The Four-Year U.S. Presidential Cycle and the Stock Market

PLEASE CLICK HERE TO ACCESS THIS ARTICLE

2014 Volume 17 Issue 2

2014 Volume 17 Issue 1

2013 Volume 16 Issue 3

2013 Volume 16 Issue 2

2013 Volume 16 Issue 1

2012 Volume 15 Issue 3

2012 Volume 15 Issue 2

2012 Volume 15 Issue 1

2011 Volume 14 Issue 4

2011 Volume 14 Issue 3

2011 Volume 14 Issue 2

2011 Volume 14 Issue 1

2010 Volume 13 Issue 4

2010 Volume 13 Issue 3

2010 Volume 13 Issue 2

2010 Volume 13 Issue 1

2009 Volume 12 Issue 4

2009 Volume 12 Issue 3

2009 Volume 12 Issue 2

2009 Volume 12 Issue 1

2008 Volume 11 Issue 4

2008 Volume 11 Issue 3

2008 Volume 11 Issue 2

2008 Volume 11 Issue 1

2007 Volume 10 Issue 4

2007 Volume 10 Issue 3

2007 Volume 10 Issue 2

2007 Volume 10 Issue 1

2006 Volume 9 Issue 4

2006 Volume 9 Issue 3

2006 Volume 9 Issue 2

2006 Volume 9 Issue 1

2005 Volume 8 Issue 4

2005 Volume 8 Issue 3

2005 Volume 8 Issue 2

2005 Volume 8 Issue 1

2004 Volume 7 Issue 3

2004 Volume 7 Issue 2

2004 Volume 7 Issue 1

2003 Volume 6 Issue 4

2003 Volume 6 Issue 3

2003 Volume 6 Issue 2

2003 Volume 6 Issue 1

2002 Volume 5 Issue 4

2002 Volume 5 Issue 3

2002 Volume 5 Issue 2

2002 Volume 5 Issue 1

2001 Volume 4 Issue 4

2001 Volume 4 Issue 3

2001 Volume 4 Issue 2

2001 Volume 4 Issue 1

2000 Volume 3 Issue 4

2000 Volume 3 Issue 3

2000 Volume 3 Issue 2

2000 Volume 3 Issue 1

1999 Volume 2 Issue 4

1999 Volume 2 Issue 3

1999 Volume 2 Issue 2

1999 Volume 2 Issue 1

1998 Volume 1 Issue 3

1998 Volume 1 Issue 2

1998 Volume 1 Issue 1

The Four-Year U.S. Presidential Cycle and the Stock Market

This article revisits the 2004 article, “Presidential Elections and Stock Market Cycles,” written by Marshall Nickles. That article found that all of the major stock market declines occurred during the first or second years of the four-year U.S. presidential cycle. No major declines occurred during the third or fourth years. More specifically, from 1950 to 2004 (using the Standard and Poor’s 500 Index), the most favorable period (MFP) for investing was from October 1 of the second year of a presidential term to December 31 of the fourth year. The remaining period—from January 1 of the first year of the presidential term to September 30 of the second year—was the least favorable period (LFP) for stock market investors. It appeared that politicians were anxious to exercise policies that were designed to pump up the economy just prior to a presidential election, which in turn had a positive affect on stock prices.[1]

Since 2004, the stock market environment has changed in ways that make it more important than ever to understand the relationship between politics and stock market behavior. Unlike the 2004 article that did not address the above in detail, this article will attempt to do so. More directly, we will focus on two broad issues. First, we provide evidence of the relationship between economics, politics, and the four-year presidential cycle; and second, we include an analysis of stock market performance during the 2008 period. In addition, we introduce a risk measurement for the stock market and argue that the 2008 stock market crash should be considered an anomaly. Finally, we conclude that the four year presidential stock market cycle is likely still in tack.

This article does not attempt to support or refute the Efficient Market Hypothesis, which states that it is not possible to “beat the market.” The academic supporters of this hypothesis believe that stocks always trade at a fair market value; therefore, it is unlikely to outperform the general market unless one assumes more risk. Rather, this article provides evidence that risk may be reduced and returns may increase when an investor considers how economic policy influences stock market prices during the presidential election cycle.

Relationship Between Politics and Economics

The 20th amendment to the U.S. constitution requires a presidential election to take place every four years, which turns out to be all years that are divisible by four (e.g. 2004, 2008, and 2012). The president assumes office the following January after the election. Once presidents take office, they realize that to get reelected they must try to make the economy as healthy as possible four years later. It is this consistency in the U.S. political process that also sets into motion fiscal policies that are frequently predictable and that often have a direct effect on the stock market. In the discipline of economics, fiscal policy is defined as an increase or decrease of taxes and or government spending. The direction that fiscal policy takes can often be directly related to the state of the economy at the time a new president is elected.

It is not surprising to see incumbent presidents push for votes by proposing tax reductions and or increasing spending on specific government programs as an election draws near. In addition, an incumbent political party may also try to persuade the Federal Reserve to complement the administration’s efforts through monetary policy, by increasing the money supply and reducing interest rates. Such fiscal and monetary policies may be introduced as early as the end of the second year of the presidential four-year term. If the results are favorable and the economy responds positively, corporate profits usually rise, and with them, stock prices—just in time for the next presidential election.

These policies can also lead to inflation, which can be disconcerting to investors. If this were to happen, a newly elected president could be pressured to reverse the fiscal and monetary stimulus policies of his or her predecessor, attempt to get inflation under control, and then hope to return to stimulus policies by midterm in preparation for the next election.

On the surface, the concept of inflation appears to be straightforward. That is to say, inflation is understood to mean rising prices. However, the real questions an investor should ask are what caused it, why can it ultimately be a negative for the stock market, and what can be done to reduce it. First, if inflation is the result of excessive fiscal and/or monetary stimulus—known as demand-pull inflation—simply reversing the stimulus policies can help to lower inflation. If, however, rising prices are caused by external factors like rapidly increasing global oil prices—known as cost-push inflation—it can be much harder to control. Since the mid-1980s, the U.S. economy has not seen much cost-push inflation.

When the Federal Reserve increases or decreases interest rates, it is often to combat inflation, to position the U.S. dollar for favorable international trade, or to address a weakening economy. The consequences of rising interest rates are increased costs for businesses and consumers, which in turn can slow aggregate spending and corporate profits, and ultimately depress stock prices.

The above sequence of events appears to be logical and may be taken for granted by many investors, but what they may fail to understand is that the sequence does not always work in lock step. In other words, the effects of rising interest rates often lag in its efficacy and may not have an immediate negative influence on the economy. This lagged relationship between rising interest rates, falling corporate profits, and ultimately declining stock prices can confuse unaware investors. This is because corporate profits can, for a period, continue to increase faster than the negative effects of rising rates. Simply put, over time rising interest rates can put downside pressure on stock prices. However, in the early stages it may not be entirely obvious what is happening to all but the most sophisticated investors, who can bid down stock prices in concert with the anticipation of falling corporate profits.

The inverse is also true: any effort to curb recessions with lower interest rates can have a lagged effect depending on the state of the economy and the magnitude of the decrease in interest rates. The lag effects on the economy can be as late as 6 to 18 months later, although it is often sooner for the stock market.[2]

Risk and the Presidential Cycle

If indeed policy makers are successful in exerting positive influences on the economy as elections approach, it should be logical to expect less volatility in the stock market. This led us to measure the relative changing levels of volatility (i.e. risk) between the first and second halves of presidential cycles. In addition, risk becomes greater the longer an investor is committed to the stock market. Therefore risk reduction may also be accomplished if one were invested for only approximately the second half of the U.S. four-year presidential cycle or about 50 percent of the time.

To verify our claim, we measured risk within presidential cycles since the 1950s. For the purpose of this study, risk is defined as market exposure to time and volatility. The Ulcer Index (UI), which was developed by Peter Martin and Byron McCann, measures such risk.[3] The UI measures the depth and duration of Draw-Downs (DD) from recent stock market peaks.[4] A Drawn-Down measures the peak-to-trough decline during a specific period for the stock market and is usually quoted as a percentage between the peak and the trough.[5] The lower the UI value the lower is the risk.

Figure 1 compares the average Ulcer Index for the first and second years of presidential cycles to that of the third and fourth years since 1950. The Ulcer Index in most presidential periods was higher in the first and second years, with just a couple of significant exceptions (1985 to 1988 and the most notable 2005 to 2008). In general however, the investment risk was higher in the first two years of the presidential cycle, consistent with underperformance of the stock market during that period.

Figure 1. Historical Ulcer Index Average during Presidential Periods

Historical Ulcer Index Average during Presidential Periods

Note: This figure shows the average Ulcer Index for the first two years of each presidential period, compared to the average for the third and fourth years.


Favorable and Unfavorable Periods

With the above in mind, one should see higher performance for the stock market in the form of favorable and unfavorable periods within stock market cycles. To analyze the historical performance of stock price behavior, we opted to use the Dow Jones Industrial Average (DJIA) instead of the commonly used Standard & Poor’s 500 Index (with a ticker symbol of SPX). The specific reasons for selecting the DJIA were as follows: First, it is recognized as a leading measure of the general market, is well published and quoted, and has been around the longest among all the general stock market measures. Second, the DJIA appears to be less risky than other popular stock market indexes like the SPX. During the period 1950 through 2011, the UI for the DJIA was 13.5 while it was 15.2 for the SPX. Third, since the S&P 500 was used in the 2004 article, the authors wanted to use another measure to validate earlier research.

We believe that an expanding level of liquidity (i.e. money) in the economy, combined with a downward trend in interest rates, are major drivers of stock market performance within the four-year presidential cycle. However, the relationship appears to be a lagging one as discussed earlier. Figure 2 shows yearly DJIA growth and lagged interest rates since the 1950s. By lagging interest rates one year, the correlation to stock price behavior becomes more obvious.

The graph shows that within the presidential cycle interest rates tend to go down in advance of the next election. We confirmed this by performing a time-series analysis which shows that, on average, interest rates in the third and fourth year of the presidential period are 0.55 percentage points lower than in the first and second years. (See Appendix 1). Figure 2 also shows that most breaks in the interest-rate reduction cycle occur soon after elections. This is consistent with the notion that right after the elections there can be pressure to raise interest rates to curb any potential inflation. There were a couple of exceptions (1977 to 1980 and 1993 to 1997), but the trend is there. In summary, we provide core evidence of the relationship between changing interest rates and the four year cycle performance.

Figure 2. Dow Jones Industrial Average Growth and Interest Rates across Presidential Periods

Dow Jones Industrial Average Growth and Interest Rates across Presidential Periods

Note: Interest rates are depicted with a one-year lag to illustrate the lagged effect of a given rate on the market.


Figure 2 also depicts the DJIA growth cycle since 1950. Note that in most presidential periods, the valleys in DJIA performance occur in the first and second years of the election periods. There were a few significant exceptions in which performance was higher in the first two years than in the last two (e.g. 1985 to 1988, 1997 to 2000, and 2005 to 2008). Nevertheless, the above facts substantiate the claim in the first article on this topic.[6] More specifically, the stock market typically underperforms in the first and second years of the presidential period, relative to the third and fourth years. To further verify our finding, we performed a time series econometric analysis, which confirms that DJIA growth is on average 7.2 percentage points higher in the third and fourth years of the presidential periods than in the first two years. (See Appendix 2.)

In summary, all of the previous evidence appears to be consistent with our claims: Policies to stimulate the economy as presidential elections approach strongly contribute to the performance of the four-year cycle. Further, there is now sufficient data that the most favorable periods (MFPs) can be validated using two stock market indicators, the SPX and the DJIA. This analysis was also corroborated by showing how the Ulcer Index (i.e. risk) was reflected in the cycles. Finally, Figure 2 shows how the four-year presidential cycle is affected by downward pressure on interest rates.

The 2008 Anomaly

Based on the earlier analysis, it would make sense to invest in the DJIA at the beginning of the favorable period and steer clear of the market during the unfavorable period. This would have been the strategy of choice from 1950 to 2004. However, the negative economic events surrounding the last 2008 presidential election temporarily broke that long-standing trend.

The period from late 2007 through early 2009 was the worst economic crisis the U.S. had seen since the depression of the 1930’s. Like the Great Depression, the 2008 economic environment was an attack on America’s financial structure. There appeared to be at least two core issues that precipitated the most recent economic and stock market upheaval. First, the stock market needs liquidity (i.e. money) steadily flowing through the economy to be profitable. That did not happen in 2008 when several major U.S. banks had to write off large amounts of defaulting mortgage loans. This temporarily dried up liquidity and required immediate Federal Reserve action. Second, the near collapse of the U.S. capital markets spread contagion worldwide. This in turn dramatically slowed economic activity globally, which ultimately put significant downside pressure on U.S. and foreign corporate earnings and both the stock and bond markets.

Because the severity of the 2008 crisis had not been seen during the 1950 to 2004 period, it must be considered an economic and stock market anomaly. Therefore, we do not believe that 2008 is representative of a long-term interruption in the past behavior of the four year presidential cycle. We do believe however, that in an environment with more globally connected financial markets where information flows electronically at a much faster speed, a phenomena that can temporarily break the historically consistent cycle that had existed for 54 years, has been augmented.

Putting the Most Favorable Period to the Test

Because the 2005 to 2008 period is an exception, considering the favorable period of the four-year presidential cycle as an investment strategy should still make sense. Figure 3 shows the current value of a 1953 initial investment of $1,000 based on three investment strategies. Investing in the DJIA during the MFPs and at commercial paper rates during the LFPs yielded a 20,468 percent return. Investing in the DJIA during the LFPs and at commercial paper rates during the MFPs yielded a 519.8 percent return. Investing in the DJIA as a long-term buy-and-hold strategy yielded a 4,408.6 percent return. Notice that the 2005 to 2008 period affected all investment strategies negatively. However, for the MFP investor, the losses from that period were almost completely offset by the gains since the 2009 stock market bottom.

Figure 3: Returns Based on Three Investment Strategies

Returns Based on Three Investment Strategies

Notes. Returns reported include dividends. Investment strategies are:
1. Most Favorable Period Investor: Invests in DJIA during the MFPs and at commercial paper rates during the LFPs.
2. Least Favorable Period Investor: Invests in DJIA during the LFPs and at commercial paper rates during the MFPs.
3. Long-Term DJIA Investor: Invested $1,000 in DJIA in 1953 and has not sold to-date.


Conclusion

The evidence provided in this article shows a propensity for the DJIA to rise during the second half of the four-year presidential cycle. We have discussed why we believe this pattern has been repetitive since 1950. Borrowing from the 2004 study, we adopted the most favorable period within the four year cycle. It begins on October 1 of the second year of the presidential term through December 31 of the fourth year, the favorable period or (MFP). This period performed much better than the unfavorable period, from January 1 in the first year of the presidential term through September 30 of the second year.

However, cycles of any type are not perfectly aligned all the time. This became evident when we attempted to match changes in interest rates and market volatility within the four year cycle. Occasionally this type of market behavior is to be expected and can usually be explained. A recent example is the economic problem in Europe. The point is that there are positive and negative macroeconomic events that can temporarily break a long standing MFP cycle. Even with a history of positive gains in the MFPs from 1950 to 2004, the 2008 market collapse, precipitated by domestic and global economic events, was too powerful for the market to overcome. Although the above was clearly an anomaly, we do not believe it will be the only exception in the future. Globalization and the internet are but two reasons for volatility and uncertainty in the years to come. However, even with the temporary break during the 2008 period, it does not mean that the favorable cycle will not resume. In fact we believe it already has. When we compared the favorable to the unfavorable period for the post 2008 time frame, the DJIA has again performed to date better during the favorable period. In conclusion, we feel that with the advent of merging international markets and modern technology, the more the average investor knows about the interrelationship between politics, economics, and the stock market, the more equipped he or she will be.


Appendix 1

We performed a Prais-Winsten time series analysis of a yearly dataset to account for autocorrelation:

Interest = β1*PresYear + β2 * Inflation + ε, where Interest is the average Federal Funds rate per year; PresYearDummy is a dummy variable with a value of 1 for the third and fourth years of each presidential period, and 0 otherwise; and Inflation is the yearly inflation rate.

The results are:


Appendix 2

We performed a Prais-Winsten time series analysis of a yearly dataset to account for autocorrelation:

ln(DJIA) = β1*PresYear + β2 * GDP + ε, where DJIA is the Dow Jones Industrial Average; PresYear is a dummy variable with a value of 1 for the third and fourth years of each presidential period, and 0 otherwise; and GDP is the real GDP per capita per year.

The results are:





[1] Nickles, Marshall. “Presidential Elections and Stock Market Cycles: Can you profit from the relationship?” Graziadio Business Review, 7 no. 3 (2004). Retrieved from 7(3) http://gbr.pepperdine.edu/2010/08/presidential-elections-and-stock-market-cycles.

[2] McConnell, Campbell, Stanley Brue, and Sean Flynn. Economics, 18th Ed. New York: McGraw-Hill Irwin, (2009), pp. 671 – 679. Also see: Thorbecke, W. “On stock market returns and monetary policy.” Journal of Finance, 52, (1997) 635 – 654. Doi: 10.1111%2Fj. 1540-6261.1997.tb04816.x.

[3] Martin, P.G. and McCain, B.B. “Financial Dictionary,” (2009). Retrieved August 17, 2012 from www.investors.com/Financialdictionary/term/ulcer_index_ui.asp.

[4] Anonymous. “FinancialDictionary,” (2012). Retrieved August 15, 2012, from www.investors.com/FinancialDictionary/Term/Drawdown.asp.

[5] Ibid.

[6] Nickles, “Presidential.”

2014 Volume 17 Issue 2

2014 Volume 17 Issue 1

2013 Volume 16 Issue 3

2013 Volume 16 Issue 2

2013 Volume 16 Issue 1

2012 Volume 15 Issue 3

2012 Volume 15 Issue 2

2012 Volume 15 Issue 1

2011 Volume 14 Issue 4

2011 Volume 14 Issue 3

2011 Volume 14 Issue 2

2011 Volume 14 Issue 1

2010 Volume 13 Issue 4

2010 Volume 13 Issue 3

2010 Volume 13 Issue 2

2010 Volume 13 Issue 1

2009 Volume 12 Issue 4

2009 Volume 12 Issue 3

2009 Volume 12 Issue 2

2009 Volume 12 Issue 1

2008 Volume 11 Issue 4

2008 Volume 11 Issue 3

2008 Volume 11 Issue 2

2008 Volume 11 Issue 1

2007 Volume 10 Issue 4

2007 Volume 10 Issue 3

2007 Volume 10 Issue 2

2007 Volume 10 Issue 1

2006 Volume 9 Issue 4

2006 Volume 9 Issue 3

2006 Volume 9 Issue 2

2006 Volume 9 Issue 1

2005 Volume 8 Issue 4

2005 Volume 8 Issue 3

2005 Volume 8 Issue 2

2005 Volume 8 Issue 1

2004 Volume 7 Issue 3

2004 Volume 7 Issue 2

2004 Volume 7 Issue 1

2003 Volume 6 Issue 4

2003 Volume 6 Issue 3

2003 Volume 6 Issue 2

2003 Volume 6 Issue 1

2002 Volume 5 Issue 4

2002 Volume 5 Issue 3

2002 Volume 5 Issue 2

2002 Volume 5 Issue 1

2001 Volume 4 Issue 4

2001 Volume 4 Issue 3

2001 Volume 4 Issue 2

2001 Volume 4 Issue 1

2000 Volume 3 Issue 4

2000 Volume 3 Issue 3

2000 Volume 3 Issue 2

2000 Volume 3 Issue 1

1999 Volume 2 Issue 4

1999 Volume 2 Issue 3

1999 Volume 2 Issue 2

1999 Volume 2 Issue 1

1998 Volume 1 Issue 3

1998 Volume 1 Issue 2

1998 Volume 1 Issue 1

Financial Swiss Army Knife: A User-Friendly Tool for Facilitating Financial Analysis and Due Diligence

This valuable tool can serve as both a translator of complex financial information and an indicator of opportunities for enhancing financial performance. Click here to download the Financial Swiss Army Knife.

[powerpress: http://gsbm-med.pepperdine.edu/gbr/audio/fall2011/JohnScully_article.mp3]

financial swiss army knifeBefore you make a decision, you want to be sure to do your homework. Investing in a company is certainly no exception. Individuals evaluating whether to invest in an existing business routinely seek to understand the business’ ability to generate free cash flow (i.e., the ability to generate cash from operations for potential distribution to investors) and to identify opportunities for improving the business’ return on equity (ROE). Of course, this is often easier said than done. Calculating free cash flow can be a time-consuming task. Similarly, demonstrating and documenting how to improve ROE can be challenging, especially when proposed ROE improvements involve scenarios more complicated than just increasing profitability through expense reduction. For example, individuals with limited understanding of ROE may not readily appreciate how, under certain circumstances, it is possible for profitability to deteriorate and yet overall ROE to improve, such as when working capital reductions and increased distributions to common stockholders combine to offset the lower profits.

In order to facilitate financial analysis and due diligence on an existing business (including calculating free cash flow and documenting ROE improvement scenarios), this paper presents a tool that enables individuals even with limited financial background to perform a detailed financial analysis and to present the results in a clear and straightforward manner.

Swiss Army Knife[1] for Financial Analysis


















Click on image to download file

















The tool, which can be downloaded by clicking here, is an Excel spreadsheet that includes six interconnected worksheets in individual tabs. Products of this tool include:


Worksheets

A: Three-year horizontal and vertical income statement analysis

B: Three-year horizontal and vertical balance sheet analysis

C: Automatic calculation of three years of financial ratios [2]

D: Clear presentation of a free cash flow analysis

E: Three-part DuPont extended return on equity (ROE) calculation for three years[3]

F: Worksheet for generating “what-if” analyses to highlight and measure opportunities for improving ROE and return on assets (ROA)[4]

Worksheets A, B, C, and E are standard tools for gauging which aspects of an entity’s financial performance are improving or deteriorating across recent accounting periods.  Worksheet D provides insights into an entity’s ability to generate funds from operations and potentially distribute cash to investors, even if that entity is not generating profits. Worksheet F facilitates what-if analysis for improving ROE and, while the worksheets generally reflect a corporate structure, sheet F’s what-if analysis can be performed on any type of business entity (sole proprietorship, partnership, etc.) by inserting into worksheet B total common equity figures rather than inputting values for individual common equity line items.

This discussion assumes readers are familiar with the basic functions of A, B, C, and E and accordingly concentrates on benefits provided by D and F.

Methodology: How it Works

For investors, the ability to generate cash from operations may serve as the ultimate barometer of an investment’s financial success or failure. Nevertheless, preparing a free cash flow analysis can be daunting because:

  • Typically published financial statements do not conveniently isolate the two key components of a free cash flow analysis, namely net operating profit after tax (NOPAT) and changes in net operating capital (NOC).
  • Published financial statements often buried within footnotes required capital expenditure, disposal, and depreciation information.
  • The impact of working capital on cash flow may be confusing to users with limited financial expertise. For example, such users may not readily recognize the adverse cash impact of growing current assets, such as receivables, and the favorable impact of increasing non-interest bearing liabilities such as accounts payable.

Worksheet D’s free cash flow presentation addresses all these concerns by:

  • Providing a clear trail for tracing NOPAT and NOC calculations back to underlying income statement and balance sheet components.
  • Utilizing information on changes in net fixed assets, eliminating the need to research footnote information.
  • Highlighting how specific working capital components impact fee cash flow.

Assuming worksheets A, B, C, and E expose areas of financial deterioration (or phrased more positively, opportunities for improvement), worksheet F can clearly quantify whether proposed remedial actions can improve ROE even if those actions adversely impact the organization’s profit dollars and profit margins. For example, suppose an entity’s days sales outstanding (DSO) has increased, impairing the organization’s total asset turnover (TAT) and causing investors to keep more equity in the organization than may otherwise be required. As a result, the organization may consider hiring additional collections-related personnel. Although this approach may increase salary expense and reduce profitability, the key issue is whether or not improved collections can sufficiently reduce receivables to allow for increased distributions to owners with the overall result being reduced assets, lower common equity, and improved ROE.

In addition, worksheet F offers a working area for easily running and documenting “what-if” scenarios for improving ROE and ROA. Clear documentation is especially important for those scenarios that may seem counter-intuitive at first, for example, the scenario described above where ROE improves despite increased expenses and lowered profitability.

Exhibit A: Starbucks

Starbucks Corporation’s financial information is employed here to illustrate how the tool works.[5] [6] Starbuck’s income statement and balance sheet data have been posted into worksheets A and B. The tool then automatically completes sheets C, D, E, and F (except for the “what-if” user input area of F).

The worksheets follow three conventions. First, Year 0 refers to the most recent year for which financial information is available, Year -1 refers to the prior year and Year -2 to the year before that. Second, in order for the sheets to calculate information correctly, Year 0 data must be posted in column M of worksheets A and B. Year-1 data must be posted to column H of these worksheets and Year-2 data to column F. And third, interest figures used on worksheets C and D represent the net of interest expense and interest income from worksheet A.

Note: The tool contains two versions of worksheet F. In the first version of worksheet F, the “what-if” (columns G, H, and I) area is left blank in order to allow users to practice running their own scenarios. In the second version (which includes the word “completed” in the sheet’s label) the “what-if” area has been completed to reflect the proposals outlined below.

We will start by examining how worksheet D identifies key components of Starbucks’ ability to generate free cash flow. The income tax rate employed here is assumed to be 35.3 percent, which is based on the actual average for the past three years as reflected on worksheet A. Individual circumstances may require other approaches for estimating the tax rate used on worksheet D.

In 2008, Starbucks produced $335.1 million in NOPAT (see cell H14) and increased its investment in net operating capital (cell H32) by $190.9 million from $2,985.0 million in 2007 to $3,175.9 in 2008. As result, Starbucks’ 2008 free cash flow (namely, the organization’s 2008 NOPAT minus the NOC change from 2007 to 2008) was $144.2 million (cell H34).

In 2009, Starbucks’ NOPAT was $373.7 million (cell L14), revealing growth of $38.6 million over 2008. However, in 2009, Starbucks’ free cash flow was $624.5 million (cell L34), accounting for growth of $480.3 million over 2008’s $144.2 million. How did Starbucks achieve such impressive 2009 free cash flow? Although 2009’s $373.7 million NOPAT was a major factor, the other major component was the $250.8 million decline in NOC to $2,925.1 million from $3,175.9 million in 2008. Closer inspection of NOC components reveals how, between 2008 and 2009, net operating working capital increased by $169.2 million (cell N24), but net PP&E declined by $420 million (cell N26).

Although all of worksheet D’s free cash flow information derives from the income statement (worksheet A) and the balance sheet (worksheet B), worksheets A and B alone do not identify the amount of free cash flow generated by an organization nor do they highlight the key factors impacting that free cash flow, for example, the key role played by Starbucks’ 2009 NOC reduction.

To summarize, benefits of worksheet D include automatic calculation of free cash flow and identification of specific components impacting that free cash flow, while avoiding the need to research footnote information for depreciation, disposal, and capital expenditure information.

Interpreting the Results

Social Media - sales are up!Next let’s see how the DuPont pro forma worksheet F can help quantify and document opportunities for improving ROE. Notice the DuPont extended worksheet (worksheet E) shows that, although PM improved from 3.04 percent in 2008 to 4.00 percent in 2009, 2009 PM still lagged considerably below 2007’s 7.15 percent. In addition, 2009’s 1.75 TAT was considerably below 2008’s 3.26 TAT. Can this information, along with information from worksheets A, B, and C, help to identify some opportunities for improving ROE?

For example, starting with PM, observe that in 2008 general and administrative expense (G&A) represented 4.4 percent of revenue (worksheet A, cell H37), whereas in 2009, G&A represented 4.6 percent revenue (cell M37). If Starbucks could have maintained a G&A target of 4.4 percent of revenue, then the company’s 2009 G&A would have been $9,774.6 million revenue * 4.4 percent, or $430.1 million, which is $22.9 million less than the actual 2009 figure. This cost reduction is posted in the P&L section of the Completed F Worksheet (cell G11). Given pretax income increases by $22.9 million as a result of this cost reduction, the income taxes should increase by $8.1 million (assuming a 35.3 percent rate, which is the average tax rate for past three years based on information from worksheet A). Posting this $8.1 million income tax increase into cell G16 results in 2008 net income increasing by $14.8 million. The worksheet automatically adjusts the equity section of the balance sheet for these increased net earnings, but in order to keep it in balance, we assume here that cash would have also increased due to the $14.8 million net of tax cost savings.

Are reasonable opportunities also available for balance sheet improvement? The income statement shows that between 2008 and 2009, total revenue declined by 5.9 percent (worksheet A, cell P14), but inventory declined by only 4.0 percent (worksheet B, cell P14). Notice also on sheet C that the inventory turnover ratio declined from 14.99 turns in 2008 to 14.70 turns in 2009. If Starbucks was able to maintain the 2008 inventory turnover ratio through 2009, then 2009 inventory would have equaled $9,774.6 total revenue divided by 14.99 turns, or $652.1 million, which is $12.8 million lower than the actual $664.9 million ending inventory. To be conservative, let’s assume that the organization would have needed to incur $4 million in higher expenses to sustain this higher inventory turnover ratio. If so, income taxes would decrease by $1.4 million (based on 35.3 percent average tax rate * $4 million) and net income would be $2.6 million lower (based on $4.0 million higher expenses offset partially by $1.4 million lower income taxes).

To reflect this information on the completed version of worksheet F, column H shows:

-$12.8 million for lower inventory (cell H26)

+$4.0 million increased expenses (cell H11)

-$1.4 million for lower income taxes (cell H16)

Assuming cash serves as the offset for all these items, then cash would change by -$2.6 million for lower net income and by +$12.8 million for lower inventory, a net of +$10.2 million.

The company would now have a total of $25 million additional cash (which is $14.8 million from G&A savings plus $10.2 million net from the inventory reduction effort). So assuming the company had actually implemented these proposed changes, the organization could presumably have returned this incremental cash to shareholders. To reflect this distribution, -$25 million is posted into cell I24.[7]

Cells B47 through G62 summarize the ROE impact of these pro forma changes. ROE increases by .46 percent to 13.29 percent from 12.83 percent. The improvement is achieved via a .12 percent increase in PM and a slight improvement in TAT from approximately 1.75 to 1.76.

Conclusion

In summary, this example based on Starbucks’  2007 through 2009 financial statement information demonstrates how users can easily employ the attached tool to:

  • Generate automatically a free cash flow analysis from underlying income statement and balance sheet information (worksheet D).
  • Quantify how specific “what-if” scenarios can impact an entity’s ROE (worksheet F) and document clearly how these scenarios impact the income statement, balance sheet, and ROE components.
  • Present results that can be readily understood by audiences with a range of financial expertise.

Anyone considering an investment in an existing business can generate a similar analysis by posting the business’ past three years of income statements and balance sheet information and allowing the tool to populate related sections throughout worksheets A through F. With this background analysis complete, an individual can then use worksheet F to propose, measure, and document detailed scenarios for improving the business’ ROE. Thus, this valuable tool can serve as both a translator of complex financial information and an indicator of opportunities for enhancing financial performance.


[1] Swiss Army Knife is a registered trademark of Victorinox AG and its affiliates, which have no relationship to the subject matter of this article.

[2] Definitions of financial ratios and free cash flow can vary slightly depending on the source. For example, some sources use average balances in the denominator when calculating turnover ratios, whereas other sources use ending balances. For two reasons the formulas employed here are based on information from Eugene F, Brigham and Michael C. Ehrhardt, Financial Management: Theory and Practice, 13 ed., Mason, Ohio: South-Western Cengage Learning, 2009, chapters 2 and 3. First, Pepperdine University Executive Programs finance classes regularly use this text and second, all data needed to complete these formulas can be found on the income statement and balance sheet, eliminating the need to research footnotes.

[3] The three-factor DuPont extended formula dissects the basic ROE formula into the underlying components of profit margin (PM), total asset turnover (TAT), and equity multiplier (EM):

ROE     =          Net income – preferred dividends/Common equity

ROE     =          PM * TAT * EM

Where

PM       =          (Net income – preferred dividends) / total sales

TAT      =          Total sales / total assets

EM       =          Total assets / common equity

[4] Although ROA is not a specific component of a typical three-part DuPont extended analysis, ROA can provide useful information when ROE is meaningless due to an entity’s negative common equity.

[5] Starbucks Corporation. (2008). 10-K Annual Report 2008. Retrieved Nov. 30, 2011 from SEC EDGAR website http://www.sec.gov/edgar.shtml.

[6] Starbucks Corporation. (2009). 10-K Annual Report 2009. Retrieved Nov. 30, 2011 from SEC EDGAR website http://www.sec.gov/edgar.shtml.

[7] Column I is reserved for distributions to shareholders, with distributions reflected as a reduction to cash in cell M24. The spreadsheet automatically generates an offsetting reduction to common equity in cell M40.

2014 Volume 17 Issue 2

2014 Volume 17 Issue 1

2013 Volume 16 Issue 3

2013 Volume 16 Issue 2

2013 Volume 16 Issue 1

2012 Volume 15 Issue 3

2012 Volume 15 Issue 2

2012 Volume 15 Issue 1

2011 Volume 14 Issue 4

2011 Volume 14 Issue 3

2011 Volume 14 Issue 2

2011 Volume 14 Issue 1

2010 Volume 13 Issue 4

2010 Volume 13 Issue 3

2010 Volume 13 Issue 2

2010 Volume 13 Issue 1

2009 Volume 12 Issue 4

2009 Volume 12 Issue 3

2009 Volume 12 Issue 2

2009 Volume 12 Issue 1

2008 Volume 11 Issue 4

2008 Volume 11 Issue 3

2008 Volume 11 Issue 2

2008 Volume 11 Issue 1

2007 Volume 10 Issue 4

2007 Volume 10 Issue 3

2007 Volume 10 Issue 2

2007 Volume 10 Issue 1

2006 Volume 9 Issue 4

2006 Volume 9 Issue 3

2006 Volume 9 Issue 2

2006 Volume 9 Issue 1

2005 Volume 8 Issue 4

2005 Volume 8 Issue 3

2005 Volume 8 Issue 2

2005 Volume 8 Issue 1

2004 Volume 7 Issue 3

2004 Volume 7 Issue 2

2004 Volume 7 Issue 1

2003 Volume 6 Issue 4

2003 Volume 6 Issue 3

2003 Volume 6 Issue 2

2003 Volume 6 Issue 1

2002 Volume 5 Issue 4

2002 Volume 5 Issue 3

2002 Volume 5 Issue 2

2002 Volume 5 Issue 1

2001 Volume 4 Issue 4

2001 Volume 4 Issue 3

2001 Volume 4 Issue 2

2001 Volume 4 Issue 1

2000 Volume 3 Issue 4

2000 Volume 3 Issue 3

2000 Volume 3 Issue 2

2000 Volume 3 Issue 1

1999 Volume 2 Issue 4

1999 Volume 2 Issue 3

1999 Volume 2 Issue 2

1999 Volume 2 Issue 1

1998 Volume 1 Issue 3

1998 Volume 1 Issue 2

1998 Volume 1 Issue 1

Money Mavericks: Confessions of a Hedge Fund Manager by Lars Kroijer

Money Mavericks: Confessions of a Hedge Fund Manager

By Lars Kroijer
FT Prentice Hall, London, 2010

[powerpress: http://gsbm-med.pepperdine.edu/gbr/audio/fall2011/BookReview_DavideAccomazzo_MoneyMavericks.mp3]

See more reviews




4 stars: Thought-provoking and intellectually stimulating material

When I heard about Kroijer’s book during a Bloomberg interview, I knew that reviewing his work would be an interesting project. I share many similarities with his experience (even though I must admit he has reached a higher level of assets under management than I have so far) and I was curious to learn about his full perspective.

In his book, Harvard MBA Kroijer describes his experience in leaving a high-paying job in finance when he was barely 30 years old to start his own hedge fund. His talent seemed under no dispute and his timing was certainly quite good (lucky?) as he picked the bottom in 2002 to launch.

Kroijer spends a large portion of the book discussing and remembering the concurrent excitement and humbleness of getting his fund off the ground. He eventually launched with a mere and much disappointing $3.5 million which gave rise to many funny stories on how little he was in an industry that thrives on constant machismo.

I could not help but remember my own humble beginnings founding Cervino Capital Management, and felt somewhat empathetic for Kroijer. An especially funny memory hit me when reading this book—I had just started out and while Cervino was just a tiny blip in the investment community, I felt like a million bucks. I was back in the hedge-fund game and had just resigned from a position with a large bank where I felt imprisoned. One night, I was sitting at a dinner party at the home of Henry Sloane, who at that time was the head of MGM. My wife and I sat next to a lovely and very understated couple; after the routine chit-chat on the evening event, the man asked me what I did for a living. I thought you would never ask, I thought to myself and proceeded to give him my most proud introduction: “Well, I am managing director at a boutique investment firm where we trade sophisticated alternative strategies around financial derivatives….and what do you do?” At this point I was expecting something like, “Oh I am a writer; I just sold my script to Henry.” Instead he replied with a big smile, “Great…I run a $6 billion dollar bond fund downtown. How much do you guys manage?” I wanted to hide under the table and never come out. “Well, we just launched,” I said sheepishly, and quickly changed the subject to the wine we were savoring.

Kroijer went on to build a medium-sized fund with a good risk-adjusted return until 2007 when, under much pressure from investors to increase the gearing of his investments, he ended up suffering his worst run at the highest level of leverage. By the end of 2007, with a negative return for the year, he closed shop and moved on to write this book.

He spends the last part of the book elaborating on the state of the industry, its overall usefulness, and the problem with fees and structure—all issues I mostly agree with.

I often get asked by my students about my hedge-fund experience and the industry overall, an industry that still carries an enormous appeal among MBAs. For those who would like to hear another candid voice on the subject, I certainly recommend Kroijer’s work. For a broader and more historical overview of the hedge fund universe, I would also recommend the book More Money than God by Sebastian Mallaby.

2014 Volume 17 Issue 2

2014 Volume 17 Issue 1

2013 Volume 16 Issue 3

2013 Volume 16 Issue 2

2013 Volume 16 Issue 1

2012 Volume 15 Issue 3

2012 Volume 15 Issue 2

2012 Volume 15 Issue 1

2011 Volume 14 Issue 4

2011 Volume 14 Issue 3

2011 Volume 14 Issue 2

2011 Volume 14 Issue 1

2010 Volume 13 Issue 4

2010 Volume 13 Issue 3

2010 Volume 13 Issue 2

2010 Volume 13 Issue 1

2009 Volume 12 Issue 4

2009 Volume 12 Issue 3

2009 Volume 12 Issue 2

2009 Volume 12 Issue 1

2008 Volume 11 Issue 4

2008 Volume 11 Issue 3

2008 Volume 11 Issue 2

2008 Volume 11 Issue 1

2007 Volume 10 Issue 4

2007 Volume 10 Issue 3

2007 Volume 10 Issue 2

2007 Volume 10 Issue 1

2006 Volume 9 Issue 4

2006 Volume 9 Issue 3

2006 Volume 9 Issue 2

2006 Volume 9 Issue 1

2005 Volume 8 Issue 4

2005 Volume 8 Issue 3

2005 Volume 8 Issue 2

2005 Volume 8 Issue 1

2004 Volume 7 Issue 3

2004 Volume 7 Issue 2

2004 Volume 7 Issue 1

2003 Volume 6 Issue 4

2003 Volume 6 Issue 3

2003 Volume 6 Issue 2

2003 Volume 6 Issue 1

2002 Volume 5 Issue 4

2002 Volume 5 Issue 3

2002 Volume 5 Issue 2

2002 Volume 5 Issue 1

2001 Volume 4 Issue 4

2001 Volume 4 Issue 3

2001 Volume 4 Issue 2

2001 Volume 4 Issue 1

2000 Volume 3 Issue 4

2000 Volume 3 Issue 3

2000 Volume 3 Issue 2

2000 Volume 3 Issue 1

1999 Volume 2 Issue 4

1999 Volume 2 Issue 3

1999 Volume 2 Issue 2

1999 Volume 2 Issue 1

1998 Volume 1 Issue 3

1998 Volume 1 Issue 2

1998 Volume 1 Issue 1

Technical Analysis: The Complete Resource for Financial Market Technicians, Second Edition

Technical Analysis: The Complete Resource for Financial Market Technicians, Second Edition
By Charles D. Kirkpatrick II, Julie R. Dahlquist
FT Press, 2010

[powerpress: http://gsbm-med.pepperdine.edu/gbr/audio/winter2011/Accomazzo-book2.mp3]

See more reviews



4 stars: Thought-provoking and intellectually stimulating materialIn the academic world, the study of the markets has for years revolved around the idea that markets are inherently efficient and all participants rational. I always found such theories a poor reflection of real-life trading and I consistently tried to integrate models and analysis that would take into consideration the “irrational” and structural inefficiency of the markets.

One such tool is technical analysis: a blend of formulas and relationships based on the observation of price and volume within the context of time. The book by Kirkpatrick and Dahlquist provides a much needed comprehensive manual of most technical analysis indicators; it is organized as a classic textbook, which makes it very user-friendly to the novice and the experienced analyst as well. This comprehensive and well-organized approach makes the book a great entry point for further analytical work; in this manual, one will not find “trading secrets” nor “holy grails,” but an efficient portal to more study in areas of interest or need for the reader.

The book cover indicates this manual as being selected as the official companion to the Market Technicians Association CMT program, a designation which has increased in prestige significantly over the last few years. Readers will also find interesting updates in the new edition in regards to behavioral biases, pattern recognition, and systems management.

Ultimately, technical analysis is a blend of science and art and the successful user of this technique will have to develop not only a specific know-how of the various indicators but a superior sensitivity on how and when to apply them; the authors of the book recognize this discretionary approach to the technique but highlight the consistent value-added information that can be captured by applying this layer of analysis.

Events over the last few years have clearly shown that a traditional approach to the markets can lead to very disastrous results; a modern investor needs to be proactive and more informed than ever on the market machinations. Fundamental analysis should be integrated with technical analysis to reduce risk and uncover more alpha-based opportunities in increasingly uncertain capital markets.

2014 Volume 17 Issue 2

2014 Volume 17 Issue 1

2013 Volume 16 Issue 3

2013 Volume 16 Issue 2

2013 Volume 16 Issue 1

2012 Volume 15 Issue 3

2012 Volume 15 Issue 2

2012 Volume 15 Issue 1

2011 Volume 14 Issue 4

2011 Volume 14 Issue 3

2011 Volume 14 Issue 2

2011 Volume 14 Issue 1

2010 Volume 13 Issue 4

2010 Volume 13 Issue 3

2010 Volume 13 Issue 2

2010 Volume 13 Issue 1

2009 Volume 12 Issue 4

2009 Volume 12 Issue 3

2009 Volume 12 Issue 2

2009 Volume 12 Issue 1

2008 Volume 11 Issue 4

2008 Volume 11 Issue 3

2008 Volume 11 Issue 2

2008 Volume 11 Issue 1

2007 Volume 10 Issue 4

2007 Volume 10 Issue 3

2007 Volume 10 Issue 2

2007 Volume 10 Issue 1

2006 Volume 9 Issue 4

2006 Volume 9 Issue 3

2006 Volume 9 Issue 2

2006 Volume 9 Issue 1

2005 Volume 8 Issue 4

2005 Volume 8 Issue 3

2005 Volume 8 Issue 2

2005 Volume 8 Issue 1

2004 Volume 7 Issue 3

2004 Volume 7 Issue 2

2004 Volume 7 Issue 1

2003 Volume 6 Issue 4

2003 Volume 6 Issue 3

2003 Volume 6 Issue 2

2003 Volume 6 Issue 1

2002 Volume 5 Issue 4

2002 Volume 5 Issue 3

2002 Volume 5 Issue 2

2002 Volume 5 Issue 1

2001 Volume 4 Issue 4

2001 Volume 4 Issue 3

2001 Volume 4 Issue 2

2001 Volume 4 Issue 1

2000 Volume 3 Issue 4

2000 Volume 3 Issue 3

2000 Volume 3 Issue 2

2000 Volume 3 Issue 1

1999 Volume 2 Issue 4

1999 Volume 2 Issue 3

1999 Volume 2 Issue 2

1999 Volume 2 Issue 1

1998 Volume 1 Issue 3

1998 Volume 1 Issue 2

1998 Volume 1 Issue 1

The Snowball: Warren Buffett and the Business of Life by Alice Schroeder

The SnowballThe Snowball: Warren Buffett and the Business of Life

By Alice Schroeder
Bantam, 2008

[powerpress: http://gsbm-med.pepperdine.edu/gbr/audio/summer2010/Book Corner/Nolan.mp3]

See more reviews


4 stars: Thought-provoking and intellectually stimulating materialI confess to having read The Snowball twice since its release in September 2008, prior to offering to review the book for GBR. This 836-page biography traces the life and career of arguably the most interesting businessman since the captains of industry during the Gilded Age. The author, who was an insurance analyst for Morgan Stanley, became Buffett’s biographer upon his invitation. Buffett provided her an extraordinary level of access to his archives, as well as over 2,000 hours of interviews with him and numerous friends, relatives, and associates. The result is a fascinatingly comprehensive story of how a stockbroker and subsequent U.S. senator’s son reached the pinnacle of accomplishment in the financial and business leadership spheres. The irony of this man is the simple, informal nature that underlies all he is and does. The book aptly illustrates that Buffett as a child displayed three prodigious traits that foretold his potential. Young Buffett loved to collect things, he loved to tally and keep an accounting of these things, and he had a towering capacity for learning and retaining knowledge. The biography follows a loose chronology weaving together the subject’s well documented business deals and associations, personal friendships, and family life. Typically an investment banking analyst with a background as a CPA and project manager at FASB might not be expected to craft a rich, complexly layered, and free-flowing work; but that is exactly what Schroeder does. She allows the reader to freely observe, without being noticed, an anthology of prominent people and business events. Far from being a heavily structured timeline, The Snowball reads like a series of interrelated anecdotes.

It is a very highly decorated book. It debuted at No. 1 on the New York Times and Publishers Weekly lists of nonfiction best-sellers. Time Magazine named The Snowball one of the 10 best books of the year. Other best-of-the-year lists on which The Snowball appeared were Publishers Weekly, The Financial Times, Business Week, USA Today, and The Washington Post. The book was selected a Top 100 Editor’s Pick and one of the five best biographies of the year by Amazon.com editors.

While many books about Buffett have simply focused on him as a businessman or investor, Schroeder has created a comprehensive narrative of this extraordinary life.  Therefore, those who seek a management guide or investing manual are surely to be perplexed by the numerous personal insights. However for the reader who enjoys biographies, history, and business, this panoramic view of an iconic life could not be more entertaining.

See more reviews

2014 Volume 17 Issue 2

2014 Volume 17 Issue 1

2013 Volume 16 Issue 3

2013 Volume 16 Issue 2

2013 Volume 16 Issue 1

2012 Volume 15 Issue 3

2012 Volume 15 Issue 2

2012 Volume 15 Issue 1

2011 Volume 14 Issue 4

2011 Volume 14 Issue 3

2011 Volume 14 Issue 2

2011 Volume 14 Issue 1

2010 Volume 13 Issue 4

2010 Volume 13 Issue 3

2010 Volume 13 Issue 2

2010 Volume 13 Issue 1

2009 Volume 12 Issue 4

2009 Volume 12 Issue 3

2009 Volume 12 Issue 2

2009 Volume 12 Issue 1

2008 Volume 11 Issue 4

2008 Volume 11 Issue 3

2008 Volume 11 Issue 2

2008 Volume 11 Issue 1

2007 Volume 10 Issue 4

2007 Volume 10 Issue 3

2007 Volume 10 Issue 2

2007 Volume 10 Issue 1

2006 Volume 9 Issue 4

2006 Volume 9 Issue 3

2006 Volume 9 Issue 2

2006 Volume 9 Issue 1

2005 Volume 8 Issue 4

2005 Volume 8 Issue 3

2005 Volume 8 Issue 2

2005 Volume 8 Issue 1

2004 Volume 7 Issue 3

2004 Volume 7 Issue 2

2004 Volume 7 Issue 1

2003 Volume 6 Issue 4

2003 Volume 6 Issue 3

2003 Volume 6 Issue 2

2003 Volume 6 Issue 1

2002 Volume 5 Issue 4

2002 Volume 5 Issue 3

2002 Volume 5 Issue 2

2002 Volume 5 Issue 1

2001 Volume 4 Issue 4

2001 Volume 4 Issue 3

2001 Volume 4 Issue 2

2001 Volume 4 Issue 1

2000 Volume 3 Issue 4

2000 Volume 3 Issue 3

2000 Volume 3 Issue 2

2000 Volume 3 Issue 1

1999 Volume 2 Issue 4

1999 Volume 2 Issue 3

1999 Volume 2 Issue 2

1999 Volume 2 Issue 1

1998 Volume 1 Issue 3

1998 Volume 1 Issue 2

1998 Volume 1 Issue 1

IT Solutions for SMBs in an Economic Downturn

In an uncertain economy, small companies often feel the pinch of reduced business activity acutely. When customer orders fall, they suffer an immediate impact as they often do not have diversified product lines or buffers in place like large firms. Suppliers and lenders seek safe, low-risk investments, often favoring large firms, while small businesses’ already stretched resources become even more so. As a result, it becomes increasingly important to do more with less, including careful, strategic, information technology portfolio investment analysis.

[powerpress http://gsbm-med.pepperdine.edu/gbr/audio/fall2009/smallbusinessit.mp3]

The U.S. Small Business Administration (SBA), the government agency responsible for assisting and protecting the interests of small businesses, created small- and medium-sized business standards, which are usually stated in terms of the number of employees or average annual receipts. SBA has established two widely used size standards: 500 employees for most manufacturing and mining industries, and $7 million in average annual receipts for most non-manufacturing industries. While there are many exceptions, these are the size standards applied in this article to distinguish small- and medium-sized businesses (SMBs) from large enterprises.

Table 1 lists the pros and cons when it comes to information resources associated with being a small- or medium-sized business.

Table 1 – Pros and Cons of IT Investment for SMBs

Pros Cons
Business processes are often immature so easier to re-engineer. Must justify IT based on a smaller number of users.
Less risk as processes modeled on fewer product lines/customers. Capital expenditure on IT difficult to justify because of high cost.
No legacy IT infrastructure to contend with. Ad-hoc approach to IT investment
because of pressure on operations, limited funds, and lack of strategic planning.
Benefits immediately seen from better data management. Established strategic IT portfolio management processes for large companies too expensive or complex.

Many SMBs fail to see the opportunities hidden in economic downturns. In reality, this is the time for them to make the most of the pros in terms of IT investment and to effectively mitigate the cons. But first, SMBs must thoroughly assess their vulnerabilities and act decisively to minimize them.

Leveraging the opportunities of the economic downturn often means focusing a high level of attention on cost improvements—usually strategic, structural improvements, such as streamlining infrastructure, adjusting the service delivery model, and redesigning the business model. Figure 1 is an example of various cost-improvement levers.[1] These projects all involve a significant number of information and process systems decisions.




Figure 1 - Cost-Improvement Levers




Adapted from Deloitte’s, “Three Steps to Sustainable and Scalable Change, Part 1: Rethinking a Company’s Business Model.”[2]

For SMBs, IT alignment with business objectives must be elevated and strategic data information flow management should be a top priority. However, these often get pushed aside in the midst of crisis management—especially if IT projects are seen as additional up-front capital expenditures.

Now, with the arrival of cloud computing, software as a service (SaaS) can provide lower-cost alternatives without the need for an internal IT group and reduced up-front capital costs. (Editor’s Note: For more on SaaS, read “Servicing the Software Industry: 7 New Rules for the Software Business.”)

As indicated above, one advantage that SMBs have over large enterprises is that they do not have legacy infrastructures. Large enterprises have to migrate these often-complex legacy systems, whereas SMBs can often build their services directly into the cloud with greater efficiency, at a lower cost, and in a streamlined, strategic manner, thus mitigating many of the challenges highlighted in Table 1. However, in order to move toward a solution, SMBS must first consider more strategic IT portfolio management based on the cost improvement levers above and critical success factors for surviving the economic downturn.

Critical Success Factors for Surviving Economic Uncertainty

Innovation

In any economy, innovation is essential to business success. While the economic downturn lasts, firms will need to find innovative ways to cut costs and to make better strategic decisions. They must also create products and services that will drive greater revenues once the economy improves.

The Internet and enterprise IT are accelerating competition within traditional U.S. industries—not because more products are becoming digital, but because more processes are. Just as a digital photo can be endlessly replicated quickly and accurately by copying the underlying bits, a company’s unique business processes can now be propagated with much higher fidelity across an organization by embedding it into enterprise information technology. As a result, an innovator with a better way of doing things can scale up with unprecedented speed to dominate an industry.[3]

To survive or, better yet, thrive in this more competitive environment, the mantra for any CEO should be “Deploy, innovate, and propagate”.[4]

  1. Deploy a consistent technology platform.
  2. Separate yourself from the pack by coming up with better ways of working.
  3. Use the platform to propagate these business innovations widely and reliably.

The most effective corporate strategy is now a function of answering three key questions: What are my capabilities? What is my position relevant to the competition? What technology should I use to help improve my results?

Strategic Planning

IT benefits the most from a long-term, disciplined, strategic view and a square focus on achieving the company’s most fundamental goals. Many units within SMBs have individual initiatives that are not centralized or integrated. They each might have their own business applications, technologies, and even data definitions. Data rationalization and integration become important once an SMB reaches a tipping point in its life cycle, such as significant growth in customers, geographic expansion, or the proliferation of product lines. It may also be required when project costs are high because individual teams are isolated, rather than harnessed together.

A unified technology platform can replace a wide variety of vertically oriented data silos that serve individual business units with a clean, horizontally oriented architecture designed to serve the company as a whole. Just like its large counterparts, an SMB’s first step is coming up with technology standards, followed by a concept of rational data architecture. The firm will have to think strategically about IT-enabled business value and to develop a plan for facilitating this value.[5]

Cost Reduction and Elimination

Expense reduction in good times is important for business; in difficult times, it is essential. IT budgets need to be rigorously scrutinized because if there is duplication built into them, there is waste. In some instances, SMBs are not utilizing their existing functionality due to outdated or inefficient processes. IT groups should examine the costs and benefits of extending refresh cycles, delaying upgrades, discontinuing maintenance agreements, and using open source platforms and applications.[6] In today’s world, we also need to stop thinking about how to perform tasks more efficiently and start thinking about how to automate work that eliminates the task entirely (and with it, the cost).[7]

Beyond Cost-Cutting

Except in the direst of circumstances, eliminating technology investments during a downturn is counterproductive. When business picks up, a firm that made such a decision would inevitably lack critical capabilities. Besides, when they are aligned with business value, many technology investments can improve a company’s profitability in the short to medium term. In fact, when business and IT professionals come together to take an end-to-end look at business processes, the resulting investments can have up to 10 times the impact of traditional IT cost reduction efforts.[8] The trick is to scan for opportunities, such as improving the customer experience, reducing revenue leakage, and improving operating advantage.

Technology investments can have a substantial impact on businesses, and such outcomes can be greater for SMBs than large enterprises because any cost cutting through process optimization is immediately apparent in the bottom line, given most SMBs’ tighter financial situation. Likewise, any additional revenue generated by better data analysis in areas such as market research shows up very quickly.[9]

To extract value from these opportunities, SMBs must make managerial improvements in the following areas:[10]

  • Developing New Insights: Few companies have successfully capitalized on the explosion of data that has occurred in recent years. Often, this information has never been mined for insights that could add value. Business and IT staffers can uncover opportunities by combining their detailed understanding of business processes with straightforward analyses of consolidated datasets to identify new opportunities for revenue leakage.
  • Optimizing Processes: As IT becomes tightly integrated with processes, breaks in workflows are often built into systems, diminishing productivity. Focusing on these areas with an integrated view of operations and technology may well reveal problems, such as outdated processes, manual steps, redundancies, and bottlenecks. A new system may be needed or, perhaps, modest enhancements or targeted workarounds will suffice.



Photo: Tom Nulens



Solutions for SMBs in the Current Economy

Operations efficiency comes from building a unified, streamlined business environment that fosters collaboration and agility. The integration of business processes can improve coordination among individuals and streamline workflows and processes, which, in turn, help to retain and satisfy customers. These systems link the order, inventory, sales, purchase, manufacturing, supply chain, and warehouse management modules within an enterprise to ensure fast and accurate information availability for those involved. All enterprise resource planning (ERP) systems in the market perform these functions, but identifying those that best meet the needs of SMBs requires careful scrutiny.

On-Demand, Hosted ERP Solutions

SaaS ERPs—sometimes called hosted software, on-demand software, or utility computing—have been the most interesting technology innovation for SMBs over the last two decades. The changes hosted software introduces—such as movement from a fat client portfolio to a thin one, from software acquisition to software subscription, and from on-premise installation to hosted Internet delivery—have been enthusiastically adopted because of the tangible business value and bottom line benefits they provide, such as:

  • Lower Total Cost of Ownership: There is little question that SaaS solutions generally provide lower computing costs initially and over a useful five-year life.[11]
  • Decreased Implementation Risk: By eliminating the computer hardware and platform software components, companies can decrease overall implementation time and the probability of project delays and implementation failure risk.
  • Outsourced Skills and Expertise: Outsourcing the IT management of ERP systems frees up internal IT resources to focus on core competencies, higher-priority projects, and strategic services. SaaS hosting enterprises also retain IT and security specialists with deep skills not found within SMBs, such as high operations availability, performance optimization, information security, disaster recovery, and business continuity.
  • Hosted Software Delivery: The more reputable SaaS systems guarantee anytime-anywhere access backed by service level agreements with financial penalties for system down time. Browser-based system access to the ERP is especially valuable to highly decentralized companies. As there is no need to purchase additional hardware and bandwidth, on-demand scaling as the business grows is another valuable benefit.
  • Subscription Pricing Model: The market has enthusiastically embraced the pay-as-you-go software-utilization pricing model over the traditional “pay-and-pray” procurement method. Pay-as-you-go pricing is a great boon for companies that cannot afford traditional ERP systems, but want to reap the benefits of informed decision-making processes. Subscription pricing also delivers a foreseeable future payment schedule, while eliminating the all-too-common cost overruns associated with on-premise ERP system implementation.

Considerations for On-Demand ERP System for SMBs

Hosted, on-demand ERP solutions offer greater flexibility for SMBs with little or no revenue in the earlier phases. Lower total cost of ownership and faster implementation are the key advantages from an SMB perspective. Because SaaS does not require a complex internal technical infrastructure for support, the initial costs are significantly lower than they would be for purchasing ERP software and running it internally. In addition, one can essentially “lease” the software, so firms have less of a big payment up front than they would with traditional, on-site ERP. However, there is still the ongoing cost of the lease to consider in calculating total cost of ownership.

On the downside, because the firm does not own the software on its own servers, there is inherently less it can do to customize the ERP to its own business needs. The software can still be configured and set up according to the firm’s needs, but when it comes to hardcore workflow redesign or software customization, SaaS is limited in its capabilities. However, unlike large businesses with complex workflows and legacy processes, SMBs have less of a need for customization. Firms should look for systems that offer greater flexibility in choosing modules and accommodating their growing needs. The other key requirement is for the most commonly used system with little or no downtime. Supporting service-oriented architecture (SOA) functionality is an added advantage because SOA allows businesses to share and collaborate more efficiently.

The challenge for all companies, including SMBs, is that going “live” has less to do with getting the software up and running than it does with clearly defining business processes, configuring the system accordingly, and ensuring that people are well trained in the new process workflows and transactions.

Conclusion

In an economic downturn, innovation is particularly essential to business success. Deploying IT serves two distinct roles—as a catalyst for innovative ideas and as an engine for delivering them. Firms should examine their processes and data to find opportunities for cutting costs through the automation and elimination of processes. By taking a careful look at operations with an integrated view of technology, firms may discover problems, manual steps, redundancies, and bottlenecks, many of which can be resolved with modest enhancements.

In terms of revenue generation, it is essential to search for opportunities, such as improving the customer experience, reducing revenue leakage, and improving operating advantage. More importantly, SMBs must leverage IT to develop new insights by examining the existing data to find opportunities to create new value for customers.

SMBs can also look at new, less expensive options for unified platform technology solutions. A strategic IT portfolio analysis that incorporates these concepts should enable small- and medium-sized businesses to survive the economic downturn and positioned for future success.


[1] Deloitte Development LLC, Three Steps to Sustainable and Scalable Change, Part 1: Rethinking a Companys Business Model, white paper, Deloitte Touche Tohmatsu, (2008).

[2] Ibid.

[3] Andrew McAfee and Erik Brynjolfsson, “Investing in the IT That Makes a Competitive Difference,” Harvard Business Review, 86, no. 7/8, (July-August 2008) [subscription required].

[4] Ibid.

[5] Charlie S. Feld and Donna B. Stoddard, “Getting IT Right,” Harvard Business Review, 82, no. 2, (February 2004). (hyperlink no longer accessible).

[6] Susan Cramm, “The Truths About IT Costs,” Harvard Business Review, 87, no. 3, (March 2009) [subscription required].

[7] Rich Murphy, “Be Bold with Smart New IT Investments: 5 Valuable IT Investment Steps for Difficult Economic Times,” ITBusinessEdge.com, June 10, 2009.

[8] James M. Kaplan, Roger P. Roberts, and Johnson Sikes, “Managing IT in a Downturn: Beyond Cost Cutting,” McKinsey Quarterly, (September 2008).

[9] Ibid.

[10] Ibid.

[11] Inside-ERP, “Midmarket ERP Solutions: Buyer, white paper, Inside-ERP.com [registration required].

2014 Volume 17 Issue 2

2014 Volume 17 Issue 1

2013 Volume 16 Issue 3

2013 Volume 16 Issue 2

2013 Volume 16 Issue 1

2012 Volume 15 Issue 3

2012 Volume 15 Issue 2

2012 Volume 15 Issue 1

2011 Volume 14 Issue 4

2011 Volume 14 Issue 3

2011 Volume 14 Issue 2

2011 Volume 14 Issue 1

2010 Volume 13 Issue 4

2010 Volume 13 Issue 3

2010 Volume 13 Issue 2

2010 Volume 13 Issue 1

2009 Volume 12 Issue 4

2009 Volume 12 Issue 3

2009 Volume 12 Issue 2

2009 Volume 12 Issue 1

2008 Volume 11 Issue 4

2008 Volume 11 Issue 3

2008 Volume 11 Issue 2

2008 Volume 11 Issue 1

2007 Volume 10 Issue 4

2007 Volume 10 Issue 3

2007 Volume 10 Issue 2

2007 Volume 10 Issue 1

2006 Volume 9 Issue 4

2006 Volume 9 Issue 3

2006 Volume 9 Issue 2

2006 Volume 9 Issue 1

2005 Volume 8 Issue 4

2005 Volume 8 Issue 3

2005 Volume 8 Issue 2

2005 Volume 8 Issue 1

2004 Volume 7 Issue 3

2004 Volume 7 Issue 2

2004 Volume 7 Issue 1

2003 Volume 6 Issue 4

2003 Volume 6 Issue 3

2003 Volume 6 Issue 2

2003 Volume 6 Issue 1

2002 Volume 5 Issue 4

2002 Volume 5 Issue 3

2002 Volume 5 Issue 2

2002 Volume 5 Issue 1

2001 Volume 4 Issue 4

2001 Volume 4 Issue 3

2001 Volume 4 Issue 2

2001 Volume 4 Issue 1

2000 Volume 3 Issue 4

2000 Volume 3 Issue 3

2000 Volume 3 Issue 2

2000 Volume 3 Issue 1

1999 Volume 2 Issue 4

1999 Volume 2 Issue 3

1999 Volume 2 Issue 2

1999 Volume 2 Issue 1

1998 Volume 1 Issue 3

1998 Volume 1 Issue 2

1998 Volume 1 Issue 1

What to Do When Traditional Diversification Strategies Fail

In 2008, market events showed that some of the protection provided by diversification is lost when correlation among asset classes changes rapidly. Now, the question is: Are traditional diversification concepts no longer applicable due to some systemic change? Or is there still a simple, repeatable approach to diversification that can lead to significant protection against loss of principle?

Many factors could be contributing to recent volatile market behavior, for example, globalization, investor fear, government policies, and alternative investments. This article explores a methodology that attempts to address these factors.

[powerpress http://gsbm-med.pepperdine.edu/gbr/audio/fall2009/diversification.mp3]

Correlation is the statistical measure of diversification; when calculated between the S&P 500 and MSCI EAFE indices over the last 30 years, a noticeable trend occurs. Correlation increased from 0.47 (from 1980 to 1990) to 0.54 (from 1990 to 2000) to 0.83 (from 2000 to 2009).[1]

Clearly, understanding how diversification of investments changes over time is very relevant.[2] For example, when liquidity became an issue in the fourth quarter of 2008, asset correlations began to approach 1.0, the point at which diversification can fail.[3] Such failure is largely due to the variation of asset correlations over time. The market stresses of 2008 and their effect on asset correlation were reported by others who saw greater positive correlation.[4] The effect of buy-and-hold strategies, along with the need for more active management techniques, was further reinforced by market observations.[5]

Hypothesis and Simple Illustration

Is there a simple, repeatable approach that can continue to provide the practical benefits of diversification? To develop assumptions and test such an approach, the following questions were addressed:

  1. What publicly available asset classes should be considered in building a diversified portfolio?
  2. How much history should be examined before making decisions?
  3. How frequently should portfolio changes be made and how do switching costs influence such decisions?
  4. What is an appropriate correlation coefficient threshold?
  5. What allocation strategy should be employed?

To explore these questions and to develop a rationale on an analytical framework, Figure 1 was constructed and tracked by representative exchange-traded funds (ETFs).


Figure 1 - Total Return of Bond, Domestic Small Cap, Domestic Large Cap, and International Asset Classes in 2008


Figure 1 shows a time series of gains and losses for each of the asset classes listed in Table 1 below. All of the asset classes, except bonds, suffered a significant loss in 2008. A broader look at 2008’s gains and losses shows that real estate and commodities fell by 39 percent and 47 percent, respectively, in addition to the domestic and international equity assets shown in Figure 1. Domestic bonds gained 5 percent, non-U.S. bonds gained 10 percent, and short-term Treasury bills returned 1.5 percent.[6]


Table 1 - Four Broad Asset Classes Tracked by ETFs


Table 2 illustrates the result of a naïve approach, which spreads assets equally across asset classes. In 2008, applying this approach to these four funds would have led to a 27-percent loss.


Table 2 - 2008 Performance of Naïve Allocation


The concept of diversification suggests that only uncorrelated assets should be held in a portfolio. To measure the correlation, or lack thereof, among assets, we calculated correlation coefficients based on returns of risky assets over a fixed period of time. A positive correlation coefficient indicates asset returns are directly related to one another, while a negative correlation coefficient suggests an inverse relationship. A correlation coefficient near zero implies the change in one risky asset has little to no effect on the change of the other.

Applying this active approach, Table 3 shows the correlation coefficient based on daily returns from 2007. The value of 1.0 along the diagonal is expected, as it is a measure of an asset’s price movement relative to itself. A correlation threshold of 80 percent implies a diversified portfolio should only hold two of these assets because the correlation coefficients associated with SPY, EFA, and IWM are all greater than 0.80. Thus, bond (AGG) and domestic large cap equities (SPY) should be selected for future allocations and SPY could be replaced with either IWM or EFA in order to satisfy the 0.80 correlation threshold.


Table 3 - Correlation Coefficients from Daily 2007 Returns Adjusted for Dividends


After selecting AGG and SPY, a naïve allocation strategy was applied to construct a portfolio and to test its performance in 2008 (Table 4). Both classes demonstrate the first part of our hypothesis—that a simple approach to diversification (e.g., applying an 80-percent threshold on correlations from the previous year) could lead to significant protection against loss of principle the following year. The results also showed that in a downward-trending equity market such as 2008, one should move to less risky, lower beta assets, thus adhering to the precepts of modern portfolio theory (MPT). The challenge is that the three equity classes had small gains and losses in 2007, providing inconclusive evidence about the broad equity market downturn to come.


Table 4 - 2008 Performance Based on Naïve Allocation and 2007 Correlation Coefficients


Analysis Assumptions and Methodology

The assumptions and methodology were based on the previous simple illustration. To address the first question—what publicly available asset classes should be considered when building a diversified portfolio?—a broad set of asset classes that have been publicly available as ETFs since January 2004 were identified. These comprised of 136 unique funds in the following asset categories: large, mid, and small cap domestic equity; international developed markets; emerging markets; commodities; bonds; domestic sectors; and real estate.

Exchange-traded funds were chosen because they are passive investments designed to track a wide variety of asset classes, and the funds are readily available to the investment community. They also carry many other advantages, including:

  1. Reduction of firm-specific risk by spreading a single investment across an assortment of individual firms,
  2. Transparency of holdings,
  3. Low cost inherent in passive investment approach, and
  4. Liquidity.[7]

The author chose to carry forward the 12-month assumption applied in the previous simple illustration, similar to the certified financial advisor community’s employment of a 200-day average to assess rapidly changing market conditions.[8] In addition, Louis G. Navellier, a well-known investment advisor, calculated his MPT review and the critical alpha/standard deviation statistic based on a year.

Portfolio rebalancing and the associated switching costs are important practical considerations.[9] The author examined them over a range of possibilities, including yearly, biannually, and quarterly. By including trading commissions at $10 per trade against an initial portfolio size of $100,000 in a tax-free account, an optimal reallocation period became apparent. (Taxes are an important cost to consider, particularly for non-pension investors; however, the effect of taxes on performance was not explored in this article.)

Based on the results from the previous illustration, a threshold of 80 percent appears to provide diversification. Other studies have used 0.95 based on mutual funds with no trading costs.[10] However, because trading costs were included in this study, the 80-percent threshold was applied to reduce the number of potential positions in the portfolio and to address the longer-term correlation growth trend observed between the S&P 500 and MSCI EAFE indices. Lastly, in an effort to maintain a simple overall approach, the aforementioned naïve strategy was employed.

Empirical Results

Figure 2 shows the resulting time series associated with the number of ETFs that were less than 80 percent correlated over the three-year study—from January 1, 2006 to December 31, 2008. The increasing correlation among asset classes is clearly illustrated by the reduction in uncorrelated funds available. The reduction of uncorrelated assets from 2006 to 2008 is consistent with the longer-term hypothesis confirmed in a similar 10-year study, which examined 30 stocks in the Dow Jones Index and 500 stocks in the S&P 500 index.[11]


Figure 2 - Number of ETFs That Are Less Than 80 Percent Correlated


With knowledge of uncorrelated funds, the naïve allocation strategy was applied annually, biannually, and quarterly. The resulting portfolios are shown in Tables 5, 6, and 7. It is important to observe the long-term relationship of bonds to stocks in these figures; as one would expect—and was shown in the previous simplified illustration—the correlation coefficient between stocks and bonds was consistently below the 80-percent threshold selected for this study. Bonds continually appeared in the portfolios over time with allocations varying between 2.4 percent and 16.7 percent.


Table 5 - Annual Portfolio Allocation Percentages with Naïve Allocation Approach and 80-Percent Correlation Threshold



Table 6 - Biannual Portfolio Allocation Percentages with Naïve Allocation Approach and 80-Percent Correlation Threshold



Table 7 - Quarterly Portfolio Allocation Percentages with Naïve Allocation Approach and 80-Percent Correlation Threshold


Table 8 shows the annual net returns based on the three reallocation periods. Due to the large allocations to domestic sectors, the S&P 500 benchmark was included for comparison. In all cases, net returns exceeded the S&P 500 benchmark on an absolute basis in each of the three years, and the best return came from annual reallocations. In addition, the author minimized 2008 losses using biannual allocations, which beat the quarterly reallocation results because of the fewer trades required (28 versus 61).


Table 8 - Net Returns with Naïve Allocation


To provide an alternate perspective, the author computed the Sharpe ratio based on monthly returns, monthly standard deviations, and a negligible risk-free rate. The results in Table 9 illustrate that, on a risk-adjusted basis over the three-year period, annual reallocations provided the optimal risk-adjusted performance. In addition, trading costs associated with increased frequency of reallocations consistently decreased the Sharpe ratio. For quarterly reallocation intervals, the naïve allocation strategy no longer beat the performance of the S&P 500 on a risk-adjusted basis.


Table 9 - Sharpe Ratio with Naïve Allocation


Observations

Periodically reallocating a portfolio using uncorrelated assets appears to be a practical approach to diversification. The events of 2008 clearly necessitate the need for such strategies to manage investment risk.

Utilizing the latest investment vehicles available from ETFs, this article provides a simple methodology, based on a naïve reallocation strategy, which accounts for the practical impact of trading costs. While diversification still appears to reduce the likelihood and severity of loss, it should not be considered foolproof and should be considered in conjunction with other forms of risk mitigation. It should be noted that this study’s results are based on a limited testing period representing a global market with some stressing conditions, including moderate upward and significant downward trends.

For individuals interested in examining their ETF portfolios and correlation coefficients, a few options are available. First, there are online tools, such as Correlation Tracker, which provides correlation coefficients for six-month, one-year, and three-year spans. For certain sector ETFs, fund providers publish information about correlation among their offerings.[12] Lastly, free internet sites, such as Google Finance and Yahoo! Finance, offer downloadable closing price information, which can be analyzed using Excel’s “covar” function.

DISCLAIMER: The exchange trade products analyzed in this article were chosen from those publicly available. They do not represent the author’s recommendations and were only used to support observations. Investment advice is neither implied, nor suggested.


[1] “Modern Portfolio Theory is History,” Money Management Executive, February 2009.

[2] U.S. Securities and Exchange Commission, Beginners’ Guide to Asset Allocation, Diversification, and Rebalancing, http://www.sec.gov/investor/pubs/assetallocation.htm.

[3] Lawrence C. Strauss, “Backing Up Equity Bets With Hard Assets,” Barron’s, April 27, 2009.

[4] Jane Bryant Quinn, “The Right Way To Diversify Your Portfolio,” The Washington Post, April 26, 2009; Steve Hanke, “Unconventional Wisdom,” Forbes, March 16, 2009; and William J. Bernstein, “Yes, Diversification Works – Eventually,” Money Magazine, April 1, 2009.

[5] Anton Troianovski, “REITs Rise Sets Back Day Traders,” The Wall Street Journal, May 2, 2009; David Pett, “Don’t Drop Portfolio Theory, Report Says,” Financial Post, April 28, 2009.

[6] Craig L. Israelsen, “Gauging the Mess,” Financial Planning, March 1, 2009.

[7] Brian Healy and Niall Gibney, “Exchange Traded Funds: Opportunities for Portfolio Diversification,” Accountancy Ireland, February 1, 2009.

[8] Don Ogden, “Market Notes,” Raymond James, May 2009.

[9] John O’Brien, “Rebalancing: A Tool for Managing Portfolio Risk,” Journal of Financial Service Professionals, 60, no. 3, (2006).

[10] J. Angus, W.O. Brown, J.K. Smith, R. Smith, “What’s in Your 403(b)? Academic Retirement Plans and the Costs of Underdiversification,” Financial Management, 36, no. 2, (2007): 1–38.

[11] M. Medo, C.H. Yeung, Y.C. Zhang, “How to Quantify the Influence of Correlations on Investment Diversification,” International Review of Financial Analysis, 18 (1–2): 34–39, 2009.

[12] Jeff Tjornehoj, Don Cassidy, and Michael Porter, “The Growing Attraction of Sector ETFs,” Lipper FundIndustry Insight Reports, October 20, 2005.

2014 Volume 17 Issue 2

2014 Volume 17 Issue 1

2013 Volume 16 Issue 3

2013 Volume 16 Issue 2

2013 Volume 16 Issue 1

2012 Volume 15 Issue 3

2012 Volume 15 Issue 2

2012 Volume 15 Issue 1

2011 Volume 14 Issue 4

2011 Volume 14 Issue 3

2011 Volume 14 Issue 2

2011 Volume 14 Issue 1

2010 Volume 13 Issue 4

2010 Volume 13 Issue 3

2010 Volume 13 Issue 2

2010 Volume 13 Issue 1

2009 Volume 12 Issue 4

2009 Volume 12 Issue 3

2009 Volume 12 Issue 2

2009 Volume 12 Issue 1

2008 Volume 11 Issue 4

2008 Volume 11 Issue 3

2008 Volume 11 Issue 2

2008 Volume 11 Issue 1

2007 Volume 10 Issue 4

2007 Volume 10 Issue 3

2007 Volume 10 Issue 2

2007 Volume 10 Issue 1

2006 Volume 9 Issue 4

2006 Volume 9 Issue 3

2006 Volume 9 Issue 2

2006 Volume 9 Issue 1

2005 Volume 8 Issue 4

2005 Volume 8 Issue 3

2005 Volume 8 Issue 2

2005 Volume 8 Issue 1

2004 Volume 7 Issue 3

2004 Volume 7 Issue 2

2004 Volume 7 Issue 1

2003 Volume 6 Issue 4

2003 Volume 6 Issue 3

2003 Volume 6 Issue 2

2003 Volume 6 Issue 1

2002 Volume 5 Issue 4

2002 Volume 5 Issue 3

2002 Volume 5 Issue 2

2002 Volume 5 Issue 1

2001 Volume 4 Issue 4

2001 Volume 4 Issue 3

2001 Volume 4 Issue 2

2001 Volume 4 Issue 1

2000 Volume 3 Issue 4

2000 Volume 3 Issue 3

2000 Volume 3 Issue 2

2000 Volume 3 Issue 1

1999 Volume 2 Issue 4

1999 Volume 2 Issue 3

1999 Volume 2 Issue 2

1999 Volume 2 Issue 1

1998 Volume 1 Issue 3

1998 Volume 1 Issue 2

1998 Volume 1 Issue 1

The Buffett Approach to Valuing Stocks

Much has been written about famed U.S. investor and Berkshire Hathaway CEO Warren Buffett’s investment style and successes. Preeminent among these writings are the oft-cited Berkshire Hathaway shareholder letters, written by the “Oracle of Omaha” himself. These informative letters have been the basis for a multitude of books. But even with an abundance of available information on “how to invest like Warren Buffett,” it is apparent that something is lacking, how does Buffett determine an acceptable price for companies of interest? This article provides an example of the process Buffett is reported to go though to determine the intrinsic value of a publicly traded company.







Photo: Bogdan Radenkovic







Starting at the Beginning

Before we get our hands dirty with the valuation aspects of the investment decision, let us review a brief outline of the qualitative and quantitative aspects of Buffett’s decision process as observed by Robert G. Hagstrom.[1] This map helps us navigate the turbulent waters of Wall Street and is comprised of business, management, financial, and market tenets.

Investment Tenets

Business

  • Is the business simple and understandable?
  • Does the business have a consistent operating history?
  • Does the business have favorable long-term prospects?

Management

  • Is management rational?
  • Is management candid with the shareholders?
  • Does management resist the institutional imperative?

Financial

  • What is the return on equity (ROE)? [Do not just focus on earnings per share (EPS).]
  • How high are the firm’s profit margins?
  • Does the firm create one dollar in market value for every dollar retained?

Market

  • What is the value of the business?
  • Can the business be purchased at a significant discount?

The valuation exercise explained in this article addresses the market tenets part of the process, which are only applicable if the firm in question meets the other qualitative and quantitative requirements. It should be noted that Buffett stresses doing your own homework and that entails more than just getting historical accounting data and dropping them into the model being presented. Buffett has often said that a primary part of his investment homework is reading: including books, newspapers, magazines, and the annual reports of the subject company and its competitors.[2][3] A thorough reading of annual reports goes a long way in addressing the questions related to the business and management tenets.

So Many Numbers, So Little Time

Okay, so you have read the annual reports and found more numbers than you know what to do with. Which are important? Which are essential? Which can be left out? In reality, all of the information presented in these disclosures is potentially useful for several reasons.

For estimating the intrinsic value of a firm, Buffett attempts to determine the expected return on equity capital (ROE) and the growth rate of book value (BV) per share, using the following accounting data: revenue, net income, book value of shareholder equity, earnings per share (EPS), dividends per share, and total shares outstanding. Price-earnings (P/E) ratios are also useful, but are not typically found in annual reports. Two of the best sources for this data are Value Line Investment Survey[4] and Standard and Poor’s stock reports.[5] Both contain all the data necessary for the valuation exercise. While they do require subscriptions, they can be accessed through most public and university libraries for free.

Estimating an Investment’s Expected Return

Ultimately, we will estimate the book value of shareholder equity 10 years into the future, although this process also works for shorter investment horizons, and we will use that figure as the basis for calculating an expected rate of return on a company’s stock. Buffett reportedly uses a threshold rate of return of 15 percent, anything less is considered unacceptable. To get to that point, we will go through several steps that are explained in great detail in books by Buffett’s former daughter-in-law, Mary Buffett.[6][7] These steps are summarized below, with a few of my own adjustments to make the analysis more robust. We will use Eaton Corporation (ETN) as our sample firm beca