Notes – The Aggressive Conservative Investor

The Aggressive Conservative Investor

by Marty Whitman, published 1979, 2005

A seeming contradiction in terms

The following note outline was rescued from my personal document archive. The outline consists of a summary of Marty Whitman’s classic value investing tome, The Aggressive Conservative Investor.

Chapter 1, An Overview

  1. Two main types of investors
    1. passive, outsider investors
      1. no control over the management of their investments
      2. no knowledge of the investment other than what is publicly disclosed
    2. activist, insider investors
      1. have control over the management of the investments
      2. privvy to non-public information and disclosures
  2. Two major types of businesses which require two different kinds of analysis
    1. strict, going-concern
      1. large, stable institutions which tend to sell the same product and finance the selling of it in similar ways over time
    2. asset-conversion firms
      1. merger/acquisitions
      2. the purchase and sale of assets in bulk
      3. major financial restructurings or recapitalizations
      4. sales of control or contests for control
      5. creation of tax shelter entities
  3. Key emphasis is placed upon financial position
    1. ability to create liquidity (from cash or from liquid assets)
    2. ability to borrow
    3. ability to generate surplus cash from operations
    4. ability to market new equity securities
  4. In contrast, conventional fundamental analysis focuses on primacy of earnings
    1. reported earnings are a fundamental determinant of stock price
    2. this primacy of earnings theory is emphasized only in special circumstances where the company is a strict going concern or when its securities are being studied via day to day share price fluctuations
    3. most securities holders are not stock traders
    4. most businesses are not strict going concerns
    5. financial position reveals itself to be a better long-run determinant of valuation because it more fully represents the character of the underlying business
  5. Concerned with fundamental rather than technical analysis
  6. What is a security?
    1. investment vehicle which allows the holder to benefit from an inactive creditor or owner role
    2. examples: common stocks, preferred stocks, bonds, leasehold interests, limited partnership participations, savings-bank deposits and commercial paper
    3. example of a non-security: fast food franchise agreement which requires the owner to participate as manager as part of the agreement
  7. Understanding the underlying business becomes increasingly important as larger amounts of funds or increasing proportions of the individual’s resources are invested in a security
  8. Additionally, understanding the business is increasingly important with diminishing seniority within the security hierarchy, which exposes the investor to increasing risk
  9. The book takes a broad perspective on the strategies and perspectives of numerous types of investors because understanding the motives of others can highlight specific opportunities and risks for the individual investor himself
  10. Emphasis is on “business internals” rather than market and economic externals
    1. most individuals have little ability to predict the latter
    2. keen awareness of the former can remove a lot of the risk from the equation and protect the investor from mistakes made about the latter
  11. Disagree with modern capital theorists
    1. most markets and common-stock prices are in disequilibrium
    2. careful and thorough perusal of publicly available documents can guard the individual from unsystematic risk
  12. Underlying conviction that the value of a business has no necessary relationship to the price of its stock
  13. The primary determinant of future earnings and common-stock prices is financial position; quality and quantity of a business’s resources
  14. “Magic formula” for investment success is not arithmetic but grows out of:
    1. experience
    2. insight
    3. maturity of judgment
  15. Three general topics covered by the book:
    1. educate outside investors about the way insiders and deal promoters tend to think
    2. help the outsider to gain familiarity with the uses and limitations of required disclosures of the SEC
    3. attempt to impart understanding about the roles of the various players in the financial community and how they each participate in the investment process
  16. Focus on four types of investments to be made in commercial paper, corporate bonds, certain leases, preferred stock, limited partnership interests and common stocks:
    1. trading investments
    2. investments in the securities of emerging companies or industries
    3. workout and special-situation investments
    4. cash-return investments

Chapter 2, The Financial-Integrity Approach to Equity Investment

  1. Successful investors-activists prioritize their concerns as the potential issuer of a loan would:
    1. First, how much can I lose?
    2. Second, how much can I make?
  2. Strong financial positions generally translate to:
    1. less risk
    2. greater ability to expand business
    3. more attractive candidate for asset-conversion activities
  3. Attractive equity investments for outsiders should have the following characteristics:
    1. strong financial position, measured not so much by presence of assets as by the absence of significant encumbrances
    2. run by reasonably honest management and control groups that are aware of the interests of creditors and other security holders
    3. availability of a reasonable amount of relevant information, necessarily falling short of “full disclosure”
    4. price out to be below the investors reasonable estimate of net asset value
  4. Primary motivation for buying is that values are “good enough”, no search for bottoms in the short-run
  5. Shortcomings of the Financial-Integrity Approach
    1. requires an enormous amount of work; sifting through documents
    2. know-who is helpful and at times essential; special information discernible only from non-public relationships
    3. the most attractive securities uncovered by FIA tend to be in inactive markets, especially post-arbitrage
    4. risk aversion results in a severely limited selection of attractive securities which might be fully enjoyed by the less risk-averse
    5. securities issued by those believed to be “predators” should be avoided
    6. FIA approach is mostly useless in areas where sufficient public disclosure can not be obtained
    7. insiders sometimes pose a risk to outsiders and because of their ability to force-out outsiders and independently appraise values, some attractive opportunities will be avoided by the FIA adherent
  6. FIA view of risk
    1. quality of the issuer
    2. price of the security
    3. financial position of the holder

Chapter 3, The Significance of Market Performance

  1. Stock market value should be weighted differently for different individuals
    1. traders; 100% because they are trading for capital appreciation
    2. investors seeking secure income; 0%, because they may want to acquire a larger position over time at lower prices
    3. vast majority of people; somewhere considerably more than 0 and considerably less than 100
  2. Investors who do not weight stock prices as 100% important:
    1. investors who would benefit from low market valuations for estate tax or personal-property tax purposes
    2. investors primarily interested in maximizing cash return and/or are continually creating cash for new investment from non-investment sources
    3. investors seeking to accumulate large positions for control or to influence control shareholders
  3. One can not beat the market by trying to beat the market; instead, long-term performance comes from buying clear values and holding them in the absence of clear evidence that a mistake has been made
    1. evidence for this mistake comes in the results of the business, not the market’s valuation of the business
  4. Market performance is more important to a portfolio of fixed size or facing continued withdrawals of cash; less important to a portfolio which is a continual recipient of new cash and is thus a dollar-averager
    1. for the dollar-averager, good market perf results in less attractive terms for continued investment, bad market perf leads to more attractive terms for continued investment
    2. dollar averaging diminishes the need to beat inflation because changes in the value of money, in the long-run, will be offset by changes in the return on securities
    3. example; a well-run fire and casualty insurance company, which receives continuous cash injections from underwriting department
  5. An outside investor holding a completely marketable security should give a weighting of close to zero to market perfomance when:
    1. he knows has reason to believe that the security’s real worth is not close to the market price
    2. he knows he will not need to liquidate in the near future
    3. he knows he will not need to use the security as collateral for borrowings
  6. Important to remember that stock market prices are not business or corporate values but a realization price that will likely not hold in the event of a merger or acquisition; market price is a value of only part of the total outstanding, not all outstanding stock
  7. Comparative measures of portfolio performance are imprecise; a company can beat its industry benchmark but still have performed poorly in an absolute sense, or vice versa
  8. Professional money managers and beating the market
    1. some economists believe that the goal of professional money mgrs is to beat the market and they have failed if they don’t
    2. many professional mgrs have other concerns than simply beating the market:
      1. maintenance of cash income
      2. maintenance of cash principal
    3. for example, is it important that a strongly capitalized insurance company outperform the market when its net investment income is increasing at 10% annualized?
  9. Investors seeking “bailouts” from their investments might weight market performance low
    1. control of a company can allow for control over cash bailouts through dividend policy, mgmt of salaries and fees
    2. control of a company can allow for non-monetary bailouts via three P’s
      1. power
      2. prestige
      3. perquisites
  10. Three types of security holders who rate market performance highly, seeking “bailout” in the market:
    1. common stock holder with minority interest in which dividend income is insignificant or not part of the objectives
    2. control stockholder and company seeking to sell securities or issue them in merger and acquisition transactions
    3. holder without a strong financial position; someone who intends to borrow or has borrowed heavily to finance his portfolio

Chapter 4, Modern Capital Theory

  1. Description of MCT and efficient portfolios
    1. an individual knows how he reacts to risk and must choose from stocks, bonds and cash
    2. he evaluates each instrument accurately in terms of risk, expected return and relative valuation/price movement
    3. assuming all assumptions are accurate, the individual creates a portfolio that provides the largest expected return for a given level of risk
    4. this best describes the environment faced by the stock trader
    5. this theory fails to account for thin markets, price formation mechanisms, non-symmetric information and general equilibrium considerations
    6. this theory is not suitable for outside investors primarily interested in income, dollar averaging or special-situation investors who ignore timing considerations, as well as all activist investors
    7. MCT also assumes the avg outside investor and his adviser are capable and able to interpret information correctly; empirical evidence points to the opposite
  2. The computer and mathematical analysis
    1. the fatal flaw of mathematical analysis is the non-quantifiable variables or ugly facts that get left out of the models assumptions
  3. On systems for playing the market
    1. Chartist-approach
      1. Not necessarily irrational or illogical
      2. Movements of the market do represent aggregate behavior, however, to date no truly successful chartist model has been created
    2. Random-walk theorists
      1. at any instant, price changes follow no predictable pattern
      2. using only trading information, there is no predictability to prices
    3. filtering rules or formula-timing
      1. best that can be said is their mechanical application can save investors from getting suckered into go-go markets or being rushed out the exits by mass panic
  4. On arbitrage
    1. topic for a professional, requires plenty of calculation and minimization of trading costs (should be a member of an NYSE firm)
    2. Thorpe and Kassouf’s book is recommended
  5. Portfolio balancing
    1. “Beta” is the estimated market sensitivity of a stock, measured in terms of an expected incremental percentage return associated with a one percent change in return of the S&P500
    2. For the avg investor, problems occur far more often with security analysis than portfolio selection
    3. Most important for someone running many millions of dollars; for everyone else, this is over-rated; all the best portfolio-balancing in the world won’t save you from poor analysis
  6. Fundamental security analysis and corporate finance
    1. Good fundamental analysis involves perception, training, understanding and a high degree of abstraction in implicit or explicit model building– picking the right variables and causal relations
    2. There are far fewer skilled practitioners than there are opportunities to practice security analysis
    3. The idea that fundamental analysis is not necessary because markets are efficient is flawed because most analysts are incompetent, which prices ultimately reflect
  7. Calculation or evaluation
    1. The problem facing any serious analyst is what the figures mean, not what they happen to be
    2. For example, imagine a company carrying real estate on its books at $1.5M; the significance changes when we learn that they represent 100,000 acres of California coastal land carried at the 1880 purchase price
    3. Valuations change depending upon the context of valuation; estate planning, income taxes, obtaining a loan, etc. all produce different valuations of the same entity

Chapter 5, Risk and Uncertainty

  1. The outsider faces greater risks than the insider
    1. he cannot acquire complete knowledge of a company, no matter how many documents he studies
    2. he (and the insider) face the possibility that the analysis is wrong
    3. he may fail to properly appraise the quality and honesty of the management
    4. he may simply fall prey to the unpredictability of the future
    5. the market may fail to realize intrinsic value for extended periods of time, even if the analysis of those values is correct
  2. Assessing the investment odds: risk and reward
    1. conventional wisdom states that the key to investment risk is the quality of the issuer
    2. high quality issuers tend to be well-known, and this knowledge is reflected in asset prices
    3. therefore, the cliche, “You have to take chances if you want to make money”
    4. but financial position of the security holder and the price of the issue are also important factors in judging risk and reward
  3. Quality of the issuer
    1. A company can become high quality just because important people within the investment community say it is; they’re often proven wrong
    2. never buy when a high quality company is being touted because it is probably overpriced then
    3. if your investment matters to you, obtain at least a rudimentary knowledge of the company before investing
  4. Price of the issue
    1. Good investors focus on how much they can lose; “risk averse”
    2. higher price translates to higher risk, lower price, lower risk
    3. there can be considerably lower risk investing in a lower quality company at a lower price than at a higher quality company at a higher price
    4. an investor with more time and expertise to spend on his analysis should weigh price considerations more heavily; an investor with less time and less expertise should weigh quality considerations more heavily
  5. Financial position of the holder
    1. an investor who buys the best quality stock at a fraction of its overall value is taking a significant risk if he can’t afford the purchase
    2. investors on margin can turn high quality investments (such as USTs) into speculative gambles
    3. investors often take losses when they do not have enough funds to live on and are forced to liquidate at an inopportune time
    4. without the resources to ignore them, an investor has no guard against stock-price fluctuations
  6. Portfolio diversification versus securities concentration
    1. diversification is a way to reduce risk in situations where the investor lacks knowledge
    2. in situations where the investor enjoys enough knowledge, confidence and financial position to weather temporary setbacks, the risk-reward ratio may be tipped in favor of concentration
  7. Considering the consequences
    1. The astute investor examines consequences as well as odds
    2. The odds can be strongly in favor of appreciation/success, but the consequences of failure so severe (insolvency) that the risk-reward ratio is still not in favor of making an investment
  8. Risk and investment objectives
    1. The cash-return investor will base his investment decision on different factors in evaluating risk than the special-situation investor, even when using the same facts
    2. Risk-reward ratio will provide the investor with a guide to use in defining his investment objectives
    3. Cash-return investors with no opportunity to investigate carefully should focus primarily on quality of the issuer
      1. reference bond rating services
      2. reference the investors own independent conclusions
      3. any doubts, don’t invest; sell if owned
      4. should limit investments to debt securities in most instances
        1. debt securities have a legally enforceable right to be paid principal and interest
        2. higher up in the capital structure in the event of an insolvency
    4. workout- or special-situation investor should focus on price of the issue
      1. he finds safety in a low price
      2. place important emphasis on the four elements of the FIA

Chapter 6, Following the Paper Trail

  1. Principle documents of the paper trail:
    1. Form 10-K; official annual business and financial report
    2. Form 10-Q; quarterly financial report, includes disclosures of certain material and extraordinary events that occurred during the three-month period
    3. Form 8-K; filed within 15 days of a reportable event, unscheduled material events or corporate changes
    4. Annual reports; most important way most public companies communicate with shareholders
    5. Quarterly reports
    6. Annual-meeting proxy statements; used to solicit votes of shareholders
    7. Merger proxy statements; issued to shareholders to vote on an asset conversion-matter such as merger, consolidation, sale of assets or liquidation (S-14)
    8. Prospectuses; registration statements issued when securities are being offered publicly (S1 & S7)
    9. Cash tender offer circulars; sent when a publicly announced offer is made to buy shares for cash
    10. Encumbrances are almost always spelled out in these documents and their footnotes
  2. The documents and how to read them
    1. Simply reading these documents will give you a good idea of whats contained within and what their use is
    2. If you can obtain copies of the preparation documents used to create the SEC officially regulated forms, you can get an idea of what the preparer has to consider in making disclosures
    3. Other important documents
      1. Forms 3 and 4; disclosure by insiders concerning their shareholdings and changes in holdings
      2. Form 144; filed by holders desiring to sell restricted stock under Rule 144
      3. Form 13F; filed by all managers with accounts of marketable equity securities greater than $100,000,000
      4. Schedules 13D; filed within ten days by persons who have acquired 5 percent or more of an outstanding security issue (or, who acquire an additional 2 percent within a 12 month period after already acquiring 5 percent)
      5. Schedules 14D; similar to 13D, filed prior to making a cash tender offer for more than 5% of shares outstanding
    4. What the paper trail doesn’t do
      1. does not provide company forecasts, company budgets and valuation appraisals of assets
      2. no real disclosure as to specifics of running the business, such as appropriate levels of capital expenditure, marketing, research and development, etc.
      3. might miss small acquisitions that do not require a shareholder vote

Chapter 7, Financial Accounting

  1. Types of accounting
    1. cost (or control or managerial)
      1. purpose is to tell a management what its costs are
      2. internal, essential to the operation of the business
    2. income-tax
      1. not supposed to measure economic reality, unlike cost-accounting
      2. designed to create an economic reality (tax bill) based on rigid set of principles (Internal Revenue Code)
      3. emphasis is on minimizing tax exposure
    3. financial
      1. sandwiched between cost accounting and income-tax accounting
      2. “primary purpose is to provide quantitative financial information about a business enterprise useful to owners and creditors”
      3. seeks to “fairly” represent the results of operations and the financial position of the company
  2. How to understand financial accounting, five major misconceptions:
    1. no need to distinguish between financial accounting versus income-tax and cost accounting
    2. financial accounting has much the same role in corporate analysis and in stock market analysis
      1. primary emphasis in corp analysis is on what numbers mean, not what they are
      2. in corp analysis, no rule that one accounting number is more important than any other; in stock market analysis, primary emphasis tends to be put on net income/earnings per share
      3. in corp analysis, profit is thought to come from the business factors themselves; stock market analysis, profit comes from what one thinks someone else will pay for the security later
      4. because stock market analysis doesn’t rely on deep understanding of the underlying business, value is sought elsewhere– in precise attainment of estimated numbers
    3. accounting can be made distortion-free an/or realistic and/or uniform
      1. financial accounting is based on Generally Accepted Accounting Principles
        1. an attempt is made to match revenues with costs on an accrual basis to the exclusion of matching cash inflow with cash outflow
        2. an attempt is made to view businesses on a going-concern basis
        3. financial-accounting is primarily based on exchange prices
        4. financial-accounting is primarily based on historical costs
        5. financial statements are designed to be general-purpose, “serve the common needs of a variety of groups”
      2. as a result, financial-accounting can not be distortion-free, realistic or uniform
      3. financial-accounting is more useful at measuring the economics results and values rather than the solvency of a business
        1. more useful for judging a strict going-concern
        2. less useful for a natural resource company, real estate or life insurance companies or companies engaged in mergers, acquisitions and imaginative financing and refinancing
        3. as an example, most high quality real estate that is well-maintained doesn’t depreciate over time, but it has to for tax and accounting purposes
    4. about the meanings of GAAP
      1. inter-industry distortions arise based upon calling similar circumstances “permanent differences” or “timing differences”
    5. about the shortcomings of the corporate audit function and the ethical standards of independent auditors in the US

Chapter 8, Generally Accepted Accounting Principles

  1. Myths and realities about the meaning of GAAP
    1. Myth #1; GAAP tends to, or ought to, be rigidly codified with a series of well-articulated do’s and don’ts
    2. Myth #2; GAAP is all-encompassing and is, or should be, designed to measure all sorts of corporate events and phenomena
    3. Myth #3; GAAP should tell the Truth, that somehow it can be made more realistic for average investors while still becoming more informative and more useful for all of its users
  2. Eleven underlying assumptions of GAAP which provide insights into its uses and limitations:
    1. ownership of, that is, title to, tangible assets is the basis of value and the means of creating income
      1. ignores the value of intangible assets, such as lack of debt or ability to create new debt, advantageous debt terms, price at which new equity can be raised, etc.
      2. some other intangibles:
        1. long-term, favorable (or unfavorable) contracts with key employees, customers and vendors
        2. trade names and patents
        3. distribution channels, such as dealer organizations
        4. manufacturing know-how
        5. licenses to do business
        6. tax-loss carry-backs (worth cash) and tax-loss carry-forwards
      3. GAAP becomes increasingly less descriptive when intangibles play a larger role in creating value and income
        1. GAAP provides good benchmarks to value the output of a steel mill, for example
        2. GAAP does not provide good bench marks for valuing the worth of a medical degree
    2. corporate asset items have independent values unmodified by their inclusion as but one small part of a going concern
      1. as a practical matter, few assets of a going concern have value that is independent of the going concern
      2. independent values exist only in asset-conversion
      3. passivity and liquidity are highly interrelated; more liquidity means less responsibility in administering the asset
    3. changes in accounting rules should not be disruptive of important existing practices unless there is conflict among establishment members
      1. GAAP is an establishment tool and its basic purpose is to aid, not to fight or alter, an existing economic system
      2. changes should be expected to be evolutionary, not revolutionary or radical
    4. a puritan work ethic is desirable; hence achievement through going-concern operations are far more desirable than achievements through asset conversions– mergers and acquisitions, reorganizations or refinancings
      1. profit should be created from going-concern operations, not capital appreciation through asset arbitrage
    5. the medium is the message
      1. immediate stock market impact is what financial statements are directed to
    6. precise definitions are a desirable goal
      1. as much as possible, items should be defined as expense or income, liability or proprietorship
      2. except for insurance-company accounting, no recognition that many items (deferred income taxes, unexpired subscriptions, low-interest rate mortgage loans, etc.) have elements of both expense and income, or liability and proprietorship
    7. GAAP is designed primarily to protect the cash buyer of securities
      1. great bulk of cash buyers of corporate securities are lending institutions– banks, insurance companies, pension trusts and finance companies
      2. GAAP tends to explain “how bad things are if you give up your cash for this security”
      3. GAAP is less suited to explain how a holder of equity securities will fare when asked to give them up for cash or other securities, such as in an acquisition or merger
    8. security holders tend to be monolithic: all have the same interests
      1. GAAP assumes all stockholders are interested in the price of the stock they own
    9. per-share market prices are per se important and are the single most significant indicator of the value of entire businesses
    10. in classifying assets or liabilities, physical substance and legal substance are deemed to be more important than economic substance
      1. often non-current, fixed assets are highly liquid due to their being subject to asset-conversation activities
      2. similarly, many current assets are locked up as part of the operation of the going-concern and are not liquid or marketable
    11. there is a basic identity of interests between a company and its various stockholder groups
      1. much more realistic to consider the relationships between company and stockholders and stockholders vs. stockholders as combinations of communities of interest and conflicts of interest
  3. Myths about the shortcomings of the corporate audit function and the ethical standards of the US independent auditing profession
    1. most speculative bubbles have been in industries or issues where GAAP is either nonexistent or of little significance in appraising a business or stock

Chapter 9, Tax Shelter (TS), Other People’s Money (OPM), Accounting Fudge Factor (AFF) and Something Off the Top (SOTT)

  1. Tax shelters
    1. people try to avoid maximum rates
    2. people try to avoid being unable to control the timing of a tax liability
    3. people try to avoid transactions that produce a taxable event but not the cash to pay for it
  2. Other People’s Money
    1. OPM is different in different situations
      1. banks, it is depositors’ money
      2. AmEx, it is paid but not cashed traveler’s checks
      3. insurance company, it is premiums paid
    2. OPM can be used to enrich an opportunistic promoter at little to no cash cost to himself
    3. OPM is dangerous for common-stock investors
      1. hard to predict the short- to intermediate-term price activity
      2. danger of loss where there is a lack of positive cash-carry (cash income on investment exceeds cash interest costs of loan)
  3. Something Off The Top
    1. insiders view outsiders SOTT as having a free ride; enjoying the profits of a company without doing the work
    2. insiders themselves enjoy SOTT through special information access, nice offices, special opportunities through business relationships and contacts, opportunities to buy cheap stock and PPM (power, prestige, money)
    3. control can often be a negative in the event of a company being “sick”; in this case, being an outsider is SOTT
    4. a general rule for public investors is to avoid companies whose mgmts have general disdain for outsiders and try to claim SOTT at their expense
  4. Some preliminaries on the Accounting Fudge Factor (AFF)
    1. there is no “right” way to account for things
    2. are you a senior lender, a common stockholder or the president of the company, etc?
    3. are you interested in cash returns, the build-up of intrinsic value, the price of the stock or some combination of the three?

Chapter 10, Securities Analysis and Securities Markets

  1. Companies and securities can only be analyzed in context; what is good or bad in one context becomes bad or good in another
  2. Variables that can not be quantified as good or bad:
    1. profit margins
    2. size
    3. liberal accounting policies
    4. low net asset value
    5. Wall Street sponsorship
    6. the trading assumption versus the investment assumption
    7. convertible securities
    8. limitations of comparative analysis
  3. Reasons for acquiring and holding securities
    1. aggressive mgmts might fully utilize liquidity, thus creating a weak financial position
    2. high book value relative to market price when price-earnings ratios are high results in low return on investment
    3. companies with high profit margins, high stock prices and low book values attract competition
    4. companies that survive and prosper in highly cyclical, unprotected industries tend to be run by able mgmts
  4. Profit margins
    1. low profit margins can be a strong reason for purchasing a security if it is believed the margins will improve; small improvements in low margin situations can result in big, leveraged returns
    2. companies with consistently high profit margins tend to be popular and thus over-priced
    3. it often happens that companies with consistently high profit margins suddenly lose them overnight
  5. Size
    1. small companies should be chosen because of the appreciation potential inherent in their prospects for growing into giant businesses
    2. many small and medium sized companies are well financed and effective competitors, meaning they are high quality issuers even if not recognized as such
    3. large firms are best selected by investors with no ability or time to get to know their investments better
    4. in general, the smaller the business, the riskier, however, there are times when high prices can make large businesses riskier on a relative basis
  6. Liberal accounting policies
    1. a firm can use liberal accounting policies to gain market sponsorship through excitement about its strong earnings profile; this market sponsorship can be used to attract financing at extremely generous rates, improving the firm’s financial position
    2. if a stock goes up far enough and its management is astute, it can use the “Chinese dollar”, or puffed value, to buy economic value elsewhere at a discount
    3. The standard of investment behavior for passivists as well as activists should be, “Worry about the investments you made, that you shouldn’t have,” not, “Worry about the investments you should’ve made, but didn’t”
  7. Advantages of a low net asset value
    1. a company with a lower NAV might have a higher ROI
    2. all assets come with encumbrances; sometimes having a lower NAV relative to a competitor with higher NAV can result in greater ROI because the higher NAV requires more maintenance and other costs to keep it current, even when not actively productive
  8. Wall Street sponsorship
    1. “sponsored security” is an issue that is recommended and/or purchased by people in the financial community who are able to lure or influence others to acquire that security
    2. important for those interested in immediate performance or timing or in owning a highly marketable, actively traded security
    3. buying poorly sponsored or unsponsored equity securities has its advantages for long term investors because this is typically where bargains are found
  9. The trading assumptions versus the investment assumptions
    1. Much advice about how to invest is given from the perspective that the market knows more than the individual investor, and thus should be heeded accordingly
  10. Convertible securities
    1. issuers of convertibles are frequently second-rank companies who include convertibility to “sweeten the deal”
  11. Limitations on comparative analysis
    1. the goal is not completeness, but “good enough”; time and knowledge are at a premium
    2. “good enough” is the standard for measuring market and business performance; no one can be best all the time or own all the resources in the world

Chapter 11, Finance and Business

  1. Heavy Debt Load
    1. high debt can be viewed as a reason to purchase a stock, especially in a bull market, because many equate it to aggressive mgmt
    2. another reason high debt can be an asset is if the debt was acquired at attractive terms and competitor firms are not able to replicate such financing
  2. Large cash positions
    1. can be a sign of unattractiveness when:
      1. entrenched, non-raidable mgmts refuse to make productive use of funds
      2. where mgmt refuses to use funds to undertake necessary expenditures
    2. watch out for companies that appear strong financially but operationally are weak because they have not invested properly in their businesses
  3. Diversification versus concentration
    1. some enterprises excel with a singular focus
    2. others benefit from diversification
    3. the jury is out
  4. Management incentives
    1. management expenses and salaries are paid before all other securities
    2. management looting is generally not a problem in larger firms, but it is widespread enough that no security holder should assume there is a community of interest between mgmt and security holders
  5. Advantages of highly cyclical companies in competitive industries
    1. the adversity and challenge of these industries tend to attract highly talented mgmt
    2. they also tend to be well financed and relatively liquid because they can’t afford not to be
  6. Going public and going private
    1. What a business is worth as a private enterprise is different from what it is worth as a public enterprise
    2. A private company can go public by selling its own equities, or it can sell out for cash to a company that is already public
    3. Many times a public company is worth far more private than public so it will go private by purchasing up shares for cash
      1. a company repurchasing stock is, in effect, going private when it does so
  7. Who runs most companies?
    1. Myth is that they’re run by their directors; day-to-day reality is they are run by their mgmt
  8. Consolidated versus consolidating financial statements
    1. Sometimes, due to cross-ownership of securities held within a senior organization, the common equity of a child company can take a “de facto” status as a senior security within the parent organization
  9. Negative values in owning assets
    1. “everything’s got a price”
    2. “I wouldn’t own that asset if you gave it to me”
    3. Because ownership of most assets entails obligations and expense, the second statement is typically truer than the first

Chapter 12, Net Asset Values

  1. The usefulness of book value in security analysis
    1. book value is an accounting number and it is limited in usefulness as any accounting number is
    2. by itself it means little; gains significance relative to other figures and information
    3. quantitative measure of assets; tells us “how much”
  2. Book value as one measure of resources
    1. the amount of resources a company has to create future earnings is a good indicator of future earnings power; book value measures available resources
    2. corporate buyers tend to focus on book value as an indicator of how they can redeploy newly acquired resources
    3. important in calculating ROI and ROE
  3. Book value as one measure of potential liquidity
    1. opportunities to create tax carry-backs can occur when a common stock is selling at a steep discount from brick-and-mortar book value and the business has been paying high tax rates
    2. useful when a profitable business is available for acquisition at a price well below net asset value as shown on the tax records
    3. IRS can end up providing a substantial amount of the cash needed to finance the acquisition
  4. Book value analysis as a competitive edge
    1. most stock traders focus on short-term earnings, which is reflected in market prices
    2. focusing on large high-quality asset values as an indicator of good future earnings could give an investor an edge as these will not be reflected in high market prices
    3. changes in earnings and P/E ratios can be sudden and violent; changes in book value, however, tend to be gradual
  5. Limitations of book value in security analyses
    1. does not, in and of itself, measure the quality of a company’s assets
      1. high-quality means approaching being down free and clear of encumbrances
      2. high-quality means the business has a mix of assets and liabilities that appear likely to produce high levels of operating earnings and cash flows
      3. high-quality means assets tend to be salable at a price that can be estimated accurately

Chapter 13, Earnings

  1. Wealth or earnings?
    1. Generation of reported income is one way to create wealth
      1. another is creating unrealized appreciation
      2. another is realizing the appreciation that has been created
    2. Reported income generation is the least tax sheltered way to grow wealth; creates incentive for asset-conversion
    3. Private company mgmt tends to minimize reported income to minimize tax burden; public company mgmt tends to maximize to enjoy higher stock price
      1. allows investor to realize gains through selling and borrowing
      2. allows the company to issue stock for cash or to acquire other companies
  2. The long-term earnings record
    1. In fundamental analysis, special attention should be given to the importance of a favorable long-term earnings record
    2. The major component of NAV for most publicly owned businesses is retained earnings
    3. Earnings record is extremely important for a strict going-concern analysis
    4. Judging the quality of an issuer is another situation where a strong long-term earnings record is important to the analysis
  3. “Parsing” the income account
    1. The static-equilibrium approach
      1. looks at current earnings and the earnings record as principal factors in market price determination
      2. market prices within an industry tend toward equilibrium– a stock out of equilibrium could be a reason for buying or selling
      3. important in i-banking world, where new issues are commonly priced at lower than typical multiples as a marketing tool
    2. The dynamic-equilibrium model
      1. uses past and current record of current earnings as a base for estimating future earnings
      2. projected increase is then used for predicting a future stock price
    3. Various definitions of earnings
      1. what accountants using GAAP report them as
      2. what accountants using GAAP report them as, as measured by overall performance, including extraordinary items and discontinued operations
      3. the increase in value of a business (incl stockholder distributions) from one period to the next; ie, changes in NAV
      4. the increase in the ability to make stockholder distributions over and above actual stockholder distributions without reducing actual invested capital
      5. the increase in the ability to make payments to all security holders, not just equity holders, during a period
      6. the increase in ability to improve future sales, accounting profits and/or cash flow during a period
    4. use caution when an expanding business’ earnings are not “real” because they can not finance their own growth without being acquired, ex, Parliament brand cigarettes from small private company Benson and Hedges
    5. may make sense to stress “earning power” (wealth creation) versus “earnings” (reported accounting earnings)

Chapter 14, Roles of Cash Dividends in Securities Analysis and Portfolio Management

  1. The three conventional theories
    1. John Burr Williams
      1. common stock is worth the sum of all the dividends expected to be paid out on it in the future, each discounted to its present worth
      2. criticism: only apply in a tax-free world where the reason for owning stocks is to receive dividends and the reason for all corp activities was to pay dividends
      3. instead, more realistic to say that common stock held by non-control stockholders is worth the sum of all the net after-tax cash expected to be realizable in the future from ownership of the common stock, with such net cash coming in the form of cash disbursements from within the company (dividends, liquidations) or from without (stock purchasers, lenders accepting stock on margin)
    2. Modigliani and Miller
      1. as long as mgmt is thought to be working in the best interests of the shareholder, retained earnings should be regarded as equivalent to a fully subscribed, preemptive issue of common stock, and therefore that dividend pay-out is not material in the valuations of a common stock
      2. criticism: no evidence that mgmts share a “community of interest” with stockholders
      3. mgmt, if they are responsive to stockholders, tend to focus on the interests of holders that will bring the best benefits to mgmt
    3. Graham and Dodd
      1. in the vast majority of companies, higher common-stock prices will prevail when earnings are paid out in dividends rather than retained in a business
      2. criticism: emphasis should be on which stock — low dividend payer or high dividend payer — is more attractive to which type of investor
  2. Cash dividends as a factor in market performance
    1. ceteris paribus, a low dividend payer is better for an investor seeking market appreciation rather than cash-carry
    2. lower dividend companies tend to sell at lower prices, thus they tend to be more attractive buys
    3. a company whose common stock is available at a lower price will have more room to increase its dividend; dividend increase record is important for some in valuing stocks
    4. lower dividends translates to higher retained earnings and thus improved financial position over time
    5. countervailing argument: high-dividend payers tend to be better buys because a high payout ratio means mgmt is more attuned to the desires of most outside stockholders
    6. stockholders can be hurt by companies paying out high dividends long after it is wise for them to do so
    7. Graham and Dodd view is valid in the short-run but seems to make less sense in the long-run
  3. The placebo effect of cash dividends
    1. dividends increase in importance for securities holders insofar as they lack confidence in their outlook or mgmt or in the reliability of disclosures
    2. dividends are a hedge against being wrong
  4. Cash dividends and portfolio management
    1. Dividends increase in importance with the shareholder’s need for immediate cash income from his portfolio
    2. dividends become a negative factor when the shareholder wants a tax shelter or has no need for income and has confidence mgmt will successfully reinvest retained earnings
    3. securities with a high cash return can be attractive due to positive cash-carry
  5. Cash dividends and legal lists
    1. cash dividend income is a legal or quasi-legal necessity for many securities holders
  6. Cash dividends and bailouts
    1. the ability to convert assets to cash is a key consideration for many buyers for control purposes; always key for outside investors
    2. assuming an investor has no control over a company whose common stock he has invested in, eventually he will want the opportunity to convert into cash
  7. The goals of security holders
    1. most owners of senior securities are interested solely in cash income
    2. in contrast, some equity holders can be interested in cash return (dividends or cash sale of shares) but many are interested in earnings return

Chapter 15, Shareholder Distributions, Primarily from the Company Point of View

  1. Cash dividends or retained earnings
    1. “proper” dividend payout policy should be made from the point of view of the corporation, not the stockholder
    2. dividend payouts are a residual use of corporate cash and company requirements for cash in other areas have primacy
    3. dividend policy should be dictated by company needs for funds for expansion as well as for margin of safety
    4. companies should retain earnings whenever they have profitable ways to deploy it– this is not determined by the price of their stock as proclaimed by the stock market
    5. high dividends can be used by mgmt to create a higher stock price and thus protect the mgmt from raids
  2. Distributions of assets other than cash
    1. can create a taxable event with no cash to pay it
  3. Liquidation
    1. any payment by a corporation to its shareholders is a form of liquidation
    2. in truth, there is no such thing as liquidation in any meaningful sense, but rather asset-conversion
  4. Stock repurchases
    1. receipts of cash are taxed on a capital-gains rate only
    2. benefits:
      1. corporation benefits because cash requirements on future dividends are reduced
      2. EPS, BVS and corp reality value per share may be enhanced
      3. can promote strong stock market price, thus increasing the companies future financial position and financing opportunities
    3. disadvantages:
      1. if buy-ins are of massive size, investors may be forced out of the company at a price much lower than corp reality, even if at a substantial premium to market prices
      2. possible conflicts with insiders who might want to purchase shares, appearance of payoffs to insiders who want to sell

Chapter 16, Losses and Loss Companies

  1. Quality considerations and tax-loss companies
    1. an organization suffering economic losses can be attractive from the POV of asset-conversion acquisitions if:
      1. the resources employed by the company can be put to another use so losses are stemmed
      2. the business lacks overwhelming amounts of indebtedness
      3. it has available to it tax benefits growing out of the former losses
  2. On accounting and income
    1. tax benefits, for accounting purposes, are treated as extraordinary items
    2. however, these benefits have very real cash consequences and can generate substantial future earnings when reinvested, regardless of how they are accounted for
  3. Be wary of acquiring equity securities of the encumbered firm
    1. the danger in investing in loss corporations is that they have become so encumbered that there is no practical way to invest safely and profitably
    2. “big-bath” write-downs should be viewed as nonrecurring from the standpoint of judging the stewardship of the mgmt
  4. Commercial banks’ portfolio losses
    1. principal earnings assets of banks are investments in loans to customers and investments in securities, notably UST and munis
    2. when interest rates rise, the banks’ loan book falls in value, so they purposefully take losses to reinvest in higher yielding securities
  5. The “turned the corner” theory
    1. many times people will invest in small, losing companies with no record of profitability with the belief that when they “turn the corner” the market will substantially appreciate their new growth records
    2. risky
      1. hard to predict the future of uncertain businesses
      2. new issues normally not priced on bargain bases relative to corporate reality
    3. these securities rarely prove attractive from the FIA

Chapter 17, A Short Primer on Asset-Conversion Investing: Prearbitrage and Postarbitrage

  1. prices paid for common stocks for investment purposes are different from prices paid for control of businesses
  2. Four types of “do-able” asset-conversion activities that might be spotted with the FIA
    1. more aggressive employment of existing assets
    2. merger and acquisition activities
    3. corporate contests for control
      1. incorporated and domiciled in states where there are no strong anti-takeover statutes
      2. share ownership is widespread or blocks are locked up in private transactions
      3. possible low will of mgmt to resist a takeover
      4. absence of impediments to takeover, such as being in a regulated industry
      5. no antitrust problems
      6. there do not appear to be important people or institutions, such as customers, employees or suppliers, who could harm the takeover target by terminating relationships
    4. going private
  3. Postarbitrage
    1. occur after an asset-conversion event when securities owned by public shareholders remain outstanding
    2. sometimes when an offer to acquire securities is announced and less than all the shares tendered are accepted, arbitragers tend to dispose of masses of stock they have accumulated shortly afterward, depressing market prices
    3. important to avoid mgmts that have a predatory predilection
    4. post-arbitrage securities tend to be relatively unmarketable or not marketable at all
    5. one important rule of thumb: acquire shares at prices two thirds or less than control shareholders paid in the recent past to obtain control

 

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Review – The Pixar Touch

The Pixar Touch

by David A. Price, published 2008

It starts with Disney

The story of Pixar is interesting because it starts and ends with Disney, but under very different circumstances in each case. The two primary characters in the company’s founding and subsequent rise to glory, Ed Catmull and John Lasseter, were both Disney aficionados and aspiring animators from the get-go. At the time each was coming of age and establishing their careers, Disney was not only the premiere animation studio to work for, it was essentially the ONLY major animation studio to work for. But Catmull almost missed playing a pivotal role in the development of computer-animation when he decided, in high school, that he was not artistically cut out to be an animator. Lasseter, by contrast, found his high school experience to be an affirming one and it was during this period of his life that he knew for sure that an animator was what he wanted to become.

The two luminaries: Ed Catmull and John Lasseter

Though they had similar aspirations (with Catmull’s muted initially), Catmull and Lasseter took quite different paths to their eventual rendezvous at LucasFilm where they would come to create a Pixar Animation-in-the-womb.

Catmull went from the computer science department at the University of Utah, which was not only the scene of huge amounts of R&D spending by the Department of Defense’s ARPA project, but was also the unwitting locus of a number of individuals who would come to be highly influential innovators in the space of computer graphic design. It was here at the university where Catmull had a second awakening and decided that while he may not have a future as a traditional animator, he might become one yet by pioneering animation in the computer-generated space.

He eventually was scooped up by an “eccentric millionaire”, Alexander Schure, who drafted Catmull as well as a number of his computer science comrades from the University of Utah computer science department to come to his mansion-turned-technical institute (the nascent New York Institute of Technology on Long Island) and essentially tinker away at computer graphic design on his dollar. Catmull and company obligingly did so until personal and family pressures drove him to seek other employment, eventually finding his way to George Lucas’s design outfit in northern California where he and a number of other defectors worked on various technology-related odd jobs for Lucas’s studio.

Meanwhile, John Lasseter graduated from high school and went into the animation program at CalArts, an art school that was partially meant to be a recruiting ground for future Disney animation talent. He was subsequently hired into Disney’s animation studios only to be later fired in a political scuffle. He, too, wound up at Lucasfilm, where he teamed up with Catmull and the other NYIT veterans to develop the proprietary Pixar Image Computer. On the side, the ambitious would-be animators continued teaching themselves the craft of computer-generated animation, a technology they were largely innovating into existence on their own. Each year they attended the SIGGRAPH convention and showed off their latest minutes-long computer-animated film clips to an awe-struck and excited audience.

Even early on, Lasseter was showing a knack for story-telling beyond his years and experience.

Exit Lucasfilm, enter Steve Jobs

Having tired of losing money on the Pixar Image Computer and the Pixar company itself for long enough, Lucas looked for a buyer at an asking price of $15M plus an additional $15M to capitalize the spun-off business. Initially, there were no takers. At one point, an executive at Disney considered purchasing the entire company at $15M to subsume it into Disney’s animation facilities, but a young Jeffrey Katzenberg felt pursuing it was a waste of time.

Another series of failed deals followed (including one in which GM almost acquired the company before board member Ross Perot shot the idea down) when Steve Jobs’s offer of $5M for the company was finally accepted.

For the next several years, Jobs stuck $5M at a time into Pixar to keep in afloat, but he, too, had trouble finding anything to do with it. Initially imagined as a hardware design company, everyone ended up being frustrated as Catmull, Lasseter and their team were truly animators at heart (and certainly not businessmen) and Jobs was impatient and still reeling from the ego-blow of being booted out of his own company at Apple. He was looking for vengeance.

Jobs almost abandoned Pixar but at the last minute he decided to hold on to the company, realizing what he controlled was an outstanding group of talented individuals, not a failing hardware business. Soon after, Pixar inked its first deal with Disney animation (under Katzenberg, who had come to see the error of his earlier ways) to create what would become the smash, breakout computer-animation genre hit, Toy Story.

Jobs, always the savvy financier just as much as he was an outstanding technologist and businessman, took the company public on November 29, 1995, one week after the premiere of Toy Story. Still hot off the success of the film, Jobs brilliantly managed to hype the IPO by placing it so close to the release of their first major film even though he was technically supposed to be observing an SEC-enforced quiet period leading up to the IPO event. Jobs 80% stake in the company was valued at around $1.1B.

The story ends with Disney

Just over a decade after going public, Disney, the long-time partner of Pixar (and the long-time dependent, as Pixar’s computer-animated films essentially had become Disney animation, not the mention a substantial part of Disney’s total film and company-wide earnings) announced its offer to acquire Pixar on January 24, 2006, for 287.5M shares of Disney valued at about $7.4B.

Pixar’s fortunes, and the fortunes of its two central figures, Catmull and Lasseter, had now come full circle. What started with inspiration, dreams and ambitions based on the world of Disney had ended as a massive payoff from that very same studio. And along the way, these gentlemen and their co-creators not only revolutionized the world of animation, they created and popularized a genre, all while maintaining a nearly uninterrupted stream of critically-acclaimed, highly profitable film franchise hits.

The moral of the story

The Pixar story carries with it many morals: Always have the courage to follow your dreams; Don’t let the absence of something stand as proof of its impossibility; A lot of life’s magic and human progress is due to lucky happenstance.

But the most enduring lesson of all from the Pixar story is most likely the fact that greatness is hard to forecast, and the future is always full of uncertainty. Before Pixar was sold to Disney for $7.4B in stock, it was first nearly kicked to the curb by Lucasfilm for a song ($5M on the original asking price of $15M) and thought to be hopeless. And this was the view of it from a highly successful film studio whose chief architect was a successful technological innovator himself! From there, the group went on to suck millions of dollars out of Steve Jobs nearly to the point of exasperation before it finally had its first major breakthrough. How many failed deals came and went before Pixar turned out to be a multi-billion dollar enterprise?

Would the Pixar we know today even have existed if no one had ever thought to drop the frustrating hardware side of the business and let these technological entrepreneurs follow their true passion in story-telling and computer-animation?

The world could always be a different place than it is. It’s easy to see how obvious everything looks when you’re at the end of the story and not the beginning.

What kind of value would you have put on Pixar in the early 1980s?

Review – The Innovator’s Dilemma

The Innovator’s Dilemma: The Revolutionary Book That Will Change the Way You Do Business

by Clayton M. Christensen, published 1997

Technological innovation always means change, but which kind?

In the world of business technology, innovation can be thought of as coming in two distinct flavors:

  • sustaining, which are new technologies that improve a product or service in a way that is valuable to existing customers or markets
  • disruptive, which are new technologies that are uncompetitive along traditional performance metrics, which are unusable or undesirable to existing customers or markets but which nonetheless can eventually come to replace the traditional market over time

Throughout history, it is the best-in-class businesses which have the most difficult time with disruptive technologies to the point that disruptive technologies are usually the death knell for the leading businesses at the time. But this raises a question: if they’re such good businesses and they’re so well-managed, how come they can’t manage their way around disruptive technology in their industry?

The answer lies at the heart of what the author refers to as the “innovator’s dilemma”:

the logical, competent decisions of management that are critical to the success of their companies are also the reasons why they lose their positions of leadership

Why do good management teams and competent decision-making processes miss disruptive technologies? Disruptive technologies:

  1. are normally simpler and cheaper, promising lower margins, not greater profits
  2. typically are first commercialized in emerging or insignificant markets
  3. are usually unwanted and unusable to leading firms’ most profitable customers

But good management teams with excellent decision-making processes are fine-tuned to search out:

  1. higher margin opportunities at best, and opportunities with minimum margin requirements based upon their existing cost structure
  2. opportunities that market research and querying of leading customers show there is a present demand for
  3. markets and growth opportunities which can have a significant impact on their business relative to their current scale

In short, every successful firm has a unique “value network” DNA that allows them to be especially dominant within a certain set of competitive circumstances.

the value network — the context within which a firm identifies and responds to customers’ needs, solves problems, procures inputs, reacts to competitors, and strives for profit

But disruptive technologies present a paradigm shift of a market into a completely different “value network” that the firm has not been evolved to survive in which results in, similar to biology, an extinction event for firms with the wrong type of value network DNA.

Crafting a response to disruptive technology

But the reality of disruptive technology is not entirely depressing for successful firms, and they can develop successful strategies for coping with disruptive technologies if they first make themselves aware of the five principles of disruptive innovation:

  1. Companies depend on customers and investors for resources
  2. Small markets don’t solve the growth needs of large companies
  3. Markets that don’t exist can’t be analyzed
  4. An organizations capabilities define its disabilities
  5. Technology supply may not equal market demand

Each of these principles holds within it a potential misstep for successful firms within their traditional value networks trying to respond to a disruptive technology. Because firms depend on their customers (primarily their leading, most profitable customers) and investors for their resources, they are often incentivized to ignore the low margin disruptive technology because their customers initially don’t want it. And because disruptive technologies start in emerging or insignificant markets, successful firms often ignore them in favor of better growth opportunities. Meanwhile, firms that DO try to take disruptive technologies seriously often commit themselves to particular investment and marketing patterns based off of market research for a market that is dynamic and prone to sudden and rapid change. At the same time, that which makes a company excellent at doing A simultaneously makes the company horrible at doing B (where B is the opposite of A), and often disruptive technologies require B responses when successful firms are honed to operate at A. The final frustration for these successful firms occurs when they attempt to enter a disruptive market with a solution that technologically exceeds the needs of its current users, causing them to withdraw in defeat only to watch the market then take off anyway!

An ironic twist

As hinted at above, it is ironic that the very strengths of leading firms in adapting their business to sustaining technologies (improvements in performance in relevant metrics that their best customers demand) are the exact things that cause them to fail to respond to disruptive technologies in a profitable, dominant way. And to make a bad story worse, it is these strengths-as-weaknesses that allow entrants in disruptive technological markets to capture important first-mover advantages for themselves, constructing barriers to entry which are later often insurmountable for established firms.

To a dominant firm, disruptive technology looks like low-margin, small market business that neither their customers nor anyone else seems to be interested in. But for entrants in the disruptive market, with radically different cost structures than dominant firms and with organizational sizes and resources better matched to the opportunities presented, disruptive markets are a wild playground full of unchallenged opportunity.

And while the dominant firms look down at lower-margin, smaller market business and shake their heads dismissively, entrant firms look up above at higher-margin, huge market opportunity and lick their chops. Every business ultimately looks upstream for higher-margin opportunities than the ones they have at present.

Is it any wonder why dominant firms are continually defeated by surprise attacks from below?

How dominant firms can successfully respond to disruptive technology

The position of the dominant firm in the face of disruptive emerging technology is not hopeless. For every yin, there is a yang. By inverting the five principles of disruptive innovation outlined earlier, dominant firms can find five guidelines for successfully responding to disruptive technology:

  1. Give responsibility for disruptive technologies to organizations whose customers need them
  2. Match the size of the organization to the size of the market
  3. Discover new and emerging markets through a flexible commitment to “plans for learning” rather than plans for implementation
  4. Create organizational capabilities and strengths which are complementary to the unique demands of the disruptive market place
  5. Resist the temptation to approach the disruptive technology with the goal of turning it into something existing customers can use, rather than serving the customers unique to the market and searching out new markets entirely

Conclusion

This book was published 15 years ago. The subtitle is, “The revolutionary book that will change the way you do business.” I don’t know if 15 years is long enough in the business world for the ideas of a book like this to be fully adapted into the mainstream but I would guess it is not. I am no business expert but this material was completely uncharted territory for me.

Frankly, I never thought I’d enjoy reading something written by a Harvard business school professor as much as I did with this book. Whereas case studies, quirky charts and statistical evidence usually bore me to the point that I often skip over them, this book was something of a page-turner for me and I found myself eager to find out “what happens next” in each subsequent chapter.

As faddish as it has become as of late to hype the increasingly rapid change of markets and business practices in general, the reality is that most markets don’t change that quickly and most business practices are timeless themselves. But for those unlucky enough to find themselves, suddenly or otherwise, in a market or business that is changing due to disruptive technology, this book could be a lifesaver at a minimum and a handbook for profiting immensely from that change at best.

You can get the essential points of the book entirely from reading my review, or skim-reading the introduction and final chapters of the book (which present a comprehensive summary of the ideas outlined above). But the case studies are invaluable in driving the point home and there are numerous nuances to Christensen’s argument that are worth savoring and considering on their own. Because of this, I unequivocally recommend that every interested reader purchase their own copy and read it in full, and thereby grant themselves an invaluable competitive advantage in the market place, whichever value network they might happen to be competing within.

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.

Review – The Big Picture: Money And Power In Hollywood

The Big Picture: Money and Power in Hollywood

by Edward Jay Epstein, published 2005

What the movie business was like in 1947

The central theme of “The Big Picture” is that the economics of the film industry and the profitability of Hollywood (both mechanistically and proportionally) have changed significantly from 1947 to the present day. By way of comparison, consider a few of the following starting statistics:

  • In 1947, the major film studios produced 500 films; in 2003, the six major studios produced 80 films
  • In 1947, 90M people out of a total population of 151M went to a theater each week in America at a cost of about $.40/ticket; in 2003, less than 12% of the population saw a movie in a given week
  • In 1947, 4.7B movie tickets were sold in America; in 2003, 1.57B were sold
  • In 1947, “feature films could be shot in less than a month, and some B films were shot in a week”; today, the average live action film takes over a year to produce and the average animated film takes 2-3 years to produce
  • In 1947, “virtually all [studio] films” made money, with the average cost of making a film at $732,000, and average net receipts of around $1.6M; in 2003, “a relatively good year, the six studios lost money on the worldwide theatrical release of most of their titles”

By 2003, the cost of producing the average film had risen to $63.8M. Although the dollar fell 7x from 1947-2003, the cost of producing a film rose 16x! Clearly, when the trend in film production is studied over time it is obvious that film production has become a substantially more capital-intensive business, it is a higher risk business (in terms of the chance and cost of failure) and it is substantially less profitable, at least in terms of theatrical release.

How and why did the economics of the film industry change, and how have film studios managed to stay in business today if their main product (theatrical film releases) are money losers on average? The answer consists of two elements: changing government regulations, and changing strategic dynamics.

Government intervention

The new studio system is the product of three government interventions. (The old one was a product of one– patents and intellectual property laws that caused movie studios to flee the Edison Trust on the East Coast, where the ET’s lawyers had a harder time pursuing patent infringement claims.)

  1. In 1948, the Justice Department issued a consent decree to the major film studios, “give up control over major retail outlets [the theater distribution system] or face the consequences of a criminal antitrust investigation”
  2. In 1970, the FCC passed the fin-syn rule on studios’ behalf, giving Hollywood an advantage over the networks in the syndication business, laying the seeds for and eventual studio takeover of the television network industry and the rise of the international, corporate media conglomerate business model
  3. In the 1990s, fin-syn was weakened and in 1995, abolished altogether by the FCC, allowing studios and networks to become part of vertically integrated conglomerates controlling production, distribution, stations, networks, cables, satellites and other means of TV transmission

A few other intervention-related items of note: the Nixon administration asked studios to portray drug users as menaces to society rather than victims of addiction, resulting in the start of perpetrators of crime frequently being depicted as drug users in film and television productions. Additionally, in 1997 Congress passed a law allowing studios to be paid through a formula for integrating antidrug messages into the plots of television series that were approved by White House Office of National Drug Control Policy.

Your tax dollars at work!

Disney changes the game

The second major change to the old studio production and profitability model was Walt Disney’s decision to focus on young children and families as the primary audience for his film and television productions. This strategy began with development of Snow White and the Seven Dwarfs, which began in 1934. Between 1937 and 1948, 400 million children’s tickets at an average cost of $.25 had been sold. The film was the first to gross over $100 million. It was also the first film to have a commercial soundtrack, the first film to have merchandising tie-ins and the first film with multiple licensable characters.

Disney’s strategic decision was brilliant– he created a niche market (children’s entertainment) that the other studios refused to enter. He had this new and growing market all to himself for a long period of time, during which he established his brand as essential and synonymous with family entertainment. He  and his successors pioneered the idea of film releases as simply the starting point in establishing a long-lived exploitable IP asset which could generate additional cash flows outside the box office through merchandising and licensing arrangements.

The way Hollywood works today

Today, the major movie studios have either been subsumed into massive, international corporate conglomerates, or else they’ve become one (like Disney). Movies are just one of their many businesses, and the role of the box office has dwindled. Many movies lose money at the box office. But this is okay because the corporate studios issue their content and IP across their other media (TV, merchandising, music, home entertainment products, etc.) to make back their money, and then some.

As one example of new studio economics, consider the film Gone in 60 Seconds— worldwide box office gross of $242M, $103.3M paid by Disney to produce the film, $23.2 for physical distribution into theaters (prints and insurance), $67.4M on worldwide advertising, $12.6M in residual fees, all in costs of $206.5M to get the film into the theater and to generate an audience to see the film. The theaters then kept $139.8M of the box office gross. Disney’s distribution arm (Buena Vista) collected $102.2M. Disney’s overhead of $17.2M for employee salaries in production, distribution and marketing and interest payments of $41.8M mean the film lost over $160M by 2003.

But that isn’t the end of the story for a film like Gone in 60 Seconds, as the film IP takes on a new life once it leaves the theatrical market and enters the world of home entertainment, where it is sold as a personal home library title, rented and licensed for syndication through major domestic and foreign TV and other media networks. For animated films (and some live action titles), there is also the opportunity to merchandise relevant IP and license the film’s IP as a movie tie-in for the products of other companies.

As can be seen from the numbers above, the two primary drivers of increased film production costs are related to the competitive aspects of film advertising and distribution and the end of the “chattel talent” system whereby studios essentially owned their stars and laborers (producers, directors and film crews), compared with the “star power” arrangements of today. According to the author,

In this new era, stars, not studios, reap the profit their brand names bring to a film.

One reason that advertising costs have risen is due to the fact that in the previous era, one admission got you in for multiple screenings and every moviegoer essentially watched every screening shown during their admission. Today, movie audiences are highly segmented. This means that studios have to “create” a new audience for each and every film, they can not count on a moviegoer purchasing a general admission ticket which will result in them watching all of their films. As one Sony marketing executive put it:

If we release twenty-eight films, we need to create twenty-eight different audiences which necessitates twenty-eight different marketing campaigns.

Additionally, the transformation of the film industry into a global market with simultaneous releases means higher advertising costs (no way to reuse promotional prints and media as films no longer have “rolling releases” across the country) and higher physical film production and distribution costs (every theater needs its own copy of the film which must be shipped there and back). And because the studios no longer “control” their talent and labor, they must be willing to pay top dollar for the name-brand stars that draw the biggest crowds.

However, the studios have also gotten savvier at advertising and cross-marketing in the age of ownership by global, corporate media conglomerates. Major Hollywood studios cross-promotionalize across their various media. A studio can get actors, directors, etc. to be interviewed on the corporate parent’s TV networks to promote an upcoming film. Corporate sponsors with TV rights for certain sports and national events can get additional advertising and exposure for the corp parents film studios as well.

Film studios have also learned how to leverage their promotional efforts through tie-in marketing and merchandising partnerships. In these relationships, a leveraged marketing and advertising budget results because your partners pay to promote your characters and content for you. For example,

[McDonald’s] invested more than $100M — four times Disney’s own advertising budget– in just one film, Monsters, Inc.

The clearinghouse system

Another essential element of the modern film business that must be understood is the “clearinghouse system.”

Studios now outsource the making and financing of most of their movies and television series to off-the-book corporations

Movies used to return almost all of their money in a year; now, revenue flows in over the lifetime of licensable rights, often lasting many decades.

When revenue flows in, it is the studio that decides (initially at least) who is entitled to what part of it, and when, and under what conditions

which works to the studios advantage because

the studios usually control the information on which the payments are based

Theaters, distribution and merchandising

Today’s theaters have three primary businesses: concessions vending, movie-exhibition, and corporate advertising. However, contrary to popular belief and news headlines, the box office is not the primary source of profits for theaters– the selling of refreshments is.

Theaters want a film with broad appeal so there are more people attending who will buy more refreshments. Additionally, they want films no longer than 128 minutes in length because every film which exceeds that limit causes them to lose a potential evening showing.

Film studios, meanwhile, simply want their films to succeed at the box office because there has historically been a connection between success at the box office and later success in the home entertainment market, which is much more profitable for them as studios end up with only 45-60% of the box office revenues on average.

Non-domestic box office and non-theatrical release have long been critical to the Hollywood model. As early as 1926, Hollywood studios represented 3/4 of European box office and 1/3 of Hollywood revenues came from Europe. In the 1950s, Hollywood film studios had a 30% share of European and Japanese box office which grew to 80% by 1990. American film studios seem to flagrantly violate the Greenwaldian strategic mantra of “compete locally”!

Paramount and Universal jointly control the largest overseas distributor, United International Pictures (UIP). Pay-per-view TV earned the six major studies $367M in 2003, a relatively modest sum of money despite the hype of the model. Other major sources of revenues in nontheatrical release are airline in-flight entertainment, hotel pay-per-view and US military theaters overseas. One of the benefits of television syndication of studio content is that almost all marketing expenses are paid by the broadcaster and the network.

Merchandising is another critical element of film studio profitability. For example, merchandising alone adds an estimated $500M profit to Disney’s bottom line each year.And The Lion King produced $1B in retail sales by itself. Streams of licensing revenues can enrich a studio’s clearinghouse for many decades.

Critical competitive dynamics of the film industry

It’s a well-known fact within the industry that “the date on which a film will open can make or break a movie.” Traditionally, the 9 months between September and May when school is in session promises only a fraction of the audience possible during the three months in the summer season. Studios must compete for a limited number of big-release slots and face a distinct “prisoner’s dilemma” strategic framework in which the refusal to cooperate in selecting movie release dates can result in massively diminished box office performance for each studio.

The studio whose film has the weaker appeal to the target audience has a strong incentive to change its slot, since if the NRG numbers prove correct, it stands to get a smaller share of a confused and cross-pressured audience and will probably fail.

A key competitive strategy for film studios is the creation of franchise films. Franchise films are more stable sources of revenue, because they’re more consistent performers at the box office and in the sell-through of the home entertainment market. Additionally, they ostensibly help to lower the costs of advertising and marketing because there is already a fan-base/audience in place which does not need convincing anew to see a franchise sequel film or buy related merchandise. Additionally, television and other syndication networks are willing to bid higher for franchise films because of their consistency and predictability.

One key to creating franchise films is close adherence to the “Midas formula.”

The Midas formula

Only a very few films account for the lion’s share of a studio’s earnings. The film’s that succeed most often and most extremely typically follow the “Midas formula”. Films which follow this lucrative formula have the following features:

  1. based on children’s stories, comic books, serials, cartoons or a theme-park ride
  2. child or adolescent protagonist
  3. fairy-tale like plot
  4. strictly platonic relationships
  5. appropriate for toy and game licensing
  6. a rating no more restrictive than PG-13
  7. end happily
  8. use digital animation
  9. cast actors who are not ranking stars (do not command gross-revenue shares)

The Disney empire is largely the result of Disney’s successors closely hewing to this formula. R-rated and live action films have far less chance to reach their break-even compared to films adhering to the Midas formula. In act, non-formula films have little, if any, possibility of becoming billion-dollar-club members.

Other facts and figures and final comments

First, a few stray facts and figures:

  • the average cost of American distribution in 2003 was $4.2M per film for the major studios, while independent films averaged $1.87M per film
  • the six major studios spent more than $1B in 2003 on film prints
  • in 2003, the average advertising expense per film was $34.8M, compared to 1947 when $60M was spent on distribution and advertising by ALL major film studios combined
  • in 1947, movies were America’s third largest retail business and the six major studios collectively earned $1.1B, or 95%, of all film “rentals” at the domestic box office
  • in 1947, there were 18,000 neighborhood theaters
  • in 1947, Clark Gable made less than $100,000 per film

Studios are moving away from physical film in favor of digital projections. This could save millions in distribution costs as there will be no more cost of producing, shipping, storing and retrieving prints from film exchanges all over the world.

A critical summary of the film studio business model from Richard Fox, a vice president at Warner Bros.:

The studios are basically distributors, banks and owners of intellectual copyrights.

Review – Value Investing: From Graham To Buffett And Beyond

Value Investing: From Graham to Buffett and Beyond

by Bruce Greenwald, Judd Kahn, Paul Sonkin and Michael van Biena, published 2001

Three valuation approaches

In the world of value investing, there are three essential ways to value a business: studying the balance sheet (asset values), studying the income statement (earnings power) or studying the value of growth.

Greenwald and company recommend using each approach contingent upon the type of company being analyzed.

The asset value (balance sheet) approach

The virtue of balance sheet analysis is that it requires little extrapolation and anticipation of future values as the balance sheet ostensibly represents values which exist today. (Note: technically, for balance sheet values to be accurate they must have a meaningful connection to future cash flows and earnings which can be generated from them, but that is beside the present point.) Additionally, the balance sheet is arranged in such a way that the items at the top are items whose present value as stated on the balance sheet is more certain because they are closer to being converted into cash (or requiring immediate cash payment), whereas those toward the bottom are less certain. The implication here is that companies trading closer to the value of net assets nearer to the top of the balance sheet are more likely undervalued than those trading closer to the value of net assets nearer to the bottom of the balance sheet.

Putting these principles into practice, when using the balance sheet method, companies which are not economically viable or are experiencing terminal decline should be valued on a liquidation basis, looking at net current asset values and severely discounting long-term fixed assets (and perhaps completely writing off the accounting value of goodwill and certain intangible items). On the other hand, companies whose viability as going concerns is fairly certain should be valued on a reproduction cost basis when using the balance sheet method, meaning calculating a value for replacing the present assets using current technology and efficiencies.

In an industry with free-entry, a company trading for substantially more than $1 per $1 of asset reproduction costs will invite competition until the market value of that company falls. Similarly, a company trading for substantially less than $1 per $1 of asset reproduction costs will find competitors exiting the industry until the market value of the company rises back to the reproduction cost of the assets. Without barriers to entry which protect the profitability of these assets, the assets are essentially worth reproduction cost as they deserve no earnings power premium.

For these firms, the intrinsic value is the asset value.

The earnings power (income statement) approach

Whereas the asset value approach relies more strongly on present market values, the earnings power valuation approach begins to introduce more estimation of the relationship between present and future earnings, as well as the cost of capital. These are decidedly less certain valuations than the asset value method as they rest on more assumption of future phenomena.

The primary assumptions are that,

  1. current earnings, properly adjusted, correspond to sustainable levels of distributable cash flow, and,
  2. that this earnings level will remain approximately constant into the indefinite future.

Based upon those assumptions, the general equation for calculating earnings power value (EPV) is:

EPV = Adjusted Earnings x 1/R

Where “R” is the current cost of capital.

Earnings adjustments, where necessary, should be made on the following basis:

  1. rectifying accounting misrepresentations; the ratio of average recurring “one-time charges” to unadjusted reported earnings should be used to make a proportional adjustment to current earnings
  2. depreciation and amortization adjustments; reported earnings need to be adjusted by the difference between stated D&A charges and what the firm actually requires to restore its assets at the end of the year to the same level they were at at the beginning of the year
  3. business cycle adjustments; companies in the trough of their business cycle should have an addition to earnings in the amount of the difference between present earnings and average earnings, while companies at the peak of their cycle should have earnings adjusted by the difference between average earnings and present earnings (a negative number)

There is a connection between the EPV of a firm and its competitive position. In consideration of economically viable industries:

  1. EPV < asset reproduction cost; management is not fully utilizing the economic potential of its assets and the solution is for management to change what it’s doing, or for management to be replaced if it refuses to do so or proves incapable of doing so
  2. EPV = asset reproduction cost; this is the norm for firms in industries with no competitive advantage, and the proximity of these two values to one another reinforces our confidence that they have been properly calculated
  3. EPV > asset reproduction cost; this is a sign of an industry with high barriers to entry, with firms inside the barriers earning more on their assets than firms outside of them. For EPV to hold up, the barriers to entry must be sustainable into the indefinite future

The difference between the EPV and the asset value of the firm in question in the third scenario is the value of the franchise of the firm with barriers to entry. In other words, the firm’s intrinsic value should equal the value of its assets plus the value of its franchise.

Similarly, in the second scenario, no premium is granted for the value of growth because with no competitive advantages, growth has no value (the cost of growth will inevitably fully consume all additional earnings power created by growth in an industry characterized by free-entry competition).

The value of growth

The value of growth is the hardest to estimate because it relies the most on assumptions and projections about the future, which is highly uncertain.

Additionally, growth has little value outside the context of competitive advantage. Growing sales typically need to be supported by growing assets: more receivables, more inventory, more plant and equipment. Those assets not offset by greater spontaneous liabilities (accounts payable, etc.) must be funded somehow, through retained earnings, larger borrowings or the sale of additional shares, reducing the amount of distributable cash and therefore lowering the value of the firm.

For firms operating at a competitive disadvantage, growth actually destroys value. Otherwise, growth only creates value within the confines of a competitive advantage. This uncertainty of growth and the competitive context of it leads the value investor to be least willing to pay for it in consideration of the other potential sources of value (assets and EPV).

Review – The Predator’s Ball: The Inside Story Of Drexel Burnham And The Rise Of The Junk Bond Raiders

The Predator’s Ball: The Inside Story of Drexel Burnham and the Rise of the Junk Bond Raiders

by Connie Bruck, published 1988

This review is going to be brief because, full disclosure, I’ve only read (as of this writing) 180 pages of this book. And honestly, that might be about all I’ll end up reading. Here’s why:

There are great Wall Street/business biography books (The First Tycoon by TJ Stiles, for example, which I will write a review of when I eventually re-read), good Wall Street/business biography books (much of what Michael Lewis has written qualifies, even though I find the author as a person to be a bit nauseating) and bad Wall Street/business biography books, a category of which Connie Bruck’s effort is a member.

Great books in this genre are exciting to read, they’re deeply researched and place major developments and character traits into a meaningful context and they leave the reader feeling like he’s gained some knowledge which is general and timeless in nature. The good books largely accomplish the same but a little less efficiently and with a little less objectivity, the author coming across as being taken by his subject matter.

The bad books offer none of the benefits (historical context, depth of mechanical understanding, deconstruction of character) and come chock full of pointless and irrelevant trivia– lots of dates, tons of deal size data and a mountain of dropped names. The writing is sycophantic and lap-dogish, the tone is that of a hyperkinetic cheerleader and the message is one of ignorant, drooling, envious amazement.

“The Predator’s Ball” is hard to read because it seems like it was hard for Bruck to write. She flings a lot of facts and figures at you but you never get the sense she understands the qualitative significance of any of it. The book is too self-conscious and self-aware– whereas in a Michael Lewis book you can easily lose yourself in the story and feel as though you’re a fly on the wall watching everything happen, Bruck’s book comes across as a series of poorly stitched together self-referential interviews where the illusion and pacing are constantly broken by the author willingly neglecting her editorial duty and allowing herself to be used as a mouthpiece by her interviewee.

And it gets worse.

Bruck spends page after page gushing about the… gushers… of money that were pouring forth on Wall Street during the junk bond-backed buyout boom of the early 80s. But in 180 pages she has yet to stop and ask herself (and then answer) where in the hell all this money is coming from? And the book is purposefully about Michael Milken and his comrades but she makes it seem like they were the only players in the entire world of finance doing any of this stuff when more likely they had competitors not only in the US but around the world. There’s no consideration of monetary policy and little discussion of the regulatory climate. It’s like this drama is unfolding in a vacuum.

It’s not only confusing but so arbitrary as to seem pointless.

By Connie Bruck’s telling, Wall Street drama is a lot like the drama of high school social politics. The book speaks of many parties, hangouts (meetings), liaisons and shenanigans and tries to convince the reader that he should care what all these “popular” kids are doing. It’s all supposed to be extremely interesting, who slept with who, who did a deal with who and for how much and how mad it made someone else. You keep turning the page under the assumption it’s all going to add up to something, that the story is going somewhere and the meaning of all of these interactions will be summarized and revealed.

It never does. That’s when you might feel compelled, as I was, to set the book down in frustration and walk away.

I bought the book because I wanted to understand the LBO world– who were the players, how did it work, why did it happen when it did and what were the major lessons? I highlighted a few things, but mostly I just want my money back.