Keep it simple!!

While I took issue with a great deal of what Mr. Buffett said in the last post, there is one point on which I completely agree. Keep it simple! In my valuation classes, I begin my class by promoting the principle of parsimony. In the physical sciences, this principle (also known as Occam's razor) specifies that when trying to explain any phenomenon, you start with the simplest possible explanation before moving on to more complicated theories.

In valuation, the principle of parsimony calls on us to use the simplest possible model to value any asset. However, there is a catch. The definiton of simplest will vary, depending upon the asset you are valuing. When valuing cash, for instance, you can just count the cash on hand; you don't need a model or elaborate assumption. When valuing a mature company, with stable and predictable, profits, knowing what the firm generated in cash flows last year may be sufficient to value the firm. When valuing a young, growth company, the simplest model may require you to forecast earnings and cash flows for an extended period. You may not like to do it (I don't think anyone does) but there is no real choice..

So, here is the bottom line. I oppose detail for the sake of detail and complexity designed to show the world how smart and sophisticated an analyst is. I think you risk mangling the valuations of simple assets by doing so. However, I think to argue that detail is always bad and that forecasting is dangerous works only if you decide that your investment space is going to be populated only by mature companies. If you, as an investor, are interested in buying growth companies (and there is no law that says you have to be) or valuing them, you have to face up to the truth. There is no way to value these companies without peeking into the future and making forecasts, and then adjusting your value for the uncertainty you feel about these forecasts.

Buffett and Munger... Shock value!

Berkshire Hathaway is having its annual meeting and the financial press is falling all over itself reporting what the sage from Omaha has to say about investing. Let me say at the outset that I have expressed my admiration for what Warren Buffet does well - the fact that he has a core philosophy that he does not deviate from and his instinct for going against the grain. Over time, he and Charlie Munger, who has operated at his right hand for decades, also say things for shock value to indicate how separated they are from both academics and other portfolio managers. Here is a listing of quotes and my responses to them.

Mr. Buffett: “There is so much that’s false and nutty in modern investing practice and modern investment banking, that if you just reduced the nonsense, that’s a goal you should reasonably hope for.”

I agree entirely. There is much that is done in portfolio management and corporate finance that does not pass the common sense test. Layering complexity on stupid ideas - that leverage always increases value, that securitization can make you a more valuable company - do not make them any less stupid.

Mr. Buffett said he was once asked by a student from the University of Chicago, a hub of modern portfolio theory, “What are we learning that’s most wrong?” To which Charlie Munger quipped, “How do you handle that in one session?”

My question to Mr. Buffett would be a simple one: What exactly is your understanding of Modern Portfolio Theory? I would wager that he would come back with Markowtiz portfolios and the CAPM. If you define modern as circa 1964, he would be right. If not, he has a lot of catching up to do.

Mr. Buffett on the efficient market hypothesis, the idea that all information is instantly priced into the market: “There’s this holy writ, the efficient market theory. How do you teach your students everything is priced properly? What do you do for the rest of the hour?”

Mr. Buffett probably does not realize this but the efficient market hypothesis is really a warning to those portfolio managers who try to trade on information - earnings announcements and acquisitions, for isntance - and day traders. To be honest, 99% of investors would be saved a lot of money, if they followed the suggestions of efficient market theorists. Let's face reality. If you define an efficient market as one where investors cannot easily take advantage of market imperfections, markets are efficient to most investors on most assets most of the time... One reason that Mr. Buffett continues to generate excess returns is that he is able to strike inside deals with managers... Do you think you or I would have been able to get the deal he got from Goldman?

Mr. Buffett on complex calculations used to value purchases: “If you need to use a computer or a calculator to make the calculation, you shouldn’t buy it.”

Spoken like a Luddite... How about an abacus, Mr. Buffett? Maybe a slide rule?

Mr. Buffett on the use of higher-order math in finance: “The more symbols they could work into their writing the more they were revered.”

Actually, I do share Mr. Buffett's concern that common sense is sometimes overwhelmed by mathematics. However, the people who are most revered in finance - Harry Markowtiz, Merton Miller and Gene Fama- are surprisingly down to earth in explaining their ideas.

Mr. Munger on the same theme: “Some of the worst business decisions I’ve ever seen are those with future projections and discounts back. It seems like the higher mathematics with more false precision should help you but it doesn’t. They teach that in business schools because, well, they’ve got to do something. ”

What would Mr. Munger do instead? Look backwards and discount forward? What part of forecasting does he think is pointless? And does he not agree with the proposition that a dollar today is worth than a dollar in year? If not, he should be sentenced to spend a year in a high inflation economy (say Zimbabwe)...

Mr. Buffett adds: “If you stand up in front of a business class and say a bird in the hand is worth two in the bush, you won’t get tenure…. Higher mathematics my be dangerous and lead you down pathways that are better left untrod.”

Depends upon your chances of getting the birds in the bush, right? If you feel that you have a 60% chance of getting the birds in the bush, is it not worth the trade off? No wait. Talking about probabilities probably is higher mathematics and I should not do it... My bad...

Mr. Buffett on the persistence of bad ideas in finance: “The famous physicist Max Planck was talking about the resistance of the human mind, even the bright human mind, to new ideas…. And he said science advances one funeral at a time, and I think there’s a lot of truth to that and it’s certainly been true in finance.”

It is true. In any discipline, for every three ideas you come up with, only one will move forward. But the solution to this is not to stop having new ideas but to churn out more...

The future of the MBA

As someone who has a vintage MBA (from 1981) and has taught MBAs for almost thirty years, I have been spending the last few months wondering about the implications of the market crisis for MBA programs globally. After decades of almost uninterrupted growth in business schools, we are starting to look at not just a mature phase but potentially a phase of decline. Using the same principles that we so blithely recommend that companies facing similar challenges should follow, it is time for action. Knowing how slowly academia moves, I am not hopeful. Here are two of the reasons why I think we should be in crisis mode:

1. The growth in the demand for MBAs has been inextricably linked with the growth in the financial services sector. Many of our incoming MBA student have left good jobs as engineers, salespeople or analysts to come back to business school, in order to make the transition to the richer pastures of investment banking. Those pastures are not only looking smaller and less attractive now than they used to be but are likely to stay that way for an extended period.

2. As teachers at business schools, it looks like we failed the test. After all, some of our best students were at the helm of the institutions that drove us off the cliff. While the rationalization that is offered by many of my colleagues is that these individuals were ignoring what they were taught in business schools, there are other influential voices that are arguing that it is what they were taught at schools that caused the collapse.

Here is what I think we need to do:
1. Prepare for much less demand for MBAs looking forward. This has implications for people who are thinking of or are in Phd programs right now, who will be going into a smaller market.
2. We need to incorporate what this crisis has taught us into how we approach whatever we teach. We do not need to over react and throw first principles out, but this is not the time for defensiveness.
3. As individual faculty , we have to think far more seriously about what competitive advantages we have over the hundreds of others who teach the same subject. If all we are doing is delivering a standard product from a pre-set template, why should someone pay tens of thousands of dollars for that product?

Are accountants learning?

While I have many areas of disagreement with accounting, there are three accounting practices that I have taken particular issue with over time.

1. Not treating employee options as expenses when granted: There should really be no debate about this. Employee options are compensation, and like all other compensation expenses should be recorded at fair value, when granted. The fair value is the option value and not the exercise value.

2. Treating leases (or at least a significant portion of them) as operating expenses: Both FASB and IASB have used the ownership of the asset as the determinant of whether a lease should be treated as an operating or capital lease. As an earlier blog post noted, this allows retailers, restaurants and other big lessees to move most of their debt off the balance sheet.

3. Treating R&D expenses as operating, rather than capital expenses: Using the tenuous argument that the benefits of R&D are too uncertain, accountants have insisted on expensing R&D. In the process, =they misstate earnings at technology and pharmaceutical firms and keep the most valuable assets of these firms off the books.

As recently as three years ago, all three practices were still entrenched in accounting statements and standards. But the times are changing. A couple of years ago, accounting finally came around to the point of view that employee options should be valued and expensed when granted (FASB 123). Now, there is chatter that accounting rules will be changed to force all leases to be treated as debt.
http://www.globest.com/news/1380_1380/insider/177832-1.html

I know that companies will be up in arms over this rule and that analysts will issue scary reports about how making this change will be devastating for compaies. I don't think so, and have written what I hope is a comprehensive paper on what treating leases right (which to me is to treat them as debt) will do to all the numbers that we use in corporate finance and valuation. Since I have been treating all lease commitments as debt, in both my corporate finance and valuation classes, it will not change how I look at companies but it will surely make it easier for me to do so:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1390280

All that is left now is for the accounting rule makers to take a look at R&D and exploration costs and the logical fixes to make their treatment consistent with capital expenditures at other firms. I have mixed feelings about this happening. On the one hand, it will be a vindication of much of what I have been arguing for, over the last decade. On the other hand, what will I have left to argue about with my accounting colleagues?

Losing, sustaining and building on brand names

In my last two posts, I argued that a brand name can add significant value to a firm and that we can sometimes estimate that value. A news item last week about Domino's started me thinking about the fragility of brand name value and whether, and how long, it can be sustained: Two employees at a Domino's filmed themselves making sandwiches for delivery, adding ingredients (too disgusting to mention) to the meals. Even worse, they put the film up on YouTube.
http://www.youtube.com/watch?v=r4ftKIMLCl0
In the next few days, this video was watched by millions of people, who thought worse of Domino's after watching the clip. A service that measures brand name perceptions in real time (though I cannot attest for the precision of their measures) concluded that the perception of Domino's among the general public went from a strong net positive to net negative as a consequence.

Events like these indicate that even strong brand names can sometimes come under assault, sometimes from events outside of their own control. Johnson and Johnson, for instance, was confronted with incidents of someone poisoning Tylenol capsules in the mid-1980s. The firm responded by pulling all Tylenol off the shelves nationally and going public with the danger, a reaction that some thought was overwrought, but is now considered a case study of what companies should do when faced with such crises. If 60, 70 or 80% of your value comes from brand name, you should do whatever needs to be done to preserve it.

While dangers to brand name can come unexpectedly from the outside, the bigger dangers comes from within the firm. Here are some examples:
a. Misunderstanding where the value comes from: In perhaps the classic marketing blunder, Coca Cola in the late 1980s made the mistake of thinking that their brand name came from taste, and started experimenting with new flavors (New Coke, anyone?). In the process, they put the entire company at risk and had to back track. Apple and Disney have had near death experiences, where they have done something similar.
b. Neglect: Since brand name values come from perception, the value of a brand name will not pass on from one generation to the next. As a company's customers age, it has to actively work to ensure that the brand name value passes on to younger customers. Companies like Quaker Oats, the Gap and Xerox have all seen their brand name values dissipate over time.
c. Spreading the brand name too thin: Finally, there is a danger to trying to extend brand names beyond their product base. I am not sure that I would pay a premium for a T-shirt with a Coca Cola logo on them or eggs with Disney character pictures imprinted on them (I am not kidding.. Check your local grocery store).

A final thought. In spite of all of the dangers that I have listed, it still remains true that brand names represent some of the longest-lasting competitive advantages to businesses. A study in a marketing journal, for instance, found that three of the top five brand names in 1925 were still on the list in 2000. I cannot think of too many other competitive strengths that would have survived this long.

Valuing brand names

If we accept the proposition that a brand name can have significant value, it seems logical to follow up by trying to estimate that value. The best way to think about how much of the value in a company comes from its brand name is to ask the hypothetical question: What will happen to this firm's value, if it lost its brand name tomorrow?

That question is not always easy to answer since the effects of brand name are everywhere in the firm and are not easily separable. They can affect the company's sales, its pricing policies and its financing costs. Getting a clean estimate of brand name value can range from difficult, to close to impossible, depending upon the company. As a general proposition, brand name value is easiest to value when:
a. There are no quality differences between a company's products and those of its competitors (other than brand name) in the sector.
b. There is at least one company in the sector that is truly "generic".

One reason I use Coca Cola in my brand name valuations is that I really cannot think of any reason why one soda should sell for a higher price than another, based on taste and quality. I know.. I know.. there is the secret formula, but making a cola or an orange soda does not strike me as incredibly difficult to do. Thus, I feel that any differences in margins between Coca Cola and a generic soda manufacturer have to be because of the brand name that Coke has built up over the last century. That is the ploy that I used to estimate that 80% of Coca Cola's value came from its brand name (in the paper that I linked to on the last blog post).

In contrast, think about trying to value Sony's or Apple's brand name. While both companies may have higher margins than their competitors, there are reasons other than brand name that we can attribute these differences to: quality in the case of Sony and a superior operating system and styling for Apple. Thus, what we assign as a value for brand name for these firms may in fact be a composite of many different competitive advantages.

Does this bother me? To me, valuing brand name, for the most part, seems to be a cosmetic exercise. It is not as if Coca Cola would ever be able to sell its brand name and stay a viable company. Thus, what I really want to be able to do is value Coca Cola as a company. The fact that I cannot then break this value down into parts seems to me a secondary problem.

The power of a brand name

I am sorry about the long hiatus from posting but I was at Disneyworld last week with two of my children. As we wandered from one line to another, frantically collecting fast passes along the way, I perused the merchandise that I passed by and pondered the power of a brand name. Every conceivable item that can be fashioned into Mickey Ears has been, from T-shirts to mugs to waffles. And once the Mickey logo is put on a product, the price takes a quantum leap upwards.

To me, this captures the power of a brand name. Stripped to basics, it allows you to charge a higher price for exactly the same product. Very few companies have this type of power, and if they do, it clearly pays off big time in pricing power.

What are the implications for valuation? A brand name company will have a higher value than an otherwise similar company (same products, same total revenues) without the brand name. Note, though, that I am not suggesting that we attach brand name premiums to intrinsic valuations as I have seen some people do. If you do your discounted cash flow valuation right, the brand name should already be embedded in that value. It is in every input in the valuation from base year profits, to margins to returns on capital to value. Adding a premium to a discounted cash flow valuation usually results in a double counting of the brand name value.

I have watched with some trepidation the attempts by accountants to try to put brand name value on the balance sheet, In fact, I have a paper on valuing brand name and other intangibles that you may find interesting:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1374562

I value Coca Cola's brand name value in this paper and develop general frameworks that can be used to value several categories of intangible assets. More on brand name and the consequences for corporate finance and valuation on the next few posts.