Management – Page 2 – Bates Creek Consulting

Bad Growth vs. Good Growth

I believe there are two kinds of sales growth, good and bad. Bad sales growth is unsustainable, and in the end counterproductive. Bad growth maximizes sales growth over optimizing the factors which can lead to good sustainable growth.

Maximum sales growth seems great (who doesn’t want sales?) but it can lead to bad outcomes. A few examples, because the most instructive examples are the bad ones. I was working with a window covering manufacturing company that had a shot at landing a national big-box retailer. The CEO wanted the business and bid hard for the work. His company immediately increased by 50% but within 18 months went bankrupt. In his eagerness to get the business he bid below his fully loaded cost for the product and began to lose money quickly.

Under investing in systems and accounting kept the client from knowing their costs or how deeply they could cut prices. I met them about 8 months after the fateful bid, when I was brought in to purchase a high volume wood blind finisher to support their growth. While doing due diligence, I compared the costs for the target to the base company. Given that the target was specialized, 10x bigger and extensively automated, I was surprised that the target reported 15% higher costs than the base company. Digging into the internal cost data identified a problem in booking inventory that caused this discrepancy. The person in charge of inventory tracking (the owner’s sister) had no accounting training and wasn’t relieving inventory accurately. Her husband ran the manufacturing operation and he’d continually boasted about efficiency he’d gained. Those gains turned out to be spurious. It took only weeks to figure out that the base company inventory was overstated and that the new “big box” business had lost so much money that the equity was wiped out.

I once worked with an insurance company offering our customers the option of purchasing their product. The company was eager to grow the book of business quickly. They suffered adverse selection as the bad risks switched insurance to get the low introductory prices. Risk was significantly under-priced and profits, which were planned for year 2, ended up in year 4. Growing fast meant taking on unqualified and riskier clients. Bigness doesn’t overcome crappyness.

I was the lead auditor on a large auto company’s financing arm. At lunch one day, the top executive at the finance subsidiary said that the front office wanted more loans written and more cars sold. Since the financing division couldn’t access funds cheaply, the loans they offered had higher interest rates than average. Low risk borrowers weren’t interested in high cost loans as they had low cost options. Consequently the only way the company could increase loans was to take on riskier borrowers. Another example of adverse selection. I asked how this would play out. He said they’d write a lot of loans (and sell cars) but in a year a higher than average portion of the new loans would stop performing. Eventually the front office would ask that he clean up these delinquencies. He then would repossess enough cars to drop his delinquency rate to average. Repossessing cars is expensive and after the increase in losses due to the disposition of these vehicles he’d then be asked to limit these losses. If the scenario worked out as he’d foretold, he would likely obtain a bonus every year for achieving his objectives.

Creating growth like this is counter-productive. Yet lots of firms think it is as simple as the CEO ordering growth to happen. Smart growth is about balancing the factors of growth. People, resources, systems, processes, time and management must be balanced against sales growth. The factors must be optimized so that growth and profits continue. Optimization can be complicated, as there can be multiple successful solutions at varying levels of profitability. Some solutions are oriented to throwing bodies at the problem, other solutions might include implementing a computer system. Both ways will work, one way offers more flexibility and the other cheaper long term costs.

Most of the factors of growth can be quantified into costs, so there is a basic cost vs. profit model that needs to be managed, but time is the factor that determines the rate of growth. A firm that grows 10% and 9% in two years is roughly equal to a firm that grows 20% and 0%. The cost vs profit trade-off has to be seen over multiple years as costs often come as a steps. Investing in a new manufacturing facility or a new computer system is a step that will need to be cost justified over five or more years. Finding ways to minimize the height of the steps, planning on when to take the steps and grouping the steps into logical order are a big part of dealing with optimizing the growth rate.

It is easy to delay investment in these factors, but eventually the problem worsens which brings growth to a halt and sometimes worse. I am not suggesting that everything will be perfect before you can start growing – and growing fast. But as much as it is wanted or needed, when the car is doing 180 mph around Le Mans, you can’t change the tires. You can fix a foundation after the building is built, but it won’t be cheap or easy. Smart growth is about about balancing and managing these trade-offs.

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Dr. John Zott is the principal consultant at Bates Creek Research & Consulting.

I am the chair of the Careers Committee at FEI Silicon Valley, a senior adjunct professor at Golden Gate University and I comment regularly on issues that affect growth businesses. If you are looking for a CFO for your consumer company, or are a former student, colleague or would just like to connect – reach out.

Paying a Price for Certainty

We all want certainty. We want our investments to average 5% return a year (7.375% if you are in the state of California), our children to grow up strong and healthy and it to only rain at night. However, life is uncertain.

Insurance is about creating certainty. A small cost is paid, instead of a small chance at a large loss. Health insurance is part pre-paid services (check-ups) and part joining a purchasing cooperative (in-network pricing is a lot cheaper than out-of-network) and part real insurance. Car insurance doesn’t include oil changes, although they do control where certain repairs are made. Not just insurance companies make money on reducing uncertainty.

I once had a competitor that sold a tuning service for radios and electronics. This advantage was a significant part of his marketing and brand value. At some time in the past, there might have been some value in swapping out vacuum tubes but since the 1960s most marine electronics were solid state. By the 1990’s there was nothing to be done to a solid state radio, and if they didn’t work out of the box, they had to go back to the manufacturer. He sold fear, uncertainty and doubt or FUD.

FUD was made famous by IBM, who would meet every new competitor in the computer industry with comments about reliability, threats of the loss of warranty coverage, rumors of financial difficulty and vague hints about losing purchasing status. For the longest time I’d hear the comment “no one got fired for buying IBM”. FUD works.

People will pay for security – even if the math suggests it is a bad bet. My firm started selling extended warranties on our products. This was a big money maker for Circuit City as electronics extended warranties had a 90-95% margin. For a while the staff wouldn’t sell them, they thought the extended warranties were a rip-off of the customers, and we had a no-hassle money back guarantee. Buying an extended warranty is not a good bet, but people appreciated the certainty and paid for it.

Eating at McDonald’s is not normally a “treat”. We select fast food because of the consistent product, price and convenience. We know what we are getting – uncertainty is reduced. Retailers who reduce uncertainty increase sales. Zappo’s can sell you shoes because they agree to take all returns. I doubt Zappo’s makes much profit on its shoes, the freight has to be killing them (see here) but given that Amazon owns them and Amazon is the worlds largest capital destroyer it is ok.

I see the problems with seeking certainty as a function of information asymmetry, competition and add-ons. The retailer that offers a money back guarantee knows how often goods are returned and when they sell you an extended warranty, the likelihood of your using the warranty. You can’t judge if it is a good deal or not. Those situations are referred to as information asymmetry, where one side knows more than the other. Learning more about failure rates can give you confidence to skip paying an extra 15% for a product, knowing the chance of fault might be 0.02%. A phone with a one year warranty and a three year overall life doesn’t present much time for a failure.

Your car insurance company knows more than you do about the likeliness of an accident and they price the insurance so that they make a profit. The car insurance company is kept honest by a competitive market place and regulators. Competitors push prices towards an equilibrium, which is lower in price than an un-competitive market.

The least competitive market is one where you have little time and no access to competitive prices or data about risk. This happens while standing in line, or in the midst of a transaction when an add-on is offered. Rental car companies are good at offering you several levels of insurance-like services (one full priced for 100% coverage, a second with a deductible, a third with a collision damage waiver) while all levels of coverage are priced extremely high. It is not unusual to pay $5-6 a day for coverage for your new car, and $40 a day for insurance for a rental car. The extended warranty is pitched to you at the register without any time to calculate the costs, benefits or risks.

Seeking security isn’t a problem, and reducing uncertainty isn’t bad. One consequence of a population that doesn’t understand probability is that we will be taken advantage of by providers of certainty. Be a smart consumer, do your research before you buy.

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Dr. John Zott is the principal consultant at Bates Creek Research & Consulting.

Six Challenges for Investor Relations

Investor relations is broken. It isn’t the people, it is the process. Most senior executive see it as a department designed to help the company put their best foot forward. The skills needed are someone who is good with powerpoint, knows numbers and can talk to analysts all day long without going crazy. I think this definition misses six key challenges for Investor Relations.

Challenge #1 Investors have no time

Investors are limited by time and attention. Investing is based on financial reports which are both long and redundant, and the amounts of disclosure are not improving investor knowledge (read this). The SEC and the FASB have turned a simple financial statement into a career generating stack of paper. A typical 10k runs 100+ pages and is stuffed with disclosures, reconciliations and accruals.

A typical financial model will go back 10 years and ideally, all the 10k’s & q’s should be read from the entire history. Most are not. I bet that fewer than 50 people outside the company conceivably completely read any 10k document. Most analysts look at changed pages from the previous document, skim the management discussion and update the models with the key data. If you own 50 stocks, your reading load might be the same as knocking off three books a week in SEC filings alone, not including the other material you read to know what is going on in the economy.

Time pressure causes investors to look for shortcuts to the intellectual rigor of a complete and detailed review. Pattern recognition conserves time and brain power. Investments are selected that are similar to past successes. Investors classify stocks by lots of methods (growth, value, etc) to eliminate the time memorizing details about every company. The intellectual demands to obtaining, sorting and absorbing the material means that complicated stories are often ignored or missed. Complicated analysis, the use of a lot of jargon just make the analysts job harder, and therefore less likely to expend the energy to invest in your firm.

Clarity increases comprehension and makes the job of an investor easier. Easier means better analysis and better communication and a better stock price.

Investor relations has to recognize the time pressure and focus on a coherent set of facts that allow a potential investor to understand the business and make a prudent investment.

Challenge #2 It’s not just numbers

For the last fifty years we’ve been training executives in quantitative analysis, and today’s MBA’s know how to deconstruct a business. Because of our emphasis on numbers, today’s executives tend to manage rather than lead. CEO’s and CFO’s certify that the financial reports to the best of their knowledge do not include misstatements, or are misleading. Making both CEO’s and CFO’s more involved in the data and detail.

Investors do not have access to the details of the business, and realistically we can’t share them. Analysts are trying to make meaning out of disclosures, so they ask a lot of questions about management’s impressions or thoughts (or my least favorite “add some color to the numbers”). When analysts ask these questions, they are asking for help understanding the bigger picture and cannot tie in the numbers to a direction or theme.

Santa Cruz cows out standing in their field

They are looking for the story behind the numbers. When a senior management team that generates and lives on numbersis selling to someone who is looking for a story, there is a disconnect.

Humans like stories (see here for Paul Zak’s HBR article) and we remember them better than the numbers. The story provides structure to our understanding and helps add meaning and relevance.

Investor relations has to communicate a story that makes sense. It has to be reasonably based on history and explain a direction and purpose for the company. It is more than the just the numbers.

Challenge #3 An Outside Perspective

Investors have one huge advantage in valuing firms that senior managers lack. They have an outsider’s perspective. Working at a hedge fund meant sorting through 2-3 firms a week. You hear what the other firm’s have been saying, you can compare this quarters disclosure to the last 15 quarters, you aren’t sitting on half a million options that are underwater. The outside perspective is very valuable, I have written about it before (see here). Outsiders haven’t drunk the company Kool-aid, they aren’t convinced of the company’s invincibility and they aren’t incentivized to worship the company mission. This perspective is valuable to CEO’s and Boards, but the criticism is dismissed because the outside view often is working off of fewer facts and CEO’s reject criticism of their strategic plans.

In a capitalist system, the investment community is the owners of the business, and we should listen to the owner, even if they are sometimes wacky.

Investor relations needs to be a vital conduit about market perspectives on company strategy. That message has to come back to senior management the board and the CEO in actionable and understandable ways.

Challenge #4 It can’t be delegated.

Management gets a chance a couple of times a year to tell their stories to the investment audience. The simplest way to tell of a management team lacks a coherent strategy is if they can’t get the message across in the 25 minute talk they give before the break-out session. If in 25 minutes you can’t get the message across to the 40 or so MBA clones that make up the ranks of stock analysts, how did you get that message across to the 10,000 high school graduates that make up your workforce? Whenever I hear jargon and business-speak when a senior executive is discussing strategy, I know that strategy is dead on arrival when it gets to the front-line worker.

All presentations should be practiced prior to being given. If we work for the investors, what message do we send when we arrive at our meeting and our report is fumbled and ill prepared? I’ve never believed the stats about how much of meaning in a conversation is non-verbal, but I respect it is very high. Stumbling through a presentation reduces personal and firm credibility.

Investor relations is the responsibility of the CEO and CFO, and hiring a director or VP does not absolve you of the responsibility of being prepared, practiced and ready when reporting to the investors.

Challenge #5 – Authenticity = Credibility

George Burns was quoted “sincerity – if you can fake that you’ve got it made”. Senior executives think of IR as a something that can be faked. After reviewing 100+ companies a year for 12+ years, I’ve seen a lot of pitches. Figuring out what the management team does and doesn’t know is how we made money. If you state that you are #1 in something, you’d better be prepared for us to check.

Most Investor relations staff get the compliance problem. All the numbers are verified, everything is properly sourced. Then the CEO or CFO make an off-hand comment that will end up on a transcript and will be fact checked. I’ve written before about the average experience of stock analysts (see here). New analysts spend a lot of time reconciling cognitive dissonance, which is a fancy way of saying, does management “walk the talk”.

I’d rather a management team was perceived accurately, even if that perception was negative, for example as aloof or uncommunicative, rather than as something they are not.

Investor relations stands for authenticity and accuracy. Senior executives aren’t clones, and should be respected as individuals. Don’t write speeches full of bafflegab and resist the use of jargon.

Challenge #6 – Everyone is an Investor

Most companies incentivize with stock options and most stock option grants are small. Outside of a relatively small circle of high paid executives, most option grants hold little perceived value. They have a cost, but the perception is that they don’t have any value until they are vested and are deeply in the money. The staff needs to hear the story as much as the analysts do. Vendors may make million dollar commitments for a new product line and they need to hear your strategy. Customers, especially when they are making a commitment to a product, need to know whether the company is viable.

The reality of today’s connected society is that the number of people who “care” about what IR has to say is much greater than before, and those listeners have much more influence the firms success.

Investor relations material should be prepared for all the stakeholders, based on their needs. The delivery of employee oriented material may be through HR, but that disclosure should be focused on the key story and theme set by the strategic plan.

Conclusion

Investor Relations needs to play a bigger role within your firm. Helping develop the strategic plan, communicating a coherent story with numbers that provide clarity and understanding. It is time that IR is more than someone who talks to analysts and comes up with a quote.

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Dr. John Zott is the principal consultant at Bates Creek Research & Consulting. I am the chair of the Careers Committee at FEI Silicon Valley, a senior adjunct professor at Golden Gate University and I comment regularly on issues that affect growth businesses. If you are looking for a CFO for your consumer company, or are a former student, colleague or would just like to connect – reach out.

Three Thoughts on Balancing Profit and Uncertainty

Life is uncertain. Any entrepreneur knows that to start a business, you have to take a chance. You can calculate the risks, manage what factors you can, work as hard as you want, plan as extensively as possible, but there is always uncertainty and risk. Frank H. Knight defined risk as events that have a probability and a severity and are calculatable. Uncertainty is defined as those events without a probability and a severity. We face both uncertain outcomes and risk in our lives.

As a professional CFO, I’ve worked to limit uncertainty and manage risk. Eliminating risk and uncertainty however is impossible and will kill a business. The very nature of profit comes from taking a chance and offering a solution for a customer. A risk-free (and low uncertainty) business doesn’t exist. The closest we have to a risk-free return is a 10 year bond, which is trading today at about 2.2%. If you want to make more than 2.2% you are going to have to take on risk.

Running a business is about balancing all the factors: risk and uncertainty, the operations and the market so at the end there is a profit and a return on capital.

Profit comes from risk taking. The risk taking must be commensurate with the return, or it is foolish. Steven Crist wrote a chapter (see here) on value in the book: Bet with the Best: Strategies from America’s Leading Handicappers. Crist points out that even bets that are likely to lose (betting on a 4:1 horse, when the payoff is 12:1) can be a good investment.

Managing risk (and opportunity) sometimes means thinking about what could change. What assumptions are foundational to the business model which if changed would result in a serious impact to the firm? Although you think that there are relatively few of these, there are many, but thankfully they are relatively rare.

Many retailers were well aware of the impact of e-commerce, but few generated a capable response. Most dumped their catalogs and full product line on the internet and waited for customers. Worse yet, few planned for the inevitable loss of market share or the increase in new competitive business models (Stichfix, Frank + Oak, Thred-up) that might arise on-line.

Nassim Taleb talks about the four largest potential losses in Las Vegas, one of which became real: Siegfried and Roy’s magic and wild animal act was ended when a tiger attacked Roy. Roy later went on to say that he had high blood pressure and believed he had a stroke during the show and the tiger sensed that and was dragging him to safety. If Roy had died from the stroke and not the tiger attack, the result would have been the same, cancellation of the show. When a great deal of income depends on the health of one man, then there is a big assumption of risk.

Business decisions can increase or decrease risk and uncertainty.

Every decision we make creates new risks and uncertainty. Selecting a new ERP system? Hiring a new executive? Changing a key purchase policy? All will create both a primary effect and secondary effects that are unknown. Not making a decision, often called strategic dithering, creates additional uncertainties. Mark Fields was recently replaced as CEO of Ford, apparently because he wasn’t moving fast enough on self-driving cars (see here). I am not certain that a faster approach to self driving cars creates a lot more value than being second with a better product. But either way is uncertain.

Too often executive teams ignore risk and uncertainty factors in making their decisions. Anecdotes are easy to understand and are compelling although they are often sample sizes of 1. In the hedge fund business we used to say “beware the narrative” as we were afraid of being seduced by the simplicity of a good story. Balancing the trade-off between customers and operations without assessing the change in risk will likely lead to increased risky behavior and calamity.

Invert the decision making model – think about increasing risk.

Risk is necessary for profit, but risk as I’ve noted is calculable. Can you decrease risk for a customer and create greater sales and profits? Grouping uncertainty and risk can decrease overall risk. That is what insurance companies do. Offering a money back guarantee on products for a retailer is simple. If you realize you can return the product, you are more likely to buy, even if you are extremely unlikely to return the product. The highest margin item I’ve ever sold was warranties on electronics. Most are never used.

If you are a SaaS business, how can you lower the customer uncertainty and increase your payout? Most firms find buying a new system a major endeavor. They’d like to be married, without the process of getting married (which is a hassle). The risks are centered in the conversion, implementation, training and the first 90 days of the new system. Firms will pay to have implementation risk decreased.

Playing safe isn’t always a good option (see here). My local community has half a dozen businesses that are clever, deliver great value and could have a national presence. They don’t because the owners are happy enough with a small local business. Every couple of years change comes to the community or one of the owners and one of these businesses dies. I am not arguing all small businesses should become Staples, but as John Shedd wrote “A ship in harbor is safe — but that is not what ships are built for.”

Conclusion

I think a lot about balancing risk and returns. If you bet the long shot that is undervalued, you may win big, but you will most likely lose. Losing isn’t bad in this case, it is just one iteration of a process that brings a profit. Avoiding risk isn’t possible, but whatever approach you take, keep an eye on the tiger.

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Dr. John Zott is the 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 looking for a CFO for your e-commerce/retail/consumer company, or are a former student, colleague or would just like to connect – reach out.

R-E-S-P-E-C-T

Mark Zuckerberg recently spent a day working in an F-150 assembly factory in Dearborn, Michigan. I don’t know why he did it, but his experience, I am sure, was valuable. I worked in a factory for a summer in between my sophomore and junior year in college, where I also learned some valuable lessons.

My factory was in Whitmore Lake, Michigan and I was a temporary summer employee. The plant is gone now, just a large piece a of concrete in a field. The company that owned the plan is gone too (and the company that owned it after that) and the plant address is listed as a superfund site.

My first lesson was when I found out that joining the union wasn’t the same as getting union representation. The UAW and the auto parts manufacturers had a deal where the temporary worker would pay union dues and a union “sign-up” fee and get union wages, but wasn’t represented by the union until after 90 days. Good for the auto companies, good for the UAW, just not as good for the temp worker. At the time the job paid pretty good, in the $7 an hour range, ~2.5x minimum wage, or inflation adjusted $25.60 an hour. Current automobile company UAW temporary wages are $15.68 an hour about 1.75x minimum wage. The current contract has two tiers, higher one for most the union voters, lower ones for new people, so things there haven’t changed.

Getting hired was easy, I took a drug test (pee’d in a cup), answered a few questions and started a couple of days later. I found myself on the line with several other fellow students from the University of Michigan working as temp’s in addition to the “permanent” staff. We manufactured bucket and bench foam seats Liquid foam was placed in an aluminum mold which a conveyor took through a large oven where the foam expanded and set. The foam seats were removed from the mold, cleaned up and then packed for shipping. My station was tucked behind the oven up against a wall, separated from the main work area by a wooden bridge that passed over the conveyor system. The mold’s exited the ovens at over 150° and the work was hot and repetitive. We worked in pairs. We had about five seconds to twist off the little foam buttons that had flowed out of the mold bleeder holes before the mold was cracked open. If we had time, we carried a wire in our hands to snake out the bleeder holes. If the bleeder holes were blocked the next seat made in the mold would be ruined.

There were a hundred petty insults at work. During a line stoppage, we swept up the floor in our area. The scrap was 2-3 inches deep around our ankles. When the foreman found out, he yelled at us. Cleaning up was the sweeper’s job (a different job class) and we weren’t supposed to sweep. The sweeper team was always working up front, since it was air conditioned, and not in the back of the factory. After that we still swept but we never swept it clean so we couldn’t get yelled at.

Management had a weak relationship with the UAW and there were a lot of arguments about the contract. For instance, the contract said when it was over 90 degrees outside for more than four hours we got free sodas. It was a hot summer and the first time we qualified, the union steward went to management and demanded our free drinks. The foreman returned with cases of off-brand drinks from a closet in the tool crib. The surprise was on us, they were undrinkable, as the temperature in the tool crib closet was easily over 100 degrees.

Toward the end of the summer the company went to a new cleaning process for the molds. The cleaner used was carbon tetrachloride (at the time used in dry cleaners and in refrigeration). One afternoon the line stopped and we were told to sit and wait. We waited 15 minutes, which was a long time for the line to be down. Finally the foreman showed up wearing an oxygen mask and tank told us there had been a dangerous spill and we were to evacuate the area. Apparently no one thought to just yell over the bridge to evacuate as soon as the spill was identified.

The carbon-tet and the heat began to cause problems for the workers. When I’d get off work, I’d see a halo around the parking lot lights. This effect went away the next morning. After a couple of weeks the effect didn’t go away until the weekend. We were then warned not to wear contact lenses to work, as the chemicals were softening our corneas. I was off for a couple of days and the company installed big fans to push fresh air down into the building. The air still smelled of course, because the fans intake was right next to the exhaust ports for the ovens. The front office staff rarely came into the factory – it was hot, uncomfortable and it smelled. When I reached my 88^th day as per the UAW contract, I was let go, which was fine with me, it was time to return to college.

My coworkers didn’t care about management or the company or self-actualization. They worked in the factory for one reason, money. In the factory, you worked to live. They didn’t want a career, they weren’t willing to eat hours so that the boss would look good, they didn’t study for professional exams or spend hours trying to figure out how to get promoted. Some of my co-workers were lazy and spent more time hiding from work rather than working, and some were high pretty much all day. However, most were focused on their life outside of work and they just wanted a good paying job, do good work, avoid hassle and go home at the end of the day. A little respect would have been nice.

A great example of modern worker motivation is shown in the movie “The Circle”. People are working long hours to make a difference and to be a part of the in-crowd. Firms expect staff to put the company first in all things, socialize with co-workers, to work diligently to meet some arbitrary performance goal, and to pour their lives into the business. Home Depot called it bleeding orange. This isn’t a new sentiment. Frank Borman, the Apollo 8 Commander, lectured at the University of Michigan about putting the company first in his executives lives. He stated that he hoped their family or their church was second, but Eastern Airlines should be first. Eastern Air Lines is long gone (sold three times), Borman, on the other hand, is still going strong at 89. I wonder if he still believes that Eastern should come first in his life?

Although “The Circle” is satire, you can’t help but recognize a lot of today’s work environment. Late night texts, work flowing into personal time, privacy disappearing and a lot of double speak covering up the pressure to work harder and get more things done. Working in a factory is simpler, you show up to work, you get paid. The results are clear, they are stacked in the warehouse. Work today is more complicated, and does not always result in clear outcomes. Respect is even more important as the assets aren’t molds and ovens sitting in a factory, but brains and know-how which goes home every night.

While working at the factory, I learned about the value of respect. CEO’s forget that people are sometimes motivated by different things. Sometimes, the staff just wants a job. In the end, all effective motivation is internal. You can’t add it on by yelling at your staff, motivational speeches, clever bonus plans or free cold drinks (although that would have been nice). You need to connect with the staff by what motivates them, not you. Respect goes a long way in business. I hope Mr. Zuckerman got that from his time at the factory.

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Overconfidence and You

There is a psychological phenomena called the Dunning-Kruger effect. It states that unskilled people may not know enough to figure out that they are below average. Dunning et al recently wrote in Why People Fail to Recognize their Own Incompetence (Current Directions in Psychological Science, 6/23/16):

…people tend to be blissfully unaware of their incompetence. This lack of awareness arises because poor performers are doubly cursed: Their lack of skill deprives them not only of the ability to produce correct responses, but also of the expertise necessary to surmise that they are not producing them.

It may feel good to think about all those “unskilled people” who go through their lives blissfully confident and unaware that they are unskilled, but to do so misses the point. By definition, half of us are below average and all of us are unskilled at some tasks.

The Dunning-Kruger effect is closely related to the overconfidence bias and self-serving bias. The overconfidence bias is the tendency for humans to be over confident about their skills, abilities and choices. Self-serving bias is when we attribute success to our skills, and failures to external factors or other people.

Unfortunately, overconfidence can be the most destructive bias and is one of the most pervasive. Everybody is overconfident, even you and me. Daniel Kahneman who wrote the book about overconfidence said he believes he is still overconfident. Self-service bias helps protect our self-esteem. Frank Knight stated that sometimes it is the belief in our own luck, and this bias dates back to the bible when Adam blames Eve for his mistake in eating the apple. Self-serving bias can be witnessed daily in the Wall Street conference call.

I cover these biases in my class on Behavioral Finance at Golden Gate University. Given a stack of behavioral finance books and some time on the internet you will find that humans aren’t the rational beings we think we are and are frequently biased in certain directions. The increasingly detailed definitions of biases seem to be primarily about generating academic papers, but the Dunning-Kruger effect is worth thinking about because it happens a lot in business.

Business leaders want to appear upbeat, positive and confident, and acting this way (see here) tends to make us confident. This isn’t the same as “fake it to you make it” (which I recommend to my students) as you know when you are faking it. Kahneman stated in his book Thinking, Fast and Slow that “An unbiased appreciation of uncertainty is a cornerstone of rationality— but it is not what people and organizations want.” We want certainty in our leaders, not complexity. There are no clear tests of business ability so it is easy for executives to be overconfident of their skills.

Ignorance more frequently begets confidence than does knowledge: it is those who know little, not those who know much, who so positively assert that this or that problem will never be solved by science. Charles Darwin

Hiring

I used to think I was a good picker of executive talent. Of the five controllers I’ve hired, the majority have gone on to be CFO’s, and I’ve had successful hires for CIO’s, President, VP Human Resources amongst others. I recently talked to Dave Arnold, a recruiter who has hired hundreds of CFO’s with success. Dave interviews 20-30 candidates a week and used to teach interviewing skills to management teams. My confidence in my interviewing skill was based on a small sample size and a comparison to other executives who may not have been great interviewers either. There is a lot of evidence that interviews aren’t that helpful for many jobs, due to interviewer incompetence and candidate dishonesty (see here and here).

I once worked with a leading recruiter for a COO position who kept sending us candidates who lacked analytical skills. Eventually after a long search the CEO hired someone. Within a year I was walking the new hire through their termination paperwork. Conversations with the recruiter revealed that the CEO had been very specific and the “weak” candidates were exactly what was requested. The recruiter knew that the CEO was wrong but eventually caved in. CEO’s who express confident answers even while they lack knowledge is known in Silicon Valley as “Founderitis” or Founder’s Syndrome (see here and here) another form of overconfidence.

With a small sample size, you are especially prone to be overconfident about hiring skill. All failures are blamed on the candidate, all success is attributed to management competence. Hiring a competent recruiting partner lowers risk and makes you smarter.

Investing

Private Equity fund managers are quite confident at investing in growth companies, even when evidence doesn’t support their confidence or skill. As a hedge fund analyst, I followed firms who kept growing even as signs of declining productivity and performance became overwhelming. Rue21 in 2012 boasted that they were opening units in Paris (Texas), London (Kentucky), even while average volumes in new units were down double digits. Apax Partners then paid $1.1b to buy this 877 unit chain in early 2013 and grew it to over 1,200 stores by the end of 2016. Associated Press reports that Rue 21 is closing 1/3 of their units in 2017 to end back at ~800 stores. To spend four years to end up where you started is a bad outcome. The trends in the industry (e-commerce!) and in Rue’s numbers (declining ROI) have continued to the surprise of their investors. And unfortunately, there is a significant chance this isn’t the last bad news out of Rue.

During the 1980s there were a group of auditors out of Texas that used to celebrate the completion of a savings & loan audit with a party which featured drinking champagne out of their boots. (I didn’t witness this, darn! I heard the story from an audit partner who’d paid a sizeable sum of money to settle the claims.)

A couple of things you should know. First, you ruin good champagne by pouring it in footwear, and secondly, wine is not particularly good for leather. Auditors who think this is a good idea probably aren’t appropriately risk and control oriented. And investors in businesses that need risk management (like a S&L) shouldn’t hire champagne swilling auditors who can’t afford stemware. The person who told the story considered himself a savvy businessman. He put the blame for the eventual failure of the S&L and expensive legal claim down to bad management, the economy and regulators and none to the audit team or the firms’ lack of risk management.

Elizabeth Holmes dropped out of college to start Theranos at 19 with $6m in venture money. This ballooned into an eventual $700m of private equity/mutual fund financing. Ms. Holmes reportedly used to keep the office in the mid-60s so she could wear her signature outfit: black mock turtleneck, black pants and puffy black vest. In January 2017, Theranos laid of 40% of the staff and in April 2017 agreed to leave the blood testing business for two years to avoid further sanctions by the Centers for Medicare & Medicaid Services.

Who invests in a company with a CEO who can’t figure out how to take off her vest? Although Ms. Holmes wanted to be Steve Jobs, she didn’t get that even Steve Jobs wasn’t always Steve Jobs.

Nassim Taleb talks about Black Swan’s as unpredictable or unforeseeable events. I’ve commented in the past (here) that “black swan” events decline as learning increases. In this case, it appears that Silicon Valley VC’s didn’t participate in the funding of Theranos and most of the money was private equity and east coast VC funds. Vanity Fair reported that Google Ventures staff had attempted to get a blood test using the proprietary Theranos Edison machine, and found instead of taking a pin prick, the test used the same samples used at any clinic. Google Ventures passed on the investment. What did they know that $700m in capital and a board full of luminaries did not? Why no medical expertise on the Board? Why was there no CFO?

Theranos was intensely secretive about its Edison technology which, based on the latest disclosures by the company, never really worked. Probably smart keeping it a secret. Every investment mistake isn’t due to overconfidence, of course, but these examples show that sometimes even the experienced are unaware of how unskilled they are.

Human Resources

There has been a litany of “bad behavior” stories in the paper recently with Uber, Snapchat, GitHub all being hit for sexual harassment and not following basic human resource standards (see here). These companies have sufficient money to hire a senior HR executive but they didn’t think they needed one. That was a bad choice. Between the bad publicity, the lawsuits and the costs to correct the problems, these firms and executives are learning the cost of ignorance.

Scaling a rapidly growing business isn’t easy. Not all of it is renting space and hiring. Being really good at technology or raising money or even having a terrific idea is helpful but it isn’t enough. It takes a team of executives. We shouldn’t be surprised however when we hear of these problems, Uber won’t admit that it has a CFO (see here) and Tesla and Github are both going through relatively rapid CFO changes (see here and here). The CEO’s including Travis Kalanick (Uber), Elizabeth Holmes (Theranos) and Chris Wanstrath (Github) had no experience running any successful business prior to their startup.

Learning is at least partially about reducing unforeseen, unexpected and negative events. There are techniques for overcoming our overconfidence and Dunning-Kruger (see here, here and here) and if practiced, can help. We also can be amused at the unskilled and how they don’t realize how incompetent they are. But we shouldn’t be amused without realizing that sometimes we are the unaware and unskilled.

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Three challenges to E-commerce

I wrote earlier about product solutions and customer focus in my post about physical stores. Bricks & Mortar stores have the advantage of having the person physically present and able to try on merchandise, see how it might look in the home, gain ideas about additional items they may want. The perfect physical store. however has a built in barrier , too narrow a customer focus, there isn’t enough sales, too wide a focus and there is too much selection and there aren’t any profits.

E-commerce holds some hope for meeting our dream shopping experience. The e-commerce company has the same advantages as physical retail when it comes to buying and some distinct advantages in assorting product. Because they ship from a central location, they can have significantly greater selection stored efficiently in a warehouse. Web-sites can track preferences and construct a set of options that better match potential needs. However, they have there own challenges. Here are three I see.

Problem 1 Freight and Time
The downside for e-commerce is the cost of freight as they are selling (and shipping) in each’s and the wait for delivery. Cost and delay remain big reasons why e-commerce won’t end up with a 100% market share.

As much as UPS/FEDEX and the post office work at it, driving to the store and loading the trunk is still the cheapest and fastest way of home delivery. Shipping costs are very high for the last mile, but are pretty reasonable for the first 1,000 miles. You can have a container into the US for under $2,000 and it can hold 20+ tons of goods.

Amazon Prime offers free freight, not Fedex and UPS. UPS posts operating margins of 3-4x Amazon’s merchandise division. Amazon, I am sure has negotiated a great deal on freight, but freight is still 10-15% of the product price. If you’ve received a package from Amazon, you know they don’t ship efficiently either – as most boxes are less than half full.

I was with an e-commerce furniture business (I was younger and much more comfortable slamming my head against a wall) and the freight issues were daunting. The product was hard to ship, had unusual shapes and had to be carried into the home. Every dent, nick, mark or spot had to be fixed, no matter how minor, either at delivery or in a second visit. Getting the goods from the factory to a store was inconsistent, and getting from factory to home was far worse. There is a reason why Ikea flat packs their furniture, it ships cheaper and any scratches you put in it are your own custom additions.

Amazon has taken steps with their lockers to reduce the cost and speed delivery, and other e-commerce sites have gotten better at packing items in bags which weigh less than boxes and ship cheaper. Drone’s won’t deliver packages cheaply, you’ve got to fight gravity, which until we invent flubber or mine unobtanium, is a loser game. Maybe driverless delivery vehicles will be an option, but realistically that is still a long way off.

The solution here is to better use the resources we have. Amazon has a same day delivery service, which is priced for prime customers at $5.99 for up to $35 and free over $35. So an order for $25 comes with a 24% shipping charge. Without prime the delivery charge is $8.99 + $0.99 an item. If the average order is $50 and three items, then the freight is also about 24%. An option, but not a cheap one.

Amazon recognizes we are still going to visit a grocery store and the Amazon lockers are nearby. The US Postal Service visits each house 6x a week, so lighter packages can use this cost-effective option. Amazon is considering a bricks and mortar store where after ordering on-line, they pick and pack your goods and you drive by and they load your trunk. This eliminates the delivery issue.

The freight and delay problem is physics, time, weight and distance. For bulky or heavier goods, or perishables this problem won’t ever go away.

Problem 2 Seeing vs Seeing & Touching & Tasting & Smelling and Hearing

If you know what you want, e-commerce is great. One copy of a book is the same as another copy. If what you want has smell, can be touched, sampled or tried on, it is a barrier to an online sale.

My wife is a knitter and my favorite socks are hand knitted. These socks are made with self striping yarn (the yarn is colored in lengths such that you naturally get stripes). Although there are a lot of on-line yarn shops, most yarn is sold in person, because knitters will be spending a lot of time holding the yarn and the feel is important.

Knitters buy a lot of yarn, but given the collection my wife has, each purchase decision is unique. Some online knitting stores offer sample skeins, lavish descriptions, or a lot of detail to help you make up your mind. All of these steps work to lower the barrier to a sale.

The catalog industry dealt with this issue for years, and J. Peterman probably does the best job of romanticizing a mundane product like a t-shirt (this one $29).

On the banks of the Seine, lots of students and tourists hoping to be mistaken for natives, lots of blue-and-white striped shirts… but that deckhand over there, throwing a hawser out to a tour boat, he’s wearing this shirt.

E-commerce has an advantage, you can show multiple pictures, multiple colors add pages of information that you couldn’t fit in a catalog. However lots of products still lack key information. This t-shirt at Walmart.com is under $6 and although the prose lacks the background story of the J. Peterman version, it is still a lot of copy. The missing piece is the fabric blend which apparently uses X-Temp technology. By the way J. Peterman doesn’t share that information either.

E-commerce companies can focus on goods that either don’t appeal to the other senses (i.e. books) or they can sell goods that you already know and enjoy and are rebuying. When they get into goods that have other sense parameters, they need creative strategies to help close the sale.

Problem 3 Personalizing and Privacy

The promise of e-commerce was to make stores more personal. They are better but are still failing.

To be the perfect store, the shop keeper needs to know you like a personal shopper does. Currently, too many sites still don’t get the reality of being human. No matter how much I like a pair of shoes, if they aren’t in size 12 (or 12.5), I can’t buy them. Humans have height, width, shapes, and we exist in a physical
space. A lot of sites have improved, but it is still maddening to pick out something and find out that the only size available is XS. The implication of not being directed to search by size is that the store has all sizes in stock. When they don’t they’ve broken a promise.

Amazon comes the closest to my fantasy perfect store. They generally suggest similar goods to what I have bought before. The algorithms are still weak and often what they push seems more important than what I want. Recently on my home page from Amazon I was shown an introduction to innovative products that included a very nice set of women’s shoes. I don’t buy women’s shoes. My wife buys shoes, but not on my Amazon account and not these.

They also featured a Tim McGraw & Faith Hill album. I don’t like Tim McGraw or Faith Hill, so wrong again.

My landing page always includes a pitch for a Kindle Fire, although I own one already (and two kindles, and yes, it is a disease). At Christmas I often buy my wife the knitting books she has placed in her wish list. Then for the next four months I am inundated with offers for more knitting books without the option to remove them from my recommendations.

Amazon’s dash button is helpful, again because so much of buying is rebuying. Once we pick a solution (for toothpaste, soap, batteries or footwear) we tend to reorder that product until we grow dissatisfied or hear of something better. So far, I’ve yet to use a dash button.

Privacy remains a big issue. Amazon’s approach is more than a little creepy as they use your searches to change the home page. However, many sites, even after logging in, offer no personalization, which is uncaring but obviously way less creepy. I don’t mind that the waitress at my local breakfast place knows my breakfast preference. I don’t mind that my favorite cashier knows my name. However, neither of them will start asking about what I am shopping for on other sites or keep a detailed record of my browsing history.

Ideally, we’d own our preferences, and share what we wanted when we arrived at the site. Our avatar would include what we normally buy, size and color preferences. And when we leave, our avatar would leave with us. That is the way it works in the real world (until they start this from Minority Report or this from real life). Until we come up with some portable way to manage our preferences and control who sees them, then we will suffer with e-commerce retailers knowing a bit too much about us for comfort.

I think all three barriers can be dealt with in time. The equilibrium between physical and virtual retail will be based on the problems, relative costs and benefits. The US Department of Commerce has e-commerce at about 12% of retail sales, which based on my experience will end up closer to 20%.

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Zombies reach a Dead End

Sandeep Shroff recently wrote about burn rate zombie companies. I’ve worked with Sandeep and he is a very sharp guy. He defines a #burnratezombie as a firm that lacks the cash to go through the process of raising capital. A firm reaches this point when the burn rate is so high and the time left is so short that the company will have to sell itself or go bust. These companies are dead but don’t know it yet.

A zombie company is normally known as one that can pay interest, but doesn’t generate enough cash to pay off the loan balance. Their loans don’t go away and they survive by holding off the debtors. These firms aren’t dead yet, and they aren’t really alive.

The Economist in January 2017, wrote about the productivity slowdown due to zombie companies which have large amounts of invested capital, but don’t generate much profits. The invested assets should probably be liquidated and the business recapitalized, but instead they limp along, making enough to keep the doors open but not enough to upgrade the equipment. A company that is just covering marginal costs can price lower than a company that is seeking to make a profit. That competition lowers return on capital and limits new entries into the market. These zombies don’t eat people – they slime the market.

I think there is another class of zombie firms that isn’t spoken about often. I call these Dead End Zombies.

Dead End Zombies consist of firms that are stuck. Like a driver lost in suburbia they’ve turned into a cul-de-sac, and they can’t continue forward. Their returns are under the cost of capital so they can’t attract investment and grow their way out of the problem. The only good strategic direction is backwards. The invested capital in the business has to be restructured and the business has to be pared back to the profitable core.

Austrian business cycle theory says that low interest rates increase borrowing and investment. Too low of rate, too much borrowing and too much investment or “mal-investment”. Easy capital is invested too quickly and there is a correction because the resulting profits are just too low. The correction causes firms to restructure and reallocate the cash to better investments. If the capital isn’t reallocated and stays stuck in these underperformers it becomes “dead” money and a Dead End Zombie.

When I think about businesses that have low profitability I apply Seldon & Colvin’s approach from “Angel Customers & Demon Customers” and split the business into customer deciles. Some segment of the customer base generates good return – the top 10%. This implies there is some segment that is at low and perhaps negative profitability. These are Seldon & Colvin’s devil customers and one cause of the poor returns. For a CFO, marginal operations that don’t add to profits end up just driving down the return on capital. Recognizing this, cutting overhead and trimming marginal operations isn’t easy and it isn’t popular. For management, a shrinking operation means a less staff, lower pay and less power. Sales declines also upset boards and shareholders.

Private Zombies

Dead end zombies can be public or private, both have challenges. A private firm that is at a dead end stage has to conserve capital to execute the transition out of non-performing assets. Selling assets can be an option. However, cutting overhead may not be possible. A recent client had half of their assets invested in low return operations with weak profits. However, even minor profits helped since they helped cover overhead. The incentive was to “extend and pretend” rather than fix, since the fix basically meant lower paychecks for the CEO and the management team.

Public Zombies

Public Dead End Zombies are usually small caps and are under followed. There is a discount due to liquidity (ability for larger investors to buy and sell shares), so they suffer a low stock price too. Small stocks without a following are called “orphans”.

As I have noted before here, G. Bennett Stewart classified firms by ROIC and growth options. Low ROIC firms, that return less than the cost of capital, Stewart titled “X-Minus” firms. The proper valuation for a firm that earns its’ cost of capital is 1x book value (or a market/book ratio of 1.00). If the firm is an X-Minus, then they are valued at less than book value. Each additional $1 the management team invests in the business is discounted in the market. So the company invests $1 and the shareholder receives 80¢.

In a public dead end zombie, the shareholders and management aren’t on the same team. As long as there is cash in the business the management team will hold on and continue to re-invest hoping for better results. Public Dead End Zombies can’t grow out of their predicament, they can’t buy back their shares, and often they can’t decrease the sales or the management team would be fired. They are stuck.

There are a lot of these firms. I looked on the Mergent database and found that there are ~2,650 public firms (not including finance, insurance, real estate) with sales of $10m or more, and 38% earn less than 4% return on equity. The smaller the market cap, the greater the odds it has low return on equity, with more than half of the firms with less than $75m market cap have sub 4% ROE’s.

The direction forward for a lot of these firms is restructuring. In a different time we’d have seen investors buying these companies with borrowed money. Unfortunately, after the banking meltdown and the beating the bankers received, there isn’t much money chasing these opportunities. This is a very big opportunity for the right investor, and the LBO will come back as value is discovered lurking in these dead end firms.

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Dr. John Zott is the 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 looking for a CFO for your e-commerce/retail/consumer company, ora former student, colleague or would just like to connect – reach out.

Two Ideas to Improve Bricks and Mortar Retailing

The Perfect Store

Imagine you are visiting your perfect store. Each item is carefully and thoughtfully selected for you. Everything from your favorite foods to clothing that fits your style, that fits your body and your budget. There are also things you need around the house, books, movies, technology all carefully and thoughtfully selected and displayed for your potential purchase. Maybe there would be a section of new items that an expert has suggested you’d enjoy. Customer service would be like an old friend saying hello.

Compare that vision with shopping today. The stores are vast and the portion that is “yours” is very small. We call it a “treasure hunt” as product is crammed in around narrow aisles and you are left searching through racks for your size. Customer service (if found) consists of “Can I help you find something” which speaks to the level of disorganization that even the staff recognizes you will need help finding what you want.

Why aren’t Bricks & Mortar stores like my perfect store?

The reason why physical stores aren’t perfect, is that narrow market segments (like an individual or family) don’t buy enough to justify the investment in inventory, real estate and staffing for a store. The store of today is not that much different than the market of 4,000 years ago. Retailers add value by buying in bulk, then ship it locally and sell the items in each’s. The merchant provides convenience, selection and a lower cost of freight.

Retailers have to appeal to a broad enough audience to achieve a certain level of gross margin dollars per square foot to pay the bills make a return on their investment. The executives may talk about the customer, but the reality is they buy thousands of the exact same thing in a range of sizes and colors. They are focused on a market segment. The retailer used to be able to add selection of add-ons with rich margins. E-commerce has ended that. Customers can comparison shop, order and pay before they leave the aisle in your store, faster and easier than standing in line at your store. E-commerce has the same dilemma if they don’t have unique products. Competition is only a click away.

The reality of physical retail is that in any single shopping trip the majority of merchandise in a store is irrelevant to you. I recently went to Home Depot for cabinet hinges. First, I was accosted by the solar guy (they must have some incentive plan) while passing by plumbing, light bulbs, paint, tools and hot water heaters. All of this selection was without value to me, I just needed hinges to hang my cabinet doors. It was worse when I was in the boating industry. The parts you need for a Hobie Getaway (my boat) are pretty different than a 32’ sailboat and are completely different than a fishing boat or a big cruising powerboat. Of the 20,000 sku’s we could cram into a store, we’d be lucky if 1,000 applied to a single customer. At least at Home Depot, I may need some of that stuff, sometime.

Physical retailers have an advantage; the customer is there in person. Here are a couple of ideas that retailers can use to better compete against the encroachment of e-commerce.

Sell Solutions, not Products.

Customers shop to solve a problem and retailers that solve problems rather than supply product will get more sales and win. Personal shoppers already do this. Selection can be a way to provide answers but this will require different selection strategies and different ways to display merchandise.

My favorite wine store in Pacific Grove was run by a former catering manager (now unfortunately retired) at a big Pebble Beach venue. He assorted his wine by the food it paired with – sections for fish, beef, chicken, deserts, cheeses. We don’t buy wine that way (anywhere) as we are focused on the the varietal, the age, the label. However, when we select wine to drink or serve we try to pair it with what we are serving. Wine stores rarely offer that advice. Someday I hope find wine that is sectioned by my real needs, like this for your brother in law, this for your book club, this for when the boss visits. Now that would be useful!

Ikea is a showroom where they solve the problem of living in a smaller space but staying organized and neat. Each vignette is designed around a hypothetical family. They are brilliant at flat packing their products and giving ideas on how to solve household problems. The furniture store in town has a sea of couches and chairs. Few are shown in a normal pattern you’d see in a home.

Focus on a Customer

Retailers who focus on product too much lose focus on the customer. Product focused firms think of buying and selling product before they thinking of serving a customer need. I think focusing on a customer segment is not as good as focusing on a single person with a problem. We are empathetic to individuals, not to classes of people.

Best Buy implemented a customer focus program called customer centricity by coming up with a series of archetype customers. Each store was then focused on one archetype (a married woman with two children who needs appliances, a college professor who likes high end stereo music, a 15 year old video game player). This was a huge step forward for Best Buy, but in the end it had to change, because to be successful they needed to address pretty much all of these segments in every store. The key point was they went from selling laptops and dishwashers to thinking about what customers needed and then rethought the store layout and service plan.

Auto parts retailers carry a lot of parts. But because of state licenses and registrations, they can buy registration information by area. They know which cars are located where, which autos are at the age where they break down, and what parts are most likely needed. Auto parts stores are focused on their customer – the owner of the 6+ year old car. When they stock parts, they stock based on the local need, and they stock all the parts for the job. They want you to leave with everything you need to get your vehicle working again.

Ikea’s hypothetical families focus their merchandise team on solving real world problems for real people. They are selling a way of living as a part of selling their furniture. They use names and have pictures of happy families (models?) supposedly living in these tiny apartments.

I think there is still life in physical retail. People like to touch, view, compare and try on goods, an experience that e-commerce can’t provide.

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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.

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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