Review – The 22 Immutable Laws Of Marketing

The 22 Immutable Laws Of Marketing: Violate Them At Your Own Risk

by Al Ries & Jack Trout, published 1993

The redundant and contradictory laws of marketing

The 22 Laws is a helpful quick-read book for those looking to dip their toe into the waters of marketing. It takes a high level approach to the strategy of marketing and is definitely a “how-to-do” not “what-to-do” title. As such, my goal in this write-up is to focus on the laws I found to be most reasonable and deserving of consideration, the combine several laws that seemed to be versions of one another or the same concept examined from different angles, and dropped a number of laws I thought were too crude to be of any use.

An abridged journal of immutable marketing laws

My abridged version of The 22 Laws is as follows:

  1. It’s better to be first than it is to be better
  2. If you can’t be first in an existing category, introduce a new one in which you can be first
  3. Target mindshare, not marketshare
  4. Perception is reality; focus on perception, not products
  5. Own an exclusive word or attribute; your product and a category keyword or attribute should be inseparable in people’s minds
  6. The only positions that count in the market are first and second, and second’s marketing strategy is dictated by first’s
  7. Marketing categories will continually bifurcate over time
  8. There is a temptation to extend brand equity to new product lines, which simply dilutes the brand and invites additional competition
  9. You must be willing to give up product line, target market or constant change in order to dominate a market
  10. Failure is to be expected and accepted
  11. Trends, not fads, are the key to long-term marketing success

Putting the 11 laws into practice

Hopefully each of the 11 abridged marketing laws above are self-explanatory. But even as simple as they are, each holds a wealth of additional implications.

Law 1 is related to the concept of competition and is tied to laws 3 and 4. If you are the first product into a market you will not only likely benefit from a first-mover advantage but, if done correctly, you will have positioned yourself to define the market. People form habits and tend to make up their mind once and then not change it. When you’re first into the market you have a fortress position within people’s minds that entrant firms must assault if they hope to dislodge you. People tend to remember those who did things first, not best. It is easier to entrench than dislodge.

This is why law 2 is important– you want to avoid being an entrant in the competitive landscape as much as you can. Much better to create a category where you are the only supplier at best, or force your competitors to be No. 2, 3, 4, etc. at worst. Once you’ve created a category you are first in, promote the category, not your brand.

Marketing is a deeply psychological enterprise, which is why laws 3-5 focus on the role perception and mental imagery play in good marketing practice. But the specific application of these psychological rules is once again strategic in nature– they are each about how you compete and limiting your competition. By owning a word or attribute, as law 5 suggests, you deny your competition the benefit of identifying their product with that word and you often get a halo effect as related words and benefits get associated with your product in the consumer’s mind as well. The most effective words are simple and benefit oriented.

Furthermore, your word should be exclusive and precise, and you should only have one. If you pick something like “quality” you haven’t said anything about your product, because everyone intends to create a product with quality. You haven’t differentiated. And if you try to pick “value and safety”, you’ll lose because you’re now competing with two opponents– the one which prides itself on value and the one which prides itself on safety. It’s harder to fight two people than one. And it should go without saying that, if available, you should always choose the most important word or attribute to focus on.

Law 6 is important to understanding the concept of relativity in marketing. Your marketing strategy should always take account of “which rung of the ladder” you’re on as certain claims and strategies won’t make sense or will sound inauthentic if given from the wrong place on the market share ladder. Further, it will never be appropriate to market as if you’re No. 1, when you’re No. 2. The advantage of No. 1 is telling everyone you’re the best. The advantage to No. 2 is telling people they have an alternative to No. 1.

Laws 7-9 deal with the concept of marketing focus, or concentrating your marketing strategy to a narrow band where you can actually be competitive. Category bifurcation is a natural process (eg., computers –> laptops vs. desktops; automobiles –> family sedans vs. economy compacts, etc.) in market evolution. Many firms make the mistake of trying to maintain leadership in all resulting markets as initial markets bifurcate, instead of sticking to the market they have an advantage in where their brand is trusted most.

Worse, they dilute their own brand by bifurcating their market themselves (eg., 7UP –> cherry 7UP vs. original 7UP). The market that 7UP made for itself as an “uncola” and the marketing strategy it followed to enable that success does not carry over to derivative products and it ends up just competing against itself. Sometimes, you simply expose yourself to more competition in the process as competitors mimic you and you further slice up a slice of the market.

This is why a successful marketing strategy entails “sacrifice”, either of product line, target market or the impetus to constantly change. Expanding product lines mean expanding competition. According to earlier marketing laws, a brand can’t mean everything or it means nothing. Expanding product lines under a brand means movement toward “meaning everything/nothing”.

Similarly, few products will appeal to everyone. Attempts to appeal to everyone usually result in appealing to no one. Focus on the target markets where your product has the strongest appeal and then dominate those markets. And when you have a marketing strategy that works and results in market dominance, leave it alone, don’t go out in search of a new market you might not dominate (while giving up your dominant position in the process!)

The eleventh law highlights the long-term nature of successful marketing strategies. Good marketing is about coming up with an angle or word that differentiates your product and then establishing a long-term marketing direction to maximize the idea or angle over time. This implies avoiding hype and the temptation to market your product as a fad and instead seek to create a trend, which is more enduring and has more competitive inertia making it harder for your opponents to fight.

The law of failure (10) is the one likely most forgotten and least appreciated. Failure will happen. Not every strategy will work out. In the event of a failure, it’s best to cut your losses early and change directions. At the same time, it’s critical to understand that the first several laws of marketing entail risk-taking (for example, being first at anything involves sticking your neck out) so occasional failure is part of the territory.

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Notes – Competition Demystified: Preface, Chapter 1

Reading notes to Competition Demystified, by Bruce Greenwald and Judd Kahn.

What is strategy?

Strategy is the art of making business decisions with respect to the actions and responses of competitors. Strategy revolves around creating, protecting and exploiting competitive advantages.

Strategy and competitive advantage go hand in hand; where there is no possibility to develop a competitive advantage, there can be no strategic decisions. Markets where competitors have similar access to customers, technology and other cost advantages are not strategic but tactical markets where the only strategy possible is to outrun the competition through operational efficiency– most competitors will be about the same size and none will manage to make or maintain an outsize profit margin as the lack of competitive advantages will drive economic profits toward average cost.

What are the differences between strategy and tactics?

The easiest way to think about the difference between strategy and tactics is to understand that strategic decisions are focused on competitors, while tactical decisions are focused on operations. In other words, strategy is external, tactics are internal in nature.

This helpful table from Competition Demystified may also convey the differences:

  • Strategic Decisions
    • Management level –> top management, board of directors
    • Resources –> corporate
    • Time frame –> long-term
    • Risk –> success or survival
    • Questions: “What business do we want to be in?”, “What critical competencies must we develop?”, “How are we going to deal with competitors?”
  • Tactical Decisions
    • Management level –> midlevel, functional, local
    • Resources –> divisional, departmental
    • Time frame –> yearly, quarterly, monthly
    • Risk –> limited
    • Questions: “How do we improve delivery times?”, “How big a promotional discount do we offer?”, “What is the best career path for our sales representatives?”

Additionally, there are two major strategic issues every business faces:

  1. the arena of competition – which external characters will affect the firm’s economic future?
  2. the management of competition – how do you anticipate and, if possible, control, the actions of these external agents?

Porter’s “Five Forces” and the Greenwald/Kahn “One Ring” that binds them

Michael Porter, author of [amazon text=Competitive Strategy&asin=0684841487] (1980), identified “Five Forces” critical to the competitive environment:

  • Substitutes
  • Suppliers
  • Potential Entrants
  • Buyers
  • Competitors Within the Industry

Greenwald and Kahn focus on one as being the dominant force, potential entrants, specifically from the viewpoint of barriers to entry.

Either the existing firms within the market are protected by barriers to entry (or to expansion), or they are not.

Barriers to entry are critical for maintaining stable businesses and above average profit margins as without them the market will be flooded with competitors whose existence serves to drive down average industry profitability.

As more firms enter, demand is fragmented among them. Costs per unit rise as fixed costs are spread over fewer units sold, prices fall, and the high profits that attracted the new entrants disappear.

The end result is all firms are placed on the operational efficiency treadmill where no firm ever reaches the goal of above average profitability and everyone must run as fast as they can simply to stay in place.

Operational effectiveness might be thought of as a strategy, indeed, as the only strategy appropriate in markets without barriers to entry.

How to conduct a strategic analysis

Ask yourself, in the market in which the firm currently competes or is considering an entrance:

  1. do any competitive advantages exist? And, if so,
  2. what kind of advantages are they?

Exploring competitive advantage

There are only three types of genuine competitive advantage:

  1. supply – a company can produce or deliver its products or services more cheaply than competitors
  2. demand – a company has access to market demand that competitors can not match, usually based upon…
    1. habit
    2. switching costs
    3. search costs
  3. economies of scale – an incumbent firm operating at large scale will enjoy lower costs than its competitors

Companies which manage to grow yet maintain profitability usually achieve this one of three ways:

  • replicate their local advantage in multiple markets
  • continue to focus on their product space as that space becomes larger
  • gradually expand their activities outward from the edges of their dominant market position

Elephants versus ants

Markets which offer competitive advantages are typically characterized by one or two large firms which possess the competitive advantage, elephants, and several smaller, less profitable “competitors”, the ants.

A firm which finds itself in a market where it is the ant should consider getting out of the market as painlessly as possible. A firm which is considering entering a market where an elephant already resides should reconsider the decision as the only real hope for competing in that market is if the elephant creates an opportunity by making a mistake.

With a competitive advantage in place, an elephant can enjoy the outsized profits of his competitive position. Still, developing strategic awareness about its competitive advantages will allow it to:

  • reinforce and protect existing advantages
  • identify areas of growth (geographic and product line-related) that are likely to yield high returns
  • develop policies that extract maximum profitability from the firm’s competitive circumstances
  • identify threats that are likely to develop
Strategic planning

In other words, strategic planning concerns itself with the different areas of business decision-making that competitors can respond to, such as:

  • pricing policies
  • new product lines
  • geographic expansions
  • capacity additions

Questions from the reading

  1. With regards to the elephant vs. ant paradigm, why do ants exist at all, that is, why don’t more firms exit markets where they are ants?
  2. What are common ways in which elephants misstep and allow competition from the ants?

Abodeely: Discounting The Value Of Experience

JJ Abodeely, author of the Value Restoration Project blog, writes about a theme that deserves more attention– that experience isn’t always an advantage and may even be a disadvantage, particularly at times like today where there appears to be a paradigm shift underway:

Consider how many firms espouse the experience of their managers as a key selling trait. The idea that experience might actually be detrimental to returns is not one that the investment management industry is willing to promote. However, an intellectually honest assessment of the role of experience in driving investment decision-making and results is in the best interest of advisors, managers and clients alike.

Perhaps even more importantly, relying on experience often means relying on a cloudy, biased recollection where our “memory is not as much a factual recording of events as it is a perception of the physical and emotional experience,” as behavioral finance professor John Nofsinger teaches us. Focusing on exposure, on the other hand, frees us to think beyond what our experience allows for. Perhaps ironically, forsaking experience for exposure may allow for a greater respect for the rhythm of history with a more objective and long-term analysis.

In practical terms, most investors today are impaired by their experiences in the 1980s and 1990s. They lack a historical understanding of secular market cycles and valuation, the closest thing we have to a law of gravity in finance. Similarly, most economists, with their data-heavy analysis, lean almost exclusively on the post-war period when modeling how the economy should behave. Most economists, strategists, analysts and investors have not experienced debt-induced financial crises, de-leveraging global economies or the demographic headwinds we face today. Nor does anybody’s experience include the ways in which today’s world is unique from any other point in history and the ways in which tomorrow’s history is completely unwritten.

Review – How To Read A Financial Report

by John A. Tracy, published 2009

There isn’t too much to say about John A. Tracy’s “How To Read A Financial Report: Wringing vital signs out of the numbers”. It’s a basic guide to understanding the income statement, balance sheet and statement of cash flows that all businesses, public and private, rely on to internally control their business as well as report the condition of their business to other investors and third parties.

It’s set up in a wide (versus standard tall) format and goes step-by-step through the various financial statements, their sub-sections and sub-accounts and the way specific items on each financial statement interact with other items on other financial statements. There are a number of tables and figures for illustrative purposes.

Below, I have summarized some of the most important takeaways to serve as a quick reference for myself going forward.

Sales Revenue and Accounts Receivable (A/R)

The average sales credit period determines the size of accounts receivable.

Accounts Receivable Turnover Ratio = Sales Revenue / Accounts Receiveable

The accounts receivable turnover ratio is most meaningful when it is used to determine the number of weeks (or days) it takes a company to convert its accounts receivable into cash.

Cash Conversion Cycle in Weeks (Days) = 52 Weeks (365 Days) / ARTR

Excess accounts receivable means that excess debt or excess owner’s equity capital is being used by the business.

Cost of Goods Sold (COGS) and Inventory

The average inventory holding period determines the size of inventory relative to annual cost of goods sold.

Inventory Turnover Ratio = COGS / Inventory

Dividing this ratio into 52 weeks (365 days) gives the average inventory holding period expressed in weeks (days).

Average Inventory Holding Period in Weeks (Days) = 52 Weeks (365 Days) / ITR

If the holding period is longer than necessary, too much capital is being tied up in inventory. The company may be cash poor because it keeps too much money in inventory and not enough in the bank. If overall inventory is too-low, stock-outs may occur.

Accounting issues: the inventory asset account is written down to record losses from falling sales prices, lower replacement costs, damage and spoilage, and shrinkage (shoplifting and employee theft). Losses may be recorded in the COGS expense account.

Inventory and Accounts Payable

One source of accounts payable is from making inventory purchases on credit. A second source of accounts payable is from expenses that are not paid immediately.

Sellers that extend credit set their prices slightly higher to compensate for the delay in receiving cash from their customers. A small but hidden interest charge is built into the cost paid by the purchasers.

Operating Expenses and Accounts Payable

The recording of unpaid expenses does not decrease cash.

Operating Expenses and Prepaid Expenses

The prepayment of expenses decreases cash.

Accounting issues: a business may be on the verge of collapse and its prepaid expenses may therefore have no future benefit and may not be recoverable (so, a large prepaid expense account should maybe be discounted to 0 in an NCAV analysis). A business may not record prepaid costs; instead it could simply record the prepayments immediately to expense. A business could intentionally delay charging off certain prepaid expenses even though the expenses should be recorded in this period.

Depreciation Expense

The allocation of the cost of a long-term operating asset to expense is called depreciation. In financial statement accounting depreciation means cost allocation.

Accelerated depreciation results in depreciation over a period of time which is considerably shorter than the actual useful life of the asset. Accelerated means front-loaded; more of the cost of a fixed asset is depreciated in the first half of its useful life than in its second half. If useful life estimates are too short (the assets are actually used many more years), than depreciation expense is recorded too quickly.

Book value represents future depreciation expense, although a business may dispose of some of its fixed assets before they are fully depreciated. Chances are that the current market replacement costs would be higher than the book value of the fixed assets– due to general inflation and the use of accelerated depreciation methods.

An expense is recorded when there is a diminishment in value of a company’s intangible assets.

Accounting issues: if the business adopts a sales pricing policy for recapturing the cost of a fixed asset over X years, then an X-year depreciation life would be most appropriate.

Accrued Liabilities and Unpaid Expenses

Typical accrued expenses:

  • accumulated vacation and sick leave pay owed
  • partial-month telephone and electricity costs incurred but not billed
  • property taxes charged to the year, but not billed
  • warranty and guarantee work on products sold in the year, so future expenses related to current sales are matched in the present period

Accounting issues: if a business is seriously behind in paying interest on its debts, the liability for unpaid interest should be prominently reported on its balance sheet to call attention to this situation.

Net Income and Retained Earnings; Earnings Per Share (EPS)

Retained earnings is not an asset and certainly is not cash.

Retained Earnings = Net Income – Dividends Paid to Shareholders

Cash Flow From Operating (Profit-Making) Activities

Cash Flow From Operating Activities (CFO) is best thought of as cash flow from profit.

Drivers of cash flow:

  • A/R – an increase hurts CFO; extending customers credit uses cash
  • Inventory – an increase hurts CFO; buying inventory uses cash
  • Prepaid expenses – an increase hurts CFO; paying for expenses uses cash
  • Depreciation – an increase helps CFO; depreciation is a non-cash expense
  • A/P – an increase helps CFO; using credit from suppliers frees up cash
  • Accrued A/P – an increase helps CFO; delaying the payment of accrued expenses conserves cash
  • Income Tax Payable – an increase helps CFO; not paying the full tax burden conserves cash

Summary for the seven cash flow adjustments:

  • Increases in operating assets cause decreases in cash flow from operations; decreases in operating assets cause increases in cash flow from operations.
  • Increases in operating liabilities help cash flow from operations; decreases in operating liabilities result in decreases in cash flow from operations.

Profit generates cash flow; cash flow does not generate profit.

 

Cash Flow From Investing and Financing Activities

The second section of the statement of cash flows summarizes investments made by the business during the year in long-term operating assets. It also includes proceeds from disposals of investments (net of tax). These are assumedly one-time cash flows, not recurring like cash flows from operations.

The third section of the statement of cash flows reports the cash flows of what are called financing activities. These are cash flows generated outside the business (new equity sales, new borrowings) or cash flows paid to parties outside the company (stock buybacks, debt repayments, dividends to shareholders).

Profit can be viewed as the internal source of cash flow and is the only renewable, recurring one if the business is in good health as a going concern.

The important question to ask is, “What did the business do with its cash flow from profit?”

The other important question is, “Can the business support its other cash flows (investing, financing) with cash from operations?” If not, the business will not remain solvent and liquid in the long-run.

Impact of Growth and Decline on Cash Flow

Cash flow can be higher or lower than net income for the period. There are three main reasons:

  • depreciation and other noncash expenses and losses
  • changes in operating assets
  • changes in operating liabilities
Growth should be good for profit next year, but growth almost always puts a dent in cash flow for the year.

A business could speed up cash flow from profit if it were able to improve its operating ratios, such as holding a smaller stock of products in inventory. If anything, however, it may allow these ratios to slip a little by offering customers more liberal credit terms to stimulate sales, which would extend the A/R credit period. Or, the business may increase the size and mix of its inventory to improve delivery times to customers and to provide better selection.

Businesses with lower fixed costs have more flexibility to swiftly respond to business declines by reducing costs, thereby improving margins.

A huge net loss for the year may be due to huge write-downs of assets (or by recording a large liability).

The total cash outlays for expenses could be more than total cash inflow from sales revenue, even after the depreciation add back is considered. This is called negative cash flow. In this situation, a business is using up its available cash at the burn rate, which can be used to determine how long a business can live without a major cash infusion.

Financial Statement Ratios

Cash Flow as % of Net Income = CFO / NI

Cash Flow per Share = CFO / Shares Out

Current Ratio = Current Assets / Current Liabilities

The Current Ratio measures short-term liquidity of the business and should be 2 or higher.

Acid Test Ratio = Cash + ST Investments + A/R / Current Liabilities

Also called the quick ratio, should be 1 or higher.

Debt to Equity Ratio = Total Liabilities / Total Stockholders Equity

Debt-to-Equity is an indicator of whether debt is being used prudently.

Times Interest Earned Ratio = Earnings Before Interest and Taxes (EBIT) / Interest Expense

TIE tests the ability of the business to pay interest from earnings.

Return on Sales Ratio = Net Income / Sales Revenue

Also known as net margin, return on sales measures the ability of the company to earn profit per $1 of sales. It is a sales efficiency ratio.

Return on Investment = Profit / Capital Invested

This is a standard formula with several variants, measuring the profit generated from a particular amount of capital invested. Also,

Return on Equity = NI / Stockholders Equity

Return on Assets = EBIT / Total Assets

The ROA is compared with the annual interest rate on the company’s borrowed money. You want the difference between these two values (spread) to be higher rather than lower. An ROA – Interest Rate > 1 represents gain on financial leverage.

Asset Turnover Ratio = Sales Revenues / Total Assets

Represents the rate at which assets are being converted into sales revenue.

Massaging the Numbers

Businesses can play many games to manipulate their reported financial numbers.

Discretionary expenses, such as repair and maintenance costs, employee training and development, advertising expenditures. Managers have a lot of control over when and how these expenses are recorded by pushing up or delaying such actions.

Stuffing the channels occurs when the manager accelerates sales by shipping more sales to the company’s captive dealers even though they haven’t ordered the products.

Window dressing, whose purpose is to make the short-term solvency and liquidity of the business look better than it really was at the end of the year.

For reporting profits soon, the CEO instructs accountants to choose accounting methods that accelerate sales revenues and delay expenses. To be conservative, the accountants can be instructed to use accounting methods that delay the recording of sales revenue and accelerate the recording of expenses.

If reported earnings are backed up with steady cash flow from operations, the quality of the earnings may be deemed as high.

A quick litmus test for judging a company’s financial performance:

If sales increased by X%, did profit increase X% as well? Did A/R, inventory and long-term operating assets increase by X%?

For example, suppose inventory jumped by 50%, even though sales revenues increased only 10%. This may result in an overstocking of inventory and lead to write-downs later.

Review – Value: The Four Cornerstones of Corporate Finance

by Tim Koller, Richard Dobbs and Bill Huyett; published 2011

Part I is about the four cornerstones of value. In a footnote in Chapter 1, authors Koller, Dobbs and Huyett define value as:

the sum of the present values of future expected cash flows– a point-in-time measure. Value creation is the change in value due to company performance… we use the market price of a company’s shares as a proxy for value and total return to shareholders as a proxy for value creation.

Further, they explain that the book explores the “four cornerstones of corporate finance” which are:

  1. companies create value by investing capital from investors to generate future cash flows at rates of return exceeding the cost of capital
    1. the combination of growth and return on invested capital (ROIC) drives value and value creation
    2. for businesses with high returns on capital, improvements in growth create the most value, but for businesses with low returns, improvements in ROIC provide the most value
  2. value is created for shareholders when companies generate higher cash flows, not by rearranging investors’ claims on those cash flows
  3. the expectations treadmill– a company’s performance in the stock market is driven by changes in the stock market’s expectations, not just the company’s actual performance; the higher the stock market’s expectations for a company’s share price become, the better a company has to perform just to keep up
  4. the value of a business depends on who is managing it and what strategy they pursue

For a real-life application of these principles, the authors highlight the recent housing bubble, namely, that the mortgage-securitization model violated the conservation-of-value principle because it rearranged risk without affecting the aggregate cash flows of home loans, while the belief that levering up these types of investments increased their value was similarly erroneous because “leverage doesn’t increase the cash flows from an investment.”

Chapter 2 explores return on invested capital (ROIC) which the authors define in simple terms  in a footnote as:

return on capital is after-tax operating profit divided by invested capital (working capital plus fixed assets)

ROIC and revenue growth “determine how revenues get converted into cash flows.” Mathematically, growth, ROIC and cash flow (represented by the investment rate) look like this:

Investment Rate = Growth / ROIC

However, Growth and ROIC have an uneven relationship:

for any level of growth, value always increases with improvements in ROIC. When all else is equal, higher ROIC is always good.

When ROIC is high, faster growth increases value, but when ROIC is low, faster growth decreases value. The dividing line between whether growth creates or destroys value is when the return on capital equals the cost of capital. When returns are above the cost of capital, faster growth increases value.

The authors advise that “most often, a low ROIC indicates a flawed business model or an unattractive industry structure.” The growth-at-all-costs mentality is flawed.

high-return companies should focus on growth, while low-return companies should focus on improving returns before growing.

In Chapter 3, the authors focus on the conservation of value, namely,

value is conserved when a company shifts the ownership of claims to its cash flows but doesn’t change the total available.

To see how managerial decisions affect the value of the business look for the cash flow impact.

On share buybacks,

when the likelihood of investing cash at low returns is high, share repurchases make sense as a tactic for avoiding value destruction.

Caution, however, because

studies of share repurchases have shown that companies aren’t very good at timing share repurchases, often buying when their share prices are high, not low.

And why should they be any better at timing their purchases than any other market timer?

As far as acquisitions are concerned, they

create value only when the combined cash flows of the two companies increase due to accelerated revenue growth, cost reductions or better use of fixed and working capital.

In Chapter 4, the authors discuss the expectations treadmill, stating that

smart investors often prefer weaker-performing companies because they have more upside potential, as the expectations are easier to beat.

The key seems to be finding companies with a high ROIC and a low P/E ratio.

Chapter 5 discusses the best owner principle. For example, some owners add value:

  • linkages with other activities in their portfolio
  • by replicating such distinctive skills as operational or marketing excellence
  • by providing better governance and incentives for the management team
  • through distinctive relationships they hold with governments, regulators or customers
Further, there is a “best owner lifecycle”, meaning that most owners are only the “best” at a given stage in a business’s development. Some excel at the start-up stage, others the growth, others still the maintenance of empire and finally a group is best at the terminal stage where a business is dismantled and its assets are sold off to other enterprises, each owner finding unique ways to increase cash flows at each stage. The implication of this is that
executives need to continually look for acquisitions of which they could be the best owner; they also need to continually examine opportunities for divesting businesses of which they might no longer be the best owner.

Empirically, “the stock market consistently reacts positively to divestitures, both sales and spin-offs.”

Part II is about the stock market. Chapter 6 explores who the stock market is. There are a lot of different participants with differing aims, skill sets and knowledge levels but the authors conclude that ultimately

professional investors–whether they manage hedge funds, mutual funds, or pension funds– are the real drivers of share prices, accounting for virtually all large trades.

The authors estimate that “intrinsic” investors hold 20% of US assets and contribute 10% of the trading volume in the U.S. market. “Intrinsic investors ultimately drive share price, because when they buy, they buy in much larger quantities.”

intrinsic investors are resources for executives, providing an objective, circumspect view of their companies, industries, and competitors by virtue of their buying and selling decisions.

Chapter 7 is about the stock market and the real economy. Here are some aggregate observations:

  • much of the stock market’s stellar performance between 1983 and 1996 was driven by the decline in interest rates and inflation, and the resultant increase in P/E ratios engineered by Federal Reserve Chairman Paul Volcker
  • by 1996, if executives understood what was driving shareholder returns, they would have known returns had to revert to normal levels
  • adjusted for inflation, large U.S. equities have earned returns to shareholders of about 6.5 to 7 percent annually, over the last 100 years
  • this number is derived from the long-term performance of companies in the aggregate, and the relationship between valuation and performance as described by the core-of-value principle
  • over the longer term, shareholder returns are unlikely to deviate much from this number unless there are radical changes in investor risk preferences or radical changes in the performance of the economy
  • long-term GDP growth would have to increase or decrease significantly, or the ratio of corporate profits to GDP would need to change (it has been constant for at least 75 years)
If, as the authors state, “high interest rates increase the nominal cost of capital, while high inflation increases the proportion of earnings that must be invested for growth”, then the implications for the coming period in the markets where we might finally face a high interest rate environment with simultaneously accelerated money printing spells falling P/E ratios across the broad market.
This means that the market as a whole has a more narrow band of longer-term performance than many realize, and that exceptional bull markets will usually be followed by a down market, and vice versa

Chapter 9 deals with earnings management. The authors state that “excessive smoothness raises concerns” that earnings are being actively managed by company leaders. Further, “consensus forecasts aren’t very good” and “analysts’ earnings estimates are not accurate; they tend to be too optimistic, and they almost never identify inflection points.” Importantly, “there is no meaningful relationship between earnings variability and TRS or valuation multiples.”

Part III deals with managing value creation. Chapter 10 is about return on capital.
A company that has a competitive advantage earns a higher ROIC because it either charges a price premium or it produces its products more efficiently (having lower costs or capital per unit) — or both. Price premiums offer the greatest opportunity to achieve an attractive ROIC, but are more difficult to achieve than cost efficiencies.

Low ROIC industries are those with undifferentiated products, high capital intensity and fewer opportunities for innovation.

There are 5 major ways to get a price premium:

  • innovative products
  • quality
  • brand
  • customer lock-on
  • rational price discipline

There are 4 major ways to get cost/capital efficiency:

  • innovative business methods
  • unique resources
  • economies of scale
  • scalability/flexibility
Ultimately, the longer a company can sustain a high ROIC the more value it will create.
ROIC excluding goodwill reflects the underlying economics of an industry or company. ROIC including goodwill reflects whether management has been able to extract value from acquisitions.

Therefore, it might be useful to study both metrics to get a better understanding of management’s competence.

Chapter 11 is about growth.

growth from creating whole new product categories tends to create more value than growth from pricing and promotion tactics to gain market share from peers.

This intuitively makes sense because the former requires the bringing into the production system of previously untapped resources, while the former simply represents the freeing up of existing resources.

There are 4 sources of revenue growth:

  • market-share increase
  • price increase
  • growth in underlying market
  • acquisitions

The limits to the pursuit of growth:

  • sustaining high growth is much more difficult than sustaining high ROIC.
  • history suggests that many mature firms will shrink in real terms
  • U.S. companies have been globalizing, which is responsible for faster sustained growth rates of some U.S. companies than the growth of the economy as a whole
  • portfolio treadmill effect: for each product that matures and declines in revenues, the company needs to find a similar-sized replacement product to stay level in revenues, and even more to keep growing
Chapter 12 examines business portfolios. One study found that “it was better to have a competitive advantage (horse) than to have a good management team (jockey).” Another study found that “companies with a passive portfolio approach underperformed companies with an active portfolio approach.” This means “buy and hold” is a flawed strategy in the long-run, because the value of businesses change according to predictable cycles of birth, growth, flat-lining and death.

The ideal multibusiness company [think, investment portfolio] is one in which each business earns an attractive ROIC with good growth prospects, where the company helps each business achieve its potential, and where executives are continually developing or acquiring similarly high-ROIC businesses and disposing of businesses that are in decline.

To avoid depressed exit prices,

a simple rule of thumb can improve a company’s timing considerably: sell sooner

“When companies do divest, they almost always do so too late, reacting to some kind of pressure.” And a process suggestion for active portfolio management:

hold regular, dedicated business exit review meetings, ensuring in the process that the topic remains on the executive agenda and that each unit receives a date stamp, or estimated time of exit

As far as diversification is concerned:

  • diversification is neither good nor bad; it depends on whether the parent company adds more value to the businesses it owns than any other potential owner could, making it the best owner of those businesses under the circumstances
  • no evidence that diversified companies generate smoother cash flows
  • there is no evidence that investors pay higher prices for less volatile companies
  • diversified companies tend to respond to opportunities more slowly than less diversified companies
  • the business units of diversified companies often don’t perform as well as those of more focused peers, partly because of added complexity and bureaucracy

I noted in the margins that “even for investors, diversification raises transaction costs and provides more opportunities to make errors in decision process.”

Chapter 13 is about M&A. A few points about M&A value creation:

  • strong operators are more successful
  • low transaction premiums are better
  • being the sole bidder helps

Chapter 15 explores capital structure.

large amounts of debt reduce a company’s flexibility to make value-creating investments, including capital expenditures, acquisitions, R&D, and sales and marketing.

Before assuming debt, an investor or business owner needs to ask:

  • what are my expected cash flows?
  • what could go wrong?
  • what unexpected opportunities could arise?
Then, “set your debt level so that you can live through bad times in your industry while having the capacity to take advantage of unexpected opportunities.”
With complex structures and financial engineering, always identify the impact on a company’s operating cash flows and the distribution of cash flows among investors.
Finally, Chapter 17 addresses managing for value.
the only way to continually grow earnings faster than revenues is to cut necessary costs for growing the business, or to not invest in new markets that will have low or negative margins for several years