Applied Investing
The alternative guide!
Mission Statement


Build Better Business Leaders.
Produce knowledgeable but deeply skeptical
investors.
Introduction






PJ King
Fund Manager – Hermes Pension Fund
Research Analyst – JP Morgan, Merrill Lynch
Civil Engineer – British Telecom
3 times voted No1 Small Cap Team in Asia
CV on BB
Getting the Admin sorted out.











Class Reps.
Time & Place.
Groups.
Course breakdown - marks
Assignments Individual – marking scheme
Assignments Group – marking scheme
JiFi – marking scheme
Choose the companies
Prizes
StockTrak & Marking Scheme
Last Lecture.
Course Marks





A) Class Participation – 10%
B) Individual Assignments – 25%
C) Group Assignments – 15%
D) Exam – 50%
NOTE: you must pass B+C combined as well
as D to pass the course. Pass mark is 50%.
Individual Assignments






I1 to I7. – go to Assignments.
Each worth 3% except for JiFi – worth 7%
6 essays and 1 JiFi note.
What I am looking for – ability to analyse the
question and put up a coherent and well
researched argument and counter argument.
Presentation to be of a professional standard.
Scoring 0 is an option – I have no heart!!
Group Assignments








G1 to G3
Each worth 5%
G1 is an in-depth analysis of a US company
G2 is an analysis of a commercial property
G3 is the report on your usage of StockTrak – How
to score this?
Depth and range of analysis is what I will be looking
for.
Presentation to be of a professional standard.
Scoring 0 is an option!!
Prizes



Best Student Overall – $200 from University
Bookshop.
StockTrack + Report (60% + 40% - my
suggestion?!?) – best scoring group wins
$500
Commercial Property – best report wins $100
of petrol vouchers.
Class Participation






Marks given for the quality of your questions
to outside speakers.
Dumb and time wasting questions score 0.
“Good Question” – score 100%.
Cookie questions score high!
State your name before asking a question.
1 question per person.
JiFi marking






Every line
Every page
Negative scores.
% difference.
Closest to ideal scores highest.
Example
What you will learn






How to analyse assets as possible investments –
with special reference to Equities.
How to value assets.
The problems of managing a portfolio.
Managing your own money as apposed to managing
others.
That most of the financial theory you have learned is
misleading and probably wrong!
Presenting Financial Ideas.
How you will learn






Using the JiFi Note
Using Case Studies
Using Team Work
Listening to lectures
Playing with a Portfolio – Stock Trak
Reading suggested background material –
yes it is part of the course. NOTE: I consider
it fair game to take exam questions from
this material!!
Why does this course need so much work?
Why does this course need so much work?


…cause I believe that it is the most important
course that you will do!
Why do I think this?
The last thing on your mind?
The last thing on your mind? - 2



Who is going to pay your pension!
….but this is important..
Why?
Demographics are against you!



The numbers of those aged over 65 will grow from
12 per cent of the population to 27 per cent in the
next 50 years
leading to a massive increase in pension and health
costs with fewer younger people to pay for it.
The issues are raised in a report presented to
retirement commissioner Diana Crossan by the
Periodic Report Group 2003, which suggests they
must be dealt with before the end of the decade.
Demographics - 2



The report shows workers under 55 will likely work
longer, get their pension later and receive less when
it comes through.
Treasury papers show the benefits of increasing the
eligibility age for the pension to 68 over six years,
starting in 2013, and the benefits to the economy of
workers retiring at 70, starting in the next five years.
The full impact of the changes would hit people
aged 20 to 40, while the measures would have a
lesser effect on those aged 40 to 55. The rest of the
working population can expect to enjoy today's
retirement age and pension.
Your future - 1





Large student loans and dropping home ownership
will cause problems for younger New Zealanders.
Middle New Zealand's living standards will fall.
Cullen's NZ Super Fund will not solve the problem,
simply ease it.
Healthcare costs will almost double to $13 billion, a
jump from 6.3 per cent of GDP to 11.1 per cent.
Crossan (retirement commissioner) said it was
essential New Zealanders realised they must make
changes to the way they saved and support the
government in making difficult choices.
Your future - 2



The government needed to get a clearer message
to New Zealanders about the current pension.
"Quite frankly, politicians are misleading us. . . Are
we as individuals quite happy to exist on $12,000 a
year?
"If we don't do something and we are forced to
increase tax on younger people to support the
expanding number of people receiving NZ
Superannuation, those young people will say, `blow
this, I'm going to Australia' and this country will go
backwards at a faster rate,"
Your future - 3



While the political parties do not have
comprehensive solutions sketched out 50 years into
the future, Act finance spokesman Rodney Hide said
a change to the pensions politicians received might
produce action.
Hide said the numbers had an "honesty" that would
make liars out of politicians who promised the earth.
Putting MPs on the same pensions as other New
Zealanders "might focus parliament's mind on the
problem".
Can you believe it?!?





From a 2003 Industry in NZ survey:
Only 6% of the 1,500 interviewed thought business or
the economy were factors likely to ensure their “ideal”
standard of living!
50% thought it was more important for the
Government to do the right thing socially than the right
thing economically.
Few people initially identified growth industries as
likely to lead to a good performing economy.
46% consider business a “necessary evil” not realizing
where the tax money that supports the country comes
from.
3 ways to get rich



Inherit it
Marry it
Make it yourself.
How to make it yourself ?

Spend less than you earn and invest the rest.
What to invest in?




Property
Own your own business
Shares
Savings accounts (the magic of
compounding!)
Survey of the successful



In a survey by a US brokerage firm of its
successful clients;
9 out of 10 had made their fortune because
they had been long term investors in a
successful private operation.
The rest because they had ample buying
power at the rare but repetitive times when
bargains were available
The successful strategy



These people did not try to sell when their
businesses looked expensive in the hope of
buying them back at a cheaper price in the
future.
They were locked into something good –
more or less permanently. This is why they
became rich.
Why not apply this approach to stock
investing?
Portfolio Dissection



The performance of the best portfolios can be boiled
down to the continuous holding of one, two or three
stocks whose price has multiplied many fold.
It is more important to hold on to winners than to
weed losers.
Losers have increasingly less influence on a
portfolio than winners if both are maintained – as
long as one does not commit the sin of cutting back
the successful one and buying more of the losing
one.
Guessing stocks or the market





Much effort has been expended in this area.
…but attempting to guess the market with
respect to timing and direction is ….
…still a gamble.
Hence ten times as many fortunes have been
made through selection as through timing.
What to do?
Speculate?



Sure…but in speculation ….
…when to buy (and sell) is much more
important than what to buy.
Mathematically more speculators must lose
than can profit.
What to invest in?





Too much effort into cyclical approach.
Trend well progressed before we recognise Bull or
Bear.
Few buy at the bottom and sell at the top – but
many lose money trying.
If a person owns a business or a farm or a property
s/he does not worry about how much it is worth
today compared to yesterday.
One looks at it as a function of earning power,
growth or long term value.
What to invest in - 2


Yet if one owns Microsoft or ANZ – less risky
and more substantial businesses they look
upon themselves as richer or poorer on a
daily basis almost!
The very fact that liquidity exists makes
people over-emphasise the price.
What to invest in – 3 - Buffett


Better to buy a good business at a fair price
than a poor business at a bargain price.
When a management with a reputation for
brilliance tackles a business with a reputation
for poor returns…guess whose reputation
remains intact?
Sure?!


But you need to be a professional with
access to all the information to make money
out of stocks & shares!
The professionals do make money….but not
the way you think.
What information to use?




More is not better in information. Studies have
shown that increasing the information to expert
decision makers does not improve their judgment.
Investment houses put a lot of emphasis on detailed
analysis by its experts. They turn out thousands of
thousands of reports.
Yet they lost a fortune for their clients in the bubble –
which bubble – any bubble!!
In depth information does not mean in depth profits.
Information - 2


Because the psychology of information is not
understood by Investment Banks, investment
experts put down their failure to lacking those
extra facts. If only we had….
Hence they overload themselves with
information which increases the cost but not
the effectiveness of their decision making.
Information - 3



Simplicity or singleness of approach (i.e.
understanding your strengths) is a very much
underestimated factor of market success.
Multiplicity of factors, even though each has a
justification, leads one to become lost in
maze of contradictory implications….
….leading to nothing better than a snap
judgment anyway.
Information - 4





Under conditions of anxiety and stress, the market becomes a
huge inkblot..
…and people just see what they want to see.
Not only can experts analyse information incorrectly, they also
tend to find false correlations.
The complexity of the market leads to an attempt to simplify and
rationalise. They find false correlation and if they are rewarded
by a positive result they come to believe that there is such a
correlation in reality.
A chartist summed it up well – If I had not made money some of
the time, I would have got market wisdom sooner. What does he
mean?
Information - 5




People can become very quickly overloaded
as a configural reasoner and information
processor.
Under conditions of information overload we
no longer process information reliably.
Confidence rises as our input of information
increases…but our decisions are not
improved…
…in fact, if the stock market is anything to go
by, they deteriorate!
The Capital Market - who needs it?




Just a lottery?
Destroys pensions and savings
Lurches from one crisis to another.
Is there another way of structuring things?
The Capital Markets-1





The Capital Markets are not perfect – but the best
we have got.
China a superb example of the power of the market.
Is Deng Xiao Ping a saint?
Corporate Scandals a strength! – boom times and
self correcting mechanism.
Closed or highly regulated systems have shown to
be ineffective in dealing with these problems
Problems of the market are human problems not
system problems
Capital Markets -2




Function to Fund Innovation
Innovation improves living standards….
…directly through new products and services
….or indirectly through driving up productivity.
Capital markets -3






Large, efficient, transparent markets…..
…enable investment in innovation ….
…lead to faster development than would
otherwise be possible.
Efficient allocation of capital is the core of
capitalism
People invest money for one reason – to get
something back (that something may not be
money …)
Does the Capital Market allocate labour
resources efficiently?
Who should allocate the capital?





Government?
What problems arise?
Individuals?
What problems arise?
Group discussion.
Adam Smith

…in the pursuit of self interest the individual
is led by an invisible hand to promote an end
which was no part of his intention. Nor is it
always the worse for society that it has no
part of it. By pursuing his own interest he
frequently promotes that of the society more
effectually than when he really intends to
promote it.
Why do I think that this course is the most
important one you will do?
Why do I think that this course is the most
important one you will do?

Because it will show you how to think about
money in a way that improves your ability to
get it and use it wisely for the benefit of
yourself, your family and society as a whole.
An investment approach…

Superior results come from acquiring part
ownership in progressive companies with the
intent of profiting from the long range
contributions to the growth of the economy,
rather than trading stock certificates in the
hope of outwitting thousands of others
engaged in the same game (Guidelines to
successful investing by Babson & Babson).
The trick is to ….


…consider oneself a part owner of the
companies whose stocks have been carefully
selected, to plan to retain such ownership as
long as you are satisfied that they will
progress at or above the rate of industry as a
whole and to place your faith in the
continuation of the country’s dynamic growth,
decade to decade.
..see also…the miracle of compounding!
So..


..invest in a given company NOT because
you think the price is going up but because
you have faith in the future of the products
manufactured or services offered, the
research done and the ability of the
management of that company compared to
others.
If one is thorough in this analysis one has a
much better chance than 50:50 of making the
correct selection.
..and..



The best guarantee against beng diverted
from one’s long term investment plan is to
buy only stocks that you want to keep.
This eliminates the risky “Two Decision”
stocks.
It stops you from becoming involved in hot
stocks and tips etc.
When to invest?







Only when the possibilities for the chosen company seem great.
Do not invest solely for income or to keep capital employed or to
hedge inflation.
When an investment is made its prospects must be so good that
you are willing to risk a large proportion of your funds in it. If it is
not worth backing fully then it is not worth doing at all.
This approach means not only avoiding diversification but also
leaving ones capital uninvested for long periods of time.
The bargain must be such as to raise your performance out of
the average class.
These opportunities will only be available when most buyers are
in panic mode.
Waiting is a very difficult game.
Success comes to those who…




Investigate thoroughly and intelligently before
buying the stocks.
Is firm of mind and does nor allow
themselves to sway in every breeze.
Who have satisfied themselves of the
soundness and progressiveness of the
companies of which they have become part
owner.
Remain calm in great uncertainty –
uncertainty is a fact of life….get used to it!
Buffett’s 5 key evaluation points





What is the certainty with which the long term economic characteristics
of the business can be evaluated.
What is the certainty with which the management can be evaluated
both in its ability to realize the full potential of the business and to wisely
employ the cash flows.
What is the likelihood that the management can be counted on to
channel the rewards from the business to the shareholders as opposed
to itself.
The purchase price of the business – a great company at a fair price
rather than a fair company at a great price.
The levels of taxation and inflation hat will be experienced and that will
determine the degree by which the investor's purchasing power return
is reduced from the gross return.
Advice


The only other fields which offers such a
broad range of opinion, loose thinking,
prejudice and free advice is health…the
environment and probably politics.
What is common about all 4?
When to sell - 1



Only 3 reasons to sell.
A mistake has been made in the original
purchase and the future is not as rosy as you
think. Emotional self control and the ability to
be honest with oneself is important here.
More money has been lost by investors trying
to get their money back than through any
other reason.
When to sell - 2


Changes resulting from the passage of time
no longer qualify it as a quality stock.
Hence the importance of keeping in close
contact with the information flow.
When to sell - 3




This should only be carried out after due
thought and attention.
When funds are low and an excellent
investment opportunity arises.
Sure it is better to get 20% p.a. from the new
investment rather than 12% p.a. from the old
one….but what are you giving up?
..and what is your factor of safety?
When not to sell.




Investors are often tempted to cut themselves off
from very profitable situations when their stocks
have had a good rise in the market.
They think that their stock has used up all its
potential and that it would be better to move to one
with more potential.
Do you think that a team manager would start
thinking “Crikey, XXX has scored lots of points for us
in the last 10 games, his/her value has probably
gone up 3 times…maybe it is time to sell him/her”
Small investors take their profits too soon and do
not sell their losers soon enough.
Part 1- Building Blocks



The JiFi
…………what is it?
Pidlite
History of the JiFi
The Arena
Portfolio
manager
Same
Company
Big Cap
Analyst
Investment
Bank
Institutional
Investor
Buy side
analyst
Cap
Analyst
Small
Strategist
Economist
Retail
investor
……why the JiFi - 1





Analyst can cover about 12 stocks.
Assume big cap stocks Market Capitalisation
of US$ 1bn.
Assume commission of 0.25%
Suppose the stock turns over once a year
Assume the analyst can get 5% of the
turnover
Analyst Return – Big Caps




US$ 1,000m * .5*.05*.002 = US$ 50k
12 stocks gives US$600k
Standard overheads means salary of
US$250k
Note: increase the churn = increase the
salary!
Analyst Return Small Cpas




Small cap analyst can only cover 12 in
traditional way also.
Suppose Market Cap US$100m. Turnover
per year about 25%. Not so competitive so
get 10% of turnover at 0.2% commission.
Income = 100*.25*.1*.002 = US$5k
Analyst pay = 12*5/2.4= US$25k
Problem





How to increase number of companies
covered
Reduce time spent on analysis.
Most time spent on the most useless part i.e.
forecasting.
Remove forecasting.
Doubles coverage!
Forecasting: can they do it? - 1


Any fool can forecast…..
….many do!!
Forecasting: can they do it? - 2




Data from a recent IBES study (data only
since 82) shows for the US:
Median forecast growth rate for any 3-5 year
period was 14.5%
Growth rate was actually 9%
Why might this be? Group Discussion.
Forecasting: can they do it? - 3






Academic Studies show that for big caps in the US
the average error is 30%!
Average error for management forecasts are 14.5%
Analysts forecasts are no better than projecting
forward past growth!
Their 1 year forecasts are WORSE than their 5 year
ones!
Studies show that long term forecasts tend to be
biased in the direction of recent success. Analysts
over react in that they are much more optimistic about
recent winners than they are about recent losers.
Why do they get paid so much then?
Forecasting - 4




A mystique has grown up around forecasting. A good
forecast is considered the holy grail.
Yet most people only look at the EPS forecast
numbers – which really do not say much about a
company.
If forecasting for yourself just project forward the
historic growth rate – it is as good as anything else!
If forecasting for others – do the same – but dress it up
and talk about the economic factors considered, the
possible effect of exchanger rates and interest rates,
which have gone into your model. It will impress the
naive and save you a lot of work!
Forecasting 5





In investment bank research companies are valued
by present and future earnings.
What the earnings are 3,4 or 5 years from now are
thought to be the most important parameter.
My theory of investment has always been founded
on my inability to tell what the earnings are going to
be 5 or 10 years from now….cause that is not the
most important issue.
Focusing on earnings over the last couple of years
is much more illuminating.
Even in horse racing great attention is paid to the
form book!
Investment Bank Research – Problems -1




90% of recommendations are either positive
or neutral. Why is this a problem?
Forecasts never far from consensus…too
risky to stray.
Widely disseminated….so what real value?
Small caps different!!
Investment Bank Research – Problems -2





Although investment is an extremely difficult
business, there is a premium on youth? – Why?
The bulk of investor’s information comes from
investment banks.
The information is given in good faith …but..
The investor is interested in his own interest.
The investment banker is primarily intersted in
selling securities – that is how he makes his bonus
JiFi as revolutionary weapon




A quick and dirty analysis for fund managers. An
initial screening.
Loved by clients as gave enough information for an
initial decision and consistent coverage on a large
number of stocks.
The Kalashnikov of the Small Cap guerilla army –
Find, Write, Move on!
Ideal training methodology for really getting an
understanding the soft stuff on which so much of
one’s assessment should be based.
Why am I getting you to do a JiFi?
JiFi elements

We will examine the layout of the JiFi and
comment on the various elements.
Financial Statements - a review



3 statements - P&L, B/S, Csf.
Building blocks of a scientific analysis of
corporate value
Not without problems – we will deal with later.
Profit & Loss - walkthrough





Turnover
Gross Profit
Operating Profit
Post Tax Profit
EPS
Sleepy Shipping Co. Ltd





Ship leasing company
Ship cost $50m
$45m in debt - no capital repayment until end
$5m in Equity
$10m p.a. leasing charge
Example - basic P/L
Profit & Loss
1997
1998
1999
10
-1
9
10
-1
9
10
-1
9
SG&A
Depreciation
Operating Profit
0
-2.5
-2.5
0
-2.5
-2.5
0
-2.5
-2.5
Interst income
Interest expense
Total Non Op Income
0
-1.8
-1.8
0
-1.8
-1.8
0
-1.8
-1.8
Pre Tax Profit
4.7
4.7
4.7
Taxation
-0.47
-0.47
-0.47
Net Profit Attrib
4.23
4.23
4.23
Income
Insurance
Gross Profit
Balance Sheet - walkthrough







Tangible Assets
Intangible Assets
Creditors
Debtors
Inventory
Debt
Equity
Example basic B/S
Balance Sheet
Fixed Assets
1996
1997
1998
1999
50
49.5
49
48.5
0.1
10
0.3
20
0.6
30
Inventory
Trade Receivables
Cash
Total Assets
50
59.6
69.3
79.1
Issued Capital
Reserves
5
5
4.23
5
8.46
5
12.69
Total Shareholder's Funds 5
9.23
13.46
17.69
45
45
45
5.37
10.84
16.41
50.37
55.84
61.41
Debt
45
Payables
Total Liabilities
45
Cashflow - walkthrough







Operating profit
Depreciation
Others
Working Capital
Interest
Tax
Capex
Example basic Csf
Cashflow
Operating Profit
Depreciation
Change in Inventory
Change in Payables
Change in Receivables
Interest
Tax
Operating Cashflow
Ship Upgrade
Free Cashflow
6.5
2.5
-0.1
5.37
-10
-1.8
-0.47
2
6.5
2.5
-0.2
5.47
-10
-1.8
-0.47
2
6.5
2.5
-0.3
5.57
-10
-1.8
-0.47
2
2
0
2
0
2
0
Risk & Reward Box
Low
Risk
Hi
Hi
Reward
Low
Star
UFO
Safe
Dog
Group Discussion - examples
PER & CAGR



PER is simply the Price per share/EPS
Compound Annual Growth Rate (CAGR)
looks at the growth rate over a number of
periods.
If EPS 1999 is 10, 2000 is 12 and 2001 is14
then CAGR = x where 14 = 10*(1+x)^2
Basic information -1




Year end. Many different y/e – most Dec. Is the
business cycle linked to the solar cycle? Why would
a company change its year end? What message
should you take?
Market Cap is the value of all the shares in issue
multiplied by the current share price.
Market High/Low – last 12 months high and low.
Shares Traded in last 6 months – this gives a feel
for how liquid the shares are. Very important for
some investors. Roach Motel syndrome!
Basic Information - 2



Ticker: this is the short code for the stock.
Various data providers have different short
codes. Most use a version of the SE code e.g
U:AXP
SEDOL: A unique identifier number e.g.
59564523, used in settlement. Not on JiFi
Board Lot: Some stocks, especially in the US
are sold in lots of say 50. So more expensive
to buy 48 (Odd Lot) shares than 50. Not
shown on JiFi
Basic Information - 3

Key shareholders: This is important as it also
gives a feel for how liquid the stock is.
Typically in Asia (in small companies) the
family will hold 60 – 70% of the shares. Also
gives comfort to shareholders if they see
some other big names in there.
What it does.


It is….this gives the reader some very basic
information on what the company does.
The reader does not want to wade through 4
or 5 pages only to find that this is a telecom
company and not a retail company as
expected
The Hook!



It is interesting because…..This is where you
need to grab the readers attention to get
them to continue reading. A creative
approach to this paragraph is essential.
A dry and boring hook – no matter how good
the numbers …..
…..is still a dry, boring and unproductive
hook!
Key external drivers




What are the key drivers for this stock
For a chip manufacturer it might be the sales
of PCs
For a fashion retailer it might be the age
demographics and disposable income.
What are the key external drivers for
Speights Brewery?
Valuation




The Valuation paragraph sets out the argument for
why you think that investors should be buying/selling
this stock.
Valuation arguments are traditionally PER or EPS or
P/B based….a mistake to my way of thinking.
We will look at valuation in more detail later
Why might my view here not be such a good idea?
Game -1




Guess a number between 1 and 100
Write on a piece of paper
The winner is the integer closest to 2/3 of the
average number.
$20 for the winner.
Game - 2



What does this teach us?
If you are going to win you need to
understand the psychology of the other
players.
How could all have got $20.
Vulnerabilities






The key to the soft stuff is to :….
…..spot and highlight the vulnerabilities….
….by questioning the management and studying the annual
report and industry reports…..
….(putting the same question in many different ways helps glean
a lot!)
….also competitors can provide a lot of information!
Vulnerabilities are often the result of poorly thought out strategy
or no strategy….hence the structured questioning approach.
The openers



When questioning management, best to ask
open questions and let them elaborate.
Don’t neglect the power of the awkward
silence…..
First questions: What is the mission
statement, what market are they aiming at.
The Soft Stuff - 1





Market Growth: is this market growing, how much is
it growing by, is it likely to continue to grow.
Market Size: How big is the market size that the
company is focused on.
What is your view of the market for tyres for vintage
cars in NZ? Give estimates.
What is your view of the market for the market for
rugby balls in NZ? Give estimates.
What is your view of the market for Alco Pops in
NZ? Give estimates.
Growth




3 different process in growth.
1. Increase in population
2. Accumulation of capital within the company
3. Technological progress which enables the
cheaper/better/variety production of items or
supply of service.
Population Growth




Business may be affected by this but it does
not cause it or have any affect on it.
True growth is organic and comes from
within.
Child Boy Man – clothes just a reflection of
growth.
Growth is active not passive!
Distinguishing Signs





The ability to create its own market is the dominating and singly
most important feature of a true growth company.
A true growth company is an active agent at the technological or
geographical frontiers of society. It is not passive. It does not
become a growth company by association.
Creativity and ambition in product development are not enough –
they must be able to make money out of it.
The enchantment with growth companies is a notorious way to
loose money. A hard headed approach to the numbers is a must.
Buying growth at a fair price is the key…buying at any price and
expecting the future to take care of itself is a disaster.
Growth - limits



Growth in the long run cannot be bigger than
GDP – why?
Sharemarkets return growth rates in
underlying GDP i.e. return = GDP growth +
inflation plus the equity risk premium above
bonds.
We will deal with the equity risk premium
later.
Comments

Comments should try to encapsulate the
information in the analysis in one sentence.
The Soft Stuff - 2



Customers: who are the customers for this
product. Customers are not the same as
consumers. Customers are who buy from the
company.
Consumers are those who consume the
product.
Why is the difference important?
The soft stuff -3




Marketing approach: how do they do their
marketing, is it consistent with the product.
Repeat Business: what % of the companies
business is repeat business from the same
customers….or is it just one off. What might be an
example here?
Cyclicality: Is the business cyclical. NZski.
Price sensitive: how sensitive is the customer to an
increase in price…..what about the electricity
industry?
Product (Service) Portfolio
Applies to companies too
Market Share
Lo
Hi
Market
Growth
Low
Rising Star
Cash Cow
Hi
UFO
Dog
Cash Cows





High market share but low growth prospects
– classic Coke, Milk in NZ
Produce lots of cash – what to do with the
cash?
Ideally into areas with high market growth
and low market share….
…otherwise return to shareholders.
Strategy: Maintain market share at minimum
cost
Dogs



Low market share & low market growth e.g.
Otago Table Wine, Exported milk powder
No more money should be committed to
Dogs
Strategy – shoot the Dog!
UFOs



Quick growing products (companies) that
started from a low base e.g. The PalmPilot,
Various packaged milk drinks…AlcoMilk?
Ensure that you a key player in the newly
developing product/service. Stave off
competition
Strategy: Invest money to introduce product
variety and streamline manufacturing
Rising Star




On this category the future of the company
and the shareholder relies.
High market share and high market growth
These will probably become the next
generation Cash Cows e.g. Amazon,
Specialty cheeses.
Strategy: Marketing spend to increase market
share.
McDonald’s Product Portfolio

What might be the McDonald’s Product
Portfolio?
McDonalds Product Portfolio




Cash Cow: Big Mac, Fries, Happy Meals
Dog: Double cheeseburger meal, McPizza.
Rising Star: Chicken Flatbread, Chicken
McNuggets
UFO: McSalad
Point to note:



Important to know where each
product/service/division/company is in the
matrix…why?
…so you know where the future growth of the
company is coming from.
For example if there are no new rising star
products then the company may have a
problem.
Money Flow



There should be a flow of money from the
Cash Cows and Dogs to the UFOs and
Rising Stars.
Some of the UFOs will fail but some will
make it to Rising Stars.
Rising Stars will become cash cows and cash
cows may become Dogs
Geography




Where do the products go to….
….are they dependent on one
country/region/area for either product sales…
….or raw material sources.
All the time we are looking to see where the
vulnerabilities are.
Growth/Orderbook/Expansion




Where will the growth for the company come
from? Which products, areas, markets?
Orderbook: How long is the orderbook….i.e.
outstanding orders.
What prospects are there for expansion –
either in product/market or in production.
What can they do to grow and develop the
market.
Market Share/Margins



For the major product/s – how big is the
market share. What is the vulnerability.
Margins: Operating Margins – what has
happened to them over the last number of
years. What vulnerability exists.
Regional Margins: How do the margins
compare to other competitors in the
region/area.
Porter 4 box model
Product differentiation
Lo
Hi
Cost Leader
Hi
Very attractive
Proposition
Cost
Advantage
Low
Commodity
Differentiated
Product
Porter 4 box model -2





Companies compete along two axes…
…..cost and differentiation.
Cost is obvious….providing a good or service
at a lower price than the competition
Differentiation….means more bells and
whistles i.e. features to differentiate the
product or service from the competition.
What might be examples of the above?
Strategy Problems



Problem can arise when the companies try
operate along 2 axes.
Having the lowest cost whilst providing the
most differentiation is usually a road to
disaster. Why?
But if one can pull it off it is highly desirable
all around.
Commodity end




At the commodity end of things a company
has 2 choices.
….be the lowest cost.
…or differentiate the product in such a way
that the consumer desires/appreciates the
product.
How best to compete if you manufacture coat
hangers…..fizzy water?
McDonalds?



Where does McDonalds fit in the Business
Strategy approach?
Property – 4% Sales from franchisees, rental
income equivalent to 10% of sales from
franchisees.
Franchisees run 85% of McDonalds stores.
Note


It is important that the company (and the
analyst) know where the competitive
advantage lies……
The analyst may not always agree with the
companies view of their competitive
advantage.
Uniqueness/CSF



Many companies think that they are unique in some
way……few are!
Competitive Edge – it is important for the analyst to
work out what the completive edge for a company is.
Usually they only have 1…thought many think that
they have more.
What are the Critical Success Factors for this
business (CSF) i.e. what must they focus on to
ensure growth over the next 5 years. How do they
measure their success in following this strategy?
Buffett’s Moat





Buffet likes to buy companies which resemble old
medieval towns i.e. ones with moats and
drawbridges.
Very difficult for the competition to take on a
company with a moat and a drawbridge!
As close as we can get to a monopoly is ideal.
Examples: ODT, local established newspapers,
Radio Stations
What about….Coke, Wrigleys?
Ansoff Matrix
New
Old
Markets
Medium Risk
Old
Low Risk
Products
New
High Risk
Medium Risk
Ansoff matrix - 2




Used to determine how a company should grown.
Shows the risks/rewards of the various strategies.
McDonalds have moved on two axes. They are
trying to turn around their business so that they are
now selling new products McSalad, Chicken
Flatbread etc to their existing customers. Attempting
to get away from the junk food label.
McDonalds are still growing geographically: it
already has 31,000 worldwide and will grow to
45,000.
Porter 5 box model
New Entrants
Suppliers
Industry
Innovation
Customers
Industry







What is happening in the industry.
Is it getting more competitive
Who are the competitors.
What market shares.
What are the key strategies of the main
competitors.
What are the strengths of the main competitors.
What are the Critical Success Factors and
competitive edge of the competitors.
Suppliers





Who are the key suppliers.
Dependent on one supplier?
How integrated with suppliers.
Could suppliers enter the business
What are the suppliers perceptions of the
target company.
Customers







Who are the key customers
What % of business goes to each
Business strategy of the customers.
Could the customers enter this business
Level of integration with customer
What are the customers perceptions of the target
company.
What aftersales…how do they measure customer
satisfaction?
New Entrants






Any new entrants coming into the business
Why?
What barriers to entry exist?
What is the NE’s strategy?
How will they cope?
What will be the target company’s response?
New Technology





What new technology is on the horizon?
Substitute Products?
How will effect this business
What will be the response
Typewriters & PCs
Operations - 1




Quality of Plant (stores, factories, computer..i.e.
what ever assets generate the major cashflow of the
business) ….examine age and efficiency of plant
and operations.
What capacity can be put through the plant/factory.
For stores, how mature are they?
What level of R&D is carried out…how do they know
whether it is effective or not?
McDonalds-1




Suppliers: Seem safer from supplier intrusion in the
market.
Customers should not pose a problem.
The Burger Industry itself is in turmoil with many
trying to exit this low return high maintenance
business Pepsico spun off Tricom in 97 and Diageo
is sold off Burger King.
New Entrants – The fastest growing sector is
sandwiches 12.8% compared to Burgers 2.8%.
There are now more Subways in the US than
McDonalds restaurants!
Operations -2






Suppliers: are they tied in, how reliant are they on a key supplier,
are they linked electronically?
Production time: How long does it take to produce an item. A real
ship and a toy ship have a big time difference.
Bottlenecks: what bottlenecks exist in the chain from ordering
from supplier to delivery to customer.
Throughput efficiency: get some estimate if possible.
Inventory control: how do they control their inventory, how do
they know when to order new supplies?
Distribution Method: how do they distribute the goods, is there a
better way?
Management Quality




What is the management style: theory x, theory y, is
it appropriate.
Labour supply: any problems, history of unrest?
Incentivisation?
How many layers of management from the board to
the person who makes the goods/meets the
customer. Note the catholic church.
Key people: who are they, how are they tied in, what
happens if they fall under a bus?
Management Involvement


What % of the equity do the management
hold?
What family involvement in the firm? Very
important for Asian companies and small
companies.
Financial Control




Subsidiary Companies: how often do they
report? What do they report? Which ratios do
they use to control them?
Consolidation: how often do they consolidate
information. Note India.
Associated companies?
How will they finance it if it really takes off?
Finance - more




Product Liability: what liability? Do they have
insurance? How much?
Cost Structure: what will they do to improve it
over the next 5 years?
What is the interest rate on the debt?
Operating margins for each division?
Drivers




What are the key political drivers in their
market?
What are the key Social ones?
The key Technological ones?
The key Environmental ones?
Inputs


The idea here is to find out which of the
inputs adds the most value. Perhaps the
company just repackages IC boards and so
in itself adds little value.
On the other hand for Speights: Water adds
little value, barley and yeast also add little
value. The most value is added in the
advertising!
Sales Box
MV/Sales
Low
Hi
3x say
Hi
Op Profit
Margin
Low
Overvalued
?
12% say
?
Undervalued
Industry and country dependent.
Cash Box
Net Debt/FCF
Low
Hi
2x say
Hi
?
Safe
Cash Int
Cover
Low
3x say
?
Danger!
Country dependent.
Value Box
MV/BV
Hi
Low
3x say
Low
Overvalued
?
(Fcf)ROE-r
10% say
?
Undervalued
Hi
Industry and country dependent.
Economic Effects for key countries of
….






Exchange rate.
Consumption.
Govt spending.
Political changes.
Interest Rates.
Tourism.
Non JiFi but important…
Money
Vanilla Coke
Time
Product Life cycle – with extension
Porter Value Chain






According to Porter there are 5 areas where value can
be added.
Inbound logistics – secured the cheapest clay for brick
making.
Operations – advantages in manufacturing e.g. up to
date machines.
Outbound logistics – advantages in delivery e.g.
cheaper transport
Sales & Marketing: Brand building.
After sales service: managing one of the key surround
elements of the product. Avaya.
Product & Surround



Almost every product has a surrounding
service.
Almost every service has an imbedded
product.
Important to have a strategy for each.
Surround
Surround
Product
For Coke what are they?
McDonalds








The Product for McDonalds, as we know is the Burger.
The surround is the whole experience in the restaurant.
Get this: According to the University of Michigan Dissatisfaction Index McD
ranked bottom of the fast food industry since 1994! It now sits below every
single airline and the IRS!
The company has lost $20 bn in market cap in the last year!
Reasons: ignored the service surround. Why – income from new stores higher
than building costs. Property boom has halted so now back to basics. But
Wendy’s is much better at operations. (Last innovative product Chicken
McNuggets introduced in 1983),
Top 4 complaints: Rude, slow, inaccurate, unprofessional
The company stopped grading its restaurants on a national standard in 1993 in
a misguided attempt to appease frustrated franchisees
Of 13,000 US Restaurants only 10% consistently hit expected service levels
Life Cycle - company
$
Growth
Maturity
Decay
Birth
Time
McDonalds Life Cycle - Birth




Birth – Ray Kroc was an operations man and fell in
love with the efficiency of the operation when he
saw his first McDonalds in 1954.
He was a fanatic for detail and systems.
This efficient system did not make any money.
In1958 McDonalds had 38 restaurants with a net
worth of $24,000. It had lost $7,000 two years
before and nearly missed payroll.
McDonalds – growth.






Kroc’s CEO Sonneborn figured out that if McD created a separate real
estate company it could lease property and stores from local landlords
and then turn around and sublease them to the franchisee.
Sonnerborn could not have cared less about hamburgers.
Sonnerborn’s scheme allowed McD to finance its explosive growth by
becoming the greatest leveraged company in the fast food race.
Greatest expansion boom in the history of retailing.
In the 5 year period from 1968 store openings went from 100 to 500 per
year. By 1974 McD had 3,000 stores, 2,000 more than second placed
Burger King.
In 1975 sales jumped 28% to $2.5 bn, and McD reported a 32%
increase in income during what was for everybody else a recessionary
year.
McDonalds - Maturity




McD real estate investments magnified the
company’s financial exposure. When things were
good they were very good…but when bad, they
were horrid.
McD ROCE peaked in 1997 at 17%, it slipped to
13% in 2002 as new stores returned less money.
As the number of US stores combed rapidly from
1994 to 2002, same store sales stayed put or
dropped.
Meanwhile debt ballooned from $6.2bn in 1999 to
$10bn last year.
McDonalds - Dog




On the service side lack of quality control increased
the number of complaints and reduced the
satisfaction from the experience.
High staff turnover (nearly 300%) had a severe toll
on service quality…not to mention the cost of
training.
McD is now trying to identify and eliminate poor
performing stores.
Only time will tell whether this dog has any life left.
Life Cycle – financial strategies
High Business risk
CSF: Grow mkt Share
Info: Mkt stats
$
Medium Business risk
CSF: Contrib per unit of
limiting factor
Info: Comparative
Competitor costs
High Business risk
CSF: time to develop
& Launch
Info: Market
Research
Growth
Maturity
Low business risk
CSF: Realisable
values
Info: Optimum
Time to exit.
Decay
Launch
Time
Life Cycle – Managerial strategies
Mktng Mgmt Style
Introduction of
professional mangers.
Controller style
management
Risk of the professional
managers takeover
$
Professional
manager run the
business for their
own benefit
Entrepreneurial
management drive
the company
Growth
Maturity
Decay
Launch
Time
Life Cycle – Usual small company version
$
Growth
Maturity
Decay
Launch
Time
Company Financial Strategy
Lo
Hi
Business
Risk
Low
Financial Risk
Hi
☺☺☺
¢£¥
!!!!!
☺☺☺
Financial Strategy - examples




Hi business risk & Hi finance risk – biotech funded
from debt – why?
Hi business risk & Lo Finance risk – Venture Capital
funded software company.
Lo business risk & Hi finance risk – ideal structure
for mature business, makes the “assets sweat”,
Utility funded by debt.
Lo business risk & Lo finance risk – very happy
management (many NZ companies!!)
Back page of JiFi

Walk through.
Part 2 - Valuations
Sweet Shop




At the end of the year does my mother want
to show an increase in earnings?
Group discussion.
If you expense as many things in your p&l as
possible, what happens to your EPS.
……what happens to your cash.
CEO’s pay



CEO’s get paid a lot of money to grow EPS.
Is there a difference between my mother and
a CEO?
What is the problem here?
3 Traditional Valuation Techniques



P/E
P/B
Yield
Sleepy Shipping Co P&L
Profit & Loss
1997
1998
1999
10
-1
9
10
-1
9
10
-1
9
SG&A
Depreciation
Operating Profit
0
-2.5
6.5
0
-2.5
6.5
0
-2.5
6.5
Interst income
Interest expense
Total Non Op Income
0
-1.8
-1.8
0
-1.8
-1.8
0
-1.8
-1.8
4.7
-0.47
4.23
0.0423
2.18
4.7
-0.47
4.23
0.0423
3.18
4.7
-0.47
4.23
0.0423
4.18
Income
Insurance
Gross Profit
Pre Tax Profit
Taxation
Net Profit Attrib
EPS
PER
1996
Sleepy Shipping Co - B/S
Balance Sheet
1996
1997
1998
1999
50
49.5
49
48.5
0.1
10
0.3
20
0.6
30
50
59.6
69.3
79.1
Issued Capital
5
Reserves
Total Shareholder's Funds 5
5
4.23
9.23
5
8.46
13.46
5
12.69
17.69
45
45
5.37
50.37
45
10.84
55.84
45
16.41
61.41
5
0.05
9.23
0.0923
13.46
0.1346
17.69
0.1769
Fixed Assets
Inventory
Trade Receivables
Cash
Total Assets
Debt
Payables
Total Liabilities
Book Value
BVps -100 shares
45
Sleepy Shipping Co Csf
Cashflow
Operating Profit
Depreciation
Change in Inventory
Change in Payables
Change in Receivables
Interest
Tax
Operating Cashflow
Ship Upgrade
Free Cashflow
6.5
2.5
-0.1
5.37
-10
-1.8
-0.47
2
6.5
2.5
-0.2
5.47
-10
-1.8
-0.47
2
6.5
2.5
-0.3
5.57
-10
-1.8
-0.47
2
2
0
2
0
2
0
Sleepy Shipping Co - PER


P/E - 2.18x, 3.18x, 4.18x
In 3 years, assuming the price per share is
equal to book value, the PER has doubled.
Sleepy Shipping Co P/B


Book Value - $0.0923, $0.1346, $0.1769
The book value has almost doubled in 3
years.
Sleepy Shipping Co. - Yield

Yield - 0.0,0.0,0.0 - no return to shareholders
- any dividend would lead to an increase in
debt.
GoGo Shipping P&L
Profit & Loss
1997
1998
1999
10
-1
9
10
-1
9
10
-1
9
SG&A
Depreciation
Operating Profit
0
-2.5
6.5
0
-2.5
6.5
0
-2.5
6.5
Others
Interst income
Interest expense
Total Non Op Income
-5
0
-1.8
-6.8
-5
0
-1.8
-6.8
-5
0
-1.8
-6.8
-0.3
0
-0.3
-0.003
-15.67
-0.3
0
-0.3
-0.003
-14.67
-0.3
0
-0.3
-0.003
-13.67
Income
Insurance
Gross Profit
Pre Tax Profit
Taxation
Net Profit Attrib
EPS
PER
GoGo Shipping Co - B/S
Balance Sheet
Fixed Assets
Inventory
Trade Receivables
Cash
Total Assets
Issued Capital
Reserves
Total Shareholder's Funds
Debt
Payables
Total Liabilities
Book Value
BVps -100 shares
1996
1997
1998
1999
50
49.5
49
48.5
50
0.1
0
10
59.6
0.3
0
20
69.3
0.6
0
30
79.1
5
-0.3
4.7
5
-0.6
4.4
5
-0.9
4.1
45
45
9.9
54.9
45
19.9
64.9
45
30
75
5
0.05
4.7
0.047
4.4
0.044
4.1
0.041
5
5
45
GoGo Shipping Co -Csf
Cashflow
Operating Profit
Depreciation
Change in Inventory
Change in Payables
Change in Receivables
Interest
Tax
Operating Cashflow
Ship Upgrade
Free Cashflow
6.5
2.5
-0.1
9.9
0
-1.8
0
17
6.5
2.5
-0.2
10
0
-1.8
0
17
6.5
2.5
-0.3
10.1
0
-1.8
0
17
2
15
2
15
2
15
GoGo Shipping Co - PER


P/E -15.67x, -14.67x,-13.67x
In 3 years, assuming the price per share is
equal to book value, the PER has fallen by
13% and is negative.
GoGo Shipping Co P/B


Book Value - $0.047, $0.044, $0.041
The book value has fallen by nearly 13% in 3
years.
GoGo Shipping Co. - Yield

Yield - 0.0,0.0,0.0 - no return to shareholders
- any dividend would lead to a decrease in
the book value.
Valuation Comparison




a) Sleepy Shipping -positive profit & zero
cash PER = 4.18x BV = $0.1769
b) GoGo Shipping - negative profit & positive
cash PER = -13.67x, BV =$0.041
c) A dividend from Sleepy would increase the
debt and hence reduce BV, from GoGo would
reduce the BV
Which to buy?
Other less common valuation
methods






Price to Sales - market cap/sales
EV/EBITDA - enterprise value/earnings
before interest, tax, depreciation, and
amortization.
SleepyP/S = 1.77, GoGo = P/S 0.41
EV/EBITDA Sleepy: 6.9x and GoGo: 2.1x
Sleepy looks better on these measures…
…..so which is correct?
Traditional Methods


Thus we can see that the traditional methods,
while still widely used, are seriously flawed.
So how should we value something?
EPS-problems with it!



EPS is defined as Net Profit/No shares in
issue.
EPS (and its associate PER) have become
some form of magic talisman.
….yet,
Problems with EPS



Commonly assumed that growing Net Profit
and EPS grows shareholder value.
Accounting based earnings do not reflect
economic value.
EPS easily manipulated.
Bonus $1m if EPS grows 10% by 2000
Profit after tax
Dividends
1998
1999
2000
1,000.0
1,030.0
1,160.0
700.0
?
No Shares
100.0
EPS
10.0
10.3
DPS
7.0
?
Retained
300.0
Start Sh Funds
10,000.0
10,300.0
End Sh Funds
10,300.0
?
?
$1m bonus to grown eps by 20%
Profit after tax
Dividends
1998
1999
2000
1,000.0
1,130.0
1,200.0
700.0
700.0
No Shares
100.0
100.0
EPS
10.0
11.3
DPS
7.0
7.0
Retained
300.0
430.0
Debt
1,000.0
?
Equity
10,000.0
10,000.0
Start Cap Employed
11,000.0
11,300.0
End Cap Employed
11,300.0
?
?
Other ways of abusing EPS






Change from FIFO to LIFO
Buy back shares
Change depreciation policy
Reduce R&D spend
Reduce advertising
Booking revenue earlier than prudent
Investor Comment

“…when returns on capital are ordinary, an
earn-more-by-putting-up-more record is not a
greater managerial achievement. You can get
the same result personally while operating
from your rocking chair. Just quadruple the
capital you commit to a savings account and
you will quadruple your earnings!”
Key Valuation Concept





You have a bank account which accrues interest at
10%. The principal is $50,000.
Every year your payout will be 10% of the principal.
So your EPS growth will be what?
If interest rates remain at 10%, what is the only way
that you can increase your payout.
A company’s assets are like the principal in a bank
account.
EPS growth does not tell you if the management
have just put more assets in!
Value of an annuity



We know form our annuity formula that the
value of an annuity which pays : $5,000 for 100 years when interest rates are
10% = $50,000 in today’s money
Question ….could we do the same with a
company?
Company’s Cashflow





If a bond or an annuity can be value by its cash flow
then why not a company?.
But do accounting rules have any effect on
cashflows?
Will the cash flowing into a company increase or
decrease depending on depreciation policy, whether
you write off R&D or capitalise it?
The cash has already been spent!..it is gone! Sunk!
Problems? Timing and risk of the cashflows
Questions






Are dividends and earnings items of the same
quality?
Are earnings and free cashflow the same?
What is an investment opportunity?
Is R&D an investment opportunity, is brand
advertising an investment opportunity?
Do depreciation rates matter?
Does brand advertising for Coca Cola have a longer
life than that for Pete’s Sandwich Bar? Should both
be treated the same?
Financial Statements-Problems




Ignores cost of Equity – expected rate of
return for the risk of investing
Ignores Opportunity Cost – what else could
have been done with the money?
Geared towards Creditors – especially
lenders.
Lenders requirements – debt servicing ability
on a very prudent basis i.e. write off R &D,
marketing etc.
What about this!






AOL Time Warner has unearned income in the shape
of magazine subscriptions. These sit on its balance
sheet year after year.
They have a minimum average life of 6 to 12 months.
These are a cash source to AOL Time Warner …an
asset they can use to finance growth…
…yet they are recorded as a liability on the balance
sheet!
This is accounted as revenue and only sometime in
the future as taxable income.
This makes no sense from a cash perspective…
The destructive side of the EPS focus





To boost eps (as we have seen) many indulge in
illegal or unethical actions.
Expenses that should be deducted are deferred.
Valuable acquisitions are avoided if big goodwill
write offs are likely.
Sensible R&D and Marketing strategies are turned
down.
Earnings growth is sustained by over investing in
dog businesses.
Accounting Rules




Not designed with Shareholders in mind.
Establish liquidation values not going concern
values.
Introduced to solve stewardship
problems…are the employees using the
company money for their own purposes.
Introduced to control conflict of interest
between bond holders and equity
holders…not paying out excessive dividends.
Note the irony here!



If company A buys an R&D rich company B…
..the accountants have no problems writing
the expensed R&D on to the balance sheet of
A in the form of goodwill….
….R&D can be an asset if acquired but not if
home grown!!
More on EPS problems



Assume a high P/E company, A, buys a low P/E
company, B, by exchanging shares….
Because fewer of A’s share are required to buy B’s
then the EPS will rise…is this good?
Suppose B buys A….EPS will fall as more shares of
B are needed to buy out A….is this bad?
Example
A
B
A buys B
B buys A
No Shares
1,000
1,000
1,500
3,000
Total Earnings
1,000
1,000
2,000
2,000
Total Value
20,000
10,000
30,000
30,000
Share Price
20.00
10.00
20.00
10.00
1.00
1.00
1.33
0.66
20
10
15
15
EPS
P/E ratio
Profit/Loss Statement - relook


What is it? - statement of profit and loss by
the firm in a year.
What is it really? A document that adheres to
a set of certain rules and assumptions which
have little meaning for the economic value
earned by a company on the capital used by
it.
What are the problems with the P&L




R&D is written off against profit as a cost very prudent but unrealistic.
Goodwill is written off against profit - again
very prudent but meaningless for an ongoing
economically viable business.
The problem is that Bankers find it hard to
value anything other than hard assets!
Profit is not equal to Cash
Balance Sheet - a relook


What is it? A statement of the assets and
liabilities of a company.
What is it really? A statement of what the
hard assets of the business would be worth if
it were liquidated today.
What are the problems with the B/S


How useful is it? If you are a banker and
expect the company to go bust soon then it is
very useful.
How useful is it really? As it stands not very
useful, as it ignores R&D as an asset and
also goodwill - which gets written off directly
or else amortized.
Cashflow Statement - a relook


What is it? A document of sources and
applications of funds/cash
What is it really? The closest thing we have
to finding out what the company is really
worth
What are the problems with the CSF


How useful is it? A late arriver on the scene
as Lenders are more interested in saleable
assets etc. Gives you a view of what the sunk
funds of the company produce cash wise.
How useful is it really? Very useful but not
beyond abuse - e.g. working capital etc.
How to value?








How to value water in the desert?
Convenience of a dishwasher
A pet
Your stamp collection
A diamond, Gold.
A bond.
A rental property.
Not paying your credit card bill on time.
3 Valuation Jewels



Utility
Sentiment
Cashflow
Valuation – art or science





Valuation relies on mathematics …
….to some extent…as with the drunk and the
lampost.
It is more important to be approximately right than
absolutely wrong.
It is quite possible to decide by inspection that a
woman is old enough to vote…without knowing her
age
….or that a man is heavier than he should be
without knowing his exact weight
Sleepy Shipping Co Csf
Cashflow
Operating Profit
Depreciation
Change in Inventory
Change in Payables
Change in Receivables
Interest
Tax
Operating Cashflow
Ship Upgrade
Free Cashflow
6.5
2.5
-0.1
5.37
-10
-1.8
-0.47
2
6.5
2.5
-0.2
5.47
-10
-1.8
-0.47
2
6.5
2.5
-0.3
5.57
-10
-1.8
-0.47
2
2
0
2
0
2
0
GoGo Shipping Co -Csf
Cashflow
Operating Profit
Depreciation
Change in Inventory
Change in Payables
Change in Receivables
Interest
Tax
Operating Cashflow
Ship Upgrade
Free Cashflow
6.5
2.5
-0.1
9.9
0
-1.8
0
17
6.5
2.5
-0.2
10
0
-1.8
0
17
6.5
2.5
-0.3
10.1
0
-1.8
0
17
2
15
2
15
2
15
GoGo & Sleepy Shipping Co
Recap


Suppose Sleepy produces the same
Cashflow for ever and Interest rates are 10%
- then the value of Sleepy = 0/0.1 -hmm!
Now GoGo produces 15/100 =0.15 per share
= if for ever then the value of GoGo shares is
0.15/0.1=1.5!
Equity Business Risk



While bonds produce a steady payment,
equities provide an erratic cashflow.
Furthermore, there are risks associated with
the cashflow from equities - competition, or
lack of customer response etc.
To get a full picture of a companies valuation
i.e. to do a sensible forecast both the
numbers and the business must be assessed
Risk & Reward






We know that there is no free lunch…well almost!
There is no reward without some risk.
What is the risk associated with putting your money
in a bank?
What is the risk of putting your money in a
Government Bond?
How about a third world Government Bond?
What about a Lotto ticket?
Risk Premium



Investors require higher returns if the risk is
higher.
In investing we look at two types of return:
the risk free return and the return required for
a higher risk – called the Risk Premium.
The risk free return is usually the return that
can be obtained on short term government
bonds e.g. 1 year.
Equity Risk Premium -1




When investing in a given share, investors look at
the opportunity cost of investing.
By investing in short term government bonds they
could get the risk free rate of return – call it rf.
By investing in an Index Fund the investor requires
the market return – say rm which will be higher than
rf. to compensate for the extra risk.
So investing in a single stock increases the risk
another notch.
Equity Risk Premium - 2



As compensation for investing in a single stock the
investor requires return which is higher than both the
risk free and the market rate. Otherwise……why
bother?
From CAPM we know that the required return for
investing in equity is k where
k=rf+β(E(rm) –rf) where β is the risk of the equity
relative to the market – called systematic risk.
EVA - introduction





In EVA we are looking to see if the return generated on
the assets employed in the company covers the cost
of these assets.
These assets are either funded by debt or by equity or
a combination of both.
Retained earnings is equity for it accrues to the
shareholders.
Why do these assets have a cost?
If the cash produced is less than the cost of capital
then value is being destroyed as the capital could be
better employed elsewhere.
EVA





For EVA we say Return/Capital > cost capital for value creation.
So EVA = Return – Capital * Cost Capital
For return we use NOPAT i.e. net operating profit after tax.
Capital is the debt plus the equity which funds the company.
Cost of Capital is the opportunity cost of the debt (i.e. the interest
rate) and the opportunity cost of the equity {k=rf+β(E(rm) –rf}
weighed in proportion.
EVA using accounting terms






EVA = Sales – Operating Costs
= Operating proft
-Tax on operating Profit
=Net operating profit after tax (NOPAT)
-Capital charge (invested capital x WACC)
Where WACC is the weighted cost of capital.
EVA adjustments







Capitalise R&D expenses
Capitalise operating lease expenses
Add back Lifo and deferred tax reserves
Add back bad debt reserves
Add back one time restructuring reserves
Add back amortisation of good will
Replace acconting depreciation with economic
depreciation
EBITDA


Many use EBITDA discounted by WACC to
give the PV of a company as opposed to
EVA.
EBITDA has the following problems: ignores
changes to working capital, no account for
capital expenditure, no appreciation of the
quality of earnings, based on accounting
rules.
Walk through Bottling Plant


Example – hand out.
Group Exercise.
Valuing a stock using EVA



Discount of future EVAs
By forecasting the future EVAs and
discounting by the WAAC we come up with a
number for the Enterprise Value of a
company.
Deducting the Debt gives us the value of the
equity.
EVA valuation
WACC =
14.93%
Year 1
Invested Core Capital
year 2
Year 3
Year 4
Year 6….
Year 5
5,420
6,202
6,888
7,245
7,490
7,490
210
432
733
1,132
1,187
1,187
Capital Charge
-809
-926
-1,028
-1,082
-1,118
-1,118
EVA
-599
-494
-295
50
69
69
-521
-374
-195
29
34
30
NoPat
PV of EVA @ WACC
-997
Opening Capital
5420
4,423
Debt
-1080
Equity
3,343
= MVA
Problems with EVA




Some industries highly cyclical – so year on year
EVA can be meaningless. Paper Industry highly
volatile.
Start ups take time to generate EVA.
Historic measure based on economic book capital
and is thus not a market measure. Investors require
a return on market values as they must pay a
market price.
β dependant.
MVA





MVA is the difference between the market value of
the firm (i.e. enterprise value) and the total capital
invested in the firm.
MVA = Market Value – Capital
Or
MVA=Invested capital +PV of all future EVAs
Problem with MVA – can be influenced by the
vagaries of the market i.e. not directly linked to EVA.
Problems with β




If a stock falls 50% in price then in accordance with the derivation
of β the stock is more riskier and not less! Why?
β cannot distinguish between companies. A one product
company selling pet rocks or hula hoops is the same as one
selling Monopoly or Barbie. i.e. does not make a distinction
between a quality company that has temporary problems a poor
quality company.
What time scale for β?
Buffett – it is better to be approximately right than precisely
wrong!
Buffett on Risk

1. The certainty with which the long term economic characteristics of the
business can be evaluated

2. The certainty with which management can be evaluated, both as to its ability
to realise the full potential of the business and to wisely employ its cashflow.

3. The certainty with which management can be counted on to channel the
reward from the business to the shareholders rather than to itself.

4.The purchase price of the business.

5. The levels of taxation and inflation that will be experienced and that will
determine the degree by which the investor's purchasing power return is
reduced from his gross return.
Share Price
Hi
Value
Lo
Hi
Sentiment
Lo
Speculate or Invest?
Hi
Invest
Value
Speculate
Lo
Hi
Sentiment
Lo
Speculate or Invest



Speculation is when you buy an asset at or higher
than its intrinsic value and hope to sell if for a profit.
Speculation does not have any tools (that I know of!)
apart from Chartism. Speculation is usually a short
term phenomenon.
Stock of good quality companies can be speculative
e.g. bull market when price is too high to give any
factor of safety.
Speculators is one who runs the risks of which he is
aware and an investor is one who runs the risk of
which he is unaware – Keynes.
Invest



Investment is buying an asset at below its intrinsic
worth and waiting for the market to realise the value
in the asset. Investing is usually for the long term.
Investing has a number of tools, EVA, DCF etc.
An investment operation is one that can be justified
on both qualitative and quantitative grounds.
Investing is making a decision based on all the
facts. One expects no surprises…but just in case
one builds in a factor of safety.
Sentiment Indicators -1
RE S T.BRANDS OF NZ.
FROM 18/4/01 T O 18/4/03 DAILY
2.20
2.10
2.00
1.90
1.80
1.70
1.60
1.50
1.40
1.30
1.20
A
M J
J
A
S
O
N D
J
F M A
M J
J
A
HIGH 2.17 3/ 5/02 LOW 1.25 28/ 2/03 LAST 1.49
S
O
N D
J
F M A
Source: DAT AST REAM
Sentiment Indicators -2
Sell
2.20
RE S T.BRANDS OF NZ.
FROM 18/ 4/01 T O 18/ 4/03 DAILY
2.10
2.00
1.90
1.80
1.70
1.60
1.50
1.40
1.30
1.20
A M J J A S O N D J F M A
ACT UAL
5 DAY
MOVING AVERAGE (M1)
20 DAY
MOVING AVERAGE (M2)
M J
J
A
S
O
N D
J
F M A
Source: DAT AST REAM
Buy
Eliot Wave
5
3
1
4
2
Pattern
repeats
over
various
time
frames
Chartism and EMH




Chartism was the first victim of the EMH.
Prices have no memory and yesterday has nothing
to do with tomorrow. Every day starts off 50:50. The
future path of the price level of a security is no more
predictable than the path of a series of cumulated
random numbers.
Few professional equity investors use charting
nowadays, although the futures market does still
make use of its techniques.
Chartist Challenge.
The Internet Bubble




Bubbles are part and parcel of the market system – they go back
to the tulip bubble in Holland during the 1600s; to the South Sea
Bubble of the 1700s in the UK. Every asset has had a bubble at
one time or other.
The Tech Bubble was different …of course…because “things are
different this time”.
2 main causes of the Tech Wreck or the dot bombs: Greed on the
part of the Investment Banks and venture capitalists and stupidity
on the part of the investors.
Einstein: 2 things are infinite; space and human stupidity… I
have some doubts, though, about the first.
Function of the Investment Banks




The function of the investment banks in the
market system is to act as gate keeper:
To give sensible solid companies a long term
investor base.
To provide retail investors with reasonably
secure shares that perform well over time.
Investment Banks are supposed to be one of
the safety valves in the system
Building sustainable businesses






Takes 10 to 15 years and requires:
…a long term perspective.
…having a growth orientation.
…..being people orientated.
…being deliberate about the culture put in place.
VC job to find people who do this…but greed led
them to focus on people who could quickly IPO.
VC failure



Richard M Burns a VC in 1999 said…
“I think it’s really important for all you entrepreneurs
…to remember this:
This will ultimately come crashing down because
companies will go public too soon, they will miss
their earnings and the whole thing will just cascade
down…The whole thing is too much orientated
towards running, towards cashing out, rather than
building a strong organization with good people
good products and defensible strategy.
Valuation Failures -1





Analysts made a number of critical mistakes in their
assumptions:
1. Rapid growth in Internet usage
2. Rapid growth in payments made to internet
companies for use of advertising or for purchase of
products.
3 Moderate costs for growing the firms – justified by
reliance on experts who projected these things.
Using these assumptions, strong future income
streams were forecast – so not a problem if currently
losing money; the discounted PV of the stream made it
look as if real economic value existed.
Valuation Mistakes - 2





Relative valuations:
New IPOs were valued on a relative basis.
Once one company had gone public on enormous valuations,
others could be measured against it. This was the usual
method….not DCF or EVA!
If DCF or EVA was used, the assumptions were much more
favorable for “New” companies as opposed to “Old” ones.
Even if companies had no profits or even no sales then they
would be valued by how many eyeball hits on its website and that
was used as the basis of comparison.
Valuation Failure - 3



Revenue was not real revenue…they were
just swapping advertising with each other..
Again no real analysis done valuations was a
multiple of revenue.
The structure was a giant Ponzi scheme.
Ponzi Schemes







Fastest way to make lots of money…..
…and lose the affection of your friends and family.
Borrow $100 from A and promise to pay him back $40 a year
interest.
Then go to B and promise her the same.
Use B’s $100 to pay back A and B’s interest….pocket $20. Use
A’s money to pay off C etc, etc.
Keep doing this……
…….until you go to jail!
Bidtimes-1



Floated on AIM in the midst of the Internet Frenzy.
Issued 5m shares at 25p each with the aim of
“..developing through selected acquisitions a group
primarily providing e-commerce solutions in the
retail and distribution sectors drawing on the
experience of the directors”
How much would one expect the shares to be
trading at 1 month later?
Bidtimes -2




Somewhere under 25p might be a good valuation as it is a cash
shell and some value should be taken off for costs of IPO etc.
The shares soared to 87.5 p – investors were this paying £3.50
to get the rights to £1.00 in cash.
Bidtimes is to make acquisitions…but has not made any yet…it
has no business ..thus any acquisition cannot add any
synergies…there is no synergy with cash!
To make sense, Bidtimes would have to buy e-commerce
businesses at less than 1/3 of their value….who would sell so
cheaply?
Bidtimes Chart
B I D TI M E S
2 1 /4 /0 3
80
70
60
50
40
30
20
10
0
2000
2001
2002
2003
P R IC E
P R IC E R E L . T O F T S E A L L S H A R E - P R IC E IN D E X
H IG H 7 6 .5 0 8 /9 /0 0 , L O W 3 .0 0 4 /4 /0 3 , L A S T 3 .1 3 1 8 /4 /0 3
S o u rc e : D A T A S T R E A M
The results of the Tech Wreck


Instead of investor’s financial support
providing the basis for the long term growth
of the new companies, many ended up
bankrupt.
Instead of their investments appreciating ,
many small investors lost large portions of
their savings and of their pensions.
Anatomy of a bubble - Euphoria






Speculative manias get started by the expansion of money, we
can look back at Y2K and find the roots of the internet bubble in
the monetary expansion leading up to that time.
Easy money leads to demand for goods or financial assets.
Increased demand presses against capacity.
Prices increase leading to new profit opportunities and attracting
still further players.
Positive feedback ensues where new investment leads to
increased income that stimulates further investment and further
income increases.
This is where we get Euphoria.
Anatomy of a bubble - mania


There is nothing so disturbing to one’s well being
and judgment as to see a friend get rich!
When the number of firms and households indulging
in these practices grows large bringing in segments
of the population that are normally aloof form such
ventures, speculation for profit leads away from
normal rational behaviour to is described as Manias.
Anatomy of a bubble - revulsion





As the speculation boom continues, interest rates, velocity of circulation
and prices all continue to mount.
At some stage a few insiders decide to take their profit and sell out. At
the top of the market there is hesitation as new recruits are balanced by
insiders who are withdrawing.
Then an uneasy period ensues where investors realize that the market
cannot go any higher and a search for liquidity begins…as some start to
pay off liabilities…the race for cash becomes a stampede as prices fall.
Prices decline, Bankruptcies increase, panic usually ensues as not
everybody is able to sell out at the top.
Revulsion against commodities or securities leads banks to cease
lending on such assets.
Anatomy of a bubble - panic





Revulsion may go on to lead to panic with people rushing to get
out before the door shuts.
Panic forms a negative feedback loop until:
1, Prices fall so low that people are tempted back in.
2. Trade is cut off by setting limits on price declines, shutting
down exchanges and closing trading.
3. A lender of last resort succeeds in convincing the market that
money will be made available in enough volume to meet the
demand for cash,
Efficient Markets?!



What does the Internet Bubble tell us about
market efficiency?
Other anomalies : the small cap effect, the
January effect, the weekend effect, “sell in
May and go away”
The best that can be said at the moment is
that the market has periods of efficiency and
inefficiency.
Portfolio Management

Market Efficiency & Jars of Beans!
Mean Return - Variances
US
US
Developed
Emerging
Absolute
Real
Private
Bonds
Equity
Equity
Equity
Return
Estate
Equity
Cash
Observations
72
72
38
13
20
21
16
72
Arithmetic Return
1.2
9.2
6.3
11.1
17.6
3.5
19.1
-0.4
Standard Deviation
6.5
21.7
18.9
27.9
11.8
5.1
20
4.1
1
7
4.7
7.7
17
3.4
17.5
-0.5
Growth Rate
Absolute Return 1




Relatively new asset class.
Exploits inefficiencies in marketable securities
positions exhibiting little or no correlation to
traditional stock and bond investments.
Are either event driven (takeovers, bankruptcy) or
value driven (short position offsets long).
Attempt to structure the investment so that it is
market neutral in contrast to benchmarking.
Absolute Return - 2




Event Driven: Merger arbitrage is the core of this
strategy. Depends on the probability that the deal
will close, its timing, expected value of the deal.
Buy Target company and Sell Acquiring company.
Value Driven; Short the overvalued and long the
undervalued.
In times of financial crisis the correlation between
event driven strategies and the market can be very
high; over the longer term different patterns of
returns show up.
Buffett’s Success




Buffett’s success, I would argue, is not dependent
on his stock picking ability. Rather it is dependent on
a combination of his:
A) Stock picking ability
B) Private Equity Management (the companies
which he has taken over and incorporated into BH).
C) His use of Absolute Return Techniques in
takeovers.
Sharpe Ratio


This ratio focuses on the excess returns that
investors hope to generate by accepting risk.
This ratio well extensively used suffers from
the same shortcomings as all historically
measured volatility ratios.
Use of Sharpe Ratio.
Excess
Time
5y end 31/12/93
1994
5y end 31/12/94
1995
5y end 31/12/95
Fund
Sharpe
Return
Return
Risk
Ratio
AGF
19.30
13.70
8.80
1.60
Index
11.20
5.50
3.50
1.60
AGF
-28.80
-32.70
14.90
-2.20
Index
-1.40
-5.30
4.00
-1.40
AGF
8.50
3.70
12.30
0.30
Index
7.80
3.00
3.50
0.90
AGF
25.90
20.30
5.80
3.50
Index
16.80
11.10
3.20
3.50
AGF
11.30
7.00
12.20
0.60
Index
8.90
4.60
3.30
1.40
Why Invest or Save?



Interest….what is it?
Interest…where does it come from?
Interest….historical attitude. Church against
the payment of interest until the middle ages
(sin of avarice).
Popular Strategies - 1



Dogs of the Dow: At the start of each year pick the
10 stocks with the highest dividend yield. From 1973
to 2001 average annual return of 16%; Dow? 12%
Elliott Wave: Sentiment indicator developed in the
1920’s.
Corporate Buybacks: Invest in companies that have
bought back enough of their own shares to
decrease the amount of shares outstanding minus
options are acquisitions – drives up eps!
Popular Strategies - 2




Chartism,
Worst performing unit trust in a group.
Stock splits.
IPO’s
3 requirements for being a billionaire






1. Market timing
2. Stock selection
3. Asset allocation.
1. Most amateurs spend their time in trying to get the market
timing right. Great if you can do it!
2. The best investors have focused on this area, Warren Buffett,
Peter Lynch etc. - again difficult to do.
3. Dominates the short to medium performance. In the long term
can be over 15% of the return. Easy to do but requires periodic
rebalancing.
Professional Approach.





Mean Variance Return of Asset Groups
Diversification across Asset Groups: allocation targets set.
Diversification within Asset Groups: allocation targets set.
“Thoughtful deliberate focus on asset allocation dominates the
agenda of long-term investors, providing a framework for all other
portfolio activity”
Focus on asset allocation relegates market timing and security
selection decisions to the background reducing the degree to
which investment results depend on mercurial unreliable factors.
Asset Groups








Domestic Equity
Domestic Bonds
Foreign Equity
Foreign Bonds
Commodities
Direct Investment.
Real Estate
Etc.
Active V Passive





In less efficient markets, active management produces potentially
sizeable returns.
For example: private equity (or VC) where market returns
contribute very little to the ultimate results and investment
selection provides the fundamental source of return.
Where markets are efficient active management loses money
against a passive strategy.
Survivorship bias makes active managers look better than they
really are.
Equal weighted analysis also looks better for active managers
than does dollar weighted evaluation.
Portfolio Measurement



Returns can be measured on a capital return basis
where just the price appreciation of the asset is
considered.
More realistic is the total return basis which
incorporates both capital return and any income
such as dividend.
Usually portfolios are measured against a relevant
index with some allowances made for dealing costs.
Indices





Indices give an indication of how various markets or market
segments are performing.
They also act as benchmarks for fund managers to be measured
against.
Two major types of Indices, market cap weighted and price
weighted average.
Dow Jones 30 is price weighed – so the average of 30 prices.
Each price is equally weighted.
S&P 500 is market cap weighted and reflects how a real portfolio
would behave as smaller market cap stocks have less effect on
the price of the Index.
Index construction




Suppose an index has 3 stocks: A – $100m,
B - $10m and C - $1,000m
Value of index at start = 1,000+100+10 =
1,110.
If B rises by 100% to $20m index rises to
1120 – 0.09%
If C rises 100% to $2,000 the index rises to
2110 – 90.0%
Large Pension Funds




For large pension funds whose assets
represent a significant % of the market, there
is no choice but to Index.
Weight of money will drive up prices against
the fund.
Satellite portfolios are set up around the main
portfolio.
Small Cap, Net Zero, Corp Governance,
Closet Indexing



If markets present no mispricings for active
managers to exploit, good results stem from
luck and not judgment.
Over time, managers in efficient markets
gravitate towards closet indexing.
They structure portfolios with only modest
deviations from the market; thus ensuring
performance in line and survival.
Liquidity




Active managers willing to accept illiquidity achieve a significant
edge in seeking high risk adjusted returns.
Market players routinely overpay for liquidity, serious investors
benefit by avoiding overpriced liquid securities and locating
bargains in less widely followed, less liquid market segments.
Small caps is a another good example of this.
Out of the way undiscovered opportunities receive little attention
from brokers who prefer high volume markets.
Speculators pay a premium for liquidity expecting markets to
accommodate reversals of a trade with immediacy and little
impact on price!
Private Equity


Selecting top-quartile managers in private
equity markets lead to much greater rewards
than in public markets. Spotting such
managers is less of challenge than spotting
similar managers in efficiently priced markets.
Active fixed income management, on the
other hand, is a classic losers game.
Dispersion of Active Management
Returns
First quartile
%
Median
%
Third Quartile
%
Range
%
9.7
9.2
8.5
1.2
US Equity
19.5
18.3
17.0
2.5
International Equity
12.6
11.0
9.7
2.9
5.9
3.9
1.2
4.7
Leveraged Buyouts
23.1
16.9
10.1
13.0
Venture Capital
25.1
12.4
3.9
21.2
Asset Class
US Fixed Income
Real Estate
Value V Momentum





Pursuit of value- oriented strategies enhances opportunities to
achieve security selection success.
Value can be purchased by identifying assets trading below fair
value.
Value investors operate with a margin of safety unavailable to
less conservative investors.
Value has as a key component an expectation of growth….so
Value and Growth (or momentum) are not really different
strategies. The reverse does not necessarily apply.
Purchasing with low P/E or low P/B is just a mindless strategy.
Asset class wealth generation .
Wealth Multiples for US asset classes 1925 to 1998
Asset Class
Multiple
Inflation
9
Treasury Bills
15
Treasury Bonds
44
Corporate Bonds
61
Large Cap stocks
2,351
Small Cap Stocks
5,117
Asset Class Diversification



Increasing (decreasing) rates may cause bond
prices and stock prices to decline (rise)
simultaneously, eliminating or reducing the hoped
for diversification effect.
Beware of changes in underlying economic
conditions having a similar effect of supposedly
diversified asset classes.
By focusing on less efficient markets and pursuing
less liquid, value oriented opportunities, investors
increase the odds of winning.
Yield Curve




This is the relationship between yield and maturity
for bonds of the same credit quality.
Normal yield curves slope upwards with higher
yields
Flat yield curves reflect constant yields.
Inverted yield curves depict environments where
short term rates exceed long term rates.
Yield Curve - 2
Yield
Time
Portfolio Problem







Supposing we have a portfolio with 3 stocks: A, B
and C.
We hold 100,000 A and the closing price is $10.
We hold 50,000 of B with a closing price of $23.
We hold 75,000 C at a closing price of $12.
We also hold $50,123 in cash awaiting purchases.
There are 1,000,000 shares in the fund.
A new investor DSP wants to invest in our fund.
What price should we sell him the new units at:
Portfolio Reporting


Generally Portfolio Managers report to their
bosses and to their shareholders every 3
months.
What problems might this reporting structure
lead to ?
Rebalancing Portfolios


Disciplined rebalancing activity requires a
strong stomach and serious staying power.
Conducted in a significant bear market,
rebalancing appears to be a losing strategy
as investors commit funds to assets showing
continuing relative price weakness.
NZ Equity Asset Classes
NZ equity classes
Dates
Asset Class
Multiple
30 Jun 88 - 31 Mar 03
NZ10
2.19
28 Jun 91 - 31 Mar 03
NZ40
2.74
28 Feb 97 - 31 Mar 03
NZSEMC
1.53
28 Dec 90 - 31 Mar 03
NZSESCI
7.87
Diversification




MPT suggests that there is such a thing as a “free
lunch”.
Portfolio diversification provides this free lunch in
that risk can be reduced without sacrificing expected
return.
Diversification occurs between asset groups and
within asset groups.
In tilting portfolios, one uses diversification or lack of
it to weigh a portfolio towards or away from specific
sectors, countries etc.
Umbrellas and Ice Cream



What would the profile of sales be for an
Umbrella Manufacturer operating in Dunedin?
How about an Ice Cream Manufacturer.
What would the Dunedin Stock Exchange
Index performance look like if it only had
these two stocks?
Specific Risk & Market Risk.




As we have seen specific risk can be diversified
away by holding stocks which have different
influences.
In theory 12 to 15 stocks are all that is needed to
diversify away specific risk.
Having eliminated specific risk, one is left with
Market risk…..
…this cannot be diversified, unless one finds
markets or asset classes which are not correlated to
it.
Diversification Problems





MPF – great in theory, very little used in reality.
Volatility not necessarily a good measure of risk,
varies and is backward looking.
Past correlations are just that – historic and by
chance; they may not correlate in the future.
No way of predicting an efficient frontier in advance.
As with most financial mathematics – just a tool to
help us think!
IPOs





IPOs are new companies coming to the market to seek funds.
The first thing one needs to consider when looking at IPOs is the
timing.
It is unlikely that those who are selling the IPO (i.e. the insiders)
are doing so at a time when they can sell it for a discount!
The insiders hold all the cards in an IPO.
Research shows that it is better to buy new companies 6 months
after they launch as broker support schemes and initial sentiment
will have waned by then.
Portfolio Checking-1






Suppose you can achieve a 15% return with a 10% volatility pa (93%
chance of making money in any given year). How does it look on a
close up view.
On a narrow timescale this translates into only 50.02% probability of
making money over any given second!
Yet your heart will not tell you that, and the loss you feel will outweigh
the pleasure you gain on the upside.
If you check your portfolio on a minute by minute basis you will have
241 pleasurable experiences and 239 miserable experiences each
day….you will be drained emotionally!
Now consider checking the portfolio on a monthly basis, you will 4
months of regret and 8 months of happiness each year.
Now if you do it on a yearly basis you will 19 pleasurable experiences
out of every 20.
Portfolio checking - 2
Scale
Probability
1 year
93.00
1 quarter
77.00
1 month
67.00
1 day
54.00
1 hour
51.30
I minute
50.17
1 second
50.02
One of the big lessons!



Every time in every bubble situation you hear
the cry “This time it is different”.
The protagonists will have 20 million different
reasons why it is different all backed up with
research and theory.
It never is….the core is the same….the
circumstances are just different….but people
find it very hard to accept this.
One of my big lessons!


Things take a lot longer to happen than you
expect.
You will generally be right in your direction
and analysis …..but your timing will be way
off.
Shorting.




Shorting means selling financial assets which you do not own in the
hope of buying them back at a cheaper price later.
Managing a short portfolio in not quite the opposite of managing a long
portfolio. For you are depending on holders to realise that the stocks
are overvalued. You are fighting investor sentiment.
Managing a short portfolio is an area where active management can
add real value in supposedly efficient and liquid markets. Not enough
attention has been paid to this area or expertise.
Large portfolios, pension funds etc. will loan stocks for a % in countries
where shorting is not allowed. This can a very useful source of income
Dealing





On line dealing – execution only is the cheapest
entry into the market if you know what you are
doing.
Mostly you will pay about $50 per trade.
For full service broking you can pay up to 5% of the
money being invested.
In some countries you pay stamp duty on dealing.
Charles Schwab, Etrade, etc are the big names in
online dealing
Bonds – use of in portfolios
Dividend Yield-1





Stocks pay dividends which, in theory, is the surplus
generated and not needed by the business.
We can use dividends to value a stock….in theory.
How do you then use DY to value a company which
does not pay a dividend?
How do you use DY to value a company which does
not pay a dividend but does share buy backs.
DY and EY are often used in conjunction with an
index to give an indication of whether stocks are
cheap or expensive relative to bonds.
Dividend Yield -2


Occasionally you will get research which says
that investing in stocks which pay dividends
gives the best return. But, like, most research
in finance, they cannot tell you which ones!
Does it matter how the Free Cash Flow gets
used in a company? Why?
DCF




DCF is Discounted Cash Flow and is equivalent to
EVA in that if done properly gives you the same
answer.
In DCF you discount the Free Cash Flow into the
future to give you the price for a stock.
Free Cash Flow is defined as the Operating Profit
after tax plus Depreciation plus changes in working
capital minus maintenance cap ex.
Free Cash Flow is the cash that could (in theory) be
distributed to shareholders.
Investment Funds





Come in all shapes and sizes.
Most do not beat the relevant index.
A way for small investors to gain diversification.
Unit Trusts, Investment Trusts, Index Funds, Ethical
Trusts, Exchange Traded Funds, Hedge Funds.
Best choice for the small investor is Index Funds.
Other Financial Instruments







Commodities – funds and physicals.
Cash
Bonds – Government and Corporate.
Currencies – Big Mac Index
Domestic Property
Commercial/Industrial Property
Futures, Options.
Bonds


Government Bonds – Zero Coupon Bond
(Strips), Inflation Indexed Bonds, standard
bonds,
Corporate Bonds – Preferred, Convertible,
Callable, Secured, Unsecured, Investment
Grade, Junk.
Portfolio Management - problems







Churning
Style
Selling
Departing from the Index composition
Cash in the portfolio – what to do?
New allocations for a very large portfolio.
Rewarding the managers.
Briar’s First Law

At some point in the life of every organization,
it’s ability to succeed despite itself runs out.
Tobin’s Q





This is the ratio of replacement cost to market cost.
In the long run this will tend towards 1 – however it
can differ significantly for long periods of time.
The British firm Smithers & Co have been big
proponents of this and have had good success
when looking at the US market.
http://www.valuingwallstreet.com/updates.shtml
33% downside for Wall Street.
Tobin’s Q graph.
Chart 1. Log "q" vs its Average.
Log of ratio of "q" to its average value
1.5
1
0.5
0
-0.5
-1
1900 1906 1912 1918 1924 1930 1936 1942 1948 1954 1960 1966 1972 1978 1984 1990 1996
Log q
Q1
2002
Buffett Buys Bonds

In July/August 2002, Buffett bought Junk
Bonds in the following companies: Amazon,
AOL, Tyco, AT&T – why?
Bond Mathematics
Companies










Wrigleys
Gilbert
Lion Brewery
Sky City
La-Z Boy
BWD Rensberg
Thor
TabCorp
Berkshire Hathaway
Sydney Aquarium
Mr Market





He is your business partner. He appears daily and, depending on his
mood, every day quotes a price he is prepared to buy your holding from
you or sell you his.
Even though the business you both hold may have stable
characteristics his price rarely is.
Poor chap has incurable emotional problems. Sometimes euphoric and
can only see great things ahead. When in this mood he will pay a quote
a very high price as he is worried you will rob him
Other times he is so depressed he can only see bad things ahead; so,
he quotes a very low price as he is afraid you will dump your holding on
him.
Mr Market is there to serve you, not to guide you….he will be back
tomorrow with another quote. It is his pocket and not his wisdom that
you will find useful.
Inflation linked bonds




These have no place in a properly defined
fixed income portfolio.
Why?
Traditional fixed income assets respond to
unanticipated inflation by declining in price.
These however respond in an opposite
fashion to the same criterion – so belong in a
different asset class.
Reversion to the Mean



Thought by many to be the most powerful
force in financial markets
If prices tend to revert to the meant then
return expectations must be adjusted to
dampen expectations for high fliers and boost
forecasts for poor performers.
The Small Cap Predictor was founded on the
return to the mean principle.
Real Estate- commercial




Characteristics of both debt and equity.
Lease payments, the contractual obligation of
tenants, resemble fixed income instruments, while
the property’s residual value contains equity like
attributes.
How to value Real Estate.
Historical numbers tend to underestimate the
volatility of Real Estate – should come some where
between the value of bonds and of equity as these
are the underlying characteristics.
Asset Class Correlation



Strong positive correlation between stocks and
bonds in normal environments produces little
diversifying powers when combining assets.
With unexpected inflation, the long term correlation
between bonds and stocks proves to be low,
providing substantial diversification to the portfolio.
During periods of deflation, low or negative
correlation between stocks and bonds helps to
diversify portfolio assets.
Private Equity- a separate asset class?





Private Equity constitutes a separate asset class because:
..they behave in a fundamentally different way from marketable
securities (reflecting, for one, illiquidity)…
…while they may show high short run correlation with publicly
quoted assets….
…reliance on this correlation is dangerous in the long term
i.e. building a portfolio of private equity holdings, assuming that
investing in small publicly available stocks are the best substitute
leaves one open to the possibility that VC will call for funds when
market prices have fallen; thus, the portfolio suffers a double
whammy!
Role of fixed income




Under normal economic conditions, the relatively low volatility of bonds
serves to mitigate portfolio risk; although much of the time bond prices
correlate with equity prices limiting the diversifying power of fixed
income allocations.
Though there is a high cost to be paid for this apparent risk reduction
i.e. the opportunity cost of investing in higher performing assets.
Investors frequently over allocate to bonds to protect from hostile
financial environments.
A low allocation to high quality, long-term, non callable bonds uses
bonds to the best effect – i.e. as protection in times of financial crisis. In
the midst of volatility panics these can outperform dramatically. Bonds
have little to offer in normal times and times of unexpected inflation.
Corporate Bonds


Corporate Bonds are tainted by the introduction of
credit risk which is almost and equity characteristic
as the value of the stream of income depends on
the financial stability of the issuer.
For callable bonds, just as the flight to quality
happens (which benefits bonds) the decline in
interest rates causes call options to become more
valuable to the issuer and hence reduces the
potential upside for the bond.
Inflation




Bad for bonds – why?
Conventional wisdom has it that in the short run, stock prices tend to
react negatively to inflation as the cost of replacement assets rises
faster than the prices the firm can charge.
However in the long term it is said that they provide and excellent
hedge against inflation as stock prices reflect a claim on real assets
denominated in real terms and share prices ultimately reflect increases
in real terms.
In reality for this to be true then there should be a correlation between
changes in share prices and changes in the market prices. Empirical
studies have not found this to be the case. Stocks at best only offer a
limited hedger against inflation.
Investor Bias





People believe that superior performance comes from hard work.
The investment world worships success. The analyst/adviser
who has made a good call is seen as a guru.
Few consider whether it is a lucky draw from the probability
distribution of possible choices.
The presumption is that success comes from skill or ability not
from accepting higher risk or that lower returns may be a result of
accepting lower risk.
Investors search for confirming evidence – they ignore
disconfirming evidence.
J M Keynes

Finally it is the long term investor, he who most promotes the
public interest, who will in practice come in for most criticism
wherever investment funds are managed by committees or
boards or banks. For it is in the essence of his behaviour that he
should be eccentric, unconventional and rash in the eyes of
average opinion. If he is successful, that will only confirm the
general belief in his rashness: and if in the short run he is
unsuccessful, which is very likely, he will not receive much mercy.
Worldly wisdom teaches that it is better for reputation to fail
conventionally than to succeed unconventionally.
Short termism






Creating wealth through a series of short term investments is difficult
risky work.
The competitive atmosphere surrounding investment management
activities encourages short term thinking.
The media encourages such behaviour with its league tables of winners
and losers.
Short periods of trailing performance data is irrelevant yet the pressure
is to perform to get to the top of these tables.
Mediocre performance inevitably results as managers incur high
transaction costs pursuing second rate ideas within the context of an
index like portfolio.
This is why so few mutual funds can beat the index on any consistent
basis.
Investment Managers



Large investment management groups must, of their nature,
become bureaucratised and system driven. This imposes
barriers to decision making and flair.
These generally seek growth and not performance for the return
comes as a function of cash under management. So the name of
the game is attracting new cash flow.
Small independent firms with excellent people and a focused
strategy for a well defined sector is the best way of finding the
contrarian path to performance enhancement.
Law of Averages.






Take a partner.
Decide which of you is A and which is B.
Let A imagine 100 tosses of a coin, B write them
down.
B toss a coin 100 times. A write them down.
What differences do you detect between the two
series.
This is knows as the “gambler’s fallacy”. The law of
averages should really be called the law of large
numbers.
Law of averages - 2


The imaginary coin tossing produces far
shorter runs than the actual coin tossing i.e.
the imaginary one contain far too many runs
of length one.
People believe that most strings of coin
tosses feature about the same number of
heads and tails: hence, they expect short
runs.
How confident are you?




The Dow Jones Index closed at 9181 in 1998. The
index does not include dividends.
The Dow started in 1886 at 40.
If it included dividends what value would it be at the
end of 1998?
Write down your best guess. Also write down a high
guess and a low guess so that you are 90%
confident that your guess lies between the low and
the high number.
Overconfident?





652,230 is the answer.
If people were well calibrated then 90 out of 100
would be between both the high and the low
number.
Mostly people are well off with their high guess not
even coming close to the number.
When people are overconfident they set narrow
confidence bands.
Therefore they get surprised more frequently than
they expect.
Conservatism

There are 100 bags of chips. Containing 1000 chips. Forty five
bags contain 700 black chips and 300 red chips. The other 55
contain 700 red chips and 300 black chips. The bags are opaque
and one is selected at random.

What probability would you assign to the event that the selected
bag contains predominantly black chips?
Now imagine that 12 chips are drawn with replacement from the
bag, These twelve draws produce 8 blacks and 4 reds. Would
you use the new information to revise your probability that the
selected bag contains predominantly black chips. If so, what new
probability would you assign?

Conservatism - 2



The bag is like a company that in the future may
operate in the black or in the red. So in, black chips
stand for good future earnings, red for poor future
earnings. Analysts start our with information that
leads them to form their initial beliefs.
The belief here is that the probability that the bag
contains predominantly black chips.
In this case as the probability is 0.45 the chances
are that the bag/company will produce poor future
earnings.
Conservatism - 3







The second question is more difficult.
The 8 black chips and 4 red chips is akin to a positive earnings
announcement. So now the question is how to react to a company
which has not been performing so well but has a positive earnings
announcement.
There are two usual answers: 45 % and 67%.
Those who chose 45% do not know how to incorporate the new
information.
Those who chose 67% focus on the fact that 2/3 of the chips drawn are
black. They ignore the prior information . Do they over react or under
react?
In fact the answer is 96.04% that the had a majority of black chips.
This is how security analysts react to earnings announcements. They
do not revise their earnings announcements enough. So surprises are
followed by more surprises
3 types of human bias



1. Heuristic – people use rules of thumb.
Often ones which do not work.
2. Frame Dependence – the way that the
decision is posed has an effect on the
outcome.
3. Inefficient Markets.
Loss aversion




You have 2 choices;
1. Accept a sure loss of $750
2. Take a chance where there is 75% chance
that you will lose $1,000 and 25% that you
will lose nothing.
What do you do?
Loss Aversion - 2




Most people gamble because they just hate to lose!
Results show that a loss has 2.5 times the impact of
a gain of the same magnitude.
Most people hold on to losing stocks determined not
to sell until the stock gets back to the price that they
paid. More money is probably lost through this
strategy than any other one.
As Buffett says – you don’t have to make it back the
same way as you lost it.
Inefficient market - 1




The Yale economist Shiller argues that there is more
volatility in the stock market and the bond market
than would be the case if process were determined
by fundamentals alone.
Investor errors are the cause of mispricing.
Investors become overly optimistic about past
winners and overly pessimistic about past losers.
Mispricing is not permanent it does revert over time:
the winners under perform and the loser outperform.
Inefficient markets - 2



How good a driver are you? Relative to the drivers
you encounter on the road, are you above average,
average or below average?
Most of us are overconfident about our driving
ability….and probably about our dealing ability also!
Investors take bad bets because they fail to realise
that they are at an informational disadvantage.
Dollar cost averaging




A technique used by many to invest in the market instead of
putting in a lump sum.
Every month put a similar amount of money into the market.
If the market falls you buy more units if it rises you buy less units.
Your average cost will be lower than if you had invested a lump
sum on day 1.
This is another example of loss aversion – as in fact the risk is
higher with a dollar cost averaging technique than with a lump
sum. Investing only 75% of the lump sum and keeping 25% in
cash is a lower risk option.
Fund Manager Performance







Give 5,000 people each a coin and tell them to toss the coin 10 times.
For a head you get 1$ for a tail nothing.
To keep score we use Eveningscore to publish the dollar pay off to each
manager. Eveningscore also publishes the performance against the
benchmark.
$5 would seem to be a fair benchmark.
Eveningscore reports that 1,905 managers beat the benchmark (38%).
6 of the managers posted a perfect score of 10 heads.
How do we pick the winners for the next round?
The chances of doing as well in the second round are only 20%.
There is a big difference in the chances of one person tossing 10 heads
in row and the chances of 1 out of 5,000 people tossing 10 heads in a
row.
Regret


Regret can have a big effect on the decisions
which people make.
Harry Markowitz the father of modern
portfolio theory once explained that his
personal asset allocation of 50% bonds 50%
equities was not an attempt at an efficient
portfolio but rather a way of minimising his
future regret!
How to be a guru.





Pull 10,000 names out of the phone book.
Mail bullish forecast to half and bearish to the other
half.
Next month, use the 5,000 names for which you had
got the prediction right. Mail half with bullish and half
with bearish forecasts.
Next month do the same to the 2,500 names which
received the “correct” forecast.
Continue doing this until you get to 500 names. Of
these maybe half will respond with money to invest in
your fund. A good return for a small outlay!
The good monkey


Another way of looking at Fund Manager
performance is to consider a vast number of
monkeys using typewriters. If the number is
big enough one of them will produce
Shakespeare's Macbeth….
…but would you sign up the monkey for a
sequel?
Fund Managers/Stock Analysts – who
needs em?


Selling shares every few months to buy new
ones takes up a lot of time and energy – not
to mention information.
Anybody having the ability to make all these
recurring decisions correctly would be very
rich – why would they work for you?
Market Commentators -1




Suppose a strategist says that the market has a
70% chance of going up and a 30% chance of going
down over the next week.
Is the strategist bullish or bearish?
What is too often forgotten is the magnitude of such
moves.
If there is a 70% chance of going up 1% and a 30%
chance of falling 10% then the total probably
outcome is a fall of 2.3%!
Market Commentators -2





It is now how likely an outcome that matters – history shows that stocks
always rise over the long term – 100% true!
…but the magnitude of the outcomes that counts. …many people are
sitting on big losses after the tech wreck.
Aside from market commentators, few get paid by how often they are
right. What they get is the profit or loss.
Commentators are entertainers; they are famous, can blind you with
numbers, witty and clever…but basically entertainers. There is no
statistical validation of their musings.
Once again in the financail industry Marketing triumphs over Reality
Portfolio Construction





Research shows that many investors hold overly conservative
portfolios…why?
..they over focus on short term losses.
Loss aversion leads to investors holding too little in equities and
too much in fixed income.
When looked at in months stocks made money 62% of the time
since 1926. Average loss almost as much as average gain.
When looked at in 5 year segments, stocks made money 90%
time with average loss only 63% of average gain.
Financial Adviser



Having a financial adviser enables the
investor to carry a psychological call option.
If the investment goes right then the investor
can take the credit for their skill and vision.
If the investment goes wrong then the adviser
can take the blame protecting the investor’s
ego.
NZ Bond Market





Highly illiquid.
Over 50% held overseas.
Poor range of Bonds.
Difficult to get data and prices.
Mostly institutional market.
NZ Equity Market – problems 1





According to Joseph Healy, NZ suffers from:
Corporate values which reward company size (assets and
turnover) and have weak links to shareholder value.
Poorly specified or non-existent return on capital objectives.
Poor corporate discipline in ensuring that capital is allocated
where it can influence required returns.
Executive incentives that are not aligned to shareholder interests.
NZ Equity Markets – Problems 2




Institutional investors fail to constructively use their “voice” to bring
about better governance and as a consequence, performance.
A sterile and often legalistic view of corporate governance that has
more to do with the administrative duties of the board than their
economic duty as agents of shareholders i.e. more compliance than
performance.
A dominance of compliance-based accounting and legal skills over
rigorous economic thinking, risk taking and entrepreneurial flair that are
key ingredients in business innovation.
A fixation with dividend policy that can disguise problems, result in
under investment in growth, and in some cases liquidate the business.
Healy comments:

There are, sadly, few great NZ corporate
success stories – businesses that have
demonstrated an enduring track record of
development and growth in shareholder
value; that is, growing from a successful
small business to a successful large
business.
Wealth Destruction in NZ



The EVA firm Stern Stewart estimates that in
aggregate the Top 40 NZ companies have failed to
produce adequate returns on risk capital and this
has resulted in an erosion of shareholder value
between 1991 and 2001 of $21bn!
The key difference between US companies and NZ
companies is that US businesses are much more
productive in their investment management.
Surely the No 1 priority for management is the
efficient and effective use of capital?!
The NZ Stockmarket -1




Market Cap of NZSE40 at the end of 1994
was $42.2 bn.
At the end of 2001 it was $42.8bn
Australian market grew from A$282bn in
1994 to A$733 bn by the end of 2001.
In 1986 the NZSE40 was also $42.4 bn and
the Australian figure was A$137 bn.
The NZ Stockmarket - 2



The average market cap of the NZSE40 at
the end of 2001 was $320m up $10m from
1994.
The Australian figure had grown from
A$250m to A$550m.
Australian companies had doubled in size
whereas NZ ones had stagnated.
EVA & the NZ market -1



The EVA ratio (EVA per dollar of capital) for
EVA positive firms is materially lower in NZ
than in the USA, UK, and Australia for firms in
the same industry.
The quantum of losses to the capital
employed in the economy is much higher in
NZ.
These losses have continued over a decade.
EVA & the NZ market -2


Going beyond the NZSE 40 and looking at
some 600 NZ companies (both public and
private), shows that the combined EVA loss
was $3.6bn for 2000…..
In 1999 the loss was $5bn
ROE of top 30 by Mkt Cap
Country
1994
1995
1996
1997
1998
1999
2000
2001
5y ave
5y ave to 2000
US
20.5
20.5
23.3
22.3
22
24.3
25.2
21.7
23.1
23.42
UK
14.4
16.6
18
17.4
17
15.8
14.2
10.2
14.92
16.48
Australia
11.1
12.4
11.4
9.7
9.8
11.3
13.8
12.9
11.5
11.2
NZ
11.4
12.9
12.1
9.9
3.7
9.2
11.7
-58
-4.7
9.32
What is wrong with NZ companies?-1




In a survey of top performing companies the FT
finds that they have the following characteristics in
common:
Strong management that is clear on its strategy,
able to communicate it easily to employees,
customers and investors and then execute it
rigorously.
The ability to innovate either in technology, design or
customer relations.
Successful international expansion.
What is wrong with NZ companies?-2




Contrast the FT characteristics with the World
Economic Forum’s global competitiveness
report for 2000 which showed that NZ
companies did not measure up in the
following 3 areas:
Developing Strategy
Harnessing Technology
Managing people and capital
BIL

Quek Leng Chan majority shareholder says
of BIL “I have a strong perception that the
company I have invested a substantial
amount of money in for so long has been
hijacked by the executive staff and directors.
The benefits have been diverted to an
unreasonable extent towards the
management and directors.”
Triple Bottom Line reporting




Very popular in NZ but not elsewhere (a bit like the Kyoto
agreement…!)
Shareholders and stakeholders are not in an adversarial
relationship. What is good for the stakeholders must be good for
the shareholders e.g. employees, customers etc.
Focusing on stakeholders as opposed to shareholders allows for
confusion and lack of focus which damages the business in the
long run.
How is the board to be held accountable when shareholder
maximisation conflicts with the interests of other stakeholders? Is
this not a recipe for more of the professional manager’s revolt?
Role of companies etc

Robert Goizeta former CEO of Coca Cola
had an interesting point of view:
Governments are created to meet civic
needs. Philanthropies are created to meet
social needs. And companies are created to
meet economic needs. Companies that do
their job well contribute to society in a very
meaningful way.
NZ dividend payouts - 1



NZ is very much out of step with the rest of the world
in it’s view of dividend payouts.
Dividends are meant to be the residual for which the
company cannot find projects at high enough rates
of return.
In NZ they are sign as a sign of virility or a way of
rewarding loyal investors….this may be so given the
poor EVA produced. Better to pay out than have the
management waste the money!
NZ dividend payouts - 2



Because of the high payout culture NZ directors feel
pressurized to keep the dividend even in time of low
cash.
This is maintained even when it leads to nonsensical
outcomes, such as not investing in high EVA
projects, or borrowing to pay the dividend - NZ has
one of the lowest investment rates in R&D in the
OECD.
In early 2001, when the company was near bust, Air
NZ did a rights issue and then paid a dividend
Private Equity in NZ - 1
World wide private equity investments
Country
US$bn
%GDP
$122.10
1.35
UK
12.20
0.94
Western Europe
15.80
0.31
Asia Pacific
7.00
0.11
Middle-East & Africa
1.40
-
Central & Eastern Europe
0.20
-
Australia
2.10
0.45
New Zealand
0.20
0.29
136.00
0.50
USA
Worldwide
Private Equity in NZ -2



In 2001, from over 20,000 companies only 20
received private equity through formal channels.
As with other markets, the bulk goes into MBO.
Potential is huge in NZ – however regulatory
supervision is important so that the market does not
become exhausted and cynical through poor issues
and underhand practices.
Takeovers -1





Are a bonanza for the shareholders of the acquired
company.
Increase the income and status of the acquirer’s
management.
Put loads of lovely money into the bonus pools of
Investment Bankers.
Reduce the wealth of the of the acquirer’s
shareholders…often substantially!
Usually reduces the value of the acquirer!
Takeovers -2

Peter Drucker says “ I will tell you a secret:
Dealmaking beats working. Dealmaking is
exciting and fun, and working is grubby.
Running anything is primarily an enormous
amount of grubby detail work….dealmaking is
romantic, sexy, that is why you have deals
that make no sense”
Takeovers - 3




75 % of all takeovers fail with in the first 18 months.
Why should a managers sell part of his company
(issuing shares for the deal) at a price that he would
not sell the whole of the company for?
“When we started we were getting 100% of our
earnings from the original business. After 10 years
we were getting 150%.”
According to Buffett, the worst thing to do with
undervalued stock is a takeover…the best thing is
to buy back the stock.
Director’s Pay - 1




In the absence of close monitoring managers can
create problems in the following ways:
Run the business for their own aggrandizement and
wealth.
Under invest in the future as they focus on market
driven short term goals,
Have different risk preferences to shareholders;
either bet the ranch in the knowledge that it will not
effect their pay; or, being fearful least they lose the
good thing that they are on to, take little or no risk.
Director’s Pay - 2




The basic pay should be an insurance that the
director and his family will live to a reasonable level.
The bonus should provide the incentive.
The bonus element should be transparent so that
the shareholders can see that the interest of the
managers and the shareholders are in line.
These days (for many reasons, not the least
because of the inaction of institutional investors) the
best way to become very rich is to be sacked as a
failure from a number of companies!
Director’s Pay - 3




EVA is again very useful in the area of Director’s
pay.
Director’s bonuses should only be linked to the
creation of shareholder value as measured by EVA.
It is the incremental increase in EVA that acts as the
value driver for a company’s share price.
EVA should be part of a balanced scorecard.
Pay for failure



It was suggested that the directors of Air New
Zealand might be a paid the equivalent of 3 times
their annual fees following their departure from the
board on the Government take over. Naturally this
caused a public outcry!
There was disbelief when the departing CEO of BIL
was paid $4m.
Is a CEO who insists on being paid for failing the
kind of CEO the company should be employing?
Director’s options.





While there is a place for options in the total compensation
package of a CEO it is important to note:
They should not be a gift, they should be tied to something
measurable which cannot be manipulated e.g. EVA and not EPS.
Options do not align the CEO and the shareholders as the
shareholder has to consider the cost of capital whereas the CEO
does not.
Secondly; there is downside risk for the shareholder but typically
none for the CEO.
Options which are repriced are a slap in the face to the
shareholder.
Executive Pay 2002

Following dismal earnings and massive
layoffs at many companies. CEO pay
declined 33% in 2002, to $7.4 million on
average. However, CEOs in the middle of the
pack actually enjoyed a rise of 5.9%, to $3.7
million, according to an annual
BusinessWeek study of executive pay,
conducted with Standard & Poor's
ExecuComp
Executive Pay 2002 -examples


American Airlines convinced union members to take
substantial pay cuts to keep it from a Chapter 11
bankruptcy filing. At the same time, the board had
voted to award multimillion-dollar retention bonuses
and safeguarded pension plans to senior
management.
Delta Airlines’ CEO took a pay cut and gave up his
2003 bonus. But the board also set him up with a
sweet pension deal that would be protected from
creditors in the event of a bankruptcy filing.
Market Efficiency



In the short term, in normal circumstances, markets
are highly efficient due to the action of traders etc.
Sentiment dominates here
In the long term, markets tend to be efficient as
sentiment can only move a stock for so long. Value
dominates here.
It is in the middle term where the greatest
inefficiencies show themselves. Sentiment and
value are very much intertwined here and if you can
separate one from the other, you will do well.
Sentiment is much more volatile than value.
Diversification-different size portfolios

The average return of all the different portfolios was
about the same for each portfolio size, though, as
one might expect, the smaller portfolios showed the
widest range between the highest and lowest
returns. In fact it became a near statistical
impossibility to beat the market as the number of
stocks in the portfolios grew, though at the same
time the chances of attaining a result far below
market returns also diminished in the larger
portfolios.
Quants




Engage in statistical risk analysis
Use historical data – though the same people
frown on chartists!
Correlations and variances are not constant.
So statistics probably only useful over the
short term.
Volatility




Is it the best way to measure risk? Why?
According to the theory positive volatility is just as
bad as negative volatility!...what are the implications
of this statement?
Highly volatile stocks, either as a group, or singly do
not give high rewards…so is this a measure of risk
or not?
Risk, as defined by volatility, has now become
ingrained in the finance industry.
Risk & Reward




Research shows that the link between risk and
reward is not as strong as many believe.
In fact the report concluded that there was not a
stable relationship between risk and reward.
High volatility does not give better results, nor does
lower volatility give lesser results.
J. Michael Murphy, "Efficient Markets, Index Funds,
Illusion, and Reality", Journal of Portfolio
Management (Fall 1977), pp. 5-20
CAP is dead!



Studies by French and Fama show that Beta
really tells us nothing.
If that the case then CAP is dead the whole
underpinning of modern finance theory is a
sham.
F&F found that the low price to book, low
PER and low market cap were the best
predictors of superior return.
Modern Finance Theory as religon

Modern finance today resembles a MesoAmerican religion, one in which the high
priest not only sacrifices the followers - but
even the church itself. The field has been so
indoctrinated and dogmatised that only those
who promoted the leading model from the
start are allowed to destroy it.
MPT as religion -2


Despite being discredited, Beta and CAPM
are still taught and indeed have been codified
into law.
The reason they are still taught is so that if
you follow them you do not get sued if your
client loses money. You have followed the
Prudent Man Principle.