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GLENTYDE
Capital Advisors

Capital Insights
Generating corporate value, one idea at a time.

Just For Grins (or is it just?)
Suppose you're offered the opportunity to play a little game. The rules are simple: You put up any amount of money you choose. A fair coin is tossed. Heads, you win a 25% gain on your stake (i.e., a 25% "return"); tails, and you lose 21% of your money. 25% gain vs. a 21% loss, and a 50/50 chance of either. Would you play? Ignoring declining marginal utility nuances, buying into the game is a pretty good bet.

Now the game is changed a bit. Instead of a coin, a button on a machine is pressed, and a screen will either light up "WIN" or "LOSE"; if the former, you win a 25% gain on your stake, if the latter, you suffer a 21% loss. Further, you're told that you must leave your money invested for any N number of plays, where N is an even number. In other words, you can choose to stay in for two plays, or four, or one hundred, or any even number you select. Also, the machine is programmed such that exactly half of the plays will result in "WIN", and exactly half will result in "LOSE".

The exact arrangement of the wins and losses across the N number of plays is arbitrary. For example, if you choose to leave your money in the game for ten plays, you're guaranteed five 25% gains and five 21% losses, although the order in which they occur is unknown. Would you play? Suppose you could choose the order of the wins and losses (say, five consecutive wins followed by five straight losses, over ten plays), would that sway your decision?

Bonus question: Can you detect any nugget of application from this hypothetical game to the matter of investment performance over time?
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Crush  The Competition, Raid  Their Market Share
(...and otherwise engage in excessive use of sports metaphors and warfare jargon...)
...and watch your  N E W O R T do a slow fade
Once a month or so the latest management science guru du jour hits the scene with The One Thing You Must Do Now Or Else Your Biz Is Toast. Business management and strategy science is big business. And among a great many of the "killer" strategies offered up by the gurus and the B-schools, there runs a common theme; to wit, a foundation on what we'll call Competitor Orientation ("CO"), in deference to the terminology used by the authors of a couple of very interesting papers I'll point to in a moment.

CO-type management strategy is one whose focus is on the performance of the company relative to its competitors. Such a strategy inevitably includes a focus on market share, which to many is the ultimate competitor-vs.-competitor yardstick. And as any cubicle denizen at such a company can readily attest, implementation of CO as a strategy is necessarily followed (and characterized) by sports and warfare metaphors dosed liberally into every conversation and memorandum. "To land this contract we gotta bring out the big guns! I'm puttin' you in the game, Noodleman; get in there, swing for the fences, and don't fumble the ball!" (from personal experience I glean that sloppily mixed metaphors are right at home in the CO world).

Economists, on the other hand, espouse profit-oriented objectives ("PO") as the best means to maximizing shareholder wealth. ("Profit" in this context refers to economic profit as opposed to accounting profit; see the related post herein on accounting net income vs. ROI.) So who's right?

First let's note that market share and profits certainly are positively correlated, so it's not that they're mutually exclusive. Rather it's a matter of asking the right cause-and-effect question. Does a focus on market share and smackin' down the rivals lead to wealth maximization, or (as the economists hold) should the focus be on profits, with competitor-beating performance then arising as a natural consequence thereof? Let's ask the researchers.

In 1996 professors J. Scott Armstrong and Fred Collopy (University of Pennsylvania and Case Western Reserve University, respectively) teamed up on an impressive piece of study1 on the CO- vs. PO- question. In 2007 Professor Armstrong got together with Dr. Kesten Green (Monash University, Australia; and Decision Research Ltd., New Zealand) for a follow-up2 to the original paper, to review fresh evidence arising subsequent to the first paper. The studies and experiments were impressively broad, spanning multiple years and institutions, along with a hearty sampling of respondents and case studies. The findings in a nutshell:
• Competitor-oriented (CO) objectives enjoy much support, being advocated in textbooks, magazines, and journals. CO-type strategies are prevalent in MBA and B-school programs, as well as in executive development courses and programs.
• As one would expect from the previous point, CO-based strategies are found in abundance throughout companies and industries.
• To compare the real-world results of CO- vs. PO-based strategies, the authors chose return on investment and survival as their objective standards. (ROI is a great choice as it's intimately connected with shareholder wealth, and survival was defined for this purpose as the avoidance of both bankruptcy and the sale of the firm as a result of poor performance.) The companies analyzed in the studies were classified as either following a CO-type strategy or a PO-type strategy.
• The results? On both counts (ROI, survival) the POs outpaced the COs by an impressive margin. The POs had superior ROI (hence had a better rate of creating owner wealth) and boasted an admirable track record of avoiding financial distress, a claim the COs were far from being able to make. All in all, it was something of a slam-dunk.
Economists: 1. Gurus: 0 (Surely Messrs. Armstrong, Collopy, and Green will forgive me that one?)

1. J. Scott Armstrong and Fred Collopy, "Competitor Orientation: Effects of Objectives and Information on Managerial Decisions and Profitability," Journal of Marketing Research, May 1996, pp. 188— 99.
2. J. Scott Armstrong and Kesten C. Green, "Competitor-oriented Objectives: The Myth of Market Share," International Journal of Business, 12(1), 117— 136, 2007.

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Startups and Sustainable Growth Rate
Just recently I helped an accountant knock out some financial and economic projections for a start-up client of his, in conjunction with the startup's discussions with investors regarding its seed and expansion funding. The client had previously taken pains to meticulously construct its own forecasts, which were (understandably) focused solely on matters of cash flow, revenue growth, and earnings projections. All well and good, but when presented with the accountant's forecasts, with their broader scope including pro forma balance sheets under a set of reasonable assumptions, the client's founders were a bit rattled by the gaping disconnect between the founders' plans for maintaining certain target capitalization (debt / equity) ratios, and the rapidly changing capitalization ratios as implied by the forecasts and as shown in the evolving pro forma balance sheets.

It caught the founders off-guard that their revenue growth projections necessarily implied that either their debt - equity ratio would have to spike into high-risk territory, or else they'd have to significantly increase the amount of external equity raised. Neither option was palatable, as the former brings the risks of financial distress or default much too close for anyone's comfort, while the latter triggers a dilution of the founders' equity far beyond what they'd find acceptable.

I pointed out to the accountant that a fairly simple application of sustainable growth rate analysis, in conjunction with the forecasting and projections work, would...
• Help the client understand the intimate linkage between P&Ls, cash flows, and evolving balance sheets; and
• Provide a simple basis for developing optimal growth plans.
In this particular case, in fact, it took only a brief bit of time to develop the inputs into a basic SGR analysis. Having done so, the capitalization implications of the founders' growth targets were made immediately and explicitly clear. Had this simple SGR analysis been a component of the planning process from the beginning, a whole lot of time and headaches spent re-working the forecasts would have been saved.

SGR analysis is no Swiss army knife, allowing one to dispense with other elements of the forecasting exercises. It is, however, in any of its popular articulations (such as Higgins' model, or Van Horne's) an easy and pretty effective method for keeping the direct linkage between revenue growth and capitalization, right out front where it belongs. Whenever you go into planning and forecasting mode (whether you're a start-up or not), I'd urge you to bring a little SGR analysis to the party. The benefit-to-effort payoff ratio is pretty darn attractive.
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When selling your company, it's not necessarily a matter of "Seen one buyer, seen 'em all."
Modern portfolio theory posits that the attractiveness of an asset cannot be assessed in isolation, but rather in the context of its contribution to the overall portfolio of which it will be a component. Asset value is inversely related to the riskiness of the returns (as usually measured by the returns' standard deviation), and so a portfolio can have a higher value than the sum of its parts, so to speak, if the individual components are carefully selected such that their volatilities offset, in a correlation sense.

The point? A private equity firm or venture capital pool is a portfolio of assets. The sophisticated PE manager / VC evaluates and selectively adds assets to its portfolio with the aforementioned theory in mind. Proper diversification and return deviations are an important part of his evaluation process, and so it isn't solely the expected return on your company in isolation that he's considering. The takeaway is that the price and terms you receive on the sale can be significantly a function of who you're selling to, and what collection of assets they presently have under management.

Note that private equity pools weren't exactly the assets the developers of portfolio theory had in mind in the evolution of the theory (liquidity issues and other fun things), and so the application of the theory to PE assets can be pretty rough around the edges. Still, the basic idea remains, and it might be of significant value when selling your company and finding that "right" buyer.
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Are you managing for accounting net income maximization or to optimize ROI?
• The magnitude of the bookkeeping bottom line is meaningless without the context of the size of the balance sheet (all economic resources) employed in the generation of that bottom line.
• A strict focus on the P&L's net tends to relegate attention to the more informative ROI / ROA concepts to a mere afterthought, at best.

Going a bit further, when you place the P&L net income into a broader ROI context—even extending it to a DuPont-style analysis—it draws the real profit value-drivers squarely into the open, allowing for a much more effective management of each component. After all, you cannot manage what you haven't yet identified.
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Prepayment penalties magnified in a low-rate environment
If you're a lender it's a "yield maintenance provision"; if you're on the borrowing side of the promissory note you'll call it a "penalty". Their existence is conceptually logical from an economic point of view, but that is of cold comfort when you find yourself refinancing or prepaying a commercial note which contains such a creature lurking in the documentation. Okay, you know it's there, you have a vague recollection of seeing it the day you signed the note. But do you really know how much you'll have to cough up when it's time to refi or or pay off early? With rates where they are right now, you either run the numbers beforehand, or get hit with a nasty surprise.

Here in mid- to late-2012 market interest rates are at historically rather low levels. Exactly the kind of scenario that spurs a popular wave of refinancings. But that very same low yield curve operates to blow up the magnitude of a typical prepayment premium to an amount you might not have anticipated. Most current prepayment premiums are written using a present-value calculation methodology, which roughly speaking sets the payoff premium at an amount that reflects the excess of the note's present value, using some specified rate benchmark or index, over the note's outstanding face amount.

Since any fixed-rate note's present value has an inverse relationship to the discount rate used in the calculation, it's immediately apparent that as market yields move lower the prepayment premium amount can quickly fill out like a python in a henhouse. The actual sensitivity of the premium to yield curve movements depends, of course, on attributes unique to the promissory note in question, such as its duration and time to maturity. The bottom line: re-visit your note's documentation well in advance of any refinancing or early payoff, and crunch those numbers carefully to understand precisely what that prepayment will cost.
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Sale-Leaseback, Wherefore Art Thou?
It may be market conditions of late, or more likely that I'm just running in the wrong circles again, but it's a bit disconcerting the lack of noise I've heard lately from the sale-leaseback space. These structures have nice conceptual appeal at the fundamental level, and deserve a place in the toolbox of value-enhancing strategies. Many companies have uncovered hidden value by divesting non-core assets, and a sale-leaseback is one way to do exactly that.

While the mathematics can be a bit complex in properly vetting a S-L proposal, no calculator is required to grasp the intuitive economic attraction. Real property assets and facilities might be a necessary ingredient in your business model, but it's a safe bet that real assets are a low-risk, low-return asset class, when compared to your core activity. You're not in the business of owning and managing a portfolio of real assets, you are a factory, or a restaurant, or a freight hauler. Your expertise is in the superior management of such higher-volatility, higher-return assets.

There are other parties, though, who do specialize in the ownership and management of real property income portfolios. They can do so in a cost-efficient manner, and can exploit certain economies of scale. They have access to the kind of low-cost funding which is targeted to such low-risk, large-scale real portfolios. So how does a sale-leaseback tie these advantages together?

In effect, you are swapping the real asset for cash, which can then be re-deployed into your core business for a higher return, more growth, and a stronger balance sheet. You reap a piece of the economic value created by re-locating the real asset into the purchaser-lessor's hands.

Couple of caveats, of course: For one, don't plunge headfirst into a S-L deal before doing the hard-headed number-crunching with a sharp pencil, as the terms pitched to you can vary significantly. For another, give careful consideration to how the deal will affect your balance sheet ratios, under your particular accounting and reporting system, and make sure you clear any problematic loan covenants beforehand.
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Glentyde Capital Advisors
P O Box 79091
Charlotte, NC 28271-7048
704-614-9555

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