur and Kleinberger). Niche retailers run into this but also big firms such as Wal-Mart, Home Depot and Best Buy. (This was a great source of short ideas, as there is nothing like a management team with their foot mashed on the growth gas pedal while new store returns are tanking.)

A great deal of consumer product firms are constrained by opportunity. They cannot further invest at similar ROIC levels. New strategies (panini’s at Starbucks?) often decrease profit rate and require large investments in process and product that don’t generate a solid return.

A lot of auditing and consulting firms are extremely profitable, but as long as they can capture new clients at full rates. You can follow a low price strategy, but in the end, you end up with low priced customers and low returns of capital.

Growth can destroy shareholder value – that is what I call dumb growth. Capital allocation requires discipline and a set of metrics and standards that are appropriate to the strategy. Investments must earn their cost of capital. But there are often strategies that offer lower (but still above average) ROIC’s, that should be explored. The Ansoff Matrix I mentioned earlier can be of help looking for opportunities.

“Z” Firms Grow Fast

A great deal of internet software and services qualifies as “Z”, above average returns, with lots of above average places to invest capital. Sales growth is a function of reinvesting profits and raising outside capital. This was perhaps captured best by the HBR article in 1996 by W. Brian Arthur “Increasing Returns and the New World of Business”, where he outlines the shift from decreasing returns on capital (like a retail chain that over expands) and increasing return on capital (the internet) where more users increase the value of the product.

A firm with attractive places to invest capital and is unconstrained will grow quickly. Ebay grew over 60% for a dozen years, although they’ve grown 5% over the past five years. Eventually that happens to every “Z” firm, they reach diminishing returns (yes, even Facebook) and growth slows.

“Pre-Z” Fast Growth and Low ROIC

There are a few pre-Z’s that have gone public, Snapchat lost $520m in 2016, and $380m in 2015. Revenue in 2016 was less than “cost of revenue”, so the customers paid actually less than it cost to deliver the service. They are growing fast, and losing money fast. Maybe Snapchat’s numbers improve although usually great growth companies make money right away.

Amazon has survived for years where the return on capital has been paltry, with the thought at some time it will turn for the better (and perhaps it has). Amazon’s operating profit from 2011-2015 totaled to $3.8b (no interest, no taxes) but the asset investment has grown $35.7b. In 2016 operating profits were $4.2b, more than previous four years added together. Amazon continues to invest to grow market share, and as long as they’ve got the cash and a 185x p/e they can continue.

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Dr. John Zott is the CFO for Carlson Wireless Technologies, and Principal consultant at Bates Creek Consulting. John is the chair of the Careers Committee at FEI Silicon Valley, a senior adjunct professor at Golden Gate University and comments regularly on issues that affect consumer businesses. If you are a former student, colleague or would just like to connect – reach out.

Being Excellent

I recently reread Daniel F. Chambliss’s article titled “The Mundanity of Excellence” from Sociological Theory (7:1 Spring 1989) – it’s another good read. The article deals with Olympic swimmers and how they are different than club or college swimmers. Dr. Chamliss notes that the “Olympic don’t just do much more of the same things…Instead they do things differently”. Their strokes are different, their discipline is different and their attitude is different. For many people this is a revelation. Olympic class swimmers do put a lot of time in, but some club and high school swimmers put in as much time. It is not quantity but quality that matters.

I started to play a lot of tennis three years ago for exercise. I was an ok player when I started out – but as I’ve continued to take lessons, I’ve continued to improve (still just ok, however). At the local courts there are players practicing the same poor form repeatedly. They will never get much better, and will all the more be frustrated when they fail to improve. There is one guy that hits at least a hundred serves a practice (all with poor form) which is about three sets of serves. One thing he’s grooved is his ability to hit the net.

Anders Ericcson is famous for his work on deliberate practice (see here) which outlined the qualities it took to improve through practice – which later became the 10,000 hour rule as written by Malcom Gladwell, in “Outliers”. The rule was that quality deliberate practice of 10,000 hours would turn the novice to an expert, complete with examples from music and computer programming. Recently (see here) there are some cracks in the foundation of the theory (it turns out just practice isn’t enough) but it remains a provocative idea.

When I was coaching my son’s soccer team we had a game when our opponents did a good job passing the ball between themselves, and we focused on our dribbling and chasing. At halftime the players commented that it seemed like the other side had more players. That is the way it seems when one team is following a better process – the ball moves more and the players don’t have to chase. They weren’t bigger, faster or stronger. They just followed a better system.

Businesses around the world are the same. We hire, train, buy, sell, process and ship something to someone, somewhere for which we get paid. Most business people don’t think of themselves working at the level of Olympic swimmers or concert musicians. Practice isn’t really required and performance doesn’t really get better with time. I don’t think this has to be true.

Great companies follow great processes that improve over time. They work together internally differently than poor companies, they look at metrics differently, they solve problems differently, and they make excellence – mundane. I think ok firms can get better. Here is how.

How many psychologists does it take to change a lightbulb?

Only one, but the lightbulb really has to want to change. You can’t get better unless you want to change. Getting better has to include the three factors that Chambliss mentioned, the task, discipline and attitude.

What we do

I’ve been to numerous training sessions where over a one or two day period you are bombarded with great ideas. After the session there is a rosy-glow amongst the staff which fades quickly when they get back to work and return to doing things the same way as before. Training is worthless unless it is put into practice. Nothing is as important as trying the ideas you’ve learned.

One tactic is a mandatory debrief after every training, conference or education session, where the team met and decided what we were going to do differently. Some ideas will be rejected, some will be tried and abandoned. But a few will stick from every session and as a group, you will get smarter.

Our Discipline

Chambliss quotes Peter Drucker about how in business it is actually a small number of practices that make an executive effective. Discipline in business is often about not taking the easy shortcut (and there are always shortcuts). Discipline, Chambliss notes, came to many swimmers by coming to practice on time and to being exact with their strokes, turns and dives.

Accounting has continued to become more refined due to regulatory pressures (SOX). However this accuracy has come with increased costs. Training for many firms is now considered a luxury and having the time to get systems working right seems impossible. The discipline is in doing it right the first time and in making sure the staff gets the training they need.

Achieving exceptional results with exceptional people is a challenge. Achieving exceptional results with ordinary people is what a good process does.

Our Attitude

The attitude of Olympic champion swimmers is that their excellent performance is mundane. They have trained for the tournament, they are prepared, they succeed. They make the unusual event normal “it’s just another swim meet” and they follow their preparatory routine so that they are ready to swim fast.

I once joined a company with a weak accounting group. I first asked my staff if we were the best finance department they’d ever worked for. The comparison was unfavorable. We then compared ourselves to the other accounting departments in the area and we decided we were likely the third best group on street we were on. Within two years we were able to become one of the best accounting groups in our sector. Timely hires and desire to get better made it happen.

Great companies also perform in a way that can seem boring too. They deliver on their customer promises every day. The Fedex truck shows up on time, the take-out at Whole Foods looks and smells delicious, the equipment you ordered works right out of the box. All of this is because performance is designed into the processes and the staff follows the process in a consistent way. Yes it does sound a little boring – but it’s worth it.

Seeing into the Fog

Bill James an article back in 2004 that deserves a read titled “Underestimating the Fog” (Baseball Research Journal No. 33, 2004). The article talks about using statistics to test hypothesis about baseball. The questions he asked dealt with whether a good catcher helps a pitcher or whether there is such a thing as clutch hitting.

Some questions can be answered through statistical analysis and some cannot. Mr. James is talking about problems that cannot be solved with the amount of data we have at hand. The fog is the uncertainty in the underlying data, which is sufficiently random enough to swamp the small effects of the particular question we are examining. Some questions, Mr. James states, will never be answered using these tools. The nature of the game won’t generate enough data, and the randomness of each factor is significantly higher than the effect we are trying to isolate. Mr. James concludes that his tools may not be good enough to see through the fog to identify if there is real skill. There is too much random noise to know for sure.

Business has a lot more fog than baseball. Baseball has a rulebook, trained umpires and is played by highly skilled individuals that have taken years to become the best. Business has no rulebook, there are no umpires and there are no playoffs and no finish line. The amount of randomness and volatility in life is so much greater than in any sport.

In business strategy selection is often done in a cloud of uncertainty and random factors. Often the factors outside our control will make the most significant differences in results, without regard to the strategy we select. Ignoring these random factors is pretending that there is nothing bad (or good) hidden in the fog. How then do we pick a strategy, since we may not control the market, or the competitors, innovation or what the Fed decides tomorrow? I suggest three things to focus on.

Be Prepared to be Lucky

I wrote up a company as a buy once and coaxed some clients into investing. Within a couple of months the company was bought at a significant premium to the original stock price. My analysis did not consider a potential buy-out (although they paid remarkably close to my target market price) and I hadn’t expected a buyout. In this case I was lucky – not good. Acquisitions, good and bad news, CEO turnover, product failures and successes can’t always be foreseen by investors.However, you can be in a position that if you are lucky, you get paid.

I like the real option approach, akin to the Scott Adams approach in his book “How to Fail at Almost Everything and Still Win Big: Kind of the Story of My Life”. A real option is a right to do something but not the obligation. Mr. Adams spent years looking for projects that could result in success. If circumstances were favorable he invested in the project, if not, he abandoned. From an investment perspective, buying value stocks is about investing in undervalued companies that are improving, with the hope that a) they will continue to improve and b) others will notice and bid up the stock price. And sometimes you get lucky and the firm gets bought out.

There is an old saying about “the harder I work the luckier I get”. Usually old sayings are repeated because there is a kernel of truth. Being prepared to be lucky means you have to be prepared for success.

Be Prepared to be Unlucky

The one thing portfolio managers do better than individual investors is that they are prepared to sell when they are wrong. Sometimes luck doesn’t work in your favor. I have a client where a key customer has lost 50% of their business due to new state regulations that were unfavorable. Sometimes shit just happens. Being prepared for luck to work against you means having back up plans and reacting quickly and appropriately as new information is learned.

Charlie Munger recommends decision trees, where he plots out how circumstance, action and luck will generate results based on the probabilities assigned. Mr. Munger is planning on both good and bad luck and still looking for a positive result.

Unfortunately what we often define as “bad” luck is just the absence of good luck. You can’t plan a July wedding in Michigan and not plan for rain.

Be Prepared for more Fog

Mr. James concludes his article “…we may have underestimated the density of the fog. The randomness of the data is the fog. What I am saying in this article is that the fog may be many times more dense than we have been allowing for. Let’s look again; let’s give the fog a little more credit. Let’s not be too sure that we haven’t been missing something important.”

The fog of business shouldn’t preclude us from selecting a strategy. There are random factors that can outweigh our actions within the firm. Recognizing the fog is thick means planning for volatility both random and systematic. Because we can’t see through the fog, it shouldn’t make us think there is nothing in the fog, or that we can’t make plans or investments.

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Finding the Right Senior Executive

Recruiting talent is probably one of the most important jobs of a management team. Unfortunately it is a pain. Deciding who to hire takes time and requires a lot of thought. The consequences of the decision are great, which causes risk adverse executives to procrastinate and delegate the decision making to a committee.

Hiring a senior team member is even more complicated. Frequently there is a contract that needs to be negotiated, options, bonuses, other perq’s and job responsibilities to be decided. A new member of the senior management team has to work within their functional group (e.g. marketing or finance) and within a senior management group. So a lot of executives have say about the process.

I won’t rehash a bunch of techniques for getting the right person. I recommend “Who: The A Method for Hiring” by Smart & Street. There are a lot of books on how to hire although relatively few about hiring a senior executive.

The root problem is simple. We are all trying to hire someone who can do the job and and fit in with the culture. There is a lot of focus on limiting the risk of hiring which perversely can increase the chance you won’t find the right candidate.

The Downside of Minimizing Hiring Risk

There are several pitfalls in this risk oriented approach. A common way to minimize risk is to find someone who has already done the task in the same industry for another larger and hopefully smarter company. This approach has big drawbacks. First, you can’t assume that the challenges you have today will be the same in two years. Hiring a CIO with experience handling a crumbling systems infrastructure makes sense when you have a crumbling infrastructure. But are they the right candidate after it’s fixed?

Secondly, hiring from bigger, hopefully smarter firms doesn’t guarantee that the candidate knows how to succeed in your environment. A firm I was with wanted to jump start their internet initiatives and hired a head of the internet division from a big company that had a successful web site . The candidate interviewed well, was smart and knew the technology. However after joining, we found they were a caretaker manager, focused on maintaining a well functioning department that they’d inherited. The new hire didn’t know how to grow a business and left after six months having made very little progress. I see this all the time, growth firms hiring the executives from industry leaders such as Intel, Microsoft, Home Depot or Wal-Mart and being surprised to find out they’ve never actually dealt with much growth.

Another risk management technique is to hire someone you’ve worked with in the past. This is pretty common in Silicon Valley and it does limit some risks. However, the chance that someone you’ve worked for in the past is perfect for a position is remote. The risk of not getting along declines but the risk of not getting the right skills and competence increases.

In addition, most executives don’t want to repeat their same experience over and over. A lot of CFO’s get tired of the numbers and seek to move into operations roles. Any work relationship you enter where the employer is hiring one thing and the employee wants to do something else is bound to be a problem. This in some ways explains the relatively short tenure for CIO, CFO positions. After a couple of years these executives are bored and are ready to move on.

The best way to minimize risk is to follow a good hiring process. Hire people that fit and have the skills you need.

Determining Fit

Fit is a function of shared values. Defining a firm’s values takes some time and the result isn’t a black or white. I’ve successfully hired formal executives into relatively informal firms. Sometimes you can open up the values of the organization by hiring someone on the edge of the company’s comfort zone. This can be difficult for the executive (and the company) if it is too far a stretch.

I recently worked with a senior executive who lasted six months on a new position. The company is very loose, with no procedures, budgets, plans or structure. The senior management team wears jeans or shorts and the decision process is very consensus oriented. The new executive was a much more formal, process oriented executive, who worked more “top-down”. The fit issues were an issue early and they only got resolved when the new executive was ejected from the business. Failures like this are both costly and painful for the participants.

Identifying values in senior executives is a lot about understanding the stories that make up their lives. How they tell that story will help the interviewer identify the values of the candidate.

The CTO of Looker, Lloyd Tabb, commented in a recent interview on his secret question for hiring. Lloyd says he looks for “we” rather than “I” in the interview conversation. This is good advice as word choice often reflects values (although be careful, word choice can also be driven by culture and social groups). The culture at Looker is very customer and team focused and “we” oriented.

Interviews don’t often include much time for free ranging values discussions but they should. The interview process should include a meal, time away from the office and be a sufficiently long process to allow the candidate to open up about goals, plans and dreams. This is sometimes called the “open kimono” approach and it requires an equal amount of sharing from the company.

Executives searching for positions can similarly learn about the company by focusing on the process, people and surroundings as they go through the interview cycle.

Skills and Competence

Senior executives have the dual role of functional head and senior executive group member. As I noted earlier, we try to minimize risk by choosing executives from the industry. This avoids functional risk but the real risk of failure is outside the functional area.

Executives fail because they can’t effect change. It isn’t functional knowledge but the ability to get things done within the organization that makes a difference. Actual industry expertise isn’t all that helpful, as is expertise in the particular software or the particular systems the firm uses. If you are planning on turning over your management team every two years, it makes sense to hire from the industry. If you are looking to build a management team for five to ten years, then look for executives who have experience getting things done successfully.

One of the most effective firms I have worked with have the majority of senior executives from outside the industry. The new perspectives have allowed them to move a lot faster and smarter than hiring from bigger, slower moving competitors. Viewpoint diversity is valuable and new perspectives bring new ideas and fresh approaches.

Some of the worst hires are candidates with industry experience in weak firms with “it was someone else’s fault” stories. Every career has a clunker or two in it, but senior executives have to be responsible for where they go to work. If an executive has been forced out of three or four firms and can’t give a reference from any of them, it’s a red flag.

A senior executive has to be open to new approaches, but have standards they will always keep. Hiring a senior executive that won’t say no to the CEO is a waste of company resources and a disservice to the firm and the shareholders. As a hedge fund analyst, if I saw a CEO that dominated the management team, it was usually an excellent short.

A rule of thumb is that every senior executive should have the skills and abilities that could result in them serving as a CEO, either with this company or with another company. If I don’t see that ability, I pass. I am sure most of these executives will not serve as CEO’s, the opportunities may not come up, they won’t want to put in the time and effort or it isn’t a good fit personally. But having the communication skills, the curiosity, the optimism and the leadership that CEO’s have will make them better members of the senior management team. And that is the best way to minimize risk.

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Sales Forecasting, Budgeting and Igor’s model

As a CFO I have struggled with sales forecasts and budgets. Either I am presented with a list of sales initiatives that add up to a multiple of the sales plan (I call it the “whatever sticks” method) or I get a sales plan that lacks any detail at all besides a growth rate which is similar to previous years rates (the same as last year method). Both outcomes leave me unsatisfied.

The “whatever sticks” method usually is a brainstormed list of ideas that haven’t been resourced or have an effective plan of action. Because the total ideas add up to a big number everyone goes into the new year excited for results, only to be surprised by the end of the first quarter when the numbers don’t turn out. The estimates for sales were often the “seven sunny days” types, which counted on a lot of luck.

I used to call this the church potluck dinner problem. Every one brings a wonderful dish to the potluck. When you begin loading up the cheap paper plate, the salad gets mushed in with the beans and the jello ends up leaking into your chicken. As the line goes on, you realize you’ve run out of room for other attractive dishes and you build a second level of food. And the plate bends as it gets wet creating more unattractive mashups and nothing tastes right.

The “same as last year” method does a better job of focusing on the current business but it generated few new ideas. Projects that needed resources weren’t identified and budgeting was based on history. If any portion of the current business was changing the plan wouldn’t be accurate and we’d be playing catch up. The sales plan should include a list of action items that are assigned, have deadlines and are likely to increase sales. Otherwise the “same as last year” plan is based on hope and not action.

I used to teach a class where we’d use a linear regression equation to forecast sales of public companies. It works. The CFO/CEO should have a separate statistical model for sales. Sometimes it is more accurate than budgeting and it always provides insights when reviewing the plans.

Sales and profits are a function of taking a chance. Risk-less profits don’t exist and all sales efforts entail investment with an expectation of a return. I’ve written before about Frank Knight’s comments about risk and uncertainty (see here). Sales efforts are generally uncertain – we don’t know what will work and what won’t, but we need a method to organize and prioritize actions. If we develop a list of sales initiatives, how are we to sort through and assign probabilities or guesstimates of effectiveness? When will we know we have enough quality, resourced initiatives? I’ve found a simple insight by Igor Ansoff that can provide some help overcoming this problem. Igor Ansoff was a management theorist who laid out a simple 2×2 matrix, on one axis markets on the other products.

I usually draw this using the axis: Same/New Customers and Same/New Products. The list of sales initiatives are assigned to one of the four boxes. For example, opening new units for a retailer is New Customers : Same Products and is shown as “Market Development” on the chart. Obtaining more of a key customers business is Current Customers/Current Products or Market Penetration as titled on the chart. Line extension or Product Development is adding additional product or services to the offering to our current customers. In the chart the Diversification strategy is in red, and that’s a good color for this approach. New Products/New Customer strategies are startups.

Using the Ansoff Matrix helps identify the uncertainties and the holes in your plans. The holes are identified as you assort the strategies into the boxes. The uncertainties can be estimated by box. Market Penetration strategies will tend to be cheaper, more numerous with small payoffs and high chance of success. Market and Product Development will have worse chance of success then Market Penetration but will have a high payoff. Diversification will have the lowest chance of success. As a CFO, I rarely include in a sales budget a diversification strategy, mostly because I’ve been burned. Many (most) diversification strategies fail and all should be tested thoroughly before counting on them for sales.

With the Ansoff Matrix you can assign a standard deviation and mean result to success for each of the initiatives and then simulate a 1000 trials of the expected strategies. Many strategies are one-tailed or are options, which can result in a positive payoff, but only if certain conditions occur. Summing the range of results for the strategies selected gives a more accurate representation of potential sales and can set expectations realistically.

Taking these extra steps focuses the management team on strategies that generate a difference, while still staying within the level of resources the company possesses. Realistically if you are a star and finish your sales objectives by mid-year, you can just generate a new set and begin again (or get back in line for seconds!)

The way to solve the church potluck problem is to focus on a few things to eat and to leave some room on your plate for later in the line. The way to solve sales budgeting conundrum is similar. Being picky is good for management teams and good for a potluck.

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