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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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.

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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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.

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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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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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.

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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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.

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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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.

Four thoughts on how to deal with Hedge Fund Investors

After being a public company CFO, I spent some time as hedge fund analyst. During that twelve years I spoke with a lot of management teams, watched hundreds of investor presentations and read a
roomful of disclosure documents.

The most interesting change in perspective was 1:1 meetings, when we’d be in a room with the CEO and CFO and we’d have an hour to ask questions. Sitting in those meetings on investor side of the table was a lot easier than being a CFO. However, the biggest difference in the two positions is time span.

When you run a company you are thinking about time differently than a hedge fund portfolio manager. Projects take years and to turn the ship is hard. Profitable business investments have to be identified, planned and implemented.  If you are a hedge fund manager, you can reshape your portfolio in an afternoon, and exit your positions within a week.

Elliot Jacques wrote about the “time span of discretion” which dealt with the time frame where the executive was focused. Most senior managers are focused on the coming 6-12 months. Most fund managers are focused on the next 2-3 months. I’ve argued before that senior management needs to raise its focus from making this year to a process of making every years’ numbers. Thinking further out will not help your discussions with a short term investor. I’ve come up with four ideas for you to think about when dealing with professional investors and the hedgies.

1)    Prepare your company presentation as a story.

Most stock analysts are intense, smart, educated and inexperienced. When they make mistakes it is usually based on relying too much on book learning and too much reliance on models. Most risk isn’t covered in an excel spreadsheet, and at best they generate a couple of point estimates for EPS based on simplistic assumptions. Their lack of experience makes them open to a good story. A well constructed narrative will sway an analyst, even if the story is simplistic and inaccurate.  Good stories have a beginning, a middle and an end. There are characters. A good story has a coherent theme and is easy to remember.

2)    Keep your messaging consistent.

Because analysts often lack the experience to tell if a management team can deliver, they simplify and judge on message consistency. If you separate a CFO and CEO at a stock conference and quiz them individually about recent events at the company, you will often hear two stories, which is a problem. If the words in the 10k don’t align with the slide deck then there is another inconsistency. Hedge fund analysts are a little more savvy, they are paid more and they have been burned a few times. They are less swayed by a story and are more tuned in to the results.

Off the cuff remarks and meetings at the bar are a danger to management teams.  I once heard a senior executive announce that they had to work the weekend on the budget. It was April. What does “having to work the weekend on the budget” mean in April? It means you are off plan.  Analysts are not your friends and there are no “off the record” conversations.

3)    Be prepared.

A management team presents the strategy to the board, to executive management, to senior management, to the employees and to the investors. If the investor presentation doesn’t sound practiced, then how much has management communicated to the company? If your presentation isn’t crystal clear, clear enough that a person with a high school education can understand, then you probably haven’t presented it the 20+ times you need to if you are going to convince the employees.  Repetition equals retention. Management teams that are not practiced fail. After valuation, this was my most reliable source of ideas. If I heard a management team stumble through the presentation of a complicated new strategy that would require thousands of employees to do something different (say make panini’s at Starbucks), I knew I had a winner short idea.

4)    Don’t take it personally.

A hedge fund trades in and out of stocks a lot. Selling your stock doesn’t mean they hate your company. It just means that they’ve found something that will move more or sooner than your company. We shorted a lot of good companies because we have to hedge our other positions, that is what we are being paid to do. I went to a lot of meetings without a preconceived notion of whether a stock was a long or a short. We’d be short for an event or a tough quarter, and then would go long.  Management teams that obsessed with whether the analyst is a “long” or a “short” wasted their efforts. Keep your ego out of it, manage what you can manage and make the company better.

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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.