The Value Mindset: Returning to the First Principles of Capitalist Enterprise

PART ONE

Value Mindset

Chapter 1

A REVOLUTION IN VALUE

Revolution is a much-abused word. Its accepted meaning is complete change. In fact, a revolution is, as the word suggests, a return to the original. There is a world of difference between a revolt and a revolution.

The value mindset is a revolutionary concept, in that it returns to the very roots of capitalism: the concept of investing resources in order to generate a return based on the risk taken. Jesus Christ’s Parable of the Talents takes the idea back two millennia.¹ Likewise, the value mindset was not alien to the original capitalists who despatched galleons to the Spice Islands or raised satanic mills on England’s green and pleasant land. These capitalists managed directly for value. The money risked was theirs, and the rewards that flowed from taking that risk—after sharing the booty with surviving sailors or paying the mill workers—came directly to them.

Fast forward to the present. What do we see? Like government, companies grow big, diversify, cross subsidize, bloat, and stagnate. As with government, goal seeking and politics compromise the quest for value. Creating value is in practice a take it or leave it option—either you create value, or you do not. There is no half way. And yet shareholder value has become a mantra, much repeated. When challenged, every chief executive will claim value lies at the heart of everything he or she does and close to the heart of every manager in the enterprise. The finance director will provide reams of numbers in support of this laudable assertion, showing how the company has met or exceeded last quarter’s or last year’s self-imposed targets. Discussion over. Is it any wonder that each feels obligated to goal seek outcomes and massage the numbers? As legendary investor Warren Buffett put it, those who make the numbers are eventually tempted to make up the numbers.² Goal seeking in soccer is straightforward; goal seeking in business is not.

Two value champions of recent years illustrate the kind of mindset that focuses fully and completely on value. They are the prophets of our revolution. The first is Isadore Sharp of the Four Seasons hotel chain, who has taken steps toward the kind of specialization we would expect of a company that reconfigures in the way we shall explore in more detail later. The second is Roberto Goizueta, the late chief executive of Coca-Cola.

Isadore Sharp is probably the doyen of the world of service. Trained as an architect, he emigrated from Israel to Canada, where he built motels throughout the 1950s. In 1961, he opened the first of his Four Seasons hotels in downtown Toronto; a second opened its doors in London in 1970. Four Seasons Hotels and Resorts now operates 57 properties in 26 countries. Even during the dark days following September 11, 2001, Four Seasons remained profitable. In many ways, it is an exemplar of good business practice.

Its secret? Four Seasons is the only company in the world to focus exclusively on midsize luxury hotels and resorts of exceptional quality. As what purports to be the world’s premier luxury hospitality company, Four Seasons instills in its employees an ethic of personal service that is second to none. And yet it owns few hotels.

Indeed, if Four Seasons had its way, it would not be burdened with ownership of hotels at all. For sure, it manages and owns hotels, but it clearly wishes it were otherwise:

It is Four Seasons’ objective to maximize the percentage of its operating earnings from the management operations segment, and generally to make investments in the ownership of hotels, resorts and Residence Clubs only where required to secure additional management opportunities or to improve the management agreements for existing properties.³

In other words, here is a hotel chain that would rather not own hotels. What is going on? All is explained a little later in the company’s key document⁴ for 2002:

Four Seasons is principally a management company. Under its management agreements, Four Seasons generally supervises all aspects of the day-to-day operations of its hotels and resorts on behalf of the owners, including sales and marketing, reservations, accounting, purchasing, budgeting and the hiring, training and supervising of staff.

In addition, at the corporate level, Four Seasons may provide strategic management services, including developing and implementing sales and marketing strategies, operating a central reservations system, recommending information technology systems, and developing database applications. It assists, where required, with sourcing financing for and developing new hotels and resorts. It advises on the design or construction of new or renovated hotels and resorts, helps with refurbishment, and purchases goods centrally.

And yet, to stress the point, it owns few hotels. Indeed, it would own no hotels if it had its way. Where, then, does the money come from? For providing a range of management services, Four Seasons generally receives a variety of fees and levies a range of charges, including a base fee, an incentive fee, a sales and marketing charge, a reservation charge, and purchasing and preopening fees. The base fee is calculated as a percentage of the gross revenues of each hotel and resort that it manages. The incentive fee, which Four Seasons is entitled to collect from the majority of the properties it manages, is calculated based on the operating performance of the hotel or resort.

Four Seasons’ fee revenues fell by $12.8 million Canadian dollars (C$), from C$160.7 million in 2001 to C$147.9 million in 2002—a decline of 8 percent.⁵ But in the first full year after September 11, 2001, given the worldwide slowdown in business and leisure travel that resulted, such figures are hardly shameful, contributing as they did to net earnings of C$21.2 million in 2002. Four Seasons’ Wealth Added—a more complete measure of value that we shall explore in more detail later—in the 15 years to the end of 2000 was some C$1.8 billion. The company’s focus on managing hotels, at the expense of owning them, is highlighted by the results from each activity. Management fees yielded C$82 million in revenues in 2002—down C$13.3 million, or 13.9 percent, from 2001. But over the same period, losses from ownership rose by C$9.4 million to C$19.6 million.⁶ Four Seasons clearly knows where its competitive advantage lies, and it is not in owning or managing a real estate portfolio.

Why is this important? Because the focus of Four Seasons on what it does best—service—in an industry where we might reasonably expect it also to own and control property, provides one of the starting points for our exploration of strategic reconfiguration. Instead of owning hotels and managing them, Four Seasons has measured up its core competencies and stepped back from the standard paradigm. This holds a lesson for all companies, and indeed for all industries, a lesson that is not confined to a split between service provision and property management. The implications spread much wider and involve the creative destruction envisaged by the great Austrian economist Joseph A. Schumpeter⁷ across a range of industries—indeed, on the grandest of scales.

Before we leave Four Seasons, the company holds one further lesson that will be useful in the journey to come. As we noted, for its management services, Four Seasons receives a range of fees and levies a number of charges. Of most interest to us at this point is the incentive fee. The base fee is contractual, like the basic wages earned by an individual. What provides the spur to excellence is the incentive fee. Incentive fees were earned from 32 of the company’s 57 hotels and resorts and from one of the two residence clubs managed by the corporation in 2002, compared with 35 of its 53 hotels and resorts and both residence clubs in 2001. That clearly reflects how the travel and hospitality trades suffered over this period. What is important is not the figures themselves but their nature as incentives. Key to our theme is the use of incentives to encourage the creation of value—which brings us to Coca-Cola, at least under our second value champion, Roberto Goizueta.

The world is full of businesses that vow to become Number One, but Coca-Cola is Number One, or at least was when Coca-Cola’s then chief executive and chairman, Roberto Goizueta, made that claim.⁸ The previous year, 1996, Coke had topped the Stern Stewart/Fortune value ranking, beating General Electric and Microsoft to top place with value creation of $2.6 billion.⁹ And the achievement was very largely Goizueta’s. He took Coke’s market value from a mere $4.3 billion in 1981, when the company appointed him chief executive, to $180 billion in 1997. In that same year, just months after making his Number One claim, he became a victim of lung cancer.

Goizueta, the son of a wealthy Cuban sugar magnate, became an impoverished immigrant when he fled to the United States following Castro’s rise to power in 1959. Between them, he and his wife had $40 and 100 shares in Coca-Cola. Earlier, having graduated with a degree in chemical engineering, the young independent-minded Goizueta had answered a newspaper ad and landed a job as an entry-level chemist with Coca-Cola. He joined on July 4, 1954, and the company offered him a job in its new Miami office in October 1960. He stayed with the company for the rest of his life.

When Goizueta became chairman and chief executive of Coke on March 1, 1981, he reportedly knew the cost of every cent of capital Coke had invested anywhere in the world—in other words, the rate of return investors could expect for investing in a basket of companies of similar risk. Therein lay his secret. As journalist John Huey put it, recalling his first meeting with Goizueta:

Basically, he said, the company now had a strategy that would focus entirely on increasing long-term share-owner value (he hated the word shareholder because he said it wasn’t precise enough). He planned to reduce the percentage of earnings paid out in dividends from almost 60 percent to around 35 percent, he explained, and for the first time Coke would take on debt. This would free the company to explore new opportunities and—very important—lower its cost of capital. He would divest businesses that weren’t likely to pay off for shareholders, and there would be no sacred cows. Performance would be rewarded; perfect attendance would not. It was the only time a CEO ever explained to me a strategy so simple that it seemed almost naïve, and I, along with everyone else outside the company, was sceptical.¹⁰

At the time, Huey pointed out, Coke was in disarray. It had lost significant momentum to hard-charging Pepsi and had yielded only a 1 percent compound annual return to shareholders for an entire decade. Its culture was one of entitlement and arrogance. It was locked in a paralyzing war with its own bottlers. And to compound its problems, the company had no communication with Wall Street and unusually hostile relations with the business press.

The key to Goizueta’s success was what was to become gospel to almost everyone who worked at Coca-Cola—that the name of the game was creating wealth for what Goizueta himself called share-owners. The key to that was efficient allocation of capital. As Goizueta warned his managers, Don’t even come to us with a project that doesn’t yield more money than the cost of money. . . . You’ll get no hearing, much less a ‘No.’¹¹

Goizueta’s maternal grandfather Marcelo Cantera, a significant influence on his life, had been a great believer in cash flow. Earnings was a manmade convention, as the saying went, but cash was cash. The larger a company was, the less it understood cash flow. The smaller the business, the better it understood cash flow.¹²

That insight is something to which we will return. Meanwhile, how did Goizueta put into practice Coca-Cola’s publicly stated mission—to create value over time for the owners of the business? Goizueta recognized that Coca-Cola was essentially two things: (1) the flavored drink developed a century earlier by Atlanta pharmacist John Styth Pemberton, and (2) its image, which was to be transformed into the world’s most powerful brand. He concentrated on these, single-mindedly. A previous acquisition of Columbia Pictures was reversed, bringing a cash windfall. Shares were bought back at what turned out to be bargain prices, in a classic move approved by Warren Buffett, who joined Coke’s board.¹³ Incentive pay was linked to value creation, making millionaires of even lower-level managers.¹⁴ And, in the name of creating value, the highest debt rating—AAA—was abandoned.

All of these activities will become familiar by the time we complete our examination of strategic configuration for value. But perhaps the most interesting of Goizueta’s actions was effectively to relinquish ownership and control of Coca-Cola’s bottlers. Once you place assets on the balance sheet, as you should do to reveal their value potential, he reasoned, the onus is on them to earn their full return on capital. Viewed through this lens, many companies peripheral to Coke’s core business, such as bottling, destroyed value. Goizueta’s argument was that Coca-Cola should not be in bottling. Would it, for instance, bottle its competitors’ products? No. The company divested its capital-intensive bottling assets, taking enough in the way of a stake to be able to influence activities, without having to burden its balance sheet.¹⁵ That way, Coke was able to control its bottling needs without tying up as much capital. Table 1.1 compares Coke’s and Pepsi’s capital employed in the last three years of Goizueta’s stewardship and demonstrates the company’s zeal.

It may not be irrelevant that, at university, Goizueta majored in chemical engineering. His stringent control of capital has a quality of small-scale, detailed focus to it. Neither is it irrelevant that he took the oath of allegiance to the U.S. flag after fleeing Cuba. He had the same straight-up-and-down loyalty to his shareholders throughout his career at the helm of Coca-Cola, an alignment with his owners’ thinking that was perhaps fostered by growing up in a family business.

We work for our share-owners. That is literally what they have put us in business to do. That may sound simplistic. But I believe that just as oftentimes the government tries to expand its role beyond the purpose for which it was created, we see companies that have forgotten the reason they exist—to reward their owners with an appropriate return on their investment. . . .

They may, in the name of loyalty, prevent change from taking place, or they may assume their business must be all things to all stakeholders. In the process, these companies totally miss their primary calling, which is to stick to the business of creating value.¹⁶

Table 1.1 Capital Employed by Coca-Cola and Pepsi-Cola ($ billions), 1995 to 1997

That value was created over time, helped by a healthy respect for the balance sheet, as the sale of bottling assets demonstrated. Crucially, a rejection of instant value—overnight, as Goizueta put it—prevented managers from becoming shortsighted:

If our mission were merely to create value, we could suddenly make hundreds of decisions that would deliver a staggering short-term windfall. We could gouge our customers and suppliers. We could cut salaries and benefits. We could stop behaving like good corporate citizens. We could even put our business up for sale to the highest bidder. But that type of behavior has nothing to do with sustaining value creation over time. To be of unique value to your owners over the long haul, you must also be of unique value to your consumers, your customers, your partners, and your fellow employees over the long haul. That is why I am against a scorched earth adherence to profit at all costs.

I am against slashing today to boost the numbers tomorrow, with no regard to what happens the following day. Certainly, harsh competitive situations can sometimes call for harsh medicine. But in the main, our share-owners look to us to deliver sustained, long-term value.¹⁷

Within a year of that supreme statement of shareholder value focus—a paradigm of the value mindset—Goizueta had died. He had earlier claimed that more than 99 percent of his personal wealth was tied up in Coca-Cola shares. In other words, he was an owner, and he thought like an owner. Therein lies one of the keys to the value mindset. It is not necessary to be an owner, but to think like one is crucial.

Sadly, Coke’s overriding focus on value creation did not survive this extraordinary American. The following year, Coca-Cola ceded first place in the Stern Stewart/Fortune value ranking to Jack Welch’s GE. The year after that, both companies had to step aside, as Bill Gates’s Microsoft claimed the laurels. Table 1.2 demonstrates that in the three years after Goizueta, Coke’s use of capital soared, even as Pepsi’s capital employed began to come under control.

Table 1.2 Capital Employed by Coca-Cola and Pepsi-Cola ($ billions), 1998 to 2000

How could Goizueta’s legacy have been so swiftly frittered away? The fact is that Goizueta was a pioneer of the value mindset. The strength of Coke’s brand survived him, but not the value culture. Like a prophet in his own land, Goizueta’s achievement was not honored by his successors. Coke’s progress in creating value after Goizueta faltered. Goizueta’s successor, Doug Ivestor, unaccountably scrapped Coke’s value-linked incentives and its unparalleled focus on value creation. Even at Coke, complacency set in.¹⁸

It is no coincidence that Four Seasons also demonstrates a determined focus on capital allocation. An important part of the company’s strategy is to maintain the strength of its balance sheet. Its latest annual report (2002) claims:

Accordingly, the Corporation intends to continue to be disciplined in the allocation of its capital. . . . The capital investment plans for the Corporation remain focused on allocating the majority of its deployed capital for investment opportunities that are intended to establish new long-term management contracts in key destinations or enhance existing management contracts. Investments and advances will only be made where the overall economic return to the Corporation justifies the investment or advance.

This, again, should come as no surprise when we learn that 58.52 percent of the shares in Four Seasons are owned by the company’s own employees. They employ capital as owners—carefully and rigorously—because they are owners.¹⁹

Together, Isadore Sharp’s Four Seasons and Coca-Cola, at least under Goizueta, give us the themes that inform this book. They illustrate the basic tenet of the value mindset—the compelling tendency for managers and other employees to think like owners, with all that follows from that, including the efficient use of capital. And, using a value mindset, they suggest that there might be potential for reorganizing companies to create enhanced value, in the form of strategic reconfiguration.

NOTES

1. The gist of the parable was that when it comes to the talents awarded to you, you must use them or lose them. The tale’s genius is that in Biblical times, talents were not only the form of human capital familiar to us, but also a unit of currency. Failing to invest either for fear of the risk is craven.

2. We are suspicious of those CEOs who regularly claim they do know the future—and we become downright incredulous if they consistently reach their declared targets. Managers that always promise to ‘make the numbers’ will at some point be tempted to make up the numbers. Annual letter to Berkshire Hathaway shareholders, 2002.

3. Four Seasons annual report, 2002.

4. Ibid.

5. Ibid.

6. Ibid.

7. Joseph A. Schumpeter, Theory of Economic Development (Somerset, N.J.: Transaction Publishers, 1980). Schumpeter, one of the greatest economists of the twentieth century, saw economies as constantly being disrupted by technological innovation, resulting in long waves of industrial activity.

8. On August 25, 1997, to delegates at Coca-Cola’s world bottler meeting, Monte Carlo.

9. The ranking was based on Market Value Added (MVA), which is the difference between a company’s enterprise value—the net debt plus the market value of equity, which is the number of shares multiplied by the share price—and the capital a company employs. In other words, MVA is the wealth created for investors over and above what they invested.

10. John Huey, In Search of Roberto’s Secret Formula, Fortune, December 29, 1997, 230.

11. David Greising, I’d Like the World to Buy a Coke: The Life and Leadership of Roberto Goizueta (New York: John Wiley & Sons, 1998), 75.

12. Hardworking and thrifty, Señor Cantera impressed on the young Roberto the importance of cash and an abhorrence of debt. Ibid., 7.

13. Ultimately, Coca-Cola bought back about a third of its shares at an average $11 each in one of the most aggressive and extended repurchase programs in the history of corporate America. Since Buffett sat on Coke’s board, Goizueta was tremendously encouraged in this kind of value-creating practice. Coke at that time was Warren Buffett’s largest holding, and Berkshire Hathaway is still Coke’s largest investor, with 200 billion shares, or 8.119 percent of the total.

14. The compensation system was the key to driving shareholder value. . . . It completely aligned bottom-line productivity with the stock price: Herbert Allen, chairman of Coke’s compensation committee, quoted in Huey, In Search of Roberto’s Secret Formula, 230.

15. Coke’s arch rival, Pepsi, followed this value-creating move, but not until well over a decade later, in 1999.

16. Roberto Goizueta, The Real Essence of Business, speech to The Executives’ Club of Chicago, November 20, 1996.

17. Ibid.

18. Warren Buffett can be wrong. In his 1997 annual letter to Berkshire Hathaway shareholders, following a touching tribute to Goizueta, he added: The Coca-Cola company will be the same steamroller [in terms of shareholder value] under Doug [Ivestor] as it was under Roberto. Buffett’s reticence on the subject of Coke’s performance in subsequent letters to shareholders speaks volumes.

19. Employee shareholdings are not universally successful, though, as United Air Lines demonstrates. In March 2003, after the airline filed for bankruptcy and after nine years of 55 percent employee ownership, enough employees sold shares to push their stake below 20 percent, triggering the official demise of the United States’ most extensive experiment in employee ownership.

Chapter 2

THE EFFICIENCY OF THE MARKET

If Four Seasons and Coca-Cola are the companies that inspire our journey, a certain type of conservative thinking hampers it. Against the market-oriented, value-focused record of Four Seasons and Coca-Cola is ranged common wisdom. Common wisdom binds with hoops of steel. Common wisdom expects, for instance, that each and every Western government will provide for its citizens from cradle to grave. We suggest value mindset alternatives to this expectation in the last part of this book.

Challenge the status quo that underpins common wisdom, and you challenge a pervasive mindset—all the assumptions that combine to create a culture. Former U.K. Prime Minister Margaret Thatcher took only the first tentative steps toward dismantling Big Government by privatizing a few key state assets, and the result was near rebellion. And yet common wisdom often gets proved wrong. We will discover later that government has not always been all-embracing and that it need not be so. Privatization has become political orthodoxy, though Big Government has yet to wither. Common wisdom can be, and is often, proved wrong.

Just as a political revolution needs a pivotal belief, so a value mindset needs a cornerstone. That cornerstone is the belief in the efficiency of the market—not just that the market works, as it so obviously does where regulation from outside is minimal, but that the market is efficient. No other economic concept is so generally maligned. Common wisdom will not have it, and common wisdom is a powerful force in our society.

The Nobel prize-winning economist Friedrich A. von Hayek once remarked that as a soldier, he had fought in a battle in which the combatants, between them, spoke 11 different languages. This drew his attention, as he wryly remarked, to the problems of social organization. In his essay Economics and Knowledge,¹ he attempted to define the perfect market and the necessary conditions for it.

A capital market is perfectly efficient if three conditions mean that prices can adjust quickly to new information. These conditions are (1) that investors incur no transaction costs when buying or selling securities; (2) that relevant information is freely available to all securities analysts and investors without charge; and (3) that all investors agree on the likely impact of available information on current and future prices. The last condition means that no investor can profit by disagreeing with other investors about the content of the available information. In the real world, of course, none of these conditions applies, and so perfection is unattainable.

Thus one can clearly see that there is a huge difference between the concept of an efficient market and one that is perfect. This is where the confusion lies. Frequently, when people suggest that markets are not efficient, what they really mean is that the market is not perfect. In fact, the market is consistently efficient—it quickly and accurately assimilates new information and cannot be beaten over the long term without taking on additional risk.

As Eugene Fama of the University of Chicago has pointed out,² the market is consistently efficient, given the information available to it. The number of players within it, purchasing and selling stocks at any given moment, evens out any inconsistencies. Each player has an incentive to make as much money as possible by exploring opportunities for arbitrage—occasions when shares appear over- or undervalued—that can be exploited, but which, overall, cancel each other out. Milton Friedman contrasted the inherent fairness of the market system with the artificial market created through goal-seeking outcomes—a theme to which we will return later. For Friedman, the role of the market "is that it permits unanimity without conformity; that it is a system of effectively proportional representation. . . . The characteristic feature of action through explicitly political channels is that it tends to require or enforce substantial conformity.³

The number of players who outperform the market, and the number who underperform the market, is far outweighed by those who simply earn the market return. (Insider trading attracts such opprobrium because it provides a way to beat the market.) Returns follow the classic bell curve. Few fund managers can crow about outperforming the market, and for this reason, as we shall see, they disparage it.⁴

Why are capital markets so widely held to be inefficient? In the same way that many of Darwin’s contemporaries remained unconvinced by the theory of natural selection because they could not see it in action, so today it seems as though the sheer, sophisticated complexity of the efficient market dazzles many of those who witness it. How can it possibly work? It is as though those who make their living by a laptop deny its efficiency because they fail fully to understand how it might work.

Those who are skeptical seem to doubt for one or more of three main reasons. The first is that imperfections in the real world destroy the efficiency with which prices adjust to new information. The second is that prices change for no economically justifiable reason. The third is self-serving—vested interests misinterpret or disregard evidence that shows that capital markets are efficient.

What are we to make of these lines of reasoning? Certainly, there is some justification in the first argument. However, it explains why markets are not perfect, rather than why they are not efficient.

The second argument—that no economically justifiable reason underpins a change in prices—can be discarded. Market prices are determined by expectations about the future, which means that they may not be apparent today. Expectations are, by their nature, changeable, and not transparent. That said, there is merit in the third argument. People misinterpret or disregard evidence that capital markets are efficient because it is in their interests to do so. Again, there is nothing wrong with self-interests, as long as Adam Smith’s invisible hand is allowed to compete them away, as the survival-of-the-fittest competes away in nature. It is when self-interests compete on unequal terms that the problem arises.

An entire ecology has built up around the reading of the market runes. It is not in anyone’s interest for the capital markets to be right. If it were agreed that they were indeed correct, the fauna dependent on that ecological niche would expire.

Chief executives—most famously RJR Nabisco’s F. Ross Johnson, as reported in Barbarians at the Gate⁵—grumble that the market is undervaluing their company. Managers reject efficient markets, which are at the heart of shareholder value, because they are too objective. The use of a Balanced Scorecard by a number of companies allows more room for maneuver.

The fund management industry has a vested interest in denying that markets are efficient because the fees of active managers only make sense if they beat market indices. If it were generally agreed that the market were right, entire families of so-called agents offering advice to owners and investors, such as analysts, would be deprived of their livelihoods.

Holding all to account, measured against the market, would take out the negotiation involved in so much financial activity.⁶ Hence, people simply do not want the market to be right. Negotiation suits them.

Markets are unbiased estimates of fair value, but there may be inconsistencies in available information. For markets to be efficient, they must simply reflect all relevant, available information. Managers may feel that markets are inefficient, but they do so because they possess information that is not yet readily available to the market place, an example of information asymmetry. Managers may argue that the market undervalues their company because it does not have enough information. Arguably, in that case, they should provide it, though not in such a way that aids competitors: Better are signals that investors understand but from which competitors cannot benefit.

Information asymmetry affects even efficient markets. Even in the halcyon years to the height of share prices in March 2000, the market was correct—and by correct, we mean that it was accurate, given the available information and given that the market trusted that information. There are highly influential figures in any market who, for a time, are lead steers⁷ in setting prices in markets. In general, they are important in the pricing mechanism because they provide valuable guidance to less informed investors about fair value, for example, Warren Buffett, Allan Gray,⁸ and Sir John Templeton, arguably the greatest global stock picker of the century. Each of them has commanded the respect of the markets through his ability to create wealth. Their ability to be right has compensated them more than adequately as investors.

However, from time to time, markets are fooled, not because the players in the markets are financially unsophisticated but because lead steers may mislead. For instance, during a recession, interest rates usually fall.⁹ But during the United States’ recession years of 1981 and 1982, a brace of chief economists—Dr. Henry Kaufman at what was then Salomon Brothers and Albert Woljinower at what was then First Boston—convinced consumers and investors alike that interest rates would rise.¹⁰ And they duly did.¹¹ In other words, these lead steers reversed the expected decline in interest rates, which normally acts as a self-correcting mechanism for the economy. Something like a minidepression ensued, with unemployment well above 12 percent in the industrial heartland of the United States. The increase in interest rates drove share prices sharply downward—again, very unusual.¹² When the markets realized their mistake, interest rates plunged, sending share and bond prices skyward.¹³ Within a month, the yield on government bonds fell to just 10.4 percent, and the Dow Jones Industrial average rose from 782 to over 1000.

The exact opposite occurred in the bull market of 1998 to March 2000, when the markets again were misled by new lead steers. Investors trusted the recommendations of U.S. technology analysts Henry Blodgett and Mary Meeker, despite the fact that Blodgett in particular scorned his own recommendations in private. Investors also followed Abby Joseph Cohen, head of investment policy at Goldman Sachs, if only because virtually every time the market fell, she urged a buy: Those who did not follow missed an opportunity. Yet in the end, the market was forced to reevaluate who it trusted. The market was indeed correct, given the information available.¹⁴ Companies themselves also misled the market. For instance, WorldCom’s peers trusted its misleading results and the information that it provided on market share.

What does this stress on the efficiency of the market mean in practice? Inevitably, it suggests that the main goal of any company should be true profitability, based on investor expectations. In other words, the definition of profitability should be set not by managers but by investors. Their expectations are what count. How does the market value this company or that company? What does it expect the company to deliver? What can the company deliver? Failure to achieve investor expectations as expressed in the share price inevitably depresses the share price.

The answer of most managers caught in the vice of investors’ expectations, as revealed in the share price, is that the market has simply valued their company incorrectly. They argue that valuation is an art, not a science; that it is opinion, not fact. This is self-serving. The fact is that the market sets expectations of performance, which, if managers are to manage for value, they must meet. Unless managers are wholly convinced of this, a value mindset will elude them. The self-serving conviction that the market is wrong will become a much more tempting star by which to steer, even if it leads to the rocks.

Knowing your value—an idea we will explore further on a corporate and individual basis later—lies at the heart of the value mindset. Within a company, a useful exercise is to gather the senior managers, the executives who manage each separate business, and confront them with the market value of the company as a whole. How much of that overall value does their business contribute? The exercise brings managers face-to-face with the value that the market believes they can deliver. If they underestimate the contribution of their business, then arguably it should be sold, since they are delivering less value than could be created by selling on the open market. Alternatively, other managers should be brought in to extract the available value. If managers overvalue their contribution, then arguably they must commit to deliver more value than the market expects. This may be challenging.

NOTES

1. In, for instance, Economica 4, no. 13 (February 1937), 33–54; at www.compilerpress.atfreeweb.com.

2. Eugene Fama, Foundations of Finance (New York: Basic, 1976).

3. Milton Friedman, Capitalism and Freedom (Chicago: University of Chicago Press, 1962), 23.

4. Those like Warren Buffett who beat the market by using their skill and patience are the outliers; they take the time and trouble to assimilate publicly available information that others do not. Additionally, Buffett not only picks companies but also helps run them.

5. Bryan Burrough and John Helyar, Barbarians at the Gate (New York: HarperCollins, 1990).

6. In the same way, if a company bases financial targets on expectations inherent in its share price and sets them in stone, then time-wasting negotiation is taken out of the target-setting process. Protests, and gaming, are useless. It’s business, not personal.

7. For a discussion on the topic, see the lead steer roundtable discussion in the Journal of Applied Corporate Finance 2, no. 3 (Fall 1989).

8. Founder and main shareholder of Allan Gray Ltd., based in Cape Town, South Africa, and Orbis, headquartered in Bermuda.

9. Interest rates fall during a recession for three reasons: (1) Demand for credit falls because of declining economic activity; (2) inflationary expectations fall as the demand for goods and services declines; and (3) funds available for lending increase as the central bank stokes bank reserves to overcome the recession.

10. They argued that the budget deficit caused by the Reagan tax cuts would lead to government borrowing crowding out private borrowing, raising interest rates at a time when interest rates would normally fall.

11. The interest rate on government stock on 30-year bonds hit a peak of 15.2 percent in August 1982.

12. Share prices normally fall before a recession and bottom out in the middle of the recession, as reduced expectation of EVA growth is more than offset by a decline in the cost of capital as interest rates fall.

13. As predicted by Joel M. Stern to presenter Louis Rukeyser on Wall Street Week, August 16, 1982.

14. What is remarkable is that although so many describe the rising market of the 1990s as a bubble, so few bought put options—which pay out when the market falls—at the time. Why not? Perhaps financial bubbles only exist in the rearview mirror of history.

Chapter 3

OTHER PEOPLE’S MONEY

Your own money is somehow different from the money you spend at work. It may be the same color. It may have the same value. But it is subtlety, well, different.

Milton Friedman, formerly of the University of Chicago, defined four ways to spend money¹ (see Table 3.1). Essentially, you spend money that is either yours or someone else’s—for our purposes, that of an employee’s company—and you spend it on yourself or someone else.

Category I in Table 3.1 refers to your spending your own money on yourself, in a supermarket or a restaurant, for example. You clearly have a strong incentive both to economize and to get as much value as you can for every dollar you spend. Category II has you spending your own money on someone else, for a birthday or a festive gift, for instance. You have some incentive to economize, but much the same incentive as in Category I to get value for money.

Table 3.1 Milton Friedman’s Four Ways to Spend Money

Category III sees you spending someone else’s money on yourself, for lunch on an expense account, for instance. Here, the rot sets in. You have no incentive to economize, but you still have a strong incentive to get your money’s worth. Category IV witnesses you spending someone else’s money on another person. You are paying for someone else’s lunch out of your expense account. You have little incentive either to economize or to try to get value for money, in terms of the lunch your guest will value most highly. However, if you are lunching, too . . . an element of Category III strongly incentivizes you to satisfy your own taste at the expense of his.

A value mindset aligns Category I with Category III, aligning the interests of a manager spending money as though it were his or her own with the interests of the owners of that money. He or she spends that money in the interests of its owners.

The benefits of this way of thinking are easily demonstrated. A cast-iron way to challenge a manager poised to make an acquisition is to ask: Would you commit your own cash? When your own money is on the line, are you prepared to pursue a particular course of action (for instance, an acquisition)? To root out the strength of commitment, we must return to the roots of capitalism.

The famed venture capitalist firm Kohlberg Kravis Roberts (KKR) is admired and loathed in equal parts, but its members undeniably stake their own money. Warren Buffett once bravely hinted that the share price of Berkshire Hathaway, the investment vehicle of which he is chief executive, was too high.² The fact that his comment was admired, rather than heralding a boardroom coup, lay partially in the fact that Buffett chances his own money. By contrast, the fall of discredited telecommunications analyst Henry Blodgett came at least in part because he urged clients to buy into particular companies that he valued not a jot himself, as the publication of disparaging private remarks regarding those companies subsequently made clear. Buffett clearly felt his reputation was important enough to him to be candid. Blodgett lacked such candor and lost his reputation as a result.

Michael Jensen and the late William Meckling, of the University of Rochester (New York), developed agency theory to explain why people spend third-party money so unwisely.³ Their idea was that the relationship between the principal—in the case of companies, the investor—and the principal’s agent fails because their interests are not aligned. The interests of agents differ from those of the principal. Hence, agents will tend to act rationally—not in the interests of the principal, but in their own interests. Naturally, the principal attempts to counter this tendency but, in doing so, incurs monitoring costs: the cost of accountants, fund managers, bankers, ratings agencies, government regulators, and so on. If we could align the interests of the principal and the agent, then monitoring costs would drop, and greater value could be created. The market provides the perfect bench-mark—in theory. In practice, as we have seen, it is rejected. The market has become a scapegoat. What can we do? It’s the market is the prevailing sentiment. By contrast, blame of anyone and everything except the market has become something of a taboo. No one wants to take blame or even give it—until a certain point. Then the roof falls in. Initially, like the laws of bankruptcy in the United States, we all get a second chance. Failure is simply the gateway to more opportunities to fail. It is all or nothing. Then, Nemesis.

At this point, shareholders may (rarely) put pressure on managers to reform—or resign. After the U.K. do-it-yourself (DIY) and retail conglomerate Kingfisher unveiled a £2 billion rights issue to purchase the French DIY group Castorama, Kingfisher’s shareholders made their support conditional on the departure of Sir Geoff Mulcahy (who still, in the event, received a £15 million payoff). Shareholders in WorldCom finally lost patience in its domineering founder, Bernie Ebbers, after its market capitalization plunged from just over $175 billion to a mere $7 billion or so. But the converse is much more likely to be true. A chief executive who turns in a lackluster performance is much more likely to be able to survive than not, given the perennial ennui of traditional shareholders.

Holding the players to account would clarify who should win praise and who deserves blame. Currently, it is in no one’s interest to play the blame game. Blame is focused on the market. Everyone has the chance to blame the market. The cycle of the economy provides regular opportunities to do this. When growth slows, the first chief executive to announce that he or she is writing off shareholders’ money—effectively, taking the money, investing it in a failed enterprise, and then taking the rap for the miscalculation—undergoes a nerve-wracking experience.⁴ Once it occurs regularly, under cover of a falling market and a rocky economy, it becomes an unpleasant, but largely accepted, fact of life, to the point where large write-offs of goodwill (already written off by the market) are no longer front-page headlines. When everyone is guilty, pointing the finger at any one individual becomes pointless.

The converse of the culture that views blame as taboo is the culture in which a chief executive who voluntarily accepts blame is doomed. In this respect, a business culture that denies blame is similar to the former Japanese culture of responsibility and shame, haji. To accept responsibility is to fall on your sword.

Accordingly, when Sir Peter Bonfield of the UK’s BT Group admitted that he had paid too much for a multi-billion-pound mobile telecommunications license and requested a rights offering, he lost the confidence of his investors and was finished as the company’s chief executive. Today, among telecommunications companies, only Vodafone has resisted writing off its licenses. As we saw, shareholders and bondholders increasingly call for the head of any chief executive who demands more money to make up for his or her failures—unless the chief executive modifies his or her variable compensation to take a hit, too.

Facing down potential accusations of blame may not always be necessary, but it gets done, all the same, backed by the common wisdom that the market can be wrong. When Hewlett-Packard’s (HP) share price fell⁵ on the announcement of its deal with Compaq, HP chief executive Carly Fiorina did just that. She brazened out the market’s verdict. The market, she implied, simply did not understand the deal. She had to say that, of course. The alternative—to admit that the market was right—would have been resignation. This is a perfect example of selective belief in the market. Effectively, when a company’s shares rise, the market is right; when a company’s shares fall, the market is wrong. Managers blame the market when the value of their company falls but take the credit when it rises. In fact, the only way to strip out any market effects on the share price of an individual company is to measure the company’s performance against its peers in the industry—if the chief executive will admit to any. Too often, they reject comparisons.

In the case of Sir Peter, shareholders did underwrite many of the strategies employed, accepting that such strategies tend to be risky, with huge rewards for success. HP investors did vote in favor of the Compaq acquisition. They deserve some blame.

We need a more incremental culture of praise and blame and of the incentives and punishments that go with these. The current standoff until the axe falls means that chief executives are understandably loathe to request more money from shareholders via a rights offering or to ask banks to restructure their loans. Academic research suggests that a chief executive has to fritter away extraordinary amounts of shareholder value before being held to account—and even then, it is not the shareholders who level the accusations. In the end, it is bondholders, protecting what they lent the company, who sign the charge sheet.

A powerful study⁶ by Professors Julian Franks, Colin Mayer, and Luc Renneboog of the London Business School, Said Business School, and Tilburg University, respectively, challenges U.K. corporate governance and shareholder activism in practice. The answer to the question that provides the title for their report—Who Disciplines Management in Poorly Performing Companies?—seems to be hardly anyone, and not who you think.

The professors split 243 U.K. companies into 10 groups based on their total shareholder return (TSR—dividends plus changes in the share price) over three years. This gave a rough indication of managers’ performance in terms of shareholder value and assigned them into 10 categories, from most shareholder friendly (creating most shareholder value) to least (most destructive of shareholder value).

The professors then counted how many executive and non-executive directors, including chief executives, were dismissed. Companies that delivered a respectable TSR, in the top eight groups, had low turnover of executive and nonexecutive directors. However, the threat to board members in the second-worst group increased dramatically: Two out of 10 chief executives were dismissed. In the worst group, 3 out of 10 chief executives were sacked. Otherwise, poor performance went unchecked.

Not only is this a miserable reckoning, but in the end, shareholders played no part in deposing the management or the board. The research suggests that it was not shareholders whose patience ran out, but bondholders, whose relationship with companies is contractual. Companies’ debt had to degenerate to close to junk status before chief executives were forced to leave. In 24 out of a sample of 34 firms with high gearing and low interest cover—a lot of debt in distress—either the chief executive or the chairman resigned. In 12 companies, both resigned.

Clearly, companies must plumb the depths before their managers face questions, but when they do, it is bondholders who, because they retain their stake, demand action. For this reason, Michael Jensen suggested that only the threat of bankruptcy truly reforms companies.⁷ This is a pity, because there is undoubtedly value in better governance—how a company represents the interests of its owners. Research suggests that a significant majority of investors—around three-quarters—say they are willing to pay a premium for a well-governed company.⁸ However, shareholders tend not to demand better corporate governance if a company is performing well, providing consistent returns, despite its governance. There is no guarantee that the governance of any conventionally successful company (and we will analyze several in Part Two of this book) will be strong. Shareholders in such a company may not press for greater transparency or demand better accountability. But if implemented, each would undoubtedly raise the company’s value performance.

Investors, who own the company by virtue of funding it with their capital, can no longer be certain of receiving the return they require, given the risk of the venture. The framework for corporate control exists but has been subverted to the self-serving ends of those agents charged with championing it—not just managers, but bankers, analysts, the media, and the various other fauna in the ecosystem of the financial markets. Self-interests are no longer competed away by Adam Smith’s invisible hand, because some are more powerful than others and are unopposed. Previously, buyout firms such as KKR challenged the system with debt-focused buyouts of publicly quoted firms, prompting Michael Jensen to predict that ownership of companies was set to change radically and that firms with publicly owned equity were an endangered species.⁹ Managers would own most of any equity going, and funding would be mainly be through high levels of debt. The plight of the managers encouraged good governance: If they failed to be efficient and to cover high interest payments, the company would lapse into bankruptcy, and they stood to lose. This was Russian roulette with a single empty chamber—one extreme but powerful answer to the problems of the late 1980s. In any event, things reverted to type. The public corporation survived, and the revolution petered out. Spurred by ungenerous valuations, some companies opted to go private; but for most, it seems that such a radical change in the way companies are funded was too scary. This was certainly too daunting for the U.S. government, which restricted such exotic and frightening takeovers, protecting incumbent management from the vultures who would have returned greater value to shareholders. The active market for corporate control was limited by the use of legal challenge.

The moral? A value mindset means that we should not destroy people’s careers if they admit to failure; but conversely, we should not excessively praise success either. People should be held accountable, but not on the basis of all or nothing. Managers are given many chances before the axe falls, and that is as it should be.