I read the old version of a great book from 2001.
If you prefer to read the pdf version click here. (links may not work in pdf)
It was a great book, well structured. Personally, I liked the first part the most.
(as in my previous book review I focus more on my learnings/insights/personal summary vs writing style etc.)
The case for expectations investing
Assets have to produce distributable Cashflows for owners, otherwise it is collecting art, not investing.
Since the price of financial assets is readily available (as an input) starting from there to derive implied expectations is a good start. Ie, building a reversed DCF model. The approach is outlined below. (look here, here and here for examples)
- Read expectations via reverse dcf
- Identify expectations opportunities, or where and when expectations revisions might take place
- Prospective buys need offer a margin of Safety and trade sufficiently below expected value
The P/E multiple is useless as a valuation measure.
Part 1: gathering the tools
Some corporate valuation basics serve as a good reminder that assets’ value is derived, ultimately, from cashflows. The easiest way to imagine this is buying a stock, never sell it, then what you buy today is a (long-term-tax) stream of dividends — not more, not less. Dividends will depend on (distributable) Cashflows and managements ability and willingness to create value (think Japanese cash hoards for big gaps between dividends and Cashflows).
For the terminal value they recommend (i) a starting point after returns on capital do not exceed cost of capital anymore and (ii) using a growing annuity for companies that can keep up with inflation.
We will earn superior returns if we anticipate revisions to the price-implied expectations. The focus should be for potential upside vs expectations. Not all expectation revisions are equal: The highest returns potential results from revisions in sales growth if the company earns returns on (incremental) capital invested far exceeding its costs of capital.
If operating margin expectations are well above the threshold margin, positive revisions in sales growth produce large increases in shareholder value. The threshold margin equals the breakeven margin a company needs to earn to maintain its value.
The distinguish between operating leverage (from spreading pre-production costs CapEx Depreciation for increasing capacity or needed upfront R&D), economies of scale result from greater efficiency with growing volumes (ie advertising, or buying cheaper in bulk from suppliers), and cost efficiencies which are unrelated to volumes (ie reconfiguring or restructuring).
Historical analyis and studying time series of data points can provide clues, ie which value drivers were most variable. Competitive strategy frameworks (table).
Michael Porter’s five forces is a useful way for analyzing industries and the attractiveness for investments.
- Threat of new entrants
- Threat if substitutes
- Rivalry among existing firms
- Bargaining power of suppliers
- Bargaining power of buyers
Game Theory is mentioned as a useful tool to think about potential competitors’ moves, as CEOs (and probably investors) think too seldomly about competitors’ reactions: ie if a chemical company increases its capacity to capture additional profits in strong markets with the risk of higher losses in down markets – what will rivals do? (a great lesson is told by The Bakken dilemma)
Michael porter also introduced modern value chain analysis:
- Customer priorities (can change)
- Channels (internet is a big disruption)
- Inputs, raw materials (supplier management becomes more important)
- Assets, core competencies (ie Nike: marketing instead of factories)
Disruptive technology or innovation is more dangerous for certain firms
- Tech rich: struggling to catch the next tech wave
- Market leaders: listen to customers and focus on current profits, often miss change
- Organizationally centralized: centralized decisions lead to missing change
Information rules: information economics can result in high upfront and low incremental costs, network effects, lock-in, often achieved by giveaways (to acquire early users), link-and-leverage (introduce new products /features or real options), and adaptation (being alert for the next big thing).
Part 2: implementing the process
Identifying expectations opportunities should almost always focus on sales growth rates. A turbo trigger is found if likely changes in margin or investment efficiency result in value changes as big as a reasonable positive/negative sales growth scenario.
Real options should be used to enrich DCF models. Common DCFs should account for usual growth of operations in place, and any large additional ‘strategic’ growth opportunities might best be accounted for by using real options analysis.
Business categories / across the economic landscape: physical, service, knowledge. Knowledge companies are free of many limitations that hinder excessive profitable growth for physical or service companies.
Part 3: Reading corporate signals
M&A, share buybacks, and incentive compensation should be viewed more critically. Employee stock options are mostly not as good as they appear for aligning interests with shareholders. The same goes for general incentive structures.