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Case Studies in Finance Managing for Corporate Value Creation
Eighth Edition
Robert F. Bruner
Kenneth M. Eades
Michael J. Schill

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CASE STUDIES IN FINANCE: MANAGING FOR CORPORATE VALUE
CREATIONS, EIGHTH EDITION
Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright
© 2018 by McGraw-Hill Education. All rights reserved. Printed in the United States of
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Library of Congress Cataloging-in-Publication Data
Names: Bruner, Robert F., 1949-author. | Eades, Kenneth M., author. | Schill, Michael J.,
author.
Title: Case studies in finance: managing for corporate value creation / Robert F. Bruner,
Kenneth M. Eades,
Michael J. Schill.
Description: Eighth Edition. | Dubuque, IA : McGraw-Hill Education, [2018] | Series:
The McGraw-Hill/Irwin series in finance, insurance, and real estate | Revised edition of
the authors’ Case studies in finance, [2014]
Identifiers: LCCN 2017023496| ISBN 9781259277191 (alk. paper) | ISBN 1259277194
(alk. paper)
Subjects: LCSH: Corporations—Finance—Case studies. | International business
enterprises—
Finance—Case studies.
Classification: LCC HG4015.5 .B78 2017 | DDC 658.15—dc23 LC record available
at https://lccn.loc.gov/2017023496
The Internet addresses listed in the text were accurate at the time of publication. The
inclusion of a website does not indicate an endorsement by the authors or McGraw-Hill
Education, and McGraw-Hill Education does not guarantee the accuracy of the
information presented at these sites.
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mheducation.com/highered
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Page v
Dedication
In dedication to
our wives
Barbara M. Bruner
Kathy N. Eades
And to the memory of
Mary Ann H. Schill
and to our children
Page vi
About the Authors
Robert F. Bruner is University Professor, Distinguished Professor of Business
Administration and Charles C. Abbott Professor of Business Administration and Dean
Emeritus of the Darden Graduate School of Business Administration at the University of
Virginia. He has taught and written in various areas, including corporate finance,
mergers and acquisitions, investing in emerging markets, innovation, and technology
transfer. In addition to Case Studies in Finance, his books include Finance Interactive,
multimedia tutorial software in Finance (Irwin/McGraw-Hill 1997), The Portable MBA
(Wiley 2003), Applied Mergers and Acquisitions, (Wiley, 2004), Deals from Hell:
M&A Lessons that Rise Above the Ashes (Wiley, 2005) and The Panic of 1907 (Wiley,
2007). He has been recognized in the United States and Europe for his teaching and case
writing. BusinessWeek magazine cited him as one of the “masters of the MBA
classroom.” He is the author or co-author of over 400 case studies and notes. His
research has been published in journals such as Financial Management, Journal of
Accounting and Economics, Journal of Applied Corporate Finance, Journal of
Financial Economics, Journal of Financial and Quantitative Analysis, and Journal of
Money, Credit, and Banking. Industrial corporations, financial institutions, and
government agencies have retained him for counsel and training. He has been on the
faculty of the Darden School since 1982, and has been a visiting professor at Harvard,
Columbia, INSEAD, and IESE. Formerly he was a loan officer and investment analyst
for First Chicago Corporation. He holds the B.A. degree from Yale University and the
M.B.A. and D.B.A. degrees from Harvard University. Copies of his papers and essays
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may be obtained from his website,
http://www.darden.virginia.edu/web/Faculty-Research/Directory/Full-time/Robert-F-Bruner/
He may be reached via email at brunerr@virginia.edu.
Kenneth M. Eades is Professor of Business Administration and Area Coordinator of
the Finance Department of the Darden Graduate School of Business Administration at
the University of Virginia. He has taught a variety of corporate finance topics including:
capital structure, dividend policy, risk management, capital investments and firm
valuation. His research interests are in the area of corporate finance where he has
published articles in The Journal of Finance, Journal of Financial Economics,
Journal of Financial and Quantitative Analysis, and Financial Management. In
addition to Case Studies in Finance, his books include The Portable MBA (Wiley
2010) Finance Interactive, a multimedia tutorial software in Finance (Irwin/McGraw-
Hill 1997) and Case Studies in Financial Decision Making (Dryden Press, 1994). He
has authored or co-authored over 70 case studies as well as a web-based, interactive
tutorial on the pricing of financial derivatives. He has received the Wachovia Award for
Excellence in Teaching Materials and the Wachovia Award for Excellence in Research.
Mr. Eades is active in executive education programs at the Darden School and has
served as a consultant to a number of corporations and institutions; including many
commercial banks and investment banks; Fortune 500 companies and the Internal
Revenue Service. Prior to joining Darden in 1988, Professor Eades was a
member of the faculties at The University of Michigan and the Kellogg School
of Management at Northwestern University. He has a B.S. from the University of
Kentucky and Ph.D. from Purdue University. His website is
http://www.darden.virginia.edu/web/Faculty-Research/Directory/Full-time/Kenneth-M-Eades/
and he may be reached via email at eades@virginia.edu.
Michael J. Schill is Professor of Business Administration of the Darden Graduate
School of Business Administration at the University of Virginia where he teaches
corporate finance and investments. His research spans empirical questions in corporate
finance, investments, and international finance. He is the author of numerous articles
that have been published in leading finance journals such as Journal of Business,
Journal of Finance, Journal of Financial Economics, and Review of Financial
Studies, and cited by major media outlets such as The Wall Street Journal. He has been
on the faculty of the Darden School since 2001 and was previously with the University
of California, Riverside, as well as a visiting professor at Cambridge and Melbourne.
He is the current course head for Darden’s core MBA finance course. He is the author
or co-author of over 40 cases and technical notes, as well as a financial market
simulation entitled Bond Trader. Prior to his doctoral work, he was a consultant with
Marakon Associates in Stamford and London. He received a B.S. degree from Brigham
Young University, an M.B.A. from INSEAD, and a Ph.D. from University of Washington.
More details are available from his website,
http://www.darden.virginia.edu/web/Faculty-Research/Directory/Full-time/Michael-J-Schill/
He may be reached via email at schill@virginia.edu.
Page viii
Contents
Dedication v
About the Authors vi
Contents viii
Foreword xi
Preface xii
Note to the Student: How To Study and Discuss Cases xxiii
Ethics in Finance xxx
1 Setting Some Themes
1 Warren E. Buffett, 2015 To think like an investor 3
2 The Battle for Value, 2016: FedEx Corp. vs. United Parcel Service, Inc. Value
creation and economic profit 23
3 Larry Puglia and the T. Rowe Price Blue Chip Growth Fund Market efficiency
43
4 Genzyme and Relational Investors: Science and Business Collide? Value creat
ion, business strategy and activist investors 63
2 Financial Analysis and Forecasting
5 Business Performance Evaluation: Approaches for Thoughtful Forecasting Fin
ancial forecasting principles 89
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6 The Financial Detective, 2016 Financial ratio analysis 107
7 Whole Foods Market: The Deutsche Bank Report Financial performance fore
casting 113
8 Horniman Horticulture Financial forecasting and bank financing 127
9 Guna Fibres, Ltd. Forecasting seasonal financing needs 133
3 Estimating the Cost of Capital
10 “Best Practices” in Estimating the Cost Estimating the cost of capital 1
45
of Capital: An Update
11 Roche Holdings AG: Funding the Genentech Acquisition Cost of debt capital
173
12 H. J. Heinz: Estimating the Cost of Capital in Uncertain Times Cost of capita
l for the firm 189
13 Royal Mail plc: Cost of Capital Cost of capital for the firm 197
14 Chestnut Foods Cost of capital for multi-division firm 207
4 Capital Budgeting and Resource Allocation
15 Target Corporation Multifaceted capital investment decisions 219
16 The Investment Detective Investment criteria and discounted cash flow
239
17 Centennial Pharmaceutical Corporation Valuation of earnout plan 241
18 Worldwide Paper Company Analysis of an expansion investment 249
19 Fonderia del Piemonte S.p.A. Capital investment decision 253
20 Victoria Chemicals plc (A): The Merseyside Project Relevant cash flows
257
21 Victoria Chemicals plc (B): Merseyside and Rotterdam Projects Mutually ex
clusive investment opportunities 265
22 The Procter & Gamble Company: Investment in Crest Whitestrips Advanced Seal
Scenario analysis in a project decision 273
23 Jacobs Division 2010 Strategic planning 285
24 University of Virginia Health System: The Long-Term Acute Care Hospital Projec
Analysis of an investment in a not-for-profit organization 293
25 Star River Electronics Ltd. Capital project analysis and forecasting 30
3
5 Management of the Firm’s Equity: Dividends and R
epurchases
26 Rockboro Machine Tools Corporation Dividend payout decision 313
27 EMI Group PLC Dividend policy 329
28 Autozone, Inc. Dividend and stock buyback decisions 347
6 Management of the Corporate Capital Structure
29 An Introduction to Debt Policy and Value Effects of debt tax shields 36
3
30 M&M Pizza Capital structure in a frictionless market 369
31 Structuring Corporate Financial Policy: Diagnosis of Problems and Evaluation of
Strategies Concepts in setting financial policy 373
32 California Pizza Kitchen Optimal leverage 391
33 Dominion Resources: Cove Point Project funding and capital structure
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409
34 Nokia OYJ: Financing the WP Strategic Plan Corporate funding alternatives
425
35 Kelly Solar Debt financing negotiation 449
36 J. C. Penney Company Liquidity management 453
37 Horizon Lines, Inc. Financial distress/restructuring/bankruptcy 467
7 Analysis of Financing Tactics: Leases, Options, and
Foreign Currency
38 Baker Adhesives Hedging foreign currency cash flows 483
39 Vale SA Debt financing across borders 489
40 J&L Railroad Risk management and hedging commodity risk 501
41 WNG Capital, LLC Economics of lease financing 513
42 MoGen, Inc. Convertible bond valuation and financial engineering 52
5
8 Valuing the Enterprise: Acquisitions and Buyou
ts
43 Methods of Valuation for Mergers and Acquisitions Valuation principles
539
44 Medfield Pharmaceuticals Valuing assets in place 559
45 American Greetings Firm valuation in stock repurchase decision 571
46 Ferrari: The 2015 Initial Public Offering Initial public offering valuation
583
47 Rosetta Stone: Pricing the 2009 IPO Initial public offering valuation 6
03
48 Sun Microsystems Valuing a takeover opportunity 623
49 Carter International Acquisition valuation and financing 645
50 DuPont Corporation: Sale of Performance Coatings Business Unit Divestitur
e 657
51 OutReach Networks: First Venture Round Valuation of early stage company
679
52 Sanofi-Aventis’s Tender Offer for Genzyme Corporate acquisition 687
53 Delphi Corporation Corporate bankruptcy 715
54 Flinder Valves and Controls Inc. Acquisition negotiation 731
Page xi
Foreword
As I think about developing the next generation of leaders in business and finance, I
naturally reflect on my own path. My career in business has taught some profound
lessons—and so did my experience at the University of Virginia’s Darden School of
Business. Both life experience and school learning are critical components in the
development of any leader. For that reason, I have supported wholeheartedly higher
education as the path toward a promising future.
As the world keeps changing, higher education must continually adapt. Practices,
processes, and business models that were once popular have faded. At the same time,
the field of Finance has witnessed dramatic changes, including the advent of new
valuation models, the rise of new markets and institutions, the invention of new financial
instruments, the impact of new information technologies, and growing globalization. In
this environment, we must think critically about the changing world, pay attention to new
ideas, and adapt in sensible ways. Business schools play a critical role in the change
process: theory suggests new approaches, empirical research tests them, and classroom
teaching transfers knowledge. The development of new teaching materials is vital to that
process.
Case studies in Finance have evolved markedly over the past 40 years. This shift
reflects the revolutionary changes in markets and organization, as well as the many
significant advances in theory and empirical research. Because case studies are an
invaluable teaching tool, it is critical that the body of cases grows with the practice of
and scholarship in Finance.
I am pleased to introduce the reader to the eighth edition of Case Studies in
Finance, by Robert F. Bruner, Kenneth M. Eades, and Michael J. Schill. These
professors exemplify the practice-oriented scholar who understands the economic
foundations of Finance and the extensive varieties of its practice. They translate
business phenomena into material that is accessible both to experienced practitioners
and novices in Finance.
This book is a valuable contribution to the teaching materials available in the field
of Finance. First, these cases link managerial decisions to capital markets and investor
expectations. At the core of most is a valuation task that requires students to look to
financial markets to resolve the problem. Second, these cases feature a wide range of
contemporary and relevant problems, including examples in real and financial options,
agency conflicts, financial innovation, investing in emerging markets, and corporate
control. They also cover classic topics in Finance, including dividend policy, the mix of
debt and equity financing, the estimation of future financial requirements, and the choice
between mutually exclusive investments. Finally, these cases invite students to harness
technology they will use in the workplace to develop key insights.
I am confident this collection will help students, scholars, and practitioners sharpen
their decision-making ability, and advance the development of the next generation of
leaders in Finance.
John R. Strangfeld
Chairman and Chief Executive Officer
Prudential Financial, Inc.
May 3, 2017
Newark, New Jersey
Page xii
Preface
The inexplicable is all around us. So is the incomprehensible. So is the unintelligible. Interviewing Babe Ruth
in 1928, I put it to him “People come and ask what’s your system for hitting home runs—that so?” “Yes,” said
the Babe, “and all I can tell ‘em is I pick a good one and sock it. I get back to the dugout and they ask me
what it was I hit and I tell `em I don’t know except it looked good.”
—Carl Sandburg
Managers are not confronted with problems that are independent of each other, but with dynamic situations
that consist of complex systems of changing problems that interact with each other. I call such situations messes
. . . Managers do not solve problems: they manage messes.
—Russell Ackoff
Orientation of the Book
Practitioners tell us that much in finance is inexplicable, incomprehensible, and
unintelligible. Like Babe Ruth, their explanations for their actions often amount to “I
pick a good one and sock it.” Fortunately for a rising generation of practitioners, tools
and concepts of Modern Finance provide a language and approach for excellent
performance. The aim of this book is to illustrate and exercise the application of these
tools and concepts in a messy world.
Focus on Value
The subtitle of this book is Managing for Corporate Value Creation. Economics
teaches us that value creation should be an enduring focus of concern because value is
the foundation of survival and prosperity of the enterprise. The focus on value also
1
2
3
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helps managers understand the impact of the firm on the world around it. These cases
harness and exercise this economic view of the firm. It is the special province of
finance to highlight value as a legitimate concern for managers. The cases in this book
exercise valuation analysis over a wide range of assets, debt, equities, and options, and
a wide range of perspectives, such as investor, creditor, and manager.
Linkage to Capital Markets
An important premise of these cases is that managers should take cues from the capital
markets. The cases in this volume help the student learn to look at the capital markets
in four ways. First, they illustrate important players in the capital markets such as
individual exemplar Warren Buffett and institutions like investment banks,
commercial banks, rating agencies, hedge funds, merger arbitrageurs, private
equity firms, lessors of industrial equipment, and so on. Second, they exercise the
students’ abilities to interpret capital market conditions across the economic cycle.
Third, they explore the design of financial securities, and illuminate the use of exotic
instruments in support of corporate policy. Finally, they help students understand the
implications of transparency of the firm to investors, and the impact of news about the
firm in an efficient market.
Respect for the Administrative Point of View
The real world is messy. Information is incomplete, arrives late, or is reported with
error. The motivations of counterparties are ambiguous. Resources often fall short.
These cases illustrate the immense practicality of finance theory in sorting out the issues
facing managers, assessing alternatives, and illuminating the effects of any particular
choice. A number of the cases in this book present practical ethical dilemmas or moral
hazards facing managers—indeed, this edition features a chapter, “Ethics in Finance”
right at the beginning, where ethics belongs. Most of the cases (and teaching plans in the
associated instructor’s manual) call for action plans rather than mere analyses or
descriptions of a problem.
Contemporaneity and Diversity
All of the cases in this book are set in the year 2006 or after and 25 percent are set in
2015 or later. A substantial proportion (57 percent) of the cases and technical notes are
new, or significantly updated. The mix of cases reflects the global business
environment: 52 percent of the cases in this book are set outside the United States, or
have strong cross-border elements. Finally the blend of cases continues to reflect the
growing role of women in managerial ranks: 31 percent of the cases present women as
key protagonists and decision-makers. Generally, these cases reflect the increasingly
diverse world of business participants.
Plan of the Book
The cases may be taught in many different combinations. The sequence indicated by the
table of contents corresponds to course designs used at Darden. Each cluster of cases in
the Table of Contents suggests a concept module, with a particular orientation.
1. Setting Some Themes. These cases introduce basic concepts of value creation,
assessment of performance against a capital market benchmark, and capital market
efficiency that reappear throughout a case course. The numerical analysis required of
the student is relatively light. The synthesis of case facts into an important framework
or perspective is the main challenge. The case, “Warren E. Buffett, 2016,” sets the
nearly universal theme of this volume: the need to think like an investor. The updated
case entitled, “The Battle for Value, 2016: FedEx Corp. vs. United Parcel Service,
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Inc.” explores the definition of business success and its connections to themes of
financial management. “Larry Puglia and the T. Rowe Price Blue Chip Growth Fund,”
is an updated version of cases in prior editions that explores a basic question
about performance measurement: what is the right benchmark against which to
evaluate success? And finally, “Genzyme and Relational Investors: Science and
Business Collide?”, is a case that poses the dilemma of managing a public company
when the objectives of the shareholders are not always easily aligned with the longterm
objectives of the company and an activist investor is pressuring the company for
change.
2. Financial Analysis and Forecasting. In this section, students are introduced to the
crucial skills of financial-statement analysis, break-even analysis, ratio analysis, and
financial statement forecasting. The section starts with a note, “Business Performance
Evaluation: Approaches for Thoughtful Forecasting”, that provides a helpful
introduction to financial statement analysis and student guidance on generating rational
financial forecasts. The case, “The Financial Detective 2016”, asks students to match
financial ratios of companies with their underlying business and financial strategies.
“Whole Foods Market: The Deutsche Bank Report” provides students with the
opportunity to reassess the financial forecast of a research analyst in light of industry
dynamics. This case can also be used an opportunity for students to hone firm
valuation skills with the evaluation of the analyst’s “buy, hold, or sell”
recommendation. “Horniman Horticulture” uses a financial model to build intuition for
the relevancy of corporate cash flow and the financial effects of firm growth. The
case, “Guna Fibres” asks the students to consider a variety of working capital
decisions, including the impact of seasonal demand upon financing needs. Other cases
address issues in the analysis of working-capital management, and credit analysis.
3. Estimating the Cost of Capital. This module begins with an article that is a survey of
“best practices” among leading firms for estimating the cost of capital during the low
interest rate regime following the 2007–08 financial crisis. The cases following the
survey article expose students to the skills in estimating the cost of capital for firms
and their business segments. The cases aim to exercise and solidify students’ mastery
of the capital asset pricing model, the dividend-growth model, and the weighted
average cost of capital formula. “Roche Holdings AG: Funding the Genentech
Acquisition” is a case that invites students to estimate the appropriate cost of debt for
a massive debt offering. The case provides an introduction to the concept of estimating
required returns. Two new cases ask the student to estimate the cost of capital for the
firm. “H.J. Heinz: Estimating the Cost of Capital in Uncertain Times” gives students
the opportunity to reassess the cost of capital following share price decline. “Royal
Mail plc:Cost of Capital” affords students the challenge of critiquing a cost of capital
estimate for recently privatized British postal service. The case “Chestnut Foods”
requires students to consider arguments for and against risk-adjusted hurdle rates in a
multi-divisional firm, as well as techniques for estimating divisional-specific cost of
capital.
Page xv
4. Capital Budgeting and Resource Allocation. The focus of these cases is the
evaluation of individual investment opportunities as well as the assessment of
corporate capital budgets. The analytical challenges range from setting the entire
capital budget for a resource-constrained firm (“Target Corporation”) to basic
time value of money problems (“The Investment Detective”). Key issues in
this module include the estimation of Free Cash Flows, the comparison of various
investment criteria (NPV, IRR, payback, and equivalent annuities), the treatment of
issues in mutually exclusive investments, and capital budgeting under rationing. This
module features several new cases. The first is “Centennial Pharmaceutical
Corporation” provides an introduction to discounted cash flow principles by asking
the student to compare values of two earnout plans. “Worldwide Paper Company” is
an updated case that serves as an introduction to estimating cash flows and calculating
the NPV of an investment opportunity. “Fonderia del Piemonte S.p.A.” is a new
addition to the book. Fonderia is an Italian company considering a capital investment
in machinery that replaces existing equipment. The student must assess the incremental
value to the company of investing in the new equipment. The Victoria Chemical cases
give students cash flow estimates for a large capital investment opportunity (“Victoria
Chemical plc (A): The Merseyside Project”) as asks the student to provide a careful
critique of the DCF analysis. The sequel case, (“Victoria Chemical plc (B):
Merseyside and Rotterdam Projects”, deepens the analysis by adding a competing and
mutually exclusive investment opportunity. “The Procter and Gamble Company: Crest
Whitestrips Advanced Seal” is a case that asks the student to value a new product
launch but then consider the financial implications of a variety of alternative launch
scenarios The case, “Jacobs Division”, presents students an opportunity to consider
the implications of strategic planning processes. “UVa Hospital System: The Longterm
Acute Care Hospital Project”, is an analysis of an investment decision within a
not-for-profit environment. In addition to forecasting and valuing the project’s cash
flows, students must assess whether NPV and IRR are appropriate metrics for an
organization that does not have stockholders. “Star River Electronics Ltd” has been
updated for this edition and presents the student will a range of issues that the new
CEO of the company must address, including the determination of the company’s cost
of capital and whether to invest in new machinery. We have used this case as an exam
for the first half of the finance principles course in the MBA program.
5. Management of the Firm’s Equity: Dividends and Repurchases. This module seeks
to develop practical principles about dividend policy and share repurchases by
drawing on concepts about dividend irrelevance, signaling, investor clienteles,
Page xvi
bonding, and agency costs. The first case, “Rockboro Machine Tools Corporation”, is
set in 2015 and concerns a company that is changing its business strategy and
considering a change in its dividend policy. The case serves as a comprehensive
introduction to corporate financial policy and themes in managing the right side of the
balance sheet. The second case, “EMI Group PLC”, is new to this edition and features
a struggling music producer in the U.K. confronted with whether it should continue to
pay a dividend despite the profit pressures it is facing. And finally, “AutoZone, Inc.”
is a leading auto parts retailer that has been repurchasing shares over many years. The
case serves as an excellent example of how share repurchases impact the
balance sheet and presents the student with the challenge of assessing the
impact upon the company’s stock price.
6. Management of the Corporate Capital Structure. The problem of setting capital
structure targets is introduced in this module. Prominent issues are the use and
creation of debt tax shields, the role of industry economics and technology, the
influence of corporate competitive strategy, the tradeoffs between debt policy,
dividend policy, and investment goals, and the avoidance of costs of distress.
Following a technical note, “An Introduction to Debt Policy and Value”, is a new
case, “M&M Pizza”, which explores the debt-equity choice within a perfect capital
market environment—a capital market with full information and no costs of trading.
This case provides an engaging environment for students to confront fundamental
financial policy theory. “California Pizza Kitchen”, is a real world analog to “M&M
Pizza” as it addresses the classic dilemma entailed in optimizing the use of debt tax
shields and providing financial flexibility for a national restaurant chain. The next four
cases are all new to the book. “Dominion Resources: Cove Point” presents the student
with the challenge of financing a large new project without creating substantial
disruption to the firm’s capital structure polices. The “Nokia OYJ: Financing the WP
Strategic Plan” presents a similar theme as management has taken a new strategic
direction and must make financing decisions that are cost effective, but also preserve
financial flexibility going forward. “Kelly Solar” concerns a start-up that needs new
funds for investment, but already has a significant amount of debt on the books that
needs to be renegotiated before new investors will find their investment to be
attractive. The case, “JC Penney Company”, presents a large retail chain that is facing
widespread performance challenges and needs to raise funds to offset the steadily
declining cash balance that will eventually create a liquidity crisis for the company.
The last case is “Horizon Lines, Inc.” The case is about a company facing default on a
debt covenant that will prompt the need for either Chapter 11 protection or a voluntary
financial restructuring.
7. Analysis of Financing Tactics: Leases, Options, and Foreign Currency. While the
preceding module is concerned with setting debt targets, this module addresses a
range of tactics a firm might use to pursue those targets, hedge risk, and exploit market
opportunities. Included are domestic and international debt offerings, leases, currency
hedges, warrants, and convertibles. With these cases, students will exercise
techniques in securities valuation, including the use of option-pricing theory. For
example, the first case, “Baker Adhesives” explores the concept of exchange-rate risk
and the management of that risk with a forward-contract hedge and a money-market
hedge. “Vale SA” is new to this edition and is a Brazilian mining company that must
choose between debt financing denominated in U.S. dollars, euros or British pounds.
The case “J&L Railroad” presents a commodity risk problem for which students are
asked to propose a specific hedging strategy using financial contracts offered on the
open market or from a commercial bank. “WNG Capital, LLC” is a new case about a
company that owns older aircraft that it leases to airlines as an alternative to the
airline buying new aircraft. “MoGen, Inc” presents the pricing challenges associated
with a convertible bond as well as a complex hedging strategy to change the Page xvii
conversion price of the convertible through the purchase of options and
issuance of warrants.
8. Valuing the Enterprise: Acquisitions and Buyouts. This module begins with an
extensive introduction to firm valuation in the note “Methods of Valuation: Mergers
and Acquisitions.” The focus of the note includes valuation using DCF and multiples.
This edition features six new cases in this module and five cases from the previous
edition. The “Medfield Pharmaceuticals” introduces students to firm valuation with
the reality of considering the difference between the value of firm assets in place and
the value of firm growth opportunities in the context of a takeover offer for a
pharmaceutical company. The case also includes important ethical considerations.
“American Greetings” was in the prior edition and provides a straightforward firm
valuation in the context of a repurchase decision and is designed to be an introduction
to firm valuation. The new case “Ferrari: The 2015 Initial Public Offering”, presents
students the opportunity to value the legendary automotive company, and consider how
to determine appropriate company comparables for a firm that is both an auto
manufacturer and a luxury brand. The case, “Rosetta Stone: Pricing the 2009 IPO”,
provides an alternative IPO valuation case with additional focus on valuation with
market multiples. “Sun Microsystems” is also returning from the previous edition and
presents a traditional takeover valuation case with opportunities to evaluate merger
synergies and cost of capital implications. The next five cases are all new to this
edition. “Carter International” involves assessing the correct price to offer to acquire
another hotel company. “DuPont Corporation: Sale of Performance Coatings” asks the
student to assess the economics of divesting a business unit that is not meeting the
strategic objectives of the firm. “Sanofi-Aventis’s Tender Offer for Genzyme” is a
sequel to the “Genzyme and Relational Investors: Science and Business Collide?” in
Page xviii
This edition offers a number of cases that give insights about investing or financing
decisions in emerging markets. These include “Guna Fibres Ltd.,” “Star River
Electronics Ltd.,” and “Baker Adhesives.”
Summary of Changes for this Edition
The eighth edition represents a substantial and significant change from the seventh
edition.
This edition offers 31 new or significantly updated cases and technical notes, which
represents 57 percent of the book. In the interest of presenting a fresh and contemporary
collection, older cases have been updated and/or replaced with new case
situations such that all the cases are set in 2006 or later and 25 percent are set
in 2015 or later. Several of the favorite “classic” cases from the first seven editions are
available online from McGraw-Hill such that instructors who adopt this edition may
copy these older cases for classroom use. These materials can be find at
which Genzyme’s CEO must decide whether to accept a tender offer to acquire
Genzyme. “Delphi Corporation” features a large auto parts company that has been in C
hapter 11 bankruptcy for two years. The student must decide in the role of a nonsecured
lender whether to vote to approve the Plan of Reorganization to emerge from
Chapter 11.
And finally, the module features a merger negotiation exercise (“Flinder Valves and
Controls Inc.”) that provides an engaging venue for investigating the distribution of
value in a merger negotiation. The comprehensive nature of cases in this module
makes them excellent vehicles for end-of-course classes, student term papers, and/or
presentations by teams of students.
www.mhhe.com/bescases8e. All cases and teaching notes have been edited to sharpen
the opportunities for student analysis.
Supplements
The case studies in this volume are supported by various resources that help make
student engagement a success:
A guide to the novice on case preparation, “Note to the Student: How to Study and
Discuss Cases” in this volume.
All of the cases in this book are accompanied by a full teaching note that contains
suggested student study questions, a hypothetical teaching plan, and a prototypical
finished case analysis. In addition, the cases also have spreadsheet files that support
student and instructor preparation of the cases. These materials are available to all
instructors at the book’s website at www.mhhe.com/bescases8e. Also at the book’s
website is an instructor’s resource manual that facilitates the use of these materials in
a standard course by providing resources on how to design a case course and how the
cases fit together.
Two of the cases provide student counterparty roles for two negotiation exercises. The
teaching materials present detailed discussions of case outcomes, one of which is
designed to be used as second class period for the case. These supplemental materials
can significantly extend student learning and expand the opportunities for classroom
discussion.
A companion book by Robert Bruner titled, Socrates’ Muse: Reflections on
Excellence in Case Discussion Leadership (Irwin/McGraw-Hill, 2002), is available
to instructors who adopt the book for classroom use. This book offers useful tips on
case method teaching. This title is available through Create, McGraw-Hill
Page xix
Acknowledgments
This book would not be possible without the contributions of many other people.
Colleagues at Darden who have taught, co-authored, contributed to, or commented on
these cases are Brandt Allen, Yiorgos Allayannis, Sam Bodily, Karl-Adam Bonnier,
Susan Chaplinsky, John Colley, Bob Conroy, Mark Eaker, Rich Evans, Bob Fair, Paul
Farris, Jim Freeland, Sherwood Frey, Bob Harris, Jared Harris, Mark Haskins, Michael
Ho, Marc Lipson, Elena Loutskina, Pedro Matos, Matt McBrady, Charles Meiburg, Jud
Reis, William Sihler and Robert Spekman. We are grateful for their collegiality and for
the support for our casewriting efforts from the Darden School Foundation, the Mayo
Center for Asset Management, the L. White Matthews Fund for Finance Casewriting, the
Batten Institute, Columbia Business School, INSEAD, the University of
Melbourne and the University of Virginia’s McIntire School of Commerce.
Colleagues at other schools provided worthy insights and encouragement toward the
development of the eight editions of Case Studies in Finance. We are grateful to the
following persons (listed with the schools with which they were associated at the time
of our correspondence or work with them):
Michael Adler, Columbia
Raj Aggarwal, John Carroll
Turki Alshimmiri, Kuwait Univ.
Ed Altman, NYU
James Ang, Florida State
Education’s on-demand and custom publishing system. Ask your learning technology
representative for more details.
Paul Asquith, M.I.T.
Bob Barnett, North Carolina State
Geert Bekaert, Stanford
Michael Berry, James Madison
Randy Billingsley, VPI&SU
Gary Blemaster, Georgetown
Rick Boebel, Univ. Otago, New Zealand
Oyvind Bohren, BI, Norway
John Boquist, Indiana
Michael Brennan, UCLA
Duke Bristow, UCLA
Ed Burmeister, Duke
Kirt Butler, Michigan State
Don Chance, VPI&SU
Andrew Chen, Southern Methodist
Barbara J. Childs, Univ. of Texas at Austin
C. Roland Christensen, Harvard
Thomas E. Copeland, McKinsey
Jean Dermine, INSEAD
Michael Dooley, UVA Law
Barry Doyle, University of San Francisco
Bernard Dumas, INSEAD
Craig Dunbar, Western Ontario
Peter Eisemann, Georgia State
Javier Estrada, IESE
Ben Esty, Harvard
Thomas H. Eyssell, Missouri
Pablo Fernandez, IESE
Kenneth Ferris, Thunderbird
John Finnerty, Fordham
Joseph Finnerty, Illinois
Steve Foerster, Western Ontario
Günther Franke, Konstanz
Bill Fulmer, George Mason
Louis Gagnon, Queens
Dan Galai, Jerusalem
Jim Gentry, Illinois
Stuart Gilson, Harvard
Robert Glauber, Harvard
Mustafa Gultekin, North Carolina
Benton Gup, Alabama
Jim Haltiner, William & Mary
Rob Hansen, VPI&SU
Philippe Haspeslagh, INSEAD
Gabriel Hawawini, INSEAD
Pekka Hietala, INSEAD
Page xx
Rocky Higgins, Washington
Pierre Hillion, INSEAD
Laurie Simon Hodrick, Columbia
John Hund, Texas
Daniel Indro, Kent State
Thomas Jackson, UVA Law
Pradeep Jalan, Regina
Michael Jensen, Harvard
Sreeni Kamma, Indiana
Steven Kaplan, Chicago
Andrew Karolyi, Western Ontario
James Kehr, Miami Univ. Ohio
Kathryn Kelm, Emporia State
Carl Kester, Harvard
Naveen Khanna, Michigan State
Herwig Langohr, INSEAD
Dan Laughhunn, Duke
Ken Lehn, Pittsburgh
Saul Levmore, UVA Law
Wilbur Lewellen, Purdue
Scott Linn, Oklahoma
Dennis Logue, Dartmouth
Paul Mahoney, UVA Law
Paul Malatesta, Washington
Wesley Marple, Northeastern
Felicia Marston, UVA (McIntire)
John Martin, Texas
Ronald Masulis, Vanderbilt
John McConnell, Purdue
Richard McEnally, North Carolina
Catherine McDonough, Babson
Wayne Mikkelson, Oregon
Michael Moffett, Thunderbird
Nancy Mohan, Dayton
Ed Moses, Rollins
Charles Moyer, Wake Forest
David W. Mullins, Jr., Harvard
James T. Murphy, Tulane
Chris Muscarella, Penn State
Robert Nachtmann, Pittsburgh
Tom C. Nelson, University of Colorado
Ben Nunnally, UNC-Charlotte
Robert Parrino, Texas (Austin)
Luis Pereiro, Universidad Torcuato di Tella
Pamela Peterson, Florida State
Larry Pettit, Virginia (McIntire)
Tom Piper, Harvard
Gordon Philips, Maryland
John Pringle, North Carolina
Ahmad Rahnema, IESE
Al Rappaport, Northwestern
Allen Rappaport, Northern Iowa
Raghu Rau, Purdue
David Ravenscraft, North Carolina
Henry B. Reiling, Harvard
Lee Remmers, INSEAD
Jay Ritter, Florida
Richard Ruback, Harvard
Jim Schallheim, Utah
Art Selander, Southern Methodist
Israel Shaked, Boston
Dennis Sheehan, Penn State
J.B. Silvers, Case Western
Betty Simkins, Oklahoma State
Luke Sparvero, Texas
Richard Stapleton, Lancaster
Laura Starks, Texas
Page xxi
Jerry Stevens, Richmond
John Strong, William & Mary
Marti Subrahmanyam, NYU
Anant Sundaram, Thunderbird
Rick Swasey, Northeastern
Bob Taggart, Boston College
Udin Tanuddin, Univ. Surabaya, Indonesia
Anjan Thakor, Indiana
Thomas Thibodeau, Southern Methodist
Clifford Thies, Shenandoah Univ.
James G. Tompkins, Kenesaw State
Walter Torous, UCLA
Max Torres, IESE
Nick Travlos, Boston College
Lenos Trigeorgis, Cyprus
George Tsetsekos, Drexel
Peter Tufano, Harvard
James Van Horne, Stanford
Nick Varaiya, San Diego State
Theo Vermaelen, INSEAD
Michael Vetsuypens, Southern Methodist
Claude Viallet, INSEAD
Ingo Walter, NYU
Sam Weaver, Lehigh
J.F. Weston, UCLA
Peter Williamson, Dartmouth
Brent Wilson, Brigham Young
Kent Womack, Dartmouth
Karen Wruck, Ohio State
Fred Yeager, St. Louis
Betty Yobaccio, Framingham State
Marc Zenner, North Carolina
Research Assistants working under our direction have helped gather data and
prepare drafts. Research assistants who contributed to various cases in this and
previous editions include Darren Berry, Chris Blankenship, Justin Brenner, Anna
Buchanan, Anne Campbell, Drew Chambers, Sean Carr, Jessica Chan, Jenny Craddock,
Lucas Doe, Jake Dubois, Brett Durick, David Eichler, Ali Erarac, Shachar Eyal, Rick
Green, Daniel Hake, Dennis Hall, Jerry Halpin, Peter Hennessy, Dot Kelly, Vladimir
Kolcin, Nili Mehta, Casey Opitz, Katarina Paddack, Suprajj Papireddy, Thien Pham,
Chad Rynbrandt, John Sherwood, Elizabeth Shumadine, Janelle Sirleaf, Jane Sommers-
Kelly, Don Stevenson, Carla Stiassni, Sanjay Vakharia, Larry Weatherford, and Steve
Wilus. We have supervised numerous others in the development of individual cases—
those worthy contributors are recognized in the first footnote of each case.
A busy professor soon learns the wisdom in the adage, “Many hands make work
light.” we are very grateful to the staff of the Darden School for its support in this
project. Excellent editorial assistance at Darden was provided by the staff of Darden
Business Publishing and the Darden Case Collection. We specifically thank Leslie
Page xxii
Mullin (Senior Editor) and Margaret Ebin, Lucinda Ewing and Debbie O’Brien
(Editors). Ginny Fisher gave stalwart secretarial support. Valuable library research
support was given by Karen Marsh King and Susan Norrisey. The patience, care, and
dedication of these people are richly appreciated.
At McGraw-Hill, Chuck Synovec has served as Brand Manager for this book.
Melissa Leick was the project manager, and Jennifer Upton served as Product
Developer for this edition. Our thanks extend to those who helped us on prior editions
as well, including Mike Junior, who originally recruited Bob Bruner to do this project,
and Michele Janicek.
Of all the contributors, our wives, Barbara M. Bruner, Kathy N. Eades, and Mary
Ann H. Schill as well as our children have endured great sacrifices as the result of our
work on this book. As Milton said, “They also serve who only stand and wait.”
Development of this eighth edition would not have been possible without their fond
patience.
All these acknowledgments notwithstanding, responsibility for these materials is
ours. We welcome suggestions for their enhancement. Please let us know of your
experience with these cases, either through McGraw-Hill/Irwin, or at the
coordinates given below.
Robert F. Bruner
University Professor
Distinguished Professor of Business Administration
Dean Emeritus of the Darden School of Business
Darden Graduate School of Business
University of Virginia
brunerr@virginia.edu4
Kenneth M. Eades
Professor of Business Administration
Darden Graduate School of Business
University of Virginia
eades@virginia.edu
Michael J. Schill
Professor of Business Administration
Darden Graduate School of Business
University of Virginia
schill@virginia.edu
Individual copies of all the Darden cases in this and previous editions may be obtained
promptly from McGraw-Hill/Irwin’s Create (http://create.mcgraw-hill.com) or from
Darden Business Publishing (telephone: 800-246-3367; https://store.darden.virginia.ed
u/). Proceeds from these case sales support case writing efforts. Please respect the
copyrights on these materials.
4
4
Page xxiii
Note to the Student: How to Study and Discuss Casess
“Get a good idea and stay with it. Dog it and work at it until it’s done, and done right.”
—Walt Disney
You enroll in a “case method” course, pick up the book of case studies or the stack of
loose-leaf cases, and get ready for the first class meeting. If this is your first experience
with case discussions, the odds are that you are clueless and a little anxious about how
to prepare for this course. That’s fairly normal but something you should try to break
through quickly in order to gain the maximum from your studies. Quick breakthroughs
come from a combination of good attitude, good “infrastructure,” and good execution—
this note offers some tips.
Good Attitude
Students learn best that which they teach themselves. Passive and mindless learning is
ephemeral. Active and mindful learning simply sticks. The case method makes learning
sticky by placing you in situations that require invention of tools and concepts in your
own terms. The most successful case students share a set of characteristics that drive
self-teaching:
1. Personal initiative, self-reliance. Case studies rarely suggest how to proceed.
Professors are more like guides on a long hike: they can’t carry you, but they can show
you the way. You must arrive at the destination under your own power. You must figure
out the case on your own. To teach yourself means that you must sort ideas out in ways
that make sense to you, personally. To teach yourself is to give yourself two gifts: the
idea you are trying to learn, and greater self-confidence in your own ability to master
the world.
Page xxiv
2. Curiosity, a zest for exploration as an end in itself. Richard P. Feynman, who won
the Nobel Prize in Physics in 1965, was once asked whether his key discovery was
worth it. He replied, “. . . [the Nobel Prize is] a pain in the . . . I don’t like honors . . .
The prize is the pleasure of finding the thing out, the kick in the discovery, the
observation that other people use it [my work]—those are the real things, the honors
are unreal to me.”1
3. A willingness to take risks. Risk-taking is at the heart of all learning. Usually one
learns more from failures than successes. The banker, Walter Wriston, once said,
“Good judgment comes from experience. Experience comes from bad judgment.”
4. Patience and persistence. Case studies are messy, a realistic reflection of the fact
that managers don’t manage problems, they manage messes. Initially, reaching a
solution will seem to be the major challenge. But once you reach a solution, you may
discover other possible solutions, and face the choice among the best alternatives.
2
5. An orientation to community and discussion. Much of the power of the case method
derives from a willingness to talk with others about your ideas and/or your points of
confusion. This is one of the paradoxes of the case method: you must teach yourself,
but not in a vacuum. The poet, T.S. Eliot, said, “there is no life not lived in
community.” Talking seems like such an inefficient method of sorting through the case,
but if exploration is an end in itself then talking is the only way. Furthermore, talking
is an excellent means of testing your own mastery of ideas, of rooting out points of
confusion, and generally, of preparing you for professional life.
6. Trust in the process. The learnings from a case-method course are impressive. They
arrive cumulatively over time. In many cases, the learnings continue well after the
Good Infrastructure
“Infrastructure” consists of all the resources that the case student can call upon. Some of
this is simply given to you by the professor: case studies, assignment questions,
supporting references to textbooks or articles, and computer data or models. But you can
go much farther to help yourself. Consider these steps:
course has finished. Occasionally, these learnings hit you with the force of a tsunami.
But generally, the learnings creep in quietly, but powerfully, like the tide. After the
case course, you will look back and see that your thinking, mastery, and appreciation
have changed dramatically. The key point is that you should not measure the success of
your progress on the basis of any single case discussion. Trust that in the cumulative
work over many cases you will gain the mastery you seek.
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1. Find a quiet place to study. Spend at least 90 minutes there for each case study.
Each case has subtleties to it, which you will miss unless you can concentrate. After
two or three visits, your quiet place will take on the attributes of a habit: you
will slip into a working attitude more easily. Be sure to spend enough time in
the quiet place to give yourself a chance to really engage the case.
2. Access a business dictionary. If you are new to business and finance, some of the
terms will seem foreign; if English is not your first language, many of the terms will
seem foreign if not bizarre. Get into the habit of looking up terms that you don’t know.
The benefit of this becomes cumulative. You can find good definitions online.
3. Skim the business news each day; read a substantive business magazine or blog
regularly; follow the markets. Reading a newspaper or magazine helps build a
context for the case study you are trying to solve at the moment, and helps you make
connections between the case study and current events. The terminology of business
and finance that you see in the publications helps reinforce your use of the dictionary,
and hastens your mastery of terms you will see in the cases. Your learning by reading
business periodicals is cumulative. Some students choose to follow a good business
news website on the Internet. These have the virtue of being inexpensive and efficient,
but they tend to screen too much. Having the printed publication in your hands, and
leafing through it, helps the process of discovery, which is the whole point of the
exercise.
4. Learn the basics of spreadsheet modeling on a computer. Many case studies now
have supporting data available for analysis in spreadsheet files, such as Microsoft
Excel. Analyzing the data on a computer rather than by hand both speeds up your
work, and extends your reach.
5. Form a study group. The ideas in many cases are deep; the analysis can get complex.
You will learn more, and perform better in class participation by discussing the
cases together in a learning team before you come to class. Your team should devote
an average of an hour to each case. High performance teams show a number of
common attributes:
a. Members commit to the success of the team.
b. The team plans ahead, leaving time for contingencies.
c. The team meets regularly.
d. Team members show up for meetings and are prepared to contribute.
e. There may or may not be a formal leader, but assignments are clear. Team members
meet their assigned obligations.
6. Get to know your professor. In the case method, students inevitably learn more from
one another than from the instructor. But the teacher is part of the learning
infrastructure too: a resource to be used wisely. Never troll for answers in advance of
a case discussion. Do your homework; use classmates and learning teams to clear up
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Good Execution
Good attitude and infrastructure must be employed properly—and one needs good
execution. The extent to which a student learns depends on how the case study is
approached. What can one do to gain the maximum from the study of these cases?
most questions so that you can focus on the meatiest issues with the teacher. Be very
organized and focused about what you would like to discuss. Remember that teachers
like to learn too: if you reveal a new insight about a case or bring a clipping about a
related issue in current events, the professor and student both gain from their time
together. Ultimately, the best payoff to the professor is the “aha” in the student’s eyes
when he or she masters an idea.
1. Reading the case. The very first time you read any case, look for the forest not the
trees. This requires that your first reading be quick. Do not begin taking notes on the
first round; instead, read the case like a magazine article. The first few paragraphs of
a well-constructed case usually say something about the problem—read those
carefully. Then quickly read the rest of the case, seeking mainly a sense of the scope of
the problems, and what information the case contains to help resolve them. Leaf
through the exhibits, looking for what information they hold, rather than for any
analytical insights. At the conclusion of the first pass, read any supporting articles or
notes that your instructor may have recommended.
2. Getting into the case situation. Develop your “awareness.” With the broader
perspective in mind, the second and more detailed reading will be more productive.
The reason is that as you now encounter details, your mind will be able to organize
them in some useful fashion rather than inventorying them randomly. Making linkages
among case details is necessary toward solving the case. At this point you can take the
notes that will set up your analysis.
The most successful students project themselves into the position of the decisionmaker
because this perspective helps them link case details as well as develop a stand
on the case problem. Assignment questions may help you do this; but it is a good idea
to get into the habit of doing it yourself. Here are the kinds of questions you might try
to answer in preparing every case:
a. Who are the protagonists in the case? Who must take action on the problem? What do
they have at stake? What pressures are they under?
b. In what business is the company? What is the nature of its product? What is the
nature of demand for that product? What is the firm’s distinctive competence? With
whom does it compete? What is the structure of the industry? Is the firm
comparatively strong or weak? In what ways?
3
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c. What are the goals of the firm? What is the firm’s strategy in pursuit of these goals?
(The goals and strategy might be explicitly stated, or they may be implicit in the way
the firm does business.) What are the firm’s apparent functional policies in
marketing (e.g., push- versus-pull strategy), production (e.g., labor
relations, use of new technology, distributed production vs. centralized),
and finance (e.g., the use of debt financing, payment of dividends)? Financial and
business strategies can be inferred from analysis of financial ratios and a sources
and uses of funds statement.
d. How well has the firm performed in pursuit of its goals? (The answer to this
question calls for simple analysis using financial ratios, such as the DuPont system,
compound growth rates, and measures of value creation.)
The larger point of this phase of your case preparation is to broaden your awareness
of issues. Perhaps the most successful investor in history, Warren Buffett, said, “Any
player unaware of the fool in the market, probably is the fool in the market.”4
Awareness is an important attribute of successful managers.
3. Defining the problem. A common trap for many executives is to assume that the issue
at hand is the real problem worthiest of their time, rather than a symptom of some
larger problem that really deserves their time. For instance, a lender is often asked to
advance funds to help tide a firm over a cash shortfall. Careful study may reveal that
the key problem is not a cash shortfall, but rather product obsolescence, unexpected
competition, or careless cost management. Even in cases where the decision is fairly
narrowly defined (such as in a capital expenditure choice), the “problem” generally
turns out to be the believability of certain key assumptions. Students who are new to
the case method tend to focus narrowly in defining problems and often overlook the
influence which the larger setting has on the problem. In doing this the student
develops narrow specialist habits, never achieving the general manager perspective. It
is useful and important for you to define the problem yourself, and in the process,
validate the problem as suggested by the protagonist in the case.
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4. Analysis: run the numbers and go to the heart of the matter. Virtually all finance
cases require numerical analysis. This is good because figure-work lends rigor and
structure to your thinking. But some cases, reflecting reality, invite you to explore
blind alleys. If you are new to finance, even these explorations will help you learn.
The best case students develop an instinct for where to devote their analysis. Economy
of effort is desirable. If you have invested wisely in problem definition, economical
analysis tends to follow. For instance, a student might assume that a particular case is
meant to exercise financial forecasting skills and will spend two or more hours
preparing a detailed forecast, instead of preparing a simpler forecast in one hour and
conducting a sensitivity analysis based on key assumptions in the next hour. An
executive rarely thinks of a situation as having to do with a forecasting method or
discounting or any other technique, but rather thinks of it as a problem of
5
judgment, deciding on which people or concepts or environmental conditions to bet.
The best case analyses get down to the key bets on which the executive is wagering
the prosperity of the firm, and his or her career. Get to the business issues quickly, and
avoid lengthy churning through relatively unimportant calculations.
5. Prepare to participate: take a stand. To develop analytical insights without making
recommendations is useless to executives, and drains the case study experience of
some of its learning power. A stand means having a point of view about the problem, a
recommendation, and an analysis to back up both of them. The lessons most worth
learning all come from taking a stand. From that truth flows the educative force of the
case method. In the typical case, the student is projected into the position of an
executive who must do something in response to a problem. It is this choice of what to
do that constitutes the executive’s “stand.” Over the course of a career, an executive
who takes stands gains wisdom. If the stand provides an effective resolution of the
problem, so much the better for all concerned. If it does not, however, the wise
executive analyzes the reasons for the failure and may learn even more than from a
success. As Theodore Roosevelt wrote:
The credit belongs to the man who is actually in the arena—whose face is
marred by dust and sweat and blood . . . who knows the great enthusiasms, the
great devotions—and spends himself in a worthy cause—who at best if he wins
knows the thrills of high achievement—and if he fails, at least fails while
daring greatly so that his place shall never be with those cold and timid souls
who know neither victory nor defeat.
6
6. In class: participate actively in support of your conclusions, but be open to new
insights. Of course, one can have a stand without the world being any wiser. To take a
stand in case discussions means to participate actively in the discussion and to
7
Conclusion: Focus on Process, and Results Will Follow
advocate your stand until new facts or analyses emerge to warrant a change. Learning
by the case method is not a spectator sport. A classic error many students make is to
bring into the case method classroom the habits of the lecture hall (i.e., passively
absorbing what other people say). These habits fail miserably in the case method
classroom because they only guarantee that one absorbs the truths and fallacies uttered
by others. The purpose of case study is to develop and exercise one’s own skills and
judgment. This takes practice and participation, just as in a sport. Here are two good
general suggestions: (1) defer significant note-taking until after class and (2) strive to
contribute to every case discussion.
7
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7. Immediately after class: jot down notes, corrections and questions. Don’t
overinvest in taking notes during class—that just cannibalizes “air time” in which you
could be learning through discussing the case. But immediately after, collect
your learnings and questions in notes that will capture your thinking. Of
course, ask a fellow student or your teacher questions that will help clarify issues that
still puzzle you.
8. Once a week, flip through notes. Make a list of your questions, and pursue
answers. Take an hour each weekend to review your notes from class discussions
during the past week. This will help build your grasp of the flow of the course.
Studying a subject by the case method is like building a large picture with small
mosaic tiles. It helps to step back to see the big picture. But the main objective should
be to make an inventory of anything you are unclear about: terms, concepts, and
calculations. Work your way through this inventory with classmates, learning teams,
and ultimately the instructor. This kind of review and follow-up builds your selfconfidence
and prepares you to participate more effectively in future case discussions.
View the case method experience as a series of opportunities to test your mastery of
techniques and your business judgment. If you seek a list of axioms to be etched in stone,
you are bound to disappoint yourself. As in real life, there are virtually no “right”
answers to these cases in the sense that a scientific or engineering problem has an exact
solution. Jeff Milman has said, “The answers worth getting are never found in the back
of the book.” What matters is that you obtain a way of thinking about business situations
that you can carry from one job (or career) to the next. In the case method it is largely
true that how you learn is what you learn.8
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Ethics in Finance
“The first thing is character, before money or anything else.”
—J. P. Morgan (in testimony before the U.S. Congress)
“The professional concerns himself with doing the right thing rather than making money, knowing that the
profit takes care of itself if the other things are attended to.”
—Edwin LeFevre, Reminiscences of a Stock Operator
Integrity is paramount for a successful career in finance and business, as practitioners
remind us. One learns, rather than inherits, integrity. And the lessons are everywhere,
even in case studies about finance. To some people, the world of finance is purely
mechanical, devoid of ethical considerations. The reality is that ethical issues are
pervasive in finance. Still, disbelief that ethics matter in finance can take many forms.
“It’s not my job,” says one person, thinking that a concern for ethics belongs to a CEO,
an ombudsperson, or a lawyer. But if you passively let someone else do your thinking,
you expose yourself to complicity in unethical decisions of others. Even worse is the
possibility that if everyone assumes that someone else owns the job of ethical
practice, then perhaps no one owns it and that therefore the enterprise has no moral
compass at all.
Another person says, “When in Rome, do as the Romans do. It’s a dog-eat-dog world:
we have to play the game their way if we mean to do business there.” Under this view,
everybody is assumed to act ethically relative to their local environment so that it is
inappropriate to challenge unethical behavior. This is moral relativism. The problem
with this view is that it presupposes that you have no identity, that you are defined like
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There is no escaping the fact that ethical reasoning is vital to the practice of business
and finance. Tools and concepts of ethical reasoning belong in the financial toolkit
alongside other valuable instruments of financial practice.
Ethics and economics were once tightly interwoven. The patriarch of
economics, Adam Smith, was actually a scholar of moral philosophy. Though
the two fields may have diverged in the last century, they remain strong complements.
Morality concerns norms and teachings. Ethics concerns the process of making morally
good decisions, or as Andrew Wicks wrote, “Ethics has to do with pursuing—and
achieving—laudable ends.” The Oxford English Dictionary defines “moral” as “Of
knowledge, opinions, judgments, etc.; Relating to the nature and application of the
distinction between right and wrong.” “Ethics,” on the other hand, is defined as “The
science of morals.” To see how decision-making processes in finance have ethical
implications, consider the following case studies.
a chameleon by the environment around you. Relativism is the enemy of personal
identity and character. You must have a view if you are rooted in any cultural system.
Prepare to take a stand.
A third person says, “It’s too complicated. Civilization has been arguing about ethics
for 3,000 years. You expect me to master it in my lifetime?” The response must be that
we use complicated systems dozens of times each day without full mastery of their
details. Perhaps the alternative would be to live in a cave, a simpler life but much less
rewarding. Moreover, as courts have been telling the business world for centuries,
ignorance of the law is no defense: if you want to succeed in the field of finance, you
must grasp the norms of ethical behavior.
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1. Fraud. For several decades, Bernard Madoff operated a money management firm that
reported annual returns of about 10% in good years and bad, performance that was
astonishing for its regularity. Madoff claimed that he was able to v earn such reliable
returns from investing in the shares of mature companies, along with a “collar” (put
and call options that limited the risk). He marketed his services to investors on the
strength of his reported performance, his years in the investment business, and his
ethnic and social affinity in prominent clubs and communities. But in the Panic of
2008, worried investors sought to withdraw their investments from the Madoff firm.
On December 10, 2008, Bernard Madoff admitted to F.B.I. agents that his investment
fund was “one big lie,” exploiting some 13,500 individual investors and charities.
Investigation and court proceedings eventually revealed that Madoff had operated a
massive “Ponzi scheme,” in which the investments by new investors were used to pay
high returns to existing investors. The collapse of his firm cost investors some $50
billion in losses. Madoff was convicted of 11 Federal crimes and received a
sentence of 150 years in jail. A number of other individuals, charities, and firms were
investigated, indicted, convicted, and/or fined on related charges. Several analysts
over the years warned that Madoff’s performance was unrealistic and probably
fraudulent; but the SEC took no action. Afterward, the agency issued a 477-page
report of an internal investigation that resulted in disciplinary actions against eight
SEC employees, but no terminations. This was the largest Ponzi scheme in history and
generated an enormous range of accusations of negligence or complicity in the fraud.
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2. Negligence. In 2011, the Financial Crisis Inquiry Commission delivered a report on
the Panic of 2008 that found “a systemic breakdown in accountability and ethics. The
integrity of our financial markets and the public’s trust in those markets are essential to
the economic well-being of our nation. The soundness and the sustained prosperity of
the financial system and our economy rely on the notions of fair dealing,
responsibility, and transparency. In our economy, we expect businesses and
individuals to pursue profits, at the same time that they produce products and services
of quality and conduct themselves well. . . . Unfortunately—as has been the
case in past speculative booms and busts—we witnessed an erosion of standards of
responsibility and ethics that exacerbated the financial crisis. This was not universal,
but these breaches stretched from the ground level to the corporate suites. They
resulted not only in significant financial consequences but also in damage to the trust
of investors, businesses, and the public in the financial system. . . . This report
catalogues the corrosion of mortgage-lending standards and the securitization pipeline
that transported toxic mortgages from neighborhoods across America to investors
around the globe. Many mortgage lenders set the bar so low that lenders simply took
eager borrowers’ qualifications on faith, often with a willful disregard for a
borrower’s ability to pay. . . . These trends were not secret. As irresponsible lending,
including predatory and fraudulent practices, became more prevalent, the Federal
Reserve and other regulators and authorities heard warnings from many quarters. Yet
the Federal Reserve neglected its mission “to ensure the safety and soundness of the
nation’s banking and financial system and to protect the credit rights of consumers.” It
failed to build the retaining wall before it was too late. And the Office of the
Comptroller of the Currency and the Office of Thrift Supervision, caught up in turf
wars, preempted state regulators from reining in abuses. . . . In our inquiry, we found
dramatic breakdowns of corporate governance, profound lapses in regulatory
oversight, and near fatal flaws in our financial system.”ix
3. Incentives that distort values. From August, 2015 to May, 2016, the share prices of
Valeant Pharmaceutical fell about 90%. This destruction of share value reflected the
accumulated doubts about the adequacy of the firm’s disclosure of accounting results
and material information pertaining to its strategy and risks. The company had grown
rapidly by acquisition and by sharply raising the prices of product lines that it had
purchased. Congress began an investigation into the firm’s practices and complained
that Valeant was withholding information. Short-sellers alleged that Valeant used a
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Laws and regulations often provide a “bright red line” to constrain bad behavior. But
ethics demand an even higher standard. Bernard Madoff broke the law against
fraudulent behavior. His family, friends, and associates seem to have looked the other
way over the years, rather than urging him not to proceed. Leading up to the Panic of
2008, many watchdogs grew lax and neglected their duties to the wider public. And in
the case of Valeant, managers and directors of the company fueled a toxic culture of
growth at any cost to others.
Why One Should Care about Ethics in Finance
Managing in ethical ways is not merely about avoiding bad outcomes. There are at least
five positive arguments for bringing ethics to bear on financial decision-making.
Sustainability. Unethical practices are not a foundation for enduring,
sustainable, enterprise. This first consideration focuses on the legacy one creates
through one’s financial transactions. What legacy do you want to leave? To incorporate
ethics into our finance mindset is to think about the kind of world that we would like to
live in, and that our children will inherit.
One might object that in a totally anarchic world, unethical behavior might be the
only path to life. But this only begs the point: we don’t live in such a world. Instead, our
world of norms and laws ensures a corrective process against unethical behavior.
related firm, Phillidor, to book fake sales—Valeant denied this, but then ceased its ties
to Phillidor and shut down its operations. The board of directors sacked its CEO. And
a prominent backer of Valeant, activist investor, Bill Ackman, “deeply and profoundly
apologize[d]” to investors for his support of Valeant’s management. Analysts cited
liberal option-based executive compensation as one stimulus for Valeant’s aggressive
behavior.
Ethical behavior builds trust. Trust rewards. The branding of products seeks to create
a bond between producer and consumer: a signal of purity, performance, or other
attributes of quality. This bond is built by trustworthy behavior. As markets reveal,
successfully branded products command a premium price. Bonds of trust tend to pay. If
the field of finance were purely a world of one-off transactions, it would seem ripe for
opportunistic behavior. But in the case of repeated entry into financial markets and
transactions, for instance by active buyers, intermediaries, and advisors, reputation can
count for a great deal in shaping the expectations of counterparties. This implicit bond,
trust, or reputation can translate into more effective and economically attractive
financial transactions and policies.
Surely, ethical behavior should be an end in itself. If you are behaving ethically only
to get rich, then you are hardly committed to that behavior. Some might even see this as
an imperfect means by which justice expresses itself.
Ethical behavior builds teams and leadership which underpin process excellence.
Standards of global best practice emphasize that good business processes drive good
outcomes. Stronger teams and leaders result in more agile and creative responses to
problems. Ethical behavior contributes to the strength of teams and leadership by
aligning employees around shared values, and building confidence and loyalty.
An objection to this argument is that in some settings promoting ethical behavior is
no guarantee of team-building. Indeed, teams might blow apart over disagreement about
what is ethical or what action is appropriate to take. But typically, this is not the fault of
ethics, rather of team processes for handling disagreements.
Ethics sets a higher standard than laws and regulations. To a large extent, the law is
a crude instrument: it tends to trail rather than anticipate behavior; it contains gaps that
become recreational exploitation for the aggressive business person; Justice may neither
be swift nor proportional to the crime; and as Andrew Wicks said, it “puts you in an
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adversarial posture with respect to others which may be counterproductive to other
objectives in facing a crisis.” To use only the law as a basis for ethical thinking is to
settle for the lowest common denominator of social norms. As former Chairman of the
Securities and Exchange Commission, Richard Breeden, said, “It is not an adequate
ethical standard to want to get through the day without being indicted.”
Some might object to this line of thinking by claiming that in a pluralistic society, the
law is the only baseline of norms on which society can agree. Therefore, isn’t the law a
“good enough” guide to ethical behavior? Lynn Paine argued that this leads to a
“compliance” mentality and that ethics takes one farther. She wrote,
“Attention to law, as an important source of managers’ rights and
responsibilities, is integral to, but not a substitute for, the ethical point of view—a point
of view that is attentive to rights, responsibilities, relationships, opportunities to
improve and enhance human well-being, and virtue and moral excellence.”
Reputation and conscience. Motivating ethical behavior only by appealing to benefits
and avoiding costs is inappropriate. By some estimates, the average annual income for a
lifetime of crime (even counting years spent in prison) is large—it seems that crime
does pay. If income were all that mattered, most of us would switch into this lucrative
field. The business world features enough cheats and scoundrels to offer any
professional the opportunity to break promises, or worse, for money. Ethical
professionals decline these opportunities for reasons having to do with the kind of
people they want to be. Amar Bhide and Howard Stevenson wrote, “The
businesspeople we interviewed set great store on the regard of their family, friends, and
the community at large. They valued their reputations, not for some nebulous financial
gain but because they took pride in their good names. Even more important, since
outsiders cannot easily judge trustworthiness, businesspeople seem guided by their
inner voices, by their consciences. . . . We keep promises because it is right to do so,
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not because it is good business.”
For Whose Interests Are You Working?
Generally the financial executive or deal designer is an agent acting on behalf of others.
For whom are you the agent? Two classic schools of thought emerge.
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Stockholders. Some national legal frameworks require directors and managers to
operate a company in the interests of its shareholders. The shareholder focus lends a
clear objective: do what creates shareholders’ wealth. This would seem to limit
charitable giving, “living wage” programs, voluntary reduction of pollution, and
enlargement of pension benefits for retirees—all of these loosely gather under the
umbrella of “social responsibility” movement in business. Milton Friedman (1962),
perhaps the most prominent exponent of the stockholder school of thought, argued that
the objective of business is to return value to its owners and that to divert the
objective to other ends is to expropriate shareholder value and threaten the survival of
the enterprise. Also, the stockholder view would argue that if all companies deviated,
the price system would cease to function well as a carrier of information about the
allocation of resources in the economy. The stockholder view is perhaps dominant in
the U.S., U.K, and other countries in the Anglo-Saxon sphere.
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Stakeholders. The alternative view admits that stockholders are an important
constituency of the firm, but that other groups such as employees, customers, suppliers,
and the community also have a stake in the activities and success of the firm. Edward
Freeman (1984) argued that the firm should be managed in the interest of the broader
spectrum of constituents. The manager would necessarily be obligated to account for
the interests and concerns of the various constituent groups in arriving at business
decisions—the aim would be to satisfy them all, or at least the most
concerned stakeholders on each issue. The complexity of this kind of
Adding complexity to the question of whose interests one serves is the fact that often
one has many allegiances—not only to the firm or client, but also to one’s community,
family, etc. Obligations that one has as an employee or professional are only a subset of
obligations one has on the whole.
What is “good”? Consequences, Duties, Virtues.
One confronts ethical issues when one must choose among alternatives on the basis of
right versus wrong. The ethical choices may be stark where one alternative is truly right
and the other truly wrong. But in professional life the alternatives typically differ more
subtly as in choosing which alternative is more right or less wrong. Ernest Hemingway
said that what is moral is what one feels good after and what is immoral is what one
feels bad after. Since feelings about an action could vary tremendously from one person
to the next, this simplistic test would seem to admit moral relativism as the only course,
an ethical “I’m OK, You’re OK” approach. Fortunately 3,000 years of moral reasoning
lend frameworks for greater definition of what is “right” and “wrong.”
“Right” and “wrong” defined by consequences. An easy point of departure is to focus
on outcomes. An action might be weighed in terms of its utility for society. Who is hurt
or helped must be taken into consideration. Utility can be assessed in terms of the
pleasure or pain for people. People choose to maximize utility. Therefore, right action is
that which produces the greatest good for the greatest number of people.
decision-making can be daunting and slow. In addition, it is not always clear which
stakeholder interests are relevant in making specific decisions. Such a definition
seems to depend highly on the specific context, which would seem to challenge the
ability to achieve equitable treatment of different stakeholder groups and across time.
But the important contribution of this view is to suggest a relational view of the firm
and to stimulate the manager to consider the diversity of those relationships.
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“Utilitarianism” has proved to be controversial. Some critics feared that this
approach might endorse gross violations of norms that society holds dear including the
right to privacy, the sanctity of contracts, and property rights, when weighed in the
balance of consequences for all. And the calculation of utility might be subject to
special circumstances or open to interpretation, making the assessment rather more
situation-specific than some philosophers could accept.
Utilitarianism was the foundation for modern neoclassical economics. Utility has
proved to be difficult to measure rigorously and remains a largely theoretical idea. Yet
utility-based theories are at the core of welfare economics and underpin analyses of
phenomena varying as widely as government policies, consumer preferences, and
investor behavior.
“Right” and “wrong” defined by duty or intentions. Immoral actions are ultimately
self-defeating. A practice of writing bad checks, for instance, if practiced universally,
would result in a world without check-writing and probably very little credit. Therefore
you should act on rules which you would require to be applied universally . You
should treat a person as an end, never as a means. It is vital to ask whether an
action would show respect for other persons and whether that action was
something a rational person would do—“If everyone behaved this way, what kind of
world would we have?”
Critics of this perspective argue that its universal view is too demanding, indeed,
impossible for a businessperson to observe. For instance, the profit motive focuses on
the manager’s duty to just one company. But Norman Bowie responds, “Perhaps
focusing on issues other than profits . . . will actually enhance the bottom line . . .
.Perhaps we should view profits as a consequence of good business practices rather
than as the goal of business.”
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“Right” and “wrong” defined by virtues. Finally, a third tradition in philosophy
argues that the debate over “values” is misplaced: the focus should be on virtues and
the qualities of the practitioner. The attention to consequences or duty is fundamentally a
focus on compliance. Instead, one should consider whether an action is consistent with
being a virtuous person. This view argues that personal happiness flowed from being
virtuous, and not merely from comfort (utility) or observance (duty). It acknowledges
that vices are corrupting. And it focuses on personal pride: “If I take this action would I
be proud of what I see in the mirror? If it were reported tomorrow in the newspaper,
would I be proud of myself?” Warren Buffett, CEO of Berkshire Hathaway, and one of
the most successful investors in modern history issues a letter to each of his operating
managers each year emphasizing the importance of personal integrity: He said that
Berkshire can afford financial losses, but not losses in reputation. He wrote, “Make sure
everything you do can be reported on the front page of your local newspaper written by
an unfriendly, but intelligent reporter.”
Critics of virtue-based ethics raise two objections. First, a virtue to one person may
be a vice to another. Solomon (1999) points out that Confucius and Nietzsche, two other
virtue ethicists, held radically different visions of virtue: Confucius extolled virtues
such as respect and piety. In contrast, Nietzsche extolled risk-taking, war-making, and
ingenuity. Thus, virtue ethics may be context-specific. Second, virtues can change over
time. What may have been regarded as “gentlemanly” behavior (i.e., formal politeness)
in the 19th Century, might have been seen by feminists in the late 20th Century as
insincere and manipulative.
Discrete definition of “right” and “wrong” remains a subject of ongoing discourse.
But the practical person can abstract from these and other perspectives useful guidelines
toward ethical work:
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How will my action affect others? What are the consequences?
Page xxxvii
What Can You Do to Promote Ethical Behavior in Your
Firm?
An important contributor to unethical business practices is the existence of a work
environment that promotes such behavior. Leaders in corporate work places need to be
proactive in shaping a high performance culture that sets high ethical expectations. The
leader can take a number of steps to shape an ethical culture.
Adopt a code of ethics. One dimension of ethical behavior is to
acknowledge some code by which one intends to live. Corporations, too, can adopt
codes of conduct that shape ethical expectations. Firms recognize the “problem of the
commons” inherent in unethical behavior by one or a few employees. In 1909, the
Supreme Court decided that a corporation could be held liable for the actions of its
employees. Since then, companies have sought to set expectations for employee
behavior, including codes of ethics. Exhibits 1 and 2 give excerpts of codes from J.P.
Morgan Chase and General Electric Company—they are clear statements that define
right behavior. Corporate codes are viewed by some critics as cynical efforts that seem
merely to respond to executive liability that might arise from white collar and other
economic crimes. Companies and their executives may be held liable for employee
behavior, even if the employee acted contrary to instructions. Mere observance of
guidelines in order to reduce liability is a legalistic approach to ethical behavior.
Instead, Lynn Paine (1994) urged firms to adopt an “integrity strategy” that uses ethics
as the driving force within a corporation. Deeply-held values would become the
foundation for decision making across the firm and would yield a frame of reference that
What are my motives and my duty here? How does this decision affect them?
Does this action serve the best that I can be?
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would integrate functions and businesses. By this view, ethics defines what a firm
stands for.
In addition, an industry or professional group can organize a code of ethics. One
EXHIBIT 1 | J.P. Morgan Chase & Co. Excerpts from Code of Conduct and Code of Ethics for
Finance Professionals
JPMC Finance Officers and Finance Professionals must act honestly, promote ethical conduct and comply with the law
. . . They are specifically required to:
Carry out their responsibilities honestly, in good faith and with integrity, due care and diligence . . .
Comply with applicable government laws, rules and regulations . . .
Never . . . coerce, manipulate, mislead or fraudulently influence the firm’s independent auditors . . .
Protect the confidentiality of non-public information relating to JPMC and its clients . . .
Address actual or apparent conflicts of interest . . .
Promptly report . . . any known or suspected violation . . .
. . .
JPMC strictly prohibits intimidation or retaliation against anyone who makes a good faith report about a known or
suspected violation of this Policy, or of any law or regulation.
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EXHIBIT 2 | Excerpts from “The Spirit and the Letter:” General Electric’s “Code of Conduct”
Statement of integrity
We have been ranked first for integrity and governance. But none of that matters if each of us does not make the right
decisions and take the right actions. . . . Do not allow anything—not “making the numbers,” competitive instincts or
even a direct order from a superior—to compromise your commitment to integrity. . . . Leaders must address
employees’ concerns about appropriate conduct promptly and with care and respect.
There is no conflict between excellent financial performance and high standards of governance and compliance—in
fact, the two are mutually reinforcing.
. . .
Obey the applicable laws and regulations . . .
Be honest, fair and trustworthy . . .
Avoid all conflicts of interest . . .
Foster an atmosphere [of] fair employment practices . . .
Strive to create a safe workplace and to protect the environment.
. . . Sustain a culture where ethical conduct is recognized, valued and exemplified by all employees. Source: “Integrity:
The Spirit and Letter of Our Commitment” General Electric Company, June 2005, page 3. A longer version of this
resource is also available at https://www.sec.gov/Archives/edgar/data/1262449/000119312508061906/dex142.htm.
example relevant for finance professionals is the Code of Ethics of the CFA Institute, the
group that confers the Chartered Financial Analyst (CFA) designation on professional
securities analysts and portfolio managers. An excerpt of the CFA Institute Code of
Ethics is given in Exhibit 3.
Talk about ethics within your team and firm. Many firms seek to reinforce a culture of
integrity with a program of seminars and training in ethical reasoning. A leader can
stimulate reflection through informal discussion of ethical developments (e.g.,
indictments, convictions, civil lawsuits) in the industry or profession or of ethical issues
that the team may be facing. This kind of discussion (without preaching) signals that it is
on the leader’s mind and is a legitimate focus of discussion. One executive regularly
raises issues such as these informally over lunch and morning coffee. Leaders believe
ethical matters are important enough to be the focus of team discussions.
Find and reflect on your dilemmas. The challenge for many finance practitioners is that
ethical dilemmas are not readily given to structured analysis, in the same way one
values a firm or balances the books. Nevertheless, one can harness the questions raised
in the field of ethics to lend some rigor to one’s reflections. Laura Nash (1981)
abstracted a list of twelve questions on which the thoughtful practitioner might reflect in
EXHIBIT 3 | CFA Institute Code of Ethics, 2014
High ethical standards are critical to maintaining the public’s trust in financial markets and in the investment
profession. . . .
Act with integrity, competence, diligence, respect . . .
Place . . . the interests of clients above their own personal interests.
Use reasonable care and exercise independent professional judgment . . .
Practice and encourage others. . . .
Promote the integrity of . . . capital markets.
Maintain and improve their professional competence . . .
Source: CFA Institute 2014. “Code of Ethics and Standard of Professional Conduct” (Charlottesville, Virginia)
http://www.cfapubs.org/doi/pdf/10.2469/ccb.v2014.n6.1
grappling with an ethical dilemma:
Act on your reflections. This may be the toughest step of all. The field of ethics can
lend structure to one’s thinking but has less to say about the action to be taken.
Confronting a problem of ethics within a team or organization, one can consider a
hierarchy of responses, from questioning and coaching to “whistle blowing” (either to
an internal ombudsperson or if necessary to an outside source), and possibly, to exit
from the organization.
1. Have I defined the problem correctly and accurately?
2. If I stood on the other side of the problem, how would I define it?
3. What are the origins of this dilemma?
4. To whom and what am I loyal, as a person and as a member of a firm?
5. What is my intention in making this decision? Page xxxviii
6. How do the likely results compare with my intention?
7. Can my decision injure anyone? How?
8. Can I engage the affected parties in my decision before I decide or take action?
9. Am I confident that my decision will be valid over a long period of time as it may
seem at this moment?
10. If my boss, the CEO, the directors, my family, or community learned about this
decision, would I have misgivings?
11. What signals (or symbols) might my decision convey, if my decision were understood
correctly? If misunderstood?
12. Are there exceptions to my position, “special circumstances” under which I might
make an alternative decision?
Conclusion
Analysis of ethical issues in finance is vital. The cases of Bernard Madoff and other
major business scandals show that ethical issues pervade the financial environment.
Ethics is one of the pillars on which stands success in finance—it builds sustainable
enterprise, trust, organizational strength, and personal satisfaction. Therefore, the
financial decision maker must learn to identify, analyze, and act on ethical issues that
may arise. Consequences, duties, and virtues stand out as three important benchmarks
for ethical analysis. Nevertheless, the results of such analysis are rarely clear-cut. But
real business leaders will take the time to sort through the ambiguities and do “the right
thing” in the words of Edwin LeFevre. These and other ethical themes will appear
throughout finance case studies and one’s career.
References and Recommended Readings
Achampong, F., and Zemedkun, W. 1995. “An empirical and ethical analysis of factors
motivating managers’ merger decisions,” Journal of Business Ethics. 14: 855–
865.
Bhide, A., and H. H. Stevenson, 1990. “Why be honest if honesty doesn’t pay,”
Harvard Business Review September-October, pages 121–129.
Bloomenthal, Harold S., 2002. Sarbanes-Oxley Act in Perspective St. Paul, MN:
West Group.
Boatright, J.R., 1999. Ethics in Finance, Oxford: Blackwell Publishers. Page xxxix
Bowie, N.E., “A Kantian approach to business ethics,” in R. E. Frederick, ed., A
Companion to Business Ethics, Malden, MA: Blackwell pages 3–16.
Carroll, A. B. 1999. “Ethics in management,” in R. E. Frederick, ed., A Companion to
Business Ethics, Malden, MA: Blackwell pages 141–152.
CFA Institute 2014. “Code of Ethics and Standard of Professional Conduct”
(Charlottesville, Virginia)
http://www.cfapubs.org/doi/pdf/10.2469/ccb.v2014.n6.1
Frederick, R.E., A Companion to Business Ethics, Oxford: Blackwell Publishers.
Freeman, R.E., 1984. Strategic Management: A Stakeholder Approach Boston:
Pittman.
Friedman, M., 1962. Capitalism and Freedom, Chicago: University of Chicago Press.
General Electric Company 2005. “Integrity: The Spirit and Letter of Our
Commitment” (June 2005). Downloaded from https://www.sec.gov/Archives/edga
r/data/1262449/000119312508061906/dex142.htm.
Jensen, M., 2005. “The agency costs of overvalued equity,” Financial Management
(Spring): 5–19.
Kidder, R., 1997. “Ethics and the bottom line: Ten reasons for businesses to do right,”
Insights on Global Ethics, Spring, pages 7–9.
Murphy, P.E. 1997. “80 Exemplary Ethics statements,” cited in L.H. Newton, “A
passport for the corporate code: from Borg Warner to the Caux Principles,” in
Robert E. Frederick, A Companion to Business Ethics, Malden, MA: Blackwell,
1999, pages 374–385.
Nash, L.L. 1981. “Ethics without the sermon,” Harvard Business Review, November-
December, pages 79–90.
Paine, L.S. 1994. “Managing for organizational integrity,” Harvard Business Review,
March-April, 106–117.
Paine, L.S., 1999. “Law, ethics, and managerial judgment,” in R. E. Frederick, ed., A
Companion to Business Ethics, Malden, MA: Blackwell pages 194–206.
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Paine, L.S. 2003. Value Shift: Why Companies Must Merger Social and Financial
Imperatives to Achieve Superior Performance New York: McGraw-Hill.
Pulliam S., 2003. A staffer ordered to commit fraud balked, and then caved. The Wall
Street Journal June 23, 2003. Page A1.
Sen, A. 1987. On Ethics and Economics Oxford: Blackwell Publishers.
Shafer, W. 2002. “Effects of materiality, risk, and ethical perceptions on fraudulent
reporting by financial executives,” Journal of Business Ethics. 38(3): 243–263.
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Solomon, R., 1999. “Business ethics and virtue.” in R. E. Frederick, ed., A
Companion to Business Ethics, Malden, MA: Blackwell pages 30–37.
Solomon, D., 2003. WorldCom moved expenses to the balance sheet of MCI. The Wall
Street Journal March 31, 2003. Downloaded from
http://online.wsj.com/article_print/0,,SB104907054486790100,00.html.
Werhane, P. 1988. “Two ethical issues in Mergers and Acquisitions,” Journal of
Business Ethics 7, 41–45.
Werhane, P. 1990. “Mergers, acquisitions, and the market for corporate control,”
Public Affairs Quarterly 4(1): 81–96.
Werhane, P. 1997. “A note on moral imagination.” Charlottesville VA: Darden Case
Collection, catalogue number UVA-E-0114.
Werhane, P. 1999. “Business ethics and the origins of contemporary capitalism:
economics and ethics in the work of Adam Smith and Herbert Spencer” in R. E.
Frederick, ed., A Companion to Business Ethics, Malden, MA: Blackwell pages
325–341.
Wicks, A., 2003. “A note on ethical decision making.” Charlottesville VA: Darden
Case Collection catalogue number UVA-E-0242.
Endnotes
Sen (1987) and Werhane (1999) have argued that Smith’s masterpiece, Wealth of
Nations, is incorrectly construed as a justification for self-interest, and that it speaks
more broadly about virtues such as prudence, fairness, and cooperation.
i
iiWicks (2003) page 5.
iiiOxford English Dictionary 1989. Vol. IX, page 1068.
ivIbid. Vol. V, page 421.
“The Con of the Century,” The Economist, December 18, 2008 at
http://www.economist.com/node/12818310.
v
Mark Seal, “Madoff’s World,” Vanity Fair, April, 2009 at
http://www.vanityfair.com/news/2009/04/
bernard-madoff-friends-family-profile.
vi
Henriques, Diana and Zachery Kouwe, “Prominent Trader Accused of Defrauding
Clients,” New York Times, December 11, 2008.
vii
“Investigation of Failure of the SEC to Uncover Bernard Madoff’s Ponzi Scheme,”
U.S. Securities and Exchange Commission, Office of Investigations, August 31, 2009.
viii
“The Financial Crisis Inquiry Report,” 2011, Philip Angelides, Chair, pages xxii,
xxiii, and xxvii–xxviii.
ix
For further information on the Valeant case study, see Stephen Gandel, “What Caused
Valeant’s Epic 90% plunge,” Fortune, March 20, 2016, at
http://fortune.com/2016/03/20/valeant-timeline-scandal/. And see Miles Johnson,
“What went wrong with Ackman and Valeant—the alternative edition” Financial Times,
March 30, 2017 at https://ftalphaville.ft.com/2017/03/30/2186644/what-went-wrong-w
ith-ackman-andx
valeant-the-alternative-edition/.
Wicks xi (2003) page 11.
Quoted in K.V. Salwen, 1991 “SEC Chief’s criticism of ex-managers of Salomon
suggests civil action is likely,” Wall Street Journal Nov. 20, A10.
xii
xiiiPaine (1999), pages 194–195.
xivBhide and Stevenson, 1990, pages 127–128.
The Utilitarian philosophers, Jeremy Bentham (1748–1832), James Mill (1773–
1836), and John Stuart Mill (1806–1873), argued that the utility (or usefulness) of ideas,
actions, and institutions could be measured in terms of their consequences.
xv
The philosopher, Immanuel Kant (1724–1804) sought a foundation for ethics in the
purity of one’s motives.
xvi
xviiBowie (1999) page 13.
This view originates in ancient Greek philosophy, starting from Socrates, Plato, and
Aristotle.
xviii
Russ Banham, “The Warren Buffett School,” Chief Executive, December 2002,
downloaded from http://www.robertpmiles.com/BuffettSchool.htm, May 19, 2003.
xix
xxSee New York Central v. United States, 212 US 481.
xxiMurphy (1997) compiles 80 exemplary ethics statements.
Source: J.P. Morgan Chase & Company, website: https://www.jpmorganchase.com/c
orporate/About-JPMC/ab-code-of-ethics.htm downloaded May 18, 2017.
xxii
Page 1
PART 1 Setting Some Themes
Page 3
CASE 1 Warren E. Buffett, 2015
On August 10, 2015, Warren E. Buffett, chair and CEO of Berkshire Hathaway Inc.,
announced that Berkshire Hathaway would acquire the aerospace-parts supplier
Precision Castparts Corporation (PCP). In Buffett’s largest deal ever, Berkshire would
purchase all of PCP’s outstanding shares for $235 per share in cash, a 21% premium
over the trading price a day earlier. The bid valued PCP’s equity at $32.3 billion. The
total transaction value would be $37.2 billion, including assuming PCP’s outstanding
debt—this was what analysts called the “enterprise value.” “I’ve admired PCP’s
operation for a long time. For good reasons, it is the supplier of choice for the world’s
aerospace industry, one of the largest sources of American exports,” Buffett said. After
the announcement, Berkshire Hathaway’s Class A shares moved down 1.1% at market
open, a loss in market value of $4.05 billion. PCP’s share price jumped 19.2% at the
news ; the S&P 500 Composite Index opened up 0.2%. Exhibit 1.1 illustrates the recent
share-price performance for Berkshire Hathaway, PCP, and the S&P 500 Index.
Exhibit 1.2 presents recent consolidated financial statements for the firm.
1
2
3
4
5
EXHIBIT 1.1 | Relative Share Price Performance of Berkshire Hathaway Class A Share, PCP, and
the S&P 500 January 1, 2015, to August 13, 2 015
Note: PCP = Precision Castparts; BRK.A = Berkshire Hathaway Class A shares; S&P500 = Standard & Poor’s 500 Index.
Data source: Google Finance.
EXHIBIT 1.2 | Berkshire Hathaway Condensed Consolidated Financial Statements
The acquisition of PCP, Berkshire Hathaway’s largest deal ever, renewed public Page 4
interest in its sponsor, Buffett. In many ways, he was an anomaly. One of the
richest individuals in the world (with an estimated net worth of about $66.5 billion
according to Forbes), he was also respected and even beloved. Though he had
accumulated perhaps the best investment record in history (a compound annual increase
in wealth for Berkshire Hathaway of 21.6% from 1965 to 2014), Berkshire Hathaway
paid him only $100,000 per year to serve as its CEO. While Buffett and other insiders
controlled 39.5% of Berkshire Hathaway, he ran the company in the interests of all
Data source: Factset.
6
shareholders. “We will not take cash compensation, restricted stock, or option grants
that would make our results superior to [those of Berkshire’s investors],” Buffett said.
“I will keep well over 99% of my net worth in Berkshire. My wife and I have never
sold a share nor do we intend to.”
Buffett was the subject of numerous laudatory articles and at least eight biographies,
yet he remained an intensely private individual. Although acclaimed by many as an
intellectual genius, he shunned the company of intellectuals and preferred to affect the
manner of a down-home Nebraskan (he lived in Omaha) and a tough-minded investor. In
contrast to the investment world’s other “stars,” Buffett acknowledged his investment
failures both quickly and publicly. Although he held an MBA from Columbia University
and credited his mentor, Benjamin Graham, with developing the philosophy of valuebased
investing that had guided Buffett to his success, he chided business schools for the
irrelevance of their finance and investing theories.
Numerous writers sought to distill the essence of Buffett’s success. What were the
key principles that guided Buffett? Could those principles be applied broadly in the 21st
century, or were they unique to Buffett and his time? By understanding those principles,
analysts hoped to illuminate the acquisition of PCP. What were Buffett’s probable
motives in the acquisition? What did Buffett’s offer say about his valuation of PCP, and
how would it compare with valuations for other comparable firms? Would Berkshire’s
acquisition of PCP prove to be a success? How would Buffett define success?
Berkshire Hathaway Inc.
Berkshire Hathaway was incorporated in 1889 as Berkshire Cotton Manufacturing and
eventually grew to become one of New England’s biggest textile producers, accounting
for 25% of U.S. cotton-textile production. In 1955, Berkshire Cotton Manufacturing
merged with Hathaway Manufacturing and began a secular decline due to inflation,
7
Page 5
technological change, and intensifying competition from foreign rivals. In 1965, Buffett
and some partners acquired control of Berkshire Hathaway, believing that its financial
decline could be reversed.
Over the next 20 years, it became apparent that large capital investments would be
required for the company to remain competitive, and that even then the financial returns
would be mediocre. Fortunately, the textile group generated enough cash in the
early years to permit the firm to purchase two insurance companies
headquartered in Omaha: National Indemnity Company and National Fire & Marine
Insurance Company. Acquisitions of other businesses followed in the 1970s and 1980s;
Berkshire Hathaway exited the textile business in 1985.
The investment performance of a share in Berkshire Hathaway had astonished most
observers. As shown in Exhibit 1.3, a $100 investment in Berkshire Hathaway stock on
September 30, 1976, would compound to a value of $305,714 as of July 31, 2015,
approximately 39 years later. The investment would result in a 305,614% cumulative
return, 22.8% when annualized. Over the same period, a $100 investment in the S&P
500 would compound to a value of $1,999 for a cumulative return of 1,899.1% or 8.0%
annualized.8
EXHIBIT 1.3 | Berkshire Hathaway Class A Shares versus S&P 500 Index over 39 Years
In 2014, Berkshire Hathaway’s annual report described the firm as “a holding
company owning subsidiaries engaged in a number of diverse business activities.”
Berkshire Hathaway’s portfolio of businesses included:
Note: Period listed as 2015 represents January 1, 2015 to July 31, 2015.
Data source: Yahoo! Finance.
9
Insurance: Insurance and reinsurance of property and casualty risks worldwide and
with reinsurance of life, accident, and health risks worldwide in addition (e.g.,
GEICO, General Re).
10
Railroad: A long-lived asset with heavy regulation and high capital intensity, the
company operated one of the largest railroad systems in North America (i.e., BNSF).
Utilities and Energy: Generate, transmit, store, distribute, and supply energy through
the subsidiary Berkshire Hathaway Energy company.
Manufacturing: Numerous and diverse manufacturing businesses were grouped into
three categories: (1) industrial products, (2) building products, and (3) consumer
products (e.g., Lubrizol, PCP).
Page 6
Exhibit 1.4 gives a summary of revenues, operating profits, capital expenditures,
depreciation, and assets for Berkshire Hathaway’s various business segments. The
company’s investment portfolio also included equity interests in numerous publicly
traded companies, summarized in Exhibit 1.5 .
Service and Retailing: Providers of numerous services, including fractional aircraftownership
programs, aviation pilot training, electronic-components distribution, and
various retailing businesses, including automotive dealerships (e.g., NetJets,
Nebraska Furniture Mart).
Finance and Financial Products: Manufactured housing and related consumer
financing; transportation equipment, manufacturing, and leasing; and furniture leasing
(e.g., Clayton Homes, ULTX, XTRA).
EXHIBIT 1.4 | Business-Segment Information for Berkshire Hathaway Inc. (dollars in millions)
Source: SEC documents.
EXHIBIT 1.5 | Major Investees of Berkshire Hathaway (dollars in millions)
Buffett’s Investment Philosophy
Warren Buffett was first exposed to formal training in investing at Columbia University,
where he studied under Benjamin Graham. A coauthor of the classic text, Security
Analysis, Graham developed a method of identifying undervalued stocks (that is, stocks
whose prices were less than their intrinsic value). This became the cornerstone of
modern value investing. Graham’s approach was to focus on the value of assets, such as
cash, net working capital, and physical assets. Eventually, Buffett modified that
approach to focus also on valuable franchises that were unrecognized by the market.
Over the years, Buffett had expounded his philosophy of investing in his chair’s
letter to shareholders in Berkshire Hathaway’s annual report. By 2005, those lengthy
*Actual purchase price and tax basis; GAAP “cost” differs in a few cases because of write-ups or write-downs that have
been required under GAAP rules.
**Excludes shares held by pension funds of Berkshire subsidiaries.
***Held under contract of sale for this amount.
Source: Berkshire Hathaway Inc. letter to shareholders, 2014.
letters had acquired a broad following because of their wisdom and their humorous,
self-deprecating tone. The letters emphasized the following elements:
1. Economic reality, not accounting reality. Financial statements prepared by
accountants conformed to rules that might not adequately represent the economic
reality of a business. Buffett wrote:
Because of the limitations of conventional accounting, consolidated reported
earnings may reveal relatively little about our true economic performance.
Charlie [Munger, Buffett’s business partner] and I, both as owners and managers,
virtually ignore such consolidated numbers . . . Accounting consequences do not
influence our operating or capital-allocation process.
Accounting reality was conservative, backward looking, and governed by generally
accepted accounting principles (GAAP), even though investment decisions should be
based on the economic reality of a business. In economic reality, intangible assets
such as patents, trademarks, special managerial expertise, and reputation might be
very valuable, yet, under GAAP, they would be carried at little or no value. GAAP
measured results in terms of net profit, while in economic reality the results of a
business were its flows of cash.
A key feature of Buffett’s approach defined economic reality at the level of the
business itself, not the market, the economy, or the security—he was a fundamental
analyst of the business. His analysis sought to judge the simplicity of the business, the
consistency of its operating history, the attractiveness of its long-term prospects, the
quality of management, and the firm’s capacity to create value.
11
2. The cost of the lost opportunity. Buffett compared an investment opportunity against
the next-best alternative, the lost opportunity. In his business decisions, he
demonstrated a tendency to frame his choices as either/or decisions rather than yes/no
Page 7
decisions. Thus an important standard of comparison in testing the attractiveness of an
acquisition was the potential rate of return from investing in the common stocks of
other companies. Buffett held that there was no fundamental difference between buying
a business outright and buying a few shares of that business in the equity market. Thus
for him, the comparison of an investment against other returns available in the market
was an important benchmark of performance.
3. Embrace the time value of money. Buffett assessed intrinsic value as the present
value of future expected performance:
[All other methods fall short in determining whether] an investor is indeed
buying something for what it is worth and is therefore truly operating on the
principle of obtaining value for his investments . . . Irrespective of whether a
business grows or doesn’t, displays volatility or smoothness in earnings, or
carries a high price or low in relation to its current earnings and book value, the
investment shown by the discounted-flows-of-cash calculation to be the cheapest
is the one that the investor should purchase.
Enlarging on his discussion of intrinsic value, Buffett used an educational example:
We define intrinsic value as the discounted value of the cash that can be taken out
of a business during its remaining life. Anyone calculating intrinsic value
necessarily comes up with a highly subjective figure that will change both as
estimates of future cash flows are revised and as interest rates move. Despite its
fuzziness, however, intrinsic value is all important and is the only logical way to
evaluate the relative attractiveness of investments and businesses.
To see how historical input (book value) and future output (intrinsic value)
can diverge, let us look at another form of investment, a college education. Think
of the education’s cost as its “book value.” If it is to be accurate, the cost should
12
Page 8
include the earnings that were foregone by the student because he chose college
rather than a job. For this exercise, we will ignore the important non economic
benefits of an education and focus strictly on its economic value. First, we must
estimate the earnings that the graduate will receive over his lifetime and subtract
from that figure an estimate of what he would have earned had he lacked his
education. That gives us an excess earnings figure, which must then be
discounted, at an appropriate interest rate, back to graduation day. The dollar
result equals the intrinsic economic value of the education. Some graduates will
find that the book value of their education exceeds its intrinsic value, which
means that whoever paid for the education didn’t get his money’s worth. In other
cases, the intrinsic value of an education will far exceed its book value, a result
that proves capital was wisely deployed. In all cases, what is clear is that book
value is meaningless as an indicator of intrinsic value.
To illustrate the mechanics of this example, consider the hypothetical case
presented in Exhibit 1.6. Suppose an individual has the opportunity to invest
$50 million in a business—this is its cost or book value. This business will throw off
cash at the rate of 20% of its investment base each year. Suppose that instead of
receiving any dividends, the owner decides to reinvest all cash flow back into the
business—at this rate, the book value of the business will grow at 20% per year.
Suppose that the investor plans to sell the business for its book value at the end of the
fifth year. Does this investment create value for the individual? One determines this by
discounting the future cash flows to the present at a cost of equity of 15%. Suppose
that this is the investor’s opportunity cost, the required return that could have been
earned elsewhere at comparable risk. Dividing the present value of future cash flows
(i.e., Buffett’s intrinsic value) by the cost of the investment (i.e., Buffett’s book
value) indicates that every dollar invested buys securities worth $1.23. Value
13
is created.
Consider an opposing case, summarized in Exhibit 1.7. The example is similar in
all respects, except for one key difference: the annual return on the investment is 10%.
The result is that every dollar invested buys securities worth $0.80. Value is
destroyed.
EXHIBIT 1.6 | Hypothetical Example of Value Creation
Source: Author analysis.
EXHIBIT 1.7 | Hypothetical Example of Value Destruction
Source: Author analysis.
Comparing the two cases in Exhibits 1.6 and 1.7, the difference in value creation
and destruction is driven entirely by the relationship between the expected returns and
the discount rate: in the first case, the spread is positive; in the second case, it is
negative. Only in the instance where expected returns equal the discount rate will
book value equal intrinsic value. In short, book value or the investment outlay may not
reflect the economic reality. One needs to focus on the prospective rates of return, and
how they compare to the required rate of return.
4. Measure performance by gain in intrinsic value, not accounting profit. Buffett
wrote:
Our long-term economic goal . . . is to maximize Berkshire’s average annual rate
of gain in intrinsic business value on a per-share basis. We do not measure the
economic significance or performance of Berkshire by its size; we measure by
per-share progress. We are certain that the rate of per-share progress will
diminish in the future—a greatly enlarged capital base will see to that. But we
will be disappointed if our rate does not exceed that of the average large
American corporation.
The gain in intrinsic value could be modeled as the value added by a business
above and beyond the charge for the use of capital in that business. The gain in
intrinsic value was analogous to the economic-profit and market-value-added
measures used by analysts in leading corporations to assess financial performance.
Those measures focus on the ability to earn returns in excess of the cost of capital.
14
5. Set a required return consistent with the risk you bear. Conventional academic and
practitioner thinking held that the more risk one took, the more one should get paid.
Thus discount rates used in determining intrinsic values should be determined by the
risk of the cash flows being valued. The conventional model for estimating the cost of
Page 9
equity capital was the capital asset pricing model (CAPM), which added a risk
premium to the long-term risk-free rate of return, such as the U.S. Treasury bond yield.
In August 2015, a weighted average of Berkshire Hathaway’s cost of equity and debt
capital was about 0.8%.
Buffett departed from conventional thinking by using the rate of return on the longterm
(e.g., 30-year) U.S. Treasury bond to discount cash flows—in August 2015, the
yield on the 30-year U.S. Treasury bond was 2.89%. Defending this practice, Buffett
argued that he avoided risk, and therefore should use a risk-free discount rate.
His firm used little debt financing. He focused on companies with predictable
and stable earnings. He or his vice chair, Charlie Munger, sat on the boards of
directors, where they obtained a candid inside view of the company and could
intervene in management decisions if necessary. Buffett once said, “I put a heavy
weight on certainty. If you do that, the whole idea of a risk factor doesn’t make sense to
me. Risk comes from not knowing what you’re doing.” He also wrote:
We define risk, using dictionary terms, as “the possibility of loss or injury.”
Academics, however, like to define “risk” differently, averring that it is the
relative volatility of a stock or a portfolio of stocks—that is, the volatility as
compared to that of a large universe of stocks. Employing databases and
statistical skills, these academics compute with precision the “beta” of a stock—
its relative volatility in the past—and then build arcane investment and capital
allocation theories around this calculation. In their hunger for a single statistic to
measure risk, however, they forget a fundamental principle: it is better to be
approximately right than precisely wrong.
15
16
17
6. Diversify reasonably. Berkshire Hathaway represented a diverse portfolio of
business interests. But Buffett disagreed with conventional wisdom that investors
should hold a broad portfolio of stocks in order to shed company-specific risk. In his
view, investors typically purchased far too many stocks rather than waiting for one
exceptional company. Buffett said:
Figure businesses out that you understand and concentrate. Diversification is
protection against ignorance, but if you don’t feel ignorant, the need for it goes
down drastically.18
Page 10
7. Invest based on information, analysis, and self-discipline, not on emotion or
hunch. Buffett repeatedly emphasized awareness and information as the foundation for
investing. He said, “Anyone not aware of the fool in the market probably is the fool in
the market.” Buffett was fond of repeating a parable told to him by Graham:
There was a small private business and one of the owners was a man named
Market. Every day, Mr. Market had a new opinion of what the business was
worth, and at that price stood ready to buy your interest or sell you his. As
excitable as he was opinionated, Mr. Market presented a constant distraction to
his fellow owners. “What does he know?” they would wonder, as he bid them an
extraordinarily high price or a depressingly low one. Actually, the gentleman
knew little or nothing. You may be happy to sell out to him when he quotes you a
ridiculously high price, and equally happy to buy from him when his price is
low. But the rest of the time, you will be wiser to form your own ideas of the
value of your holdings, based on full reports from the company about its
operation and financial position.
Buffett used this allegory to illustrate the irrationality of stock prices as compared
to true intrinsic value. Graham believed that an investor’s worst enemy was not the
stock market, but oneself. Superior training could not compensate for the absence of
19
20
the requisite temperament for investing. Over the long term, stock prices should have a
strong relationship with the economic progress of the business. But daily market
quotations were heavily influenced by momentary greed or fear and were an
unreliable measure of intrinsic value. Buffett said:
As far as I am concerned, the stock market doesn’t exist. It is there only as a
reference to see if anybody is offering to do anything foolish. When we invest in
stocks, we invest in businesses. You simply have to behave according to what is
rational rather than according to what is fashionable.
Accordingly, Buffett did not try to “time the market” (i.e., trade stocks based on
expectations of changes in the market cycle)—his was a strategy of patient, long-term
investing. As if in contrast to Mr. Market, Buffett expressed more contrarian goals:
“We simply attempt to be fearful when others are greedy and to be greedy only when
others are fearful.” Buffett also said, “Lethargy bordering on sloth remains the
cornerstone of our investment style,” and “The market, like the Lord, helps those
who help themselves. But unlike the Lord, the market does not forgive those who know
not what they do.”
21
22
23
24
8. Look for market inefficiencies. Buffett scorned the academic theory of capitalmarket
efficiency. The efficient-markets hypothesis (EMH) held that publicly known
information was rapidly impounded into share prices, and that as a result, stock prices
were fair in reflecting what was known about the company. Under EMH, there were
no bargains to be had, and trying to outperform the market would be futile. “It has been
helpful to me to have tens of thousands turned out of business schools that taught that it
didn’t do any good to think,” Buffett said.
I think it’s fascinating how the ruling orthodoxy can cause a lot of people to think
the earth is flat. Investing in a market where people believe in efficiency is like
25
Precision Castparts
“In the short run, the market is a voting machine but in the long run, it is a weighing
machine.”
—Benjamin Graham
The vote was in and the market’s reaction to Berkshire Hathaway’s acquisition of PCP
indicated disapproval. The market ascribed $4.05 billion less value to Berkshire
playing bridge with someone who’s been told it doesn’t do any good to look at
the cards.26
Page 11
9. Align the interests of agents and owners. Explaining his significant ownership
interest in Berkshire Hathaway, Buffett said, “I am a better businessman because I am
an investor. And I am a better investor because I am a businessman.”
As if to illustrate this sentiment, he said:
A managerial “wish list” will not be filled at shareholder expense. We will not
diversify by purchasing entire businesses at control prices that ignore long-term
economic consequences to our shareholders. We will only do with your
money what we would do with our own, weighing fully the values you
can obtain by diversifying your own portfolios through direct purchases in the
stock market.
For four out of six Berkshire directors, more than 50% of the family net worth was
represented by shares in Berkshire Hathaway. The senior managers of Berkshire
Hathaway subsidiaries either held shares in the company or were compensated under
incentive plans that imitated the potential returns from an equity interest in their
business unit, or both.
27
28
29
30
Hathaway after the announced acquisition than before it. At the same time, the value of
PCP jumped more than $5 billion, close to 20% of the market value of the firm. The
market seemed to be saying that Buffett and Berkshire had overpaid for the business.
Buffett didn’t seem to think so. And despite his age, he didn’t appear to be slowing
down. PCP was the largest acquisition in a string of large purchases over the past
several years, including Duracell, Kraft, Heinz, and Burlington Northern Santa Fe,
totaling more than $70 billion in deal value in all. These acquisitions, along with many
more over the years, followed a similar blueprint (Exhibit 1.8). The gist of the
acquisition criteria seemed to be relatively straightforward—Berkshire Hathaway
looked for well-run businesses producing consistent results offered at a fair price. As
Berkshire Hathaway stated in its press release following the PCP acquisition:
PCP fits perfectly into the Berkshire model and will substantially increase our
normalized per-share earning power. Under CEO Mark Donegan, PCP has become
the world’s premier supplier of aerospace components (most of them destined to
EXHIBIT 1.8 | Berkshire Hathaway Acquisition Criteria
Source: Berkshire Hathaway Inc. annual report, 2014.
Page 12
be original equipment, though spares are important to the company as well).
Mark’s accomplishments remind me of the magic regularly performed by Jacob
Harpaz at IMC, our remarkable Israeli manufacturer of cutting tools. The two men
transform very ordinary raw materials into extraordinary products that are used by
major manufacturers worldwide. Each is the da Vinci of his craft. PCP’s products,
often delivered under multi year contracts, are key components in most large
aircraft.
PCP manufactured complex metal components and products for very specific
applications, mainly in the critical aerospace and power applications. The components
were used in products with highly complex engineering processes, such as large jetaircraft
engines. Its customer base was concentrated and sophisticated, including
General Electric, Pratt & Whitney, and Rolls-Royce, for whom they had been supplying
castings for multiple decades.
Exhibit 1.9 presents PCP’s income statement and balance sheet ending March 31,
2015. Exhibit 1.10 provides financials on comparable firms. Exhibit 1.11 provides
valuation multiples for comparable firms. The beta of PCP, measured after the
acquisition announcement, was 0.38.
31
32
EXHIBIT 1.9 | PCP Consolidated Financial Statements
*Note – Fiscal year ends March 31. Period listed as 2015 represents March 31, 2014 to March 31, 2015
Note: The market value of PCP’s equity shortly before the announcement of the acquisition by Berkshire Hathaway was
$31,208 million.
Data source: Edgar.
Excludes restructuring charges.
Excludes equity in unconsolidated investments.
Excludes noncontrolling interests.
1
2
3
EXHIBIT 1.10 | Comparable Firms
Note: Dollar values are in millions except for share prices and dividends per share, which are in dollar units. Shares
outstanding (O/S) are stated in millions.
ALCOA, INC., engages in lightweight metals engineering and manufacturing. Its products are used worldwide in aircraft,
automobiles, commercial transportation, packaging, oil and gas, defense, and industrial applications.
LISI SA engages in the manufacturing of multifunctional fasteners and assembly components for three business
sectors: Aerospace, Automotive, and Medical.
THYSSENKRUPP AG engages in the production of steel. The Components Technology business area offers
components for the automotive, construction, and engineering sectors.
ALLEGHENY TECHNOLOGIES, INC., engages in the manufacture of specialty materials and components for different
industries, which include aerospace and defense, oil and gas, and chemical processing, as well as electrical energy.
CARPENTER TECHNOLOGY CORP. engages in developing, manufacturing, and distributing cast/wrought and powdermetal
stainless steels. It operates through Specialty Alloys Operations and Performance Engineered Products
segments.
Data sources: Company reports; Factset.
EXHIBIT 1.11 | Valuation of PCP Based on Multiples for Comparable Firms
Data Source: Factset.
1
Conclusion
The announcement of Berkshire Hathaway’s acquisition of PCP prompted some critical
commentary. The Economist magazine wrote,
But [Buffett] is far from a model for how capitalism should be transformed. He is
a careful, largely ethical accumulator of capital invested in traditional businesses,
preferably with oligopolistic qualities, whereas what America needs right now is
more risk-taking, lower prices, higher investment and much more competition. You
won’t find much at all about these ideas in Mr. Buffett’s shareholder letters.
Conventional thinking held that it would be difficult for Warren Buffett to maintain
his record of 21.6% annual growth in shareholder wealth. Buffett acknowledged that
“a fat wallet is the enemy of superior investment results.” He stated that it was the
firm’s goal to meet a 15% annual growth rate in intrinsic value. Would the PCP
acquisition serve Berkshire Hathaway’s long-term goals? Was the bid price
appropriate? How did Berkshire Hathaway’s offer measure up against the company’s
valuation implied by the multiples for comparable firms? Did Berkshire Hathaway
overpay for PCP? Was the market’s reaction rational?
Or did Buffett pay a fair price for a great business? If so, what determines a fair
price? What makes a great business? And why would Berkshire Hathaway be interested
in buying PCP? Why would PCP be interested in selling itself to Berkshire Hathaway?
What value did Berkshire Hathaway bring to the equation?
The calculation of the implied values for PCP based on the median of the peer firms’ multiples takes the product of the
median value of the multiples of comparable firms (line 8) and multiplies it times the relevant base (revenue, EBITDA,
EBIT, net income, or book value) for PCP. The same method is used for the calculation of the implied value based on the
average or mean of the peer firms’ multiples (line 9). For instance, the implied value based on the median multiple of
EBIT ($37,755 million) is derived by multiplying 14.51 (the mean EBIT multiple for the comparable firms) times $2,602
million (the EBIT of PCP).
1
33
34
35

CASE 2
Page 23
Page 24
The Battle for Value, 2016: FedEx Corp. versus
United Parcel Service, Inc.
2015 was a transformative year for FedEx with outstanding financial results, more
powerful customer solutions, and actions to generate increased long-term value for
shareowners. We believe FedEx is on a dynamic trajectory that will make 2016 very
successful. Our company has never been better positioned to build shareowner value.
—FedEx CEO Frederick W. Smith, Annual Report 2015
Our 2015 results demonstrate that UPS can thrive in [today’s] challenging
environment, as shown by our continued ability to meet the expectations of customers
and investors alike. The continued execution of our proven strategies will enable
UPS to maintain positive momentum in the coming year and beyond.
—UPS CEO David Abney, Annual Report 2015
On April 29, 2016, FedEx Corp., the American courier delivery company, received
final government approval on its bid to acquire TNT Express (TNT), a Dutch logistics
and delivery firm with road and air delivery services all over the world, for $4.8
billion. Ever since FedEx made the public bid to acquire TNT, many industry insiders
expected TNT’s strong European road network to bolster FedEx’s presence in a region
and market in which it had failed to compete with its long-standing rival, United Parcel
Service, Inc. (UPS), for a bigger share of the world’s ever-increasing e-commerce
shipments.
The approval came as a bitter blow to American package-delivery rival
UPS, which had tried to buy TNT in 2013, only to be blocked by European Union
regulators who viewed the potential merger as obstructing healthy competition. Still,
UPS had plenty to celebrate. The company had just announced record first-quarter sales
of $14.4 billion, up 3.2% over the same quarter the previous year, driven by growth in
both its domestic and international small-package segments. The company was starting
to see its recent investments in technology and productivity improvements pay off, with
its cost per package falling 1.9% for the same period. This was impressive for a
company whose return on equity the previous year was a whopping 210%.
Against this backdrop, industry observers wondered how the titanic struggle
between FedEx and UPS would develop, particularly for investors in the two firms.
Was the performance of the companies in recent years predictive of the future?
International reach and extensive logistics services were widely seen as the litmus test
for corporate survival of delivery companies in the new millennium. Which company
was better positioned to attract the capital necessary to win this competitive battle?
United Parcel Service, Inc.
Founded in 1907, UPS was the largest package-delivery company in the world.
Consolidated parcel delivery, both on the ground and through the air, was the primary
business of the company, although increasingly the company offered more-specialized
transportation and logistics services.
Known in the industry as “Big Brown,” UPS had its roots in Seattle, Washington,
where 19-year-old Jim Casey started a bicycle-messenger service called American
Messenger Company. After merging with a rival firm, Motorcycle Delivery Company,
the company focused on department-store deliveries, and that remained true until the
1940s. Renamed United Parcel Service of America, UPS started an air-delivery service
in 1929 by putting packages on commercial passenger planes. The company entered its
strongest period of growth during the post–World War II economic boom and, by 1975,
UPS had reached a milestone when it promised package delivery to every address in the
Page 25
continental United States. That same year the company expanded outside the country
with its first delivery to Ontario, Canada. The following year, UPS began service in
West Germany with 120 of its trademark-brown delivery vans.
The key to the success of UPS, later headquartered in Atlanta, Georgia, was
efficiency. According to BusinessWeek, “Every route is timed down to the traffic light.
Each vehicle was engineered to exacting specifications. And the drivers . . . endure a
daily routine calibrated down to the minute.” But this demand for machinelike
precision met with resistance by UPS’s heavily unionized labor force.
For most of the company’s history, UPS stock was owned solely by UPS’s
managers, their families, former employees, or charitable foundations owned by UPS.
The company acted as the market maker with its own shares, buying or selling shares at
a fair market value determined by the board of directors each quarter. By the
end of the millennium, company executives determined that UPS needed the
added flexibility of publicly traded stock in order to pursue a more aggressive
acquisition strategy.
In November 1999, UPS became a public company through a public equity offering
and corporate reorganization. Before this reorganization, the financially and
operationally conservative company had been perceived as slow and plodding.
Although much larger than FedEx, UPS had been unable to effectively compete directly
in the overnight-delivery market, largely because of the enormous cost of building an air
fleet. But after going public, UPS initiated an aggressive series of acquisitions,
beginning with a Miami-based freight carrier operating in Latin America and a
franchise-based chain of stores providing packing, shipping, and mail services called
Mail Boxes Etc. (later renamed The UPS Store) with more than 4,300 domestic and
international locations.
More assertive than ever before, the UPS of the new millennium was the product of
1
2
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extensive reengineering efforts and a revitalized business focus. Whereas the company
had traditionally been the industry’s low-cost provider, UPS now began investing
heavily in a full range of highly specialized business services. As a sign of this shift, the
company revamped its logo for the first time since 1961, emphasizing its activities in
the wider supply-chain industry. The expansive “What can brown do for you?”
campaign was also launched around this time to promote UPS’s business-facing
logistics and supply-chain services.
Another example was UPS’s extensive push into more complex industries like health
care. Health care logistic services (which were bucketed into the company’s supplychain
and freight segments) allowed pharmaceutical and medical-device companies to
outsource their logistics to UPS pharmacists, who were able to fulfill, pack, and ship
customers’ orders from UPS’s worldwide health care warehouses, even when
medications included temperature specifications or required cross-border transport. By
2015, this segment had experienced huge growth and saw no signs of slowing in the face
of the world’s aging population that increasingly wanted home delivery of health care
products.
Alongside its health care offerings, UPS also looked to emerging markets for
growth. In 2014, CEO David Abney claimed that “growing internationally and
diversifying our customer base” across regions was a top priority for UPS. By 2015,
international package operations accounted for 21% of revenues. Exhibit 2.1 presents
segment (ground and express) and geographic (international and U.S. domestic) revenue
data for both FedEx and UPS. The company also invested in information technology to
improve its profitability. In 2013, for example, UPS launched cutting-edge
route-optimization software for its drivers that was intended to set the stage for
even more personalized service offerings and efficient deliveries when its rollout was
complete in 2017.
3
By 2015, UPS offered package-delivery services in more than 220 countries and
territories (with every address in the United States and Europe covered) and was
moving more than 18 million packages and documents through its network every day. Its
immense volumes in the higher-margin ground segment and aligned assets that served
both ground and express shipments gave it a margin advantage compared to FedEx. UPS
employed 440,000 people and had 104,926 vehicles and 650 jet aircraft. UPS reported
revenues of $58 billion and net profit of nearly $5 billion. Exhibit 2.2 provides recent
operating results for UPS.
EXHIBIT 2.1 | Revenues for FedEx and UPS by Business and Geography Segment (Millions)
*FedEx Services provides back-office support to FedEx’s three transportation segments and printing and retail support to
customers through FedEx Office.
Data source: Company SEC filings.
4
EXHIBIT 2.2 | Operating Results for UPS Inc. (period ending Dec. 31, in millions)
FedEx Corporation
FedEx first took form as Fred Smith’s undergraduate term paper for a Yale University
economics class. Smith’s strategy dictated that FedEx would purchase the planes that it
required to transport packages, whereas all other competitors used the cargo space
*Economic Profit (EVA) is calculated as EBIT *(1 − t) − CofC × (T. Debt + T. St. Eq), where t = 40% and CofC = 8%.
Data source: Capital IQ, Morningstar, company annual reports.
available on passenger airlines. In addition to using his own planes, Smith’s key
innovation was a hub-and-spoke distribution pattern, which permitted cheaper and
faster service to more locations than his competitors could offer. In 1971, Smith
invested his $4 million inheritance and raised $91 million in venture capital to launch
the firm—the largest venture-capital start-up at the time.
In 1973, on the first night of continuous operation, 389 FedEx employees delivered
186 packages overnight to 25 U.S. cities. In those early years, FedEx, then known as
Federal Express Corporation, experienced severe losses, and Smith was nearly ousted
from his chair position. By 1976, FedEx finally saw a modest profit of $3.6 million on
an average daily volume of 19,000 packages. Through the rest of the 1970s, FedEx
continued to grow by expanding services, acquiring more trucks and aircraft, and raising
capital. The formula was successful. In 1981, FedEx generated more revenue than any
other U.S. air-delivery company.
By 1981, competition in the industry had started to rise. Emery Air Freight began to
imitate FedEx’s hub system and to acquire airplanes, and UPS began to move into the
overnight air market. The United States Postal Service (USPS) positioned its overnight
letter at half the price of FedEx’s, but quality problems and FedEx’s “absolutely
positively overnight” ad campaign quelled that potential threat. In 1983, FedEx reached
$1 billion in revenues and seemed poised to own the market for express delivery.
During the 1990s, FedEx proved itself as an operational leader, even receiving the
prestigious Malcolm Baldrige National Quality Award from the president of the United
States. FedEx was the first company ever to win in the service category. Part of this
success could be attributed to deregulation and to operational strategy, but credit could
also be given to FedEx’s philosophy of “People-Service-Profit,” which reflected its
emphasis on customer focus, total quality management, and employee participation.
Extensive attitude surveying, a promote-from-within policy, effective grievance
Page 27
procedures that sometimes resulted in a chat with Fred Smith himself, and an emphasis
on personal responsibility and initiative not only earned FedEx a reputation as a
great place to work, but also helped to keep the firm largely free of unions.
FedEx’s growth occurred within the context of fundamental change in the business
environment. Deregulation of the domestic airline industry after 1977 permitted larger
planes to replace smaller ones, thereby permitting FedEx to purchase several Boeing
727s starting in 1978, which helped reduce its unit costs. Deregulation of the trucking
industry also permitted FedEx to establish an integrated regional trucking system that
lowered its unit costs on short-haul trips, enabling the company to compete more
effectively with UPS. Rising inflation and global competitiveness compelled
manufacturers to manage inventories more closely and to emulate the just-in-time supply
programs of the Japanese, creating a heightened demand for FedEx’s rapid and carefully
monitored movement of packages. And, finally, technological innovations enabled
FedEx to achieve important advances in customer ordering, package tracking, and
process monitoring.
Despite making its name as the pioneer of the overnight-delivery market, FedEx
continued to expand beyond its lower-margin express offerings throughout the first
decade of the 2000s. In addition to purchasing Kinko’s 1,200 retail stores and
eventually rebranding them as FedEx Office (a full-service print-and-ship retail chain),
in 2012, FedEx started to move its capex focus from its crown-jewel express segment
(where capital expenditures from 2013 to 2015 were mainly used to modernize its
outdated fleet) to higher-margin ground services in order to increase capacity in its U.S.
ground network. By 2015, these efforts had paid off: FedEx Ground’s revenues had
grown significantly over the past five years, and the company was providing faster
deliveries to more U.S locations than its competition, in large part due to its industryleading
automation-optimized efficiency. The ground segment’s independent operation
5
of drivers and trucks as separate from its parallel express-network assets, however,
gave rival UPS and its integrated asset system the margin advantage.
By the end of 2015, FedEx had net income of over $1 billion on revenues of about
$48 billion. Exhibit 2.3 provides recent operating results for FedEx. FedEx Express’s
aircraft fleet consisted of 647 aircraft, FedEx Ground had about 95,000 ground vehicles
and trailers, and FedEx Freight operated approximately 65,000 vehicles and trailers.
The company operated with more than 325,000 team members and handled more than 11
million packages daily across its ground and express services.
6
7
EXHIBIT 2.3 | Operating Results for FedEx Corp. (period ending May 31, in millions)
The U.S. Delivery Market–Changing Shape
Barclays estimated the 2015 U.S. package delivery market to be $90 billion. The
market was commonly segmented along three dimensions: weight, mode of transit, and
timeliness of service. The weight categories consisted of letters (weighing 0−2.0
*Economic Profit (EVA) is calculated as EBIT * (1 − t) − CofC x (T. Debt + T. St. Eq), where t = 40% and CofC = 8%.
Data source: Capital IQ, Morningstar, company annual reports.
8
pounds), packages (2.0−150 pounds), and freight (over 151 pounds). The mode Page 28
of transit categories were air (i.e., express) and ground. Time categories were
overnight, deferred delivery (second-day delivery), three-day delivery, and, lastly,
regular delivery, which occurred four or more days after pickup.
The rise of e-commerce had created a colossal shift in package-delivery density, as
low-density residential deliveries from e-commerce sales had overtaken higher-density
business-to-business package deliveries that had once driven sales at the large shipping
companies. As online retailers outpaced their brick-and-mortar peers, e-commerce
sales skyrocketed; in 2015 alone, e-commerce sales grew 14.6%, according to the U.S.
Department of Commerce.” Many believed that FedEx’s package volume was poised to
benefit most from this growth due to the numerous online retailers that employed FedEx
for timely deliveries, but recently it was UPS that had the upper hand, with market share
of 54% for U.S. e-commerce shipments in 2014, leaving FedEx with 30%, and USPS
the remaining 16%.
As the booming e-commerce market grew, many high-volume e-tailers, such as
Amazon, commanded bigger discounts from their shipping partners. In 2012, Amazon
had launched Amazon Logistics, with its own delivery-van network. A growing number
of retailers, such as Wal-Mart and Amazon, were even starting to explore unmanned
aerial vehicles as a potential alternative means of delivery. By 2014, Amazon was
upstaging its private shipping vendors by offering Sunday delivery and same-day
delivery service in various cities through the USPS. As retailers looked for downstream
solutions to managing deliveries, an expectation arose that the delivery market, already
polarized between high-value, next-day-guaranteed services and economy options,
could see the economy segment suffer at the expense of retailers’ own initiatives.
Others expected shippers to experience a potential shift in demand away from pricier
express deliveries as consumers favored free shipping on their online orders through
9
10
11
ground service.
Competition
Amid these mixed expectations for future demand, a closer look at the industry’s 2015
revenues in the United States revealed that the air-express segment’s revenues were
fairly evenly split across FedEx and UPS, whereas in the ground segment, UPS reaped
the majority of sales. See Figure 2.1.
Although higher-margin ground operations were attractive to shippers,
complications in the segment arose from the lower density of residential deliveries
common among ground orders. To continue to grow their ground operations without
focusing on those low-density last-mile trips, both UPS and FedEx contracted USPS’s
FIGURE 2.1 | U.S. package market revenue share (%), by segment—2015.
Data source: Brandon Oglenski, Eric Morgan, and Van Kegel, “North American Transportation and Shipping Equity
Research,” Barclays, May 2, 2016: 31.
Page 29
Parcel Select Ground service, which helped businesses move shipments at the back end
of their deliveries. Through the service, the private companies delivered packages to
the local post office, after which USPS handled the last-mile drop-off. FedEx
referred to this partnership with USPS, which launched in 2009, as SmartPost,
while UPS’s version, launched in 2011, was offered as SurePost, and the service
allowed the shipping companies to offer customers even cheaper pricing without
wasting van and driver resources.
This similarity of execution on these partnered ground operations reflected the longstanding
competition between FedEx and UPS and their frequently parallel strategies.
Exhibit 2.4 provides a detailed summary of the major events marking the competitive
rivalry between FedEx and UPS. Significant dimensions of this rivalry included the
following:
Customer focus. Both companies emphasized their focus on the customer. This meant
listening carefully to the customer’s needs, providing customized solutions rather than
standardized products, and committing to service relationships.
Pricing. The shipping rivals always moved in lockstep on parcel-pricing fees. In the
face of e-commerce retailers adopting the frequent use of large packages for
lightweight products, however, the shippers who priced parcels by weight alone
started to take a margin hit when those poorly priced packages took up valuable space
in delivery trucks. In order to maximize the profitability of e-commerce deliveries, in
May 2014, FedEx announced that it would start using dimensional weight to calculate
the billable price for all ground packages, effective at the start of 2015. UPS quickly
followed with the same announcement the following month.
Operational reengineering. Given the intense price competition, the reduction of unit
costs became a priority. Cost reduction was achieved through the exploitation of
economies of scale, investment in technology, and business-process reengineering,
Page 30
which sought to squeeze unnecessary steps and costs out of the service process.
Information technology. Information management became central to the
operations of both UPS and FedEx. Every package handled by FedEx, for instance,
was logged into COSMOS (Customer, Operations, Service, Master Online System),
which transmitted data from package movements, customer pickups, invoices, and
deliveries to a central database at the Memphis, Tennessee, headquarters. UPS relied
on DIADs (Delivery Information Acquisition Devices), which were handheld units
that drivers used to scan package barcodes and record customer signatures.
Service expansion. FedEx and UPS increasingly pecked at each other’s service
offerings. In 2011, for example, UPS launched MyChoice, which allowed customers to
control the time of their deliveries online. FedEx quickly followed suit in 2013,
launching Delivery Manager, which allowed customers to schedule dates, times, and
locations of deliveries from their phones. FedEx even launched a repair shop for
devices like iPhones and Nooks in 2012, capitalizing on its retail space and existing
shipping capabilities.
Logistics services. The largest shipping innovations entailed offering integrated
logistics services to large corporate clients. These services were aimed at providing
total inventory control to customers, including purchase orders, receipt of goods,
order entry and warehousing, inventory accounting, shipping, and accounts receivable.
While this service line was initially developed as a model wherein the shippers
stored, tracked, and shipped across client’s brick-and-mortar stores, these services
eventually expanded to include shipping directly to consumers, as in the health care
segment.
EXHIBIT 2.4 | Timeline of Selective Competitive Developments

The impact of the fierce one-upmanship between FedEx and UPS was clearly reflected
in their respective investment expenditures. From 2010 to 2015, capital expenditures for
FedEx and UPS increased by 54% and 71%, respectively. During this period, FedEx’s
aggressive growth strategy, evident in its acquisitions and its investment in the relatively
outdated Express aircraft fleet, nearly doubled those of “Big Brown,” which benefited
from its more modern fleet.
International Package-Delivery Market
In 2015, the global parcel-shipping market was dominated by UPS, FedEx, and DHL,
with international services representing 22% and 28% of revenues for UPS and FedEx
that year, respectively. FedEx made significant investments in developing European
delivery capabilities in the 1980s before eventually relinquishing its European hub in
1992, causing it to rely on local partners to deliver to Europe for the ensuing decade. In
1995, FedEx expanded its routes in Latin America and the Caribbean, and later
introduced FedEx AsiaOne, a next-business-day service between Asian countries and
the United States via a hub in Subic Bay, Philippines.
UPS broke into the European market in earnest in 1988, with the acquisition of
10 European courier services. To enhance its international delivery systems, UPS
created a system that coded and tracked packages and automatically billed customers
for customs duties and taxes. In 2012, UPS expanded its European offerings by
purchasing Kiala, a European company that gave customers delivery options at nearby
Data source: Google Finance, Morningstar, Value Line, and Capital IQ.
shops and gas stations close to their homes, before replicating the service for Page 31
UK customers the following year. By 2015, the company planned to double its
investment in Europe to nearly $2 billion over five years.
Much like the U.S. domestic market, the international package-delivery market of the
first decade of the 2000s was given its greatest boost by the explosion of e-commerce.
Compared to same-country online shopping, cross-border shipping was only a fraction
of global e-commerce spending in 2015, but it was the piece that was growing most
quickly, at an annual rate of over 25%. Websites like Amazon Marketplace and Etsy
allowed shoppers to purchase goods from sellers all over the world, while expecting an
ease of shipping similar to that provided by domestic retailers. As a result of this
growing segment of online sales, FedEx, UPS, and others were quickly adapting their
service offerings to make cross-border shopping as smooth as possible. FedEx, for
example, purchased Bongo in 2014, later rebranded as FedEx Cross Border, which
aimed to help retailers face cross-border selling issues, including regulatory
compliance and credit-card-fraud protection, while connecting them to global
consumers.
Performance Assessment
Virtually all interested observers—customers, suppliers, investors, and employees—
watched the competitive struggle between UPS and FedEx for hints about the next stage
of the drama. The conventional wisdom was that if a firm were operationally excellent,
strong financial performance would follow. Indeed, FedEx had set a goal of producing
“superior financial returns,” while UPS targeted “a long-term competitive return.”
Had the two firms achieved their goals? Moreover, did the trends in financial
performance suggest whether strong performance could be achieved in the future? In
pursuit of answers to those questions, the following exhibits afford several possible
12
13
14 15
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avenues of analysis.
Financial Success
The success of the two companies could be evaluated based on a number of financial
and market performance measures. Exhibit 2.5 presents the share prices, earnings per
share (EPS), and price–earnings ratios for the two firms. Also included are the annual
total return from holding each share (percentage gain in share price plus dividend yield)
and the economic value add, reflecting the value created or destroyed each year by
deducting a charge for capital from the firm’s net operating profit after taxes.
Exhibits 2.2 and 2.3 present a variety of analytical ratios computed from the financial
statements of each firm.
EXHIBIT 2.5 | Financial and Market Performance
Data source: Google Finance, Morningstar, Value Line, and Capital IQ.
The thinking of the several securities analysts who followed FedEx and UPS in
2015 and 2016 reflected the uncertainty surrounding the future performance for the two
arch-rival shipping companies. Exhibits 2.6 and 2.7 contain excerpts from various
equity research reports that indicate the analysts’ outlook held for UPS and FedEx.
EXHIBIT 2.6 | Recent Equity Analysts’ Outlook for UPS
William Greene, Alexander Vecchio, and Diane Huang, “Greene/United Parcel Service—The Most Important Strategic
Question,” Morgan Stanley, No. 25356723 from Investext Current Reports database (accessed Feb. 3, 2017).
Kelly Dougherty, Matt Frankel, and Cleo Zagrean, “UPS—It’s All about the Peak,” Macquarie Group, No. 27249020 from
Investext Current Reports database (accessed Feb. 3, 2017).
Keith Schoonmaker, “UPS, Inc.,” Morningstar, No. 27249776 from Investext Current Reports database (accessed Feb.
3, 2017).
Source: Analyst reports from specified sources.
1
2
3
EXHIBIT 2.7 | Recent Equity Analysts’ Outlook for FedEx
Operational Success
Beyond their financial performance, the rival companies’ strengths and successes could
also be examined using various measures of operational excellence:
Keith Schoonmaker, “FedEx Corp.,” Morningstar, No. 27901878 from Investext Current Reports database (accessed
Feb. 3, 2017).
Brandon Oglenski, Eric Morgan, and Van Kegel, “FedEx Corp–Some Holiday Cheer,” Barclay’s, No. 27771203 from
Investext Current Reports database (accessed Feb. 3, 2017).
Kelly Dougherty, Matt Frankel, and Cleo Zagrean, “FedEx–Still the One,” Macquarie Group, No. 27761106 from Investext
Current Reports database (accessed Feb. 3, 2017).
Source: Analyst reports from specified sources.
1
2
3
Marketing: In 2015, brand consultancy Interbrand’s annual ranking of top global
brands ranked UPS at number 29 and FedEx at 86, representing little change from
UPS’s rank of 27 and FedEx’s distant 92 for 2014. This favoring of UPS reflected the
payoffs of its full-service-promoting campaigns of the early years of the 2000s.
16
Employee satisfaction: Fortune magazine’s annual ranking of the world’s mostadmired
companies was based on nine factors related to financial performance and
corporate reputation, with four of those factors specifically relating to HR attributes
(quality of management, ability to attract and retain talented people, innovation, and
product and service quality). In 2015, Fortune awarded FedEx with the number 12
spot overall, with UPS coming in at number 24. FedEx’s apparent excellence with
regard to talent management was also reflected by the Great Place to Work Institute,
naming FedEx Express as one of the top global companies to work for for the fourth
year in a row. The more unionized UPS, where strikes were not uncommon, seemed
to lag behind its rival in its commitment to its employees.
17
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Holiday performance: High-volume holiday-delivery performance was always seen
as a strong test of a shipping company’s effectiveness, and FedEx and UPS
traditionally adopted different strategies approaching the peak season. Despite the
holidays of 2013 and 2014 favoring FedEx’s automation at its hubs, its independentcontractor
model (paying ground drivers by package rather than by hour) and practice
of turning down peak volumes based on quantities customers shipped during nonpeak
months, by 2015, the tide had turned. That year, UPS finally managed to prove its peak
execution capabilities; its strategy of increasing capacity to handle higher volumes
allowed it to achieve an on-time-delivery rate nearing 98% the week before
Christmas. For the same period, FedEx struggled to handle a late surge of e-commerce
shipments that were delivered after the holiday (though the company wouldn’t provide
numbers).18
Customer satisfaction: The American Customer Satisfaction Index (ACSI), the only
national, cross-industry measure of companies’ perceptions among consumers, ranked
shipping companies each year based on nearly 10,000 customers’ responses
concerning ease of tracking, package condition on arrival, helpfulness of in-store staff,
and other factors related to recent delivery experiences. Until 2009, FedEx was
ranked number one, but the two shippers leveled out in recent years, and by 2014 and
2015, both UPS and FedEx remained neck and neck, having identical ACSI scores of
19
Outlook for FedEx and UPS
Observers of the air-express package-delivery industry pondered the recent
performance of the two leading firms and their prospects. What had been the impact of
the intense competition between the two firms? Which firm was doing better? The
companies faced a watershed moment with the growth of e-commerce and FedEx’s
aggressive push into Europe. Might their past performance contain clues about the
prospects for future competition?
82, well above USPS’s scores of 73 and 75 for the same years.19
CASE 3
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Page 44
Larry Puglia and the T. Rowe Price Blue Chip
Growth Fund
By late 2016, Larry J. Puglia had been managing the $33 billion T. Rowe Price Blue
Chip Growth Fund (Blue Chip Growth Fund) for more than 23 years. One of the fund’s
original managers, Puglia had been the sole manager of the open-ended mutual fund
since 1997 and had generated superior returns on average for his investors over the life
of the fund.
Since inception in mid-1993 through September 30, 2016, the fund had returned an
average annual total return of 10.12%, outperforming the 9.12% return of the fund’s
benchmark, the Standard & Poor’s 500 Index (S&P 500). For most fund managers,
beating the S&P 500 in any single year was an accomplishment, yet Puglia had served
his investors well by performing better than competitor funds both in bull markets, such
as that of the late 1990s, as well as the bear markets, such as that of the first decade of
the 2000s. Exhibit 3.1 presents a summary of the Blue Chip Growth Fund. Exhibits 3.2
and 3.3 show the fund’s performance and annual return versus its benchmark and other
funds in the large-cap growth category.
1
2
EXHIBIT 3.1 | Morningstar, Inc., Report on T. Rowe Price Blue Chip Growth Fund: Summary1
Source: © 2016 Morningstar, Inc. All rights reserved. Reproduced with permission. Morningstar, T. Rowe Price Blue Chip
Growth Fund TRBCX, release date June 7, 2016: 1
© 2016 Morningstar, Inc. All rights reserved. The information contained herein: (1) is proprietary to Morningstar and/or
its content providers; (2) may not be copied or distributed; (3) does not constitute investment advice offered by
Morningstar; and (4) is not warranted to be accurate, complete, or timely. Neither Morningstar nor its content providers
are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee
of future results. Use of information from Morningstar does not necessarily constitute agreement by Morningstar, Inc., of
any investment philosophy or strategy presented in this publication.
1
EXHIBIT 3.2 | Morningstar, Inc., Summary of T. Rowe Price Blue Chip Growth Fund: Performance1
Source: © 2016 Morningstar, Inc. All rights reserved. Reproduced with permission. Morningstar T. Rowe Price Blue Chip
Growth Fund TRBCX, release date June 7, 2016: 11.
© 2016 Morningstar, Inc. All rights reserved. The information contained herein: (1) is proprietary to 1 Morningstar and/or
While Puglia, working out of T. Rowe Price’s Baltimore, Maryland, headquarters,
rarely had the best overall performance in any given year, and other managers had
beaten his results over short-term periods, his overall long-term performance relative to
the index was truly impressive. He ranked 20th out of 558 U.S. stock mutual funds with
a single portfolio manager, and Morningstar had awarded the Blue Chip Growth Fund
its coveted five-star rating for the fund’s five-year performance, placing it in the top
10% of 1,285 mutual funds investing in large-capitalization growth stocks. Puglia had
also been nominated by Morningstar as one of five finalists for Domestic Fund Manager
of the Year in 2013. The fund had been recognized as an IBD Best Mutual Funds 2016
Awards winner by Investor’s Business Daily (IBD). In addition, Money Magazine
consistently named the fund to its annual selection of best funds, and Kiplinger’s
Personal Finance magazine included the fund on its list of 25 favorite funds.
its content providers; (2) may not be copied or distributed; (3) does not constitute investment advice offered by
Morningstar; and (4) is not warranted to be accurate, complete, or timely. Neither Morningstar nor its content providers
are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee
of future results. Use of information from Morningstar does not necessarily constitute agreement by Morningstar, Inc., of
any investment philosophy or strategy presented in this publication.
EXHIBIT 3.3 | Morningstar Performance Comparison of T. Rowe Price Blue Chip Growth Fund, the
Large-Cap Growth Category, and the Broad Market Index (Average Total Returns %–Sept. 30, 2016)
Data source: Morningstar, T. Rowe Price Blue Chip Growth Fund TRBCX,
athttp://performance.morningstar.com/fund/performance-return.action?t=TRBCX&region=usa&culture=en-US (accessed
Nov. 21, 2016).
Note: Average total return includes changes in principal value, reinvested dividends, and capital gain distributions. For
periods of one year or longer, the returns are annualized. For periods less than one year, the return figures are not
annualized and represent total return for the period.
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Puglia’s results seemed to contradict conventional academic theories, which
suggested that, in markets characterized by high competition, easy entry, and
informational efficiency, it would be extremely difficult to beat the market on a
sustained basis. Observers wondered what might explain such consistent
outperformance by a fund manager and how it could be sustained.
The Mutual-Fund Market
The global mutual-fund market represented $37.2 trillion in worldwide assets at the end
of 2015. Investment companies in the United States accounted for almost half the global
market, with $18.1 trillion in assets; U.S. investment company assets first topped $1
trillion in 1990, growing to $5.8 trillion in 1998 and $18.1 trillion in 2015. Ninety-three
million individuals and 44% of U.S. households owned mutual funds in 2015. In 2015,
individual investors owned about 86% of the assets held by U.S. investment companies.
Mutual funds provided several benefits for individual retail investors. First, they
gave investors the ability to diversify their portfolios—that is, invest in many different
securities simultaneously, thereby reducing the risks associated with owning any single
stock. By purchasing shares in a mutual fund, investors without significant amounts of
capital could efficiently diversify their portfolios, investing as if they had the sizable
amount of capital usually necessary to achieve such efficiency. Mutual funds also
offered scale economies in trading and transaction costs, economies unavailable to the
typical individual investor. Second, mutual funds provided retail investors with
professional management and expertise devoted to analysis of securities, which in
theory could lead to higher-than-average returns. A third view was that the
mutual-fund industry provided, according to one observer, “an insulating layer
between the individual investor and the painful vicissitudes of the marketplace” :
This service, after all, allows individuals to go about their daily lives without
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spending too much time on the aggravating subject of what to buy and sell and
when, and it spares them the even greater aggravation of kicking themselves for
making the wrong decision. . . . Thus, the money management industry is really
selling “more peace of mind” and “less worry,” though it rarely bothers to say so.
Between 1970 and 2015, the number of mutual funds offered in the United States
grew from 361 to 9,520. This total included many different types of funds; each pursued
a specific investment focus and could be classified in one of several categories, such as
aggressive-growth, growth, growth-and-income, international, option, balanced, or a
variety of bond or fixed-income funds. Funds could be further segmented by company
size based on the market capitalization (market cap), calculated by multiplying the
number of shares outstanding by share price. Investors could, for example, opt to invest
in large-cap, mid-cap, or small-cap growth funds. Funds whose principal focus of
investing was common stocks or equities represented the largest segment of the industry.
The growth in the number and types of mutual funds reflected a major shift in
retirement plans for U.S. workers. Prior to the 1980s, most workers were covered by
traditional defined-benefit (DB) pension plans, which were funded by employers and
managed by institutional money managers hired by the employers. Changes to the U.S.
tax code in the 1970s set the stage for a major shift, which would have broad
implications for the mutual-fund industry. First, the Employee Retirement Income
Security Act of 1974 established the self-directed Individual Retirement Account (IRA)
through which workers could save and invest individually for their retirement on a taxdeferred
basis. Second, large U.S. companies began to replace their DB pension plans
with defined-contribution (DC) plans such as 401(k) and 403(b) plans. The new plans,
named for the relevant sections of the U.S. tax code, shifted the burden and
responsibility of saving and managing retirement assets from corporate employers to
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individual employees. Exhibit 3.4 shows the growth in retirement-plan assets over the
period from 1975 to 2015. By 2015, $7.1 trillion of IRA and DC plan assets were
invested through mutual funds.
The shift into DC plans created a broader customer base for the mutual-fund
industry, as well as a deeper penetration of the total market for financial
services. With DC plans, each worker had an individual investment account that could
hold multiple mutual funds, whereas a company’s DB plan held the assets of tens of
thousands of workers in a single investment account. Funds owned in an employee’s
name after a vesting period remained in the employee’s name even if they switched
employers. By 2015, 44.1% or 54.9 million U.S. households owned mutual funds, up
from 5.7% or 4.6 million U.S. households in 1980.
The breadth of mutual-fund alternatives tended to encourage fund switching,
especially from one type of fund to another within a family of funds. The switching
behavior reflected the increased participation of growing numbers of relatively
inexperienced and unskilled retail investors; their interest in market-timing-oriented
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EXHIBIT 3.4 | Retirement Plan Assets by Categories 1975 and 2015 (billions of dollars, end-ofperiod)
CAGR = compound annual growth rate.
Data source: Created by author based on data from Investment Company Institute,
https://www.ici.org/research/stats/retirement (accessed Dec. 16, 2016).
*Data are estimated.
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investment strategies; and the greater range of mutual funds from which to choose, all of
which increased volatility in the market. In short, as the mutual-fund industry grew and
segmented, mutual-fund money became “hotter” (tended to turn over faster).
As a result of the growth in the industry, the institutional investors who managed
mutual funds, pension funds, and hedge funds on behalf of individual investors grew in
power and influence. By 2015, mutual funds owned 31% of the outstanding stock of U.S.
companies. The power and influence of institutional asset managers was apparent in
their trading muscle—their ability, coupled with their willingness, to move huge sums of
money in and out of securities. The rising role of institutional investors investing on
behalf of millions of individual account holders resulted in increases in trading volume,
average-trade size, and block trading (a single trade of more than 10,000 shares).
Mutual-Fund Basics
When individuals invested in an open-ended mutual fund, their ownership was
proportional to the number of shares purchased. The value of each share was called the
fund’s net asset value (NAV). The NAV, computed after market close each day, was the
fund’s total assets less liabilities divided by the number of mutual-fund shares
outstanding, or:
The investment performance of a mutual fund was measured as the increase or decrease
in NAV plus the fund’s income distributions during the period (i.e., dividends and
capital gains), expressed as a percentage of the fund’s NAV at the beginning of the
investment period, or:
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Investors in mutual funds generally paid two types of fees for their investments: onetime
transaction fees and ongoing management fees. A fund’s transaction fee, or sales
load, covered sales commissions paid to brokers for selling the fund. The sales load
could be a front-end or back-end load. A front-end sales load shaved off as much as 6%
of an individual’s initial investment. A back-end load, in contrast, enabled investors to
invest all of their money and defer paying the sales load until they redeemed the shares.
Some companies eschewed the use of brokers and pursued a no-load strategy, selling
funds directly to investors.
In addition to any sales load imposed, investors paid fees for the ongoing
management and operation of the mutual fund. Expenses included management fees for
managing the investments, administrative costs, advertising and promotion expenses,
and distribution and service fees. Expenses were calculated as a percentage of the
fund’s total assets (the expense ratio), and were charged to all shareholders
proportionally. Expense ratios ranged from as low as 0.2% to as high as 2.0%. As seen
in Exhibit 3.5, expense ratios were lower for index funds (funds designed to replicate
the performance of a specific market index) than they were for actively managed funds
which sought to outperform a market index. Because the expense ratio was regularly
deducted from the portfolio, it reduced the fund’s NAV, thereby lowering the fund’s
gross returns. Depending on the magnitude of the fund’s expense ratio, the net effect of
loads and expense ratios on shareholder returns could be substantial.18
EXHIBIT 3.5 | Expense Ratios of Actively Managed and Index Funds in Basis Points 1996–2015
Another drag on shareholders’ returns was the tendency to keep some portion of fund
assets in cash either to invest in attractive investment opportunities or to meet
shareholder redemptions. As economist and industry observer Henry Kaufman warned
in 1994, a sudden economy-wide shock from interest rates or commodity prices could
spook investors into panic-style redemptions from mutual funds, which could force the
funds themselves to liquidate investments, sending security prices into a tailspin.
Unlike the banking industry, which enjoyed the liquidity afforded by the U.S. Federal
Reserve to respond to the effects of panic by depositors, the mutual-fund industry
enjoyed no such government-backed reserve, and thus fund managers often carried a
certain amount of cash to meet redemptions.
A final drag on shareholders’ returns was taxes. Mutual funds collected taxable
dividends for the shares they held and generated taxable capital gains whenever they
sold securities at a profit. Dividends received and capital gains and losses were
reflected in the daily NAV. The funds could avoid paying corporate taxes on dividends
earned and capital gains realized during the year if they distributed the investment
Note: Expense ratios are measured as asset-weighted averages. Data exclude mutual funds available as investment
choices in variable annuities and mutual funds that invest primarily in other mutual funds.
Data source: Created by author based on data from Investment Company Institute and Lipper,
https://www.ici.org/pressroom/news/16_news_trends_expenses (accessed Dec. 16, 2016).
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income to shareholders prior to year-end. The distribution shifted the tax liability from
the investment company to individual shareholders.
Mutual funds generally distributed the year’s realized capital gains and dividend
income to shareholders in December. Dividends and capital gains had, of course, been
collected and realized throughout the year, and were reflected in the daily NAV as they
occurred. On the day of the distribution, the NAV was reduced by the amount of the
distribution. As an example, imagine a mutual fund with an NAV of $10 per share that
had realized capital gains of $1.12 per share during the year. In December, the mutual
fund would distribute $1.12 per share to its investors and the new NAV would be $8.88.
Thus an investor with 100 shares who chose to receive the distribution in cash would
have $112 in cash plus 100 shares worth $888 for a total investment value of $1,000.
An investor who held 100 shares with an NAV of $10 prior to a distribution that he
chose to reinvest would hold the original 100 shares with a new NAV of $8.88 plus
12.612 new shares ($1.12 × 100 shares/8.88 per share), for a total of 112.612 shares
worth $1,000 ($8.88 × 12.612 shares). When funds were held in taxable rather than taxdeferred
accounts, capital gains distributions triggered both unexpected and unwanted
tax liabilities for investors, and reduced the net returns to investors.
Most mutual-fund managers relied on some variation of the two classic schools of
securities analysis for choosing investments
Technical analysis: This approach involved the identification of profitable
investment opportunities based on trends in stock prices, volume, market
sentiment, and the like.
Fundamental analysis: This approach relied on insights afforded by an analysis
of the economic fundamentals of a company and its industry: supply and demand,
costs, growth prospects, and the like.
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While variations on those approaches produced above-average returns in certain years,
there was no guarantee that they would produce such returns consistently over time.
Performance of the Mutual-Fund Industry
The two most frequently used measures of mutual-fund performance were (1) the annual
growth rate of NAV assuming reinvestment of all dividend and capital-gain distributions
(the total return on investment) and (2) the absolute dollar value today of an investment
made at some time in the past. Those measures were then compared with the
performance of a benchmark portfolio such as the Russell 2000 Index or the S&P 500
Composite Index. Exhibit 3.6 provides performance data on a range of mutual-fund
categories. The Russell, S&P 500, Dow Jones, and Value Line indices offered
benchmarks for the investment performance of hypothetical stock portfolios.
Academicians criticized those performance measures for failing to adjust for the
relative risk of the mutual fund. Over long periods, as Exhibit 3.7 shows, different types
of securities yielded different levels of total return, and each type of security was
associated with differing degrees of risk (measured as the standard deviation of
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EXHIBIT 3.6 | Morningstar Performance Comparison of U.S. Mutual-Fund Categories
Note: Data through November 11, 2016. Returns are simple averages. For periods of one year or longer, the returns are
annualized. For periods of less than one year, the return figures are not annualized and represent total return for the
period.
Data source: Morningstar.
returns). Thus the relationship between risk and return was reliable both on average and
over time. For instance, it would be expected that a conservatively managed mutual fund
would yield a lower return—precisely because it took fewer risks.
After adjusting for the risk of the fund, academic research indicated that mutual
funds had the ability to perform up to the market on a gross-return basis, but when all
expenses were factored in, the funds underperformed the market benchmarks. In a paper
first published in 1968, Michael Jensen reported that gross risk-adjusted returns were
−0.4% and that net risk-adjusted returns (i.e., net of expenses) were −1.1%. Later
studies found that, in a sample of 70 mutual funds, net risk-adjusted returns were
essentially zero, and some analysts attributed this general result to the average 1.3%
expense ratio of mutual funds and their tendency to hold cash.
In his best-selling book, A Random Walk Down Wall Street, a classic investment
tome first published in 1973, Burton Malkiel, an academic researcher, concluded that a
passive buy-and-hold strategy (of a large, diversified portfolio) would do as well for
the investor as the average mutual fund. Malkiel wrote:
Even a dart-throwing chimpanzee can select a portfolio that performs as well as
one carefully selected by the experts. This, in essence, is the practical application
of the theory of efficient markets. . . . The theory holds that the market appears to
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EXHIBIT 3.7 | Mean and Standard Deviation of Annual Returns by Major U.S. Asset Category
Data source: Stocks, Bonds, Bills, and Inflation 2014 Yearb ook (Chicago: Ibbotson Associates, 2015): 34.
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adjust so quickly to information about individual stocks and the economy as a
whole, that no technique of selecting a portfolio—neither technical nor
fundamental analysis—can consistently outperform a strategy of simply buying and
holding a diversified group of securities such as those that make up the popular
market averages. . . . [o]ne has to be impressed with the substantial volume of
evidence suggesting that stock prices display a remarkable degree of efficiency. . .
. If some degree of mispricing exists, it does not persist for long. “True value will
always out” in the stock market.
Many scholars accepted and espoused Malkiel’s view that the stock market followed a
“random walk,” where the price movements of the future were uncorrelated with the
price movements of the past or present. This view denied the possibility that there could
be momentum in the movements of common stock prices. According to this view,
technical analysis was the modern-day equivalent of alchemy. Academics also
dismissed the value and effectiveness of fundamental analysis. They argued that capital
markets’ information was efficient–that the data, information, and analytical conclusions
available to any one market participant were bound to be reflected quickly in share
prices.
The belief that capital markets incorporated all the relevant information into existing
securities’ prices was known as the efficient market hypothesis (EMH), and was
widely, though not universally, accepted by financial economists. If EMH were correct
and all current prices reflected the true value of the underlying securities, then arguably
it would be impossible to beat the market with superior skill or intellect.
Economists defined three levels of market efficiency, which were distinguished by
the degree of information believed to be reflected in current securities’ prices. The
weak form of efficiency maintained that all past prices for a stock were incorporated
into today’s price; prices today simply followed a random walk with no correlation
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with past patterns. Semistrong efficiency held that today’s prices reflected not only all
past prices, but also all publicly available information. Finally, the strong form of
market efficiency held that today’s stock price reflected all the information that could be
acquired through a close analysis of the company and the economy. “In such a market,”
as one economist said, “we would observe lucky and unlucky investors, but we
wouldn’t find any superior investment managers who can consistently beat the market.”
Proponents of EMH were both skeptical and highly critical of the services provided
by active mutual-fund managers. Paul Samuelson, the Nobel Prize–winning economist,
said:
[E]xisting stock prices already have discounted in them an allowance for their
future prospects. Hence . . . one stock [is] about as good or bad a buy as another.
To [the] passive investor, chance alone would be as good a method of selection as
anything else.
Tests supported Samuelson’s view. For example, in June 1967, Forbes magazine
established an equally weighted portfolio of 28 stocks selected by throwing darts at a
dartboard. By 1984, when the magazine retired the feature article, the initial $28,000
portfolio with $1,000 invested in each stock was worth $131,698, a 9.5% compound
rate of return. This beat the broad market averages and almost all mutual funds. Forbes
concluded, “It would seem that a combination of luck and sloth beats brains.”
Despite the teachings of EMH and the results of such tests, some money managers—
such as Larry Puglia—had significantly outperformed the market over long periods. In
reply, Malkiel suggested that beating the market was much like participating in a cointossing
contest where those who consistently flip heads are the winners. In a cointossing
game with 1,000 contestants, half will be eliminated on the first flip. On the
second flip, half of those surviving contestants are eliminated. And so on, until, on the
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seventh flip, only eight contestants remain. To the naïve observer, the ability to flip
heads consistently looks like extraordinary skill. By analogy, Malkiel suggested that the
success of a few superstar portfolio managers could be explained as luck.
Not surprisingly, the community of professional asset managers viewed those
scholarly theories with disdain. Dissension also grew in the ranks of academicians as
research exposed anomalies inconsistent with the EMH. For example, evidence
suggested that stocks with low price-to-earnings (P/E) multiples tended to outperform
those with high P/E multiples. Other evidence indicated positive serial correlation (i.e.,
momentum) in stock returns from week to week or from month to month. The evidence
of these anomalies was inconsistent with a random walk of prices and returns.
The most vocal academic criticism came from the burgeoning field of “behavioral
finance,” which suggested that greed, fear, and panic could be much more significant
factors in determining stock prices than mainstream theories would suggest. Critics of
EMH argued that events such as the stock-market crash of October 1987 were
inconsistent with the view of markets as fundamentally rational and efficient. Lawrence
Summers, economist and past president of Harvard University, argued that the 1987
crash was a “clear gap with the theory. If anyone did seriously believe that price
movements are determined by changes in information about economic fundamentals,
they’ve got to be disabused of that notion by [the] 500-point drop” which erased more
than 22% of market value in a single day. Following the 1987 crash, Yale University
economist Robert Shiller concluded: “The efficient market hypothesis is the most
remarkable error in the history of economic theory. This is just another nail in its
coffin.”
Market events such as the Internet bubble of the late 1990s and the global financial
crisis of 2007–2009 further added to the belief that market participants were not always
rational and the EMH was flawed. Yet, despite the mounting evidence of its
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shortcomings, the EMH remained the dominant model in the academic community.
The Rise of Passive Investing
More than 20 years after graduating from Princeton University in 1951, where he wrote
his senior thesis on “The Economic Role of the Investment Company,” John C. Bogle
founded the Vanguard Group and established a fund whose investment goal was to match
—not beat—the performance of a market index. Bogle’s First Index Investment Trust
launched on December 31, 1975, and was quickly dismissed as folly by many.
Investors, critics proclaimed, would not be satisfied with receiving average returns.
Over time, Bogle’s fund, which tracked the S&P 500, and was eventually renamed
the Vanguard 500 Index Fund, proved critics wrong. Without expensive portfolio
managers or research analysts to compensate, the fund charged a low expense ratio of
0.16%. Without portfolio managers trading in and out of securities, the fund’s turnover
rate was 3%, meaning that year-end capital-gains distributions were negligible, making
the fund extremely tax efficient for taxable investors.
At least some investors decided that the benefits of being average outweighed the
costs of trying to be above average. From approximately $11 million in assets in 1975,
the fund grew to $262.80 billion in assets on September 30, 2016. Vanguard also
grew. By December 2015, the company employed 14,000 individuals and offered more
than 300 U.S. and non-U.S. funds, serving more than 20 million investors from
approximately 170 countries.
Vanguard’s success was noticed. In particular, other investment companies
developed and offered index funds, and by 2015, $2.2 trillion was invested in indexbased
mutual funds. Exhibit 3.8 shows the growing percentage of assets invested in
equity index funds from 2000 to 2015, and Exhibit 3.9 shows how outflows from
actively managed funds matched the inflows to passively managed investment funds
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from 2009 to 2015.44
EXHIBIT 3.8 | Percentage of Equity Mutual Funds’ Total Net Assets Invested in Index Funds 2000–
2015
Data source: Created by author based on data from Investment Company
Institute,http://www.icifactbook.org/ch2/16_fb_ch2 (accessed Dec. 16, 2016).
Note: Equity mutual fund flows include net new cash flow and reinvested dividends. Data exclude mutual funds
that invest primarily in other mutual funds.
Data source: Created by author based on data from Investment Company
Institute,http://www.icifactbook.org/ch2/16_fb_ch2 (accessed Dec. 16, 2016).
Larry Puglia and the T. Rowe Price Blue Chip Growth
Fund
At a time when many investors were eschewing actively managed funds such as Puglia’s
in favor of passive investments designed to track stock-market indices, Puglia’s
investment performance stood out. Morningstar, the well-known statistical service for
the investment community, gave the Blue Chip Growth Fund its second-highest rating,
four stars for overall performance, placing it in the top 32.5% of 1,482 funds in its
category. Morningstar rated funds with at least a three-year history based on riskadjusted
return (including the effects of transaction fees such as sales loads and
redemption fees) with emphasis on downward variations and consistent performance.
According to Morningstar, a high rating could reflect above-average returns, belowaverage
risk, or both.
Puglia graduated summa cum laude from the University of Notre Dame and went
one to earn an MBA from the Darden School of Business, where he graduated with
highest honors. A Certified Public Accountant (CPA), Puglia also held the Chartered
Financial Analyst (CFA) designation. Puglia learned his first lessons about investing
from his father, a traditional buy-and-hold investor. “He would buy good companies and
literally hold them for 15 or 20 years.”
Puglia, 56, joined T. Rowe Price in 1990 as an analyst following the financial
services and pharmaceutical industries. He worked closely with portfolio manager Tom
Broadus (co-manager of the Blue Chip Growth Fund from mid-1993 until leaving the
fund on May 1, 1997), who provided additional lessons about investing. Broadus
warned the young analyst that his investment style would sometimes be out of sync with
EXHIBIT 3.9 | Monthly Cumulative Flows to and Net-Share Issuance of U.S. Equity Mutual Funds and
Index Exchange-Traded Funds (ETFs) January 2007–December 2015 (in billions of dollars)
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the market. Part of the portfolio manager’s job, he told Puglia, was to recognize that and
lose as little as possible.
When the Blue Chip Growth Fund launched in 1993, its managers engaged in
considerable debate over “what constituted a ‘blue-chip growth company.’ Some people
felt we should own the old Dow Jones smokestack companies; others said we needed to
own the Ciscos and the Microsofts. After giving it a lot of thought, we decided that it
was durable, sustainable earnings-per-share growth that confers blue-chip status on a
company. That’s what allows it to garner an above-average price-earnings ratio, and
that’s what allows you to really hold such an investment for the long term and allows
your wealth to compound. So that’s basically what we’re trying to do—we’re trying to
find companies with durable, sustainable earnings-per-share growth, and we want to
hold those companies for the long term.”
The fund’s objective was long-term capital growth, with income only a secondary
consideration. Consequently, Puglia invested in well-established large and mediumsized
companies that he believed had potential for above-average earnings growth.
More specifically, Puglia looked for companies with leading market positions, seasoned
management that allocated capital effectively, and strong returns on invested capital.
To be included in his portfolio, a company needed several things :
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1. Growing market share and market size. In Puglia’s view, a leading market position
conferred both cost advantages and pricing advantages. A company with superior
market share generally made its products more cheaply, and also enjoyed more pricing
flexibility. As important as growing market share was growing market size. Superior
market share in a declining marketplace was not a good indicator, so Puglia also
evaluated the market for a company’s products and how large the total addressable
market could grow over time.
2. Competitive advantage(s): Puglia used Harvard Business School professor Michael
Puglia was assisted in this process by a very highly regarded global research team that
included more than 250 industry analysts, as well as portfolio managers responsible for
other funds. Together, members of the research team covered more than 2,300 public
companies around the globe, almost two-thirds of global markets by market
capitalization. The firm’s recruiting and internal mentoring programs allowed it to
attract and develop talented investment analysts, who formed a pool of well-trained and
experienced candidates for portfolio manager positions.
T. Rowe Price’s culture and structure encouraged and facilitated close and frequent
collaboration between managers and analysts and equity and fixed-income
professionals. Its performance evaluation and compensation practices rewarded
collaboration and focused on long-term, rather than short-term, results. Management
regularly promoted the strength and contributions of the research team to clients,
directly or through its website, and shared research supporting its approach to active
management.
Puglia, like most of the firm’s portfolio managers, had initially served as an analyst,
and considered analyst recommendations and insights from the research team to be
Porter’s competitive analysis to identify companies with sustainable competitive
advantage, what legendary value investor Warren Buffett referred to as “economic
castles protected by unbreachable moats.”51
3. Strong fundamentals including above-average earnings growth, stable-to-improving
margins, strong free cash flow, and return on equity.
4. Seasoned management with a demonstrated track record: Puglia looked for evidence
of management’s ability to allocate capital to the highest-return businesses and pare
away low-returning businesses; and to manage expenses aggressively. He compared a
company that generates superior return and has strong free-cash flow but lacks strong
management to a fast ship without a rudder. Sooner or later, it will run aground.
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instrumental to the stock-selection process. With assistance from the research team and
robust firm resources, he focused on identifying companies with durable free-cash-flow
growth.
Although most investment candidates were identified through analyst
recommendations, Puglia also employed other identification methods, including
screening databases for various characteristics, such as steady earnings growth and
return on equity over one, three, and five years. Puglia explained, “We’ll look under
every stone,” searching news reports, economic data, and even rivals’ portfolios for
investment ideas. “There are plenty of other managers out there with excellent track
records,” he said, “and we’re willing to learn from others where possible.”
Identifying a potential investment through screening was only one quantitative aspect
of the investment research and decision-making process. For each company of interest,
Puglia calculated the company’s “self-sustaining growth rate,” multiplying return on
equity by 1 minus the payout ratio (percentage of earnings paid out in dividends). A
company with a 25% return on equity paying out 10% of earnings in dividends, would,
for example, have a self-sustaining growth rate of 22.5%. Recognizing the limitations
of return on equity or other measures based upon GAAP or book accounting, Puglia and
the research team also used free cash flow extensively in quantitative analysis and stock
selection. If a company met Puglia’s quantitative criteria, he and the research team
would do further qualitative research, including meeting with corporate management
and corroborating their assertions and other data with customers, suppliers, and
competitors.
According to Morningstar, $10,000 invested in the Blue Chip Growth Fund at its
inception in mid-1993 would have grown to $94,021 in assets on September 30, 2016.
Puglia’s fund significantly outperformed the average growth for the large-cap-growth
category of $56,185 and growth from investing in the S&P 500, which returned $76,100.
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As news of Puglia’s performance record spread, more and more investors moved their
money to the Blue Chip Growth Fund, such that over the life of the fund, more than $15
billion of new money was added to the fund’s assets under management. Even so, Puglia
remained modest; he knew his investing style would not always be in sync with the
markets and that the fund’s returns could vary quite a bit at times from the S&P 500.
During those times, Puglia would recall the advice of his former co-manager to
recognize the shift and lose as little as possible.
Conclusion
Judged from an historical perspective, Puglia’s investment success seemed exceptional.
His long-run, market-beating performance defied conventional academic theories.
Investors, scholars, and market observers wondered about the sources of such superior
performance and about its sustainability. At of the end of 2016, was it rational for an
equity investor to buy shares in the Blue Chip Growth Fund, or for that matter any
actively managed fund? Investors and other observers wondered whether and for how
long Puglia could continue to outperform the market. In particular, they wondered
whether he would be able to sustain his performance under the weight of having
$30 billion in assets to invest.
CASE 4
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Genzyme and Relational Investors: Science and
Business Collide?
For Marblehead Neck, Massachusetts, it was an unusually warm morning in April 2009,
so Henri Termeer decided to take a leisurely walk on the beach. Termeer had some
serious issues to consider and often found that the fresh sea air and solitude did
wonders for his thought process. For more than 20 years, Termeer had been the
chairman and CEO of Genzyme Corporation, based in Cambridge, Massachusetts.
Under his watch, Genzyme had grown from an entrepreneurial venture to one the
country’s top-five biotechnology firms (Exhibit 4.1 shows Genzyme’s financial
statements).
EXHIBIT 4.1 | Income Statements

There were bumps along the way accompanying Termeer’s achievements, and a
recent event was one of them. The week before, Termeer had sat in a presentation by
Ralph Whitworth, cofounder and principal of a large activist investment fund,
Relational Investors (RI). Whitworth’s company now had a 2.6% stake in Genzyme
(Exhibit 4.2 shows Genzyme’s top 10 shareholders). Whitworth had a history of
engagements with the board of directors of numerous companies, and in several
instances, the CEO had been forced to resign. In January, when RI had announced its
initial 1% investment in Termeer’s company, the two men had met for a meeting at the JP
Morgan Healthcare Conference, and the discussion had been amicable. Whitworth and
his team then traveled in April to Genzyme’s headquarters and talked about Genzyme’s
core business, value creation, and the lack of transparency in some of the company’s
communications.
Data source: Genzyme Corporation, 10-K filing, 2008.
Data source: Genzyme Corporation, 10-K filings, 2007 and 2008
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EXHIBIT 4.2 | Top 10 Shareholders, March 31, 2009
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Termeer was proud of his company’s accomplishments, shown by the number of
people with rare diseases who had been successfully treated with Genzyme’s products.
He was also pleased with the long-term growth in the price of Genzyme’s stock, which
had easily outperformed the market over the last several years. In fact, the company had
just posted record revenues of $4.6 billion for 2008. Although the 2007–08
financial crisis had affected the stock market overall, Genzyme, along with the
biotechnology industry, was faring better than most (see Exhibit 4.3 for charts on
Genzyme’s stock performance).
Data source: Forms 13F filed by investors.
EXHIBIT 4.3 | Genzyme (GENZ) vs. S&P 500 (S&P) and NASDAQ Biotechnology Index (NBI),
Weekly Close—Base = 1/1/2003
But a bigger blow came about a month after Termeer’s first introduction to
Whitworth. An operational problem surfaced in the company’s plant in Allston,
Data source: Bloomberg.
Massachusetts, followed by an official warning letter from the U.S. Food and Drug
Administration (FDA) on February 27, 2009. The company responded to the FDA by
publicly disclosing its manufacturing issues. Genzyme began conducting a quality
assessment of its system, and Whitworth had expressed his confidence in the company’s
actions to address the issues. Recent news on the impending health care reform bill also
hit companies in the health care sector hard. Genzyme’s stock price, which had declined
by 21% over five trading days, had yet to recover.
On top of handling Whitworth’s demands, Termeer had to prepare for the
shareholders’ annual meeting scheduled for May 21. As Termeer mulled over the
sequence of past events, the name of Whitworth’s RI fund suggested to him that
relationship building was its modus operandi and that perhaps Whitworth genuinely
wanted to help Genzyme increase its performance. Up to this time, Termeer had not
considered RI to be a threat, but if there were other corporate activists or hedge funds
monitoring his company and looking to set its corporate policy, then maybe he should
take note that Genzyme now had an “activist” investor. What should he do?
Biotechnology
Cheeses, beer, and wine had at least one thing in common: the application of biological
science in the form of bacteria processing. The use of living organisms to stimulate
chemical reactions had been taking place for thousands of years. But since the mid-20th
century, when revolutionary research in genetics led to the description of the structure of
DNA, molecular biology had been transformed into a thriving industry. Products among
the 1,200 plus biotechnology companies in 2008 included innovations in the treatment of
multiple sclerosis, rheumatoid arthritis, cancer, autoimmune disorders, and diabetes.
Biotechnology drugs were normally far more complex to produce than the chemicalbased
blockbuster drugs developed by Big Pharma companies. The U.S. Supreme Court
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recognized patent rights on genetically altered life forms in the early 1980s, and the U.S.
Congress passed the Orphan Drug Act in 1983. Intended to attract investment for
research and development (R&D) in the treatment of rare diseases (those affecting less
than 200,000 people), the act gave companies that brought successful drugs to market a
seven-year monopoly on sales.
This exclusive sales incentive was not a free lunch, however; its purpose was to
offset the numerous uncertainties in biotechnology development. Many of these
uncertainties pertained to the U.S. drug approval process itself, one of the most rigorous
in the world. In addition to the extremely high cost of R&D, a lengthy process was
required to get new products to market. After a particular disease was targeted, its
treatment went through a series of chemical tests to determine therapeutic
effectiveness and to uncover potential side effects. Preclinical studies were then
done by testing animals over a period of years. Only then could the company submit an
investigational new drug application to the FDA to begin clinical testing on humans.
Clinical trials on humans consisted of three phases: (1) testing the drug’s safety by
giving small doses to relatively healthy people; (2) administering the drug to patients
suffering from the targeted disease or condition; and (3) employing random doubleblind
tests to eliminate bias in the process. Typically, one group of patients was given
the potential drug, and the other group was given an inert substance or placebo. Due to
the rigorous nature of the clinical trials, only about 5% to 10% of drugs that reached the
testing stage ultimately received approval for marketing. Not surprisingly, the
biotechnology industry’s R&D spending as a percentage of revenues was among the
highest of any U.S. industry group.
The level of R&D expenditures made it crucial to get new drugs to market quickly.
The FDA’s Center for Drug Evaluation and Research was responsible for reviewing
therapeutic biological products and chemical-based drugs. Unfortunately, inadequate
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funding and staffing of the FDA resulted in missed deadlines and a low level of final
approvals. In 2008, the regulator approved 24 new drugs, out of which only 6 were
biologic. By 2009, it was estimated that, on average, new products took more than
eight years to get through the clinical development and regulatory process.
The industry weathered the financial storms in 2007–08 relatively well, as demand
for biotechnology products depended more on the population’s health than the economy
(see Exhibit 4.4 for financial metrics for Genzyme and its major competitors). This was
particularly true for large-cap companies with strong cash flows that did not need to
access capital markets. Of more importance to some industry observers was that strong
biotechnology companies might come under increased merger and acquisition (M&A)
pressure from Big Pharma because these companies faced patent expirations on key
blockbuster drugs in the coming years.
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5
EXHIBIT 4.4 | Biotechnology Financial Metrics as of December 2008
Genzyme Corporation
Henry Blair, a Tufts University scientist, and Sheridan Snyder founded Genzyme in 1981
to develop products based on enzyme technologies. Using venture capital funding, they
purchased a small company, Whatman Biochemicals Ltd., which was absorbed into
Genzyme. In 1983 (the same year that the Orphan Drug Act was passed), they recruited
Henri Termeer to be president, joining the other 10 employees. Termeer had spent the
previous 10 years with Baxter Travenol (later Baxter International), including several
years running its German subsidiary. He left his lucrative position at Baxter to join the
start-up. Shortly after Termeer became CEO, Genzyme raised $28.5 million in its 1986
Notes: (a) Share buybacks for Genzyme and Cephalon represent purchases to satisfy option exercises.
Data Sources: Company 10-K filings, 2008; Silver, “Biotechnology” exhibits.
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IPO and began trading on the NASDAQ (ticker: GENZ).
An accidental meeting between Termeer and a former Baxter colleague
turned into a masterful acquisition for Genzyme. On a return flight from Chicago
to Boston in 1989, Termeer and Robert Carpenter, chairman and CEO of Integrated
Genetics (IG), based in Framingham, Massachusetts, discussed the businesses and
finances of the two companies. Several months later, Genzyme purchased IG with its
own stock for the equivalent of $31.5 million or less than $3 per share. Overnight
Genzyme’s expertise received a considerable boost in several areas of biotechnology:
molecular biology, protein and nuclear acid chemistry, and enzymology. Carpenter
served as executive vice president of Genzyme for the next two years and was elected
to the board of directors in 1994 (Exhibit 4.5 lists Genzyme board members).
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EXHIBIT 4.5 | Board of Directors, March 31, 2009
Avoiding the glamorous blockbuster drug industry, Termeer established Genzyme’s
footprint in the treatment of genetic disorders. His goal was to create targeted drugs
to completely cure these diseases, despite the statistically small populations that were
afflicted. In the company’s formative years, Termeer focused R&D on lysosomal storage
Note: Date in parentheses is the first year elected to the board.
Data source: Genzyme Corporation, 14A filing, April 13, 2009.
disorders (LSDs). Commonalities among LSD patients were inherited life-threatening
enzyme deficiencies that allowed the buildup of harmful substances. Cures were aimed
at creating the genetic material to generate the deficient enzymes naturally in these
patients.
Genzyme’s most rewarding product was the first effective long-term enzyme
replacement therapy for patients with a confirmed diagnosis of Type I Gaucher’s
disease. This inherited disease was caused by deficiency of an enzyme necessary for the
body to metabolize certain fatty substances. The deficiency produced several crippling
conditions such as bone disease, enlarged liver or spleen, anemia, or thrombocytopenia
(low blood platelet count).
Initially, the product was known as Ceredase and received a great deal of attention
for its life-saving treatment. It was approved by the FDA in 1991 and protected by the
Orphan Drug Act, but its success was not without controversy. The price for Ceredase
was $150,000 per patient, per year, making it one of the most expensive drugs sold at
the time. Genzyme argued that the price reflected the extraordinary expense of
production; a year’s supply for a single patient required enzyme extraction from
approximately 20,000 protein-rich placentas drawn from a multitude of hospitals around
the world. By 1994, however, Genzyme’s laboratories had developed Cerezyme, a
genetically engineered replacement for Ceredase that was administered via intravenous
infusion. Cerezyme was approved by the FDA in 1995 and also qualified for protection
under the Orphan Drug Act.
Further successes against LSDs included Fabrazyme (to treat Fabry disease) and
Myozyme (to treat Pompe disease). Fabry disease was caused by GL-3, a substance in
cells lining the blood vessels of the kidney. Pompe disease shrank a patient’s muscles,
eventually affecting the lungs and heart. These two drugs, along with Cerezyme, formed
the core business of the company and were developed and sold by its genetic disease
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segment (GD).
Termeer was particularly proud of Genzyme’s scientific team for developing
Myozyme. Pompe disease was a debilitating illness that affected both infants
and adults. The symptoms for adults included a gradual loss of muscle strength and
ability to breathe. Depending on the individual, the rate of decline varied, but patients
eventually needed a wheelchair and ultimately died prematurely most often because of
respiratory failure. The symptoms were similar for infants, but progressed at a faster
rate, so death from cardiac or respiratory failure occurred within the first year of life.
The first human trials for Myozyme were conducted on a small sample of newborns and
resulted in 100% of the infants surviving their first year. This success was so dramatic
that the European regulators approved the drug for infants and for adults.
Concurrent with the company’s focus on genetic disorders, it also invested in the
development of hyaluronic acid-based drugs to reduce the formation of postoperative
adhesions. Initially, it raised funds in 1989 through a secondary stock offering and an
R&D limited partnership. The research the company conducted was significantly
advanced by the acquisition of Biomatrix, Inc., in 2000, forming the biosurgery segment
(BI).
Termeer also searched for nascent biotechnology research companies that had good
products but limited capital or marketing capabilities. As a result, he created numerous
alliances and joint ventures, providing funding in exchange for a share of future revenue
streams. As one example, Genzyme formed a joint venture in 1997 with GelTex
Pharmaceuticals, which specialized in the treatment of conditions in the gastrointestinal
tract. GelTex’s first drug, RenaGel, bound dietary phosphates in patients with chronic
kidney dysfunction.
After 1997, Termeer completed a host of acquisitions. To some extent, the
opportunity for these acquisitions resulted from the economic woes of other
biotechnology firms whose clinical failures affected their funding abilities, resulting in
research cuts and layoffs. Smaller start-up firms were vulnerable to economic stress if
their flagship drug failed to succeed in time. These conditions suited Termeer, who had
begun a broad strategy to diversify. But his strategy was not without risks because even
drugs acquired in late-stage development had not yet been approved by the FDA.
Many of Genzyme’s acquisitions were new drugs in various stages of development
(Exhibit 4.6 shows Genzyme’s major acquisitions). They were generally considered to
be incomplete biotechnologies that required additional research, development, and
testing before reaching technological feasibility. Given the risk that eventual regulatory
approval might not be obtained, the technology may not have been considered to have
any alternative future use. In those cases, Genzyme calculated the fair value of the
technology and expensed it on the acquisition date as in-process research and
development (IPR&D).
Over time, Genzyme reorganized or added business segments based on its own
EXHIBIT 4.6 | Acquisitions: 1997–2007 (in millions of dollars)
Data Sources: LexisNexis, “Genzyme Corporation” Mergers and Acquisitions; Genzyme Corporation 10-K filings, 2000–
07; Montgomery, 165.
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R&D results and the addition of acquired firms. By December 2008, the company was
organized into four major segments: GD, cardiometabolic and renal (CR), BI, and
hematologic oncology (HO). (Exhibit 4.7 displays segment product offerings and the
fraction of 2008 revenues generated by each product).
In its presentation, RI had analyzed the performance of Genzyme’s business
segments using a metric called cash flow return on investment or CFROI. The idea was
to quantify the profit generated with respect to the capital that was invested in
EXHIBIT 4.7 | Main Products by Segment
Data source: Genzyme Corporation, 10-K filings, 2008 and 2009.
each business line (Exhibit 4.8 shows the CFROI estimates by RI for 2008). Termeer
asked Genzyme’s CFO to review the analysis. He believed the performance of the GD
division was correct, but he was not sure about the low performance of the other
segments.
The goal of Termeer’s diversification strategy was to create solutions for curing
more common diseases and to broaden the groups of patients who benefited. Termeer
was also a member of the board of directors of Project HOPE, an international
nonprofit health education and humanitarian assistance organization. Through a
partnership with Project HOPE, Genzyme provided life-saving treatment at no cost to
patients in developing countries, particularly those with inadequate health care services
or medical plans.
Like most biotechnology firms, Genzyme did not pay dividends to its shareholders.
EXHIBIT 4.8 | Genzyme—Estimates of CFROI by Segment (2008)
Note: Cash ROIC = Adjusted Cash Profits/Average Invested Capital.
Source: Relational Investors.
9
As it stated, “We have never paid a cash dividend on our shares of stock. We currently
intend to retain our earnings to finance future growth and do not anticipate paying any
cash dividends on our stock in the foreseeable future.” The company had repurchased
shares of its common stock amounting to $231.5 million in 2006 and $143 million in
2007, but these were offset by issuances of shares to honor option exercises. There was
no open market share repurchase program.
In terms of operations, the $200 million manufacturing facility Genzyme had built in
Allston produced the company’s primary genetic drugs, Cerezyme, Fabrazyme, and
Myozyme. A new facility was being constructed in Framingham, and major international
facilities were located in England, Ireland, and Belgium. Administrative activities,
sales, and marketing were all centered in Cambridge and Framingham. All was well
until the first quarter of 2009, when Termeer received the FDA warning letter in
February outlining deficiencies in the Allston plant. The “significant objectionable
conditions” fell into four categories: maintenance of equipment, computerized systems,
production controls, and failure to follow procedures regarding the prevention of
microbiological contamination. The problems in the Allston plant could be traced
back to Termeer’s decision to stretch the production capacity of the plant to meet an
unanticipated demand for Myozyme. Production had increased, but the strain placed on
the complex processes eventually led to the problems cited by the FDA. Anything that
disrupted the production of the plant concerned Termeer because it produced Genzyme’s
best-selling products, and those medications were critical to the well-being of the
patients who used them.
Relational Investors
If only one word were used to describe 52-year-old Ralph Whitworth, cofounder of
Relational Investors, it would be “performance.” While attending high school in
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Nevada, he raced his red 1965 Pontiac GTO against friends on the desert roads near
his home town of Winnemucca, outperforming them all. After obtaining a JD from
Georgetown University Law Center, Whitworth accepted a job with T. Boone
Pickens, the famous “corporate raider” of the 1980s, and gained what he called
“a PhD in capitalism” in the process. He left Pickens in 1996 to found RI with David
Batchelder whom he had met while working for Pickens. The largest initial investment
was the $200 million that came from the California Public Employees’ Retirement
System (CalPERS). In recognition of RI’s performance, CalPERS had invested a total of
$1.3 billion in RI by 2008. (Exhibit 4.9 illustrates RI’s annual performance.)
RI was commonly classified by observers as an “activist” investment fund. The
typical target firm was a company whose discounted cash flow analysis provided a
higher valuation than the company’s market price. Whitworth trained his executives to
view the gap between a company’s intrinsic value and its market price as the result of
an entrenched management taking care of itself at the expense of its shareholders.
Specifically, Whitworth felt the value gap came primarily from two sources: (1) money
not being spent efficiently enough to earn adequate returns, and/or (2) the company
suffered from major corporate governance issues. Common causes of
underperformance were firm diversification strategies that were not providing an
adequate return to shareholders, poor integration results with a merger partner or
12
EXHIBIT 4.9 | Relational Investors—Calendar Year Performance (%)
Note: RI was not required to disclose publicly its performance results. CalPERS disclosed its investment returns in RI’s
Corporate Governance Fund, and this serves as a good proxy for RI’s performance.
Data source: “Performance Analysis for the California Public Employers’ Retirement System,” Wilshire Consulting (Santa
Monica, CA), September 30, 2010.
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14
acquisition, or the misalignment of management incentives.
Once a firm was targeted, RI typically took a 1% to 10% stake in it and then
engaged management with questions backed up by a RI detailed analysis. Depending
upon the particular responses from executives and directors, Whitworth would follow
one of several paths. For example, he might request certain changes or consider making
criticisms public. Resistance might result in isolated pressure on one or more
executives or board members. In other instances, Whitworth might request a seat on the
board, suggest a change in executive management or board composition, or initiate a
proxy fight. Management and board compensation was a favorite target of RI criticism
—one that was never well received by the target firm. Similar to most people’s view of
an athlete, Whitworth had no objections regarding high compensation for executives, so
long as they performed. (Exhibit 4.10 illustrates some of RI’s major corporate
governance engagements in the past.)
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EXHIBIT 4.10 | Relational Investors—High-Profile Corporate Governance Engagements
Page 70
As one example, in late 2006, Whitworth and Batchelder contacted the board of
Home Depot requesting changes in the company’s strategy. By then, RI had purchased $1
billion of Home Depot stock. Specifically, they criticized CEO Robert Nardelli’s
decision to shift the company’s focus to a lower-margin commercial supply business,
which Nardelli considered a growth opportunity. This proved to be commercially
unsuccessful. As a result, Nardelli had increased revenues, which was in keeping with
his board-approved incentive contract, but earnings suffered. After the engagement of
RI, Batchelder joined the board, and Nardelli was ousted.
In another instance, this time with Sovereign Bancorp, corporate governance
was the key issue. One director was found to have executed private transactions in
branch offices. Another had an undisclosed ownership in a landscaping company that
the bank hired. Instead of the more normal compensation of $80,000 paid to board
members of similarly sized banks, Sovereign Bancorp’s board members received
$320,000 a year. After uncovering these events and fighting with the board, Whitworth
succeeded in being elected to it, and the CEO Jay Sidhu was ousted.
At its peak, RI’s engagements comprised a total portfolio of $8.4 billion at the end
of third quarter 2007. Given the drop in share prices following the financial crisis and
the impact of several redemptions from investors, RI’s portfolio value had been reduced
to $4.3 billion by the end of March 2009. (Exhibit 4.11 lists the amount of RI’s
engagements as of September 30 for each year since 2001 as well as the active
engagements that RI had as of March 31, 2009).
NOTES: (a) Represents end-of-quarter periods until the time of the case (3/2009);
(b) Represents the MV when RI held its maximum % in the company. RI’s position in $ may have been higher at another
time.
Sources: Relational Investors, 13F filings to March 31, 2009.
Jonathan R. Laing, “Insider’s Look Out,” Barron’s, February 19, 2007.
Aaron Bernstein and Jeffrey M. Cunningham, “Whitworth: The Alchemist in the Boardroom,” Directorship, June/July 2007.
16
Which Path to Follow?
When Termeer finished his walk on the beach, he returned to the office, where he
reviewed Whitworth’s presentation slides. The main slide illustrated RI’s calculation of
the present value of each of Genzyme’s divisions plus its R&D pipeline. The sum of
these, representing RI’s valuation of Genzyme, is compared to the company’s current
EXHIBIT 4.11 | Relational Investors—Portfolio Investments
March 31, 2009.
Data source: Relational Investors, Form 13F.
*
stock price (Exhibit 4.12 shows RI’s valuation analysis of Genzyme). It showed that
Genzyme’s share price was trading at $34 below its fundamental value—a significant
discount. RI then offered recommendations as to how Genzyme could address this:
Termeer reflected on the first two items on the RI list. During his presentation,
Whitworth stated how impressed he was with Genzyme’s growth and complemented
EXHIBIT 4.12 | Relational Investors’ Fundamental Valuation of Genzyme
Source: Relational Investors.
1. Improve capital allocation decision making to ensure that spending would be focused
on the investment with the highest expected return.
2. Implement a share-buyback or dividend program.
3. Improve board composition by adding more members with financial expertise.
4. Focus executive compensation on the achievement of performance metrics.
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Termeer on how well he had been able to create significant shareholder value. But
Whitworth anticipated that the years of successful growth were about to lead to high
positive cash flow for several years. (Exhibit 4.13 shows how RI expected Genzyme to
generate significant cash flow in the coming years.) That positive cash flow would
create new challenges for Termeer. Whitworth explained that CEOs often failed to
realize that value-adding investment opportunities were not available at the level of the
cash flows being produced. As the CEOs continued to invest the large cash flows into
lower-return investments, the market would eventually react negatively to the
overinvestment problem and cause the share price to decline. Whitworth argued that it
was better for management to distribute the newly found cash flow as part of a
share repurchase program. Moreover, he thought Genzyme could leverage its
share repurchases by obtaining external funding because Genzyme’s balance sheet could
support a significant increase in debt.
EXHIBIT 4.13 | Relational Investors’ Estimates of Genzyme’s Free Cash Flow
Source: Relational Investors.
Termeer realized it would be difficult for him to change his conservative views
about leverage, particularly in light of the fact that he had been so successful in building
the company without relying on debt. The thought of using debt to enhance a share
repurchase program was doubly difficult for him to accept. But even more important
was his opinion that one had to take a long-term view to succeed in biotechnology.
Whitworth seemed to see investments as simply a use of cash, whereas Termeer saw
investments as being critical to the business model and survival of Genzyme. In fact, the
higher cash flow level would make it easier to fund the investments because it would
reduce or eliminate the need to access capital markets. Termeer had always envisioned
a future where diagnostics and therapeutics would be closer together, and now he
recognized that this future would require Genzyme to pursue a variety of technologies on
an on-going basis.
Then Termeer’s eyes caught the third item on the list about adding board members
with financial expertise. This brought to mind the earlier demands by another activist
investor, Carl Icahn, who had purchased 1.5 million shares of Genzyme during third
quarter 2007. Termeer had strongly protested Icahn’s involvement, and with the
support of the board made a public plea to shareholders that ultimately led Icahn to sell
his Genzyme shares and turn his attention to Biogen Idec, another major biotechnology
company.
In Termeer’s mind, Icahn was more than just an activist investor. During his long
career, Icahn had earned the title of “corporate raider” by taking large stakes in
companies that often culminated in a takeover or, at a minimum, in a contentious proxy
fight. Earlier in the year, Icahn had taken a large position in MedImmune, Inc., and
helped arrange the sale of the company to AstraZeneca PLC. Were the current
circumstances such that Icahn would see another opportunity to target Genzyme again?
Where would Whitworth stand on this? “After all, at the end of the day, both Icahn and
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Whitworth are just after the cash flow,” said Termeer.
Other recent events were on Termeer’s mind as well. Genentech, the second-largest
U.S. biotechnology firm and one of Genzyme’s competitors, had just lost a bitterly
contested hostile takeover from Roche Holding AG at the start of 2009. This takeover
reminded Termeer of the possibility that some Big Pharma companies were looking to
expand their operations into biotechnology.
As Termeer reflected on the last 26 years spent creating and building Genzyme, he
realized that Whitworth’s RI fund had been a shareholder for less than a year and held
only 2.6% of the shares. It was no surprise these two men held such different
viewpoints of what Genzyme had to offer to its owners and to society. Termeer, aware
that he needed a strategy for dealing with Whitworth, had identified three
different approaches he could take:
He had arranged for a phone call with Whitworth in the following week. Regardless of
his approach, Termeer expected that Whitworth would probably request a hearing at the
board meeting, which was scheduled two days before the annual shareholders’ meeting
on May 21. The prospect of such a meeting with the board only served to emphasize the
importance of Termeer’s having a strategy for the upcoming call with Whitworth and
making decisions that would be in the best interest of his company.
1. Fight Whitworth as he had fought Icahn. To do this, he would need to enlist the board
to join him in what would be a public relations battle for shareholder support.
2. Welcome Whitworth onto the board to reap the benefits of his experience in how to
create shareholder value. In this regard, he could think of Whitworth as a free
consultant.
3. Manage Whitworth by giving him some items on his list of demands but nothing that
would compromise the core mission of Genzyme.

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PART 2 Financial Analysis and Forecasting
CASE 5
Page 89
Business Performance Evaluation: Approaches for
Thoughtful Forecasting
Every day, fortunes are won and lost on the backs of business performance assessments
and forecasts. Because of the uncertainty surrounding business performance, the
manager should appreciate that forecasting is not the same as fortune-telling;
unanticipated events have a way of making certain that specific forecasts are never
exactly correct. This note purports, however, that thoughtful forecasts greatly aid
managers in understanding the implications of various outcomes (including the most
probable outcome) and identify the key bets associated with a forecast. Such forecasts
provide the manager with an appreciation of the odds of business success.
This note examines principles in the art and science of thoughtful financial
forecasting for the business manager. In particular, it reviews the importance of (1)
understanding the financial relationships of a business enterprise, (2) grounding
business forecasts in the reality of the industry and macroenvironment, (3) modeling a
forecast that embeds the implications of business strategy, and (4) recognizing the
potential for cognitive bias in the forecasting process. The note closes with a detailed
example of financial forecasting based on the example of the Swiss food and nutrition
company Nestle.
Understanding the Financial Relationships of the
Business Enterprise
Financial statements provide information on the financial activities of an enterprise.
Much like the performance statistics from an athletic contest, financial statements
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provide an array of identifying data on various historical strengths and weaknesses
across a broad spectrum of business activities. The income statement (also
known as the profit-and-loss statement) measures flows of costs, revenue, and
profits over a defined period of time, such as a year. The balance sheet provides a
snapshot of business investment and financing at a particular point in time, such as the
end of a year. Both statements combine to provide a rich picture of a business’s
financial performance. The analysis of financial statements is one important way of
understanding the mechanics of the systems that make up business operations.
Interpreting Financial Ratios
Financial ratios provide a useful way to identify and compare relationships across
financial statement line items. Trends in the relationships captured by financial ratios
are particularly helpful in modeling a financial forecast. The comparison of ratios
across time or with similar firms provides diagnostic tools for assessing the health of
the various systems in the enterprise. These tools and the assessments obtained with
them provide the foundation for financial forecasting.
We review common financial ratios for examining business operating performance.
It is worth noting that there is wide variation in the definition of financial ratios. A
measure such as return on assets is computed many different ways in the business world.
Although the precise definitions may vary, there is greater consensus on the
interpretation and implication of each ratio. This note presents one such definition and
reviews the interpretation.
Growth rates: Growth rates capture the year-on-year percentage change in a
particular line item. For example, if total revenue for a business increases from $1.8
million to $2.0 million, the total revenue growth for the business is said to be 11.1%
[(2.0 − 1.8)/1.8]. Total revenue growth can be further decomposed into two other
1
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growth measures: unit growth (the growth in revenue due to an increase in units sold)
and price growth (the growth in revenue due to an increase in the price of each unit). In
the above example, if unit growth for the business is 5.0%, the remaining 6.1% of total
growth can be attributed to increases in prices or price growth.
Margins: Margin ratios capture the percentage of revenue that flows into profit or,
alternatively, the percentage of revenue not consumed by business costs. Business
profits can be defined in many ways. Gross profit reports the gains to revenue after
subtracting the direct expenses. Operating profit reports the gains to revenue after
subtracting all associated operating expenses. Operating profit is also commonly
referred to as earnings before interest and taxes (EBIT). Net profit reports the gains to
revenue after subtracting all associated expenses, including financing expenses and
taxes. Each of these measures of profits have an associated margin. For example,
if operating profit is $0.2 million and total revenue is $2.0 million, the operating margin
is 10% (0.2/2.0). Thus, for each revenue dollar, an operating profit of $0.10 is
generated and $0.90 is consumed by operating expenses. The margin provides
the analyst with a sense of the cost structure of the business. Common definitions of
margin include the following:
Gross margin = Gross profit/Total revenue
where gross profit equals total revenue less the cost of goods sold.
Operating margin = Operating profit/Total revenue
where operating profit equals total revenue less all operating expenses (EBIT).
NOPAT margin = Net operating profit after tax (NOPAT)/Total revenue
where NOPAT equals EBIT multiplied by (1 − t), where t is the prevailing marginal
income tax rate. NOPAT measures the operating profits on an after-tax basis without
accounting for tax effects associated with business financing.
Net profit margin = Net income/Total revenue
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where net income or net profit equals total revenue less all expenses for the period. A
business that has a high gross margin and low operating margin has a cost structure that
maintains high indirect operating expenses such as the costs associated advertising or
with property, plant, or equipment (PPE).
Turnover: Turnover ratios measure the productivity, or efficiency, of business
assets. The turnover ratio is constructed by dividing a measure of volume from the
income statement (i.e., total revenue) by a related measure of investment from the
balance sheet (i.e., total assets). Turnover provides a measure of how much business
flow is generated per unit of investment. Productive or efficient assets produce high
levels of asset turnover. For example, if total revenue is $2.0 million and total assets
are $2.5 million, the asset-turnover measure is 0.8 times (2.0/2.5). Thus, each dollar of
total asset investment is producing $0.80 in revenue or, alternatively, total assets are
turning over 0.8 times a year through the operations of the business. Common measures
of turnover include the following:
Accounts receivable turnover = Total revenue/Accounts receivable
Accounts receivable turnover measures how quickly sales on credit are collected.
Businesses that take a long time to collect their bills have low receivable turnover
because of their large receivable levels.
Inventory turnover = Cost of goods sold/Inventory
Inventory turnover measures how inventory is working in the business, and whether the
business is generating its revenue on large levels or small levels of inventory. For
inventory turnover (as well as payable turnover) it is customary to use cost of sales as
the volume measure because inventory and purchases are on the books at cost rather
than at the expected selling price.
PPE turnover = Total revenue/Net PPE
PPE turnover measures the operating efficiency of the fixed assets of the
business. Businesses with high PPE turnover are able to generate large amounts of
revenue on relatively small amounts of PPE, suggesting high productivity or asset
efficiency.
Asset turnover = Total revenue/Total assets
Total capital turnover = Total revenue/Total capital
Total capital is the amount of capital that investors have put into the business and is
defined as total debt plus total equity. Since investors require a return on the total
capital they have invested, total capital turnover provides a good measure of the
productivity of that investment.
Accounts payable turnover = Cost of goods sold/Accounts payable
Accounts payable turnover measures how quickly purchases on credit are paid.
Businesses that are able to take a long time to pay their bills have low payable turnover
because of their large payables levels.
An alternative and equally informative measure of asset productivity is a “days”
measure, which is computed as the investment amount divided by the volume amount
multiplied by 365 days. This measure captures the average number of days in a year that
an investment item is held by the business. For example, if total revenue is $2.0 million
and accounts receivable is $0.22 million, the accounts receivable days measure is
calculated as 40.2 days (0.22/2.0 × 365). The days measure can be interpreted as that
the average receivable is held by the business for 40.2 days before being collected. The
lower the days measure, the more efficient is the investment item. If the accounts
receivable balance equals the total revenue for the year, the accounts receivable days
measure is equal to 365 days as the business has 365 days of receivables on their
books. This means it takes the business 365 days, on average, to collect their accounts
receivable. While the days measure does not actually provide any information that is not
already contained in the respective turnover ratio (as it is simply the inverse of the
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turnover measure multiplied by 365 days), many managers find the days measure to be
more intuitive than the turnover measure. Common days measures include the following:
Accounts receivable days = Accounts receivable/Total revenue × 365 days
Inventory days = Inventory/Cost of goods sold × 365 days
Accounts payable days = Accounts payable/Cost of goods sold × 365 days
Return on investment: Return on investment captures the profit generated per dollar
of investment. For example, if operating profit is $0.2 million and total assets are $2.5
million, pretax return on assets is calculated as operating profit divided by total assets
(0.2/2.5), or 8%. Thus, the total dollars invested in business assets are generating pretax
operating-profit returns of 8%. Common measures of return on investment include the
following:
Return on equity (ROE) = Net income/Shareholders’ equity
where shareholders’ equity is the amount of money that shareholders have put into the
business. Since net income is the money that is available to be distributed back to equity
investors, ROE provides a measure of the return the business is generating for
the equity investors.
Return on assets (ROA) = NOPAT/Total assets
where NOPAT equals EBIT × (1 − t), EBIT is the earnings before interest and taxes, and
t is the prevailing marginal income tax rate. Like many of these ratios, there are many
other common definitions. One common alternative definition of ROA is the following:
Return on assets (ROA) = Net income/Total assets
and, lastly,
Return on capital (ROC) = NOPAT/Total capital
Since NOPAT is the money that can be distributed back to both debt and equity investors
and total capital measures the amount of capital invested by both debt and equity
investors, ROC provides a measure of the return the business is generating for all
investors (both debt and equity). It is important to observe that return on investment can
be decomposed into a margin effect and a turnover effect. That relationship means that
the same level of business profitability can be attained by a business with high margins
and low turnover, such as Nordstrom, as by a business with low margins and high
turnover, such as Wal-Mart. This decomposition can be shown algebraically for the
ROC:
Notice that the equality holds because the quantity for total revenue cancels out across
the two right-hand ratios. ROE can be decomposed into three components:
This decomposition shows that changes in ROE can be achieved in three ways: changes
in net profit margin, changes in total capital productivity, and changes in total capital
leverage. This last measure is not an operating mechanism but rather a financing
mechanism. Businesses financed with less equity and more debt generate higher ROE
but also have higher financial risk.
Using Financial Ratios in Financial Models
Financial ratios provide the foundation for forecasting financial statements because
financial ratios capture relationships across financial statement line items that tend to be
preserved over time. For example, one could forecast the dollar amount of gross profit
for next year through an explicit independent forecast. However, a better approach is to
forecast two ratios: a revenue growth rate and a gross margin. Using these two ratios in
combination one can apply the growth rate to the current year’s revenue, and Page 94
then use the gross margin rate to yield an implicit dollar forecast for gross profit. As an
example, if we estimate revenue growth at 5% and operating margin at 24%, we can
apply those ratios to last year’s total revenue of $2.0 million to derive an implicit gross
profit forecast of $0.5 million [2.0 × (1 + 0.05) × 0.24]. Given some familiarity with the
financial ratios of a business, the ratios are generally easier to forecast with accuracy
than are the expected dollar values. The approach to forecasting is thus to model future
financial statements based on assumptions about future financial ratios.
Financial models based on financial ratios can be helpful in identifying the impact
of particular assumptions on the forecast. For example, models can easily allow one to
see the financial impact on dollar profits of a difference of one percentage point in
operating margin. To facilitate such a scenario analysis, financial models are commonly
built in electronic spreadsheet packages such as Microsoft Excel. Good financial
forecast models make the forecast assumptions highly transparent. To achieve
transparency, assumption cells for the forecast should be prominently displayed in the
spreadsheet (e.g., total revenue growth rate assumption cell, operating margin
assumption cell), and then those cells should be referenced in the generation of the
forecast. In this way, it becomes easy not only to vary the assumptions for different
forecast scenarios, but also to scrutinize the forecast assumptions.
Grounding Business Forecasts in the Reality of the
Industry and Macroenvironment
Good financial forecasts recognize the impact of the business environment on the
performance of the business. Financial forecasting should be grounded in an
appreciation for industry- and economy-wide pressures. Because business performance
tends to be correlated across the economy, information regarding macroeconomic
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business trends should be incorporated into a business’s financial forecast. If, for
example, price increases for a business are highly correlated with economy-wide
inflation trends, the financial forecast should incorporate price growth assumptions that
capture the available information on expected inflation. If the economy is in a recession,
then the forecast should be consistent with that economic reality.
Thoughtful forecasts should also recognize the industry reality. Business prospects
are dependent on the structure of the industry in which the business operates. Some
industries tend to be more profitable than others. Microeconomic theory provides some
explanations for the variation in industry profitability. Profitability within an industry is
likely to be greater if (1) barriers to entry discourage industry entrants, (2) ease of
industry exit facilitates redeployment of assets for unprofitable players, (3) industry
participants exert bargaining power over buyers and suppliers, or (4) industry
consolidation reduces price competition. Table 5.1 shows the five most and the five
least profitable industries in the United States based on median pretax ROAs for all
public firms from 2005 to 2014. Based on the evidence, firms operating in the
apparel and accessory retail industry should have systematically generated more
profitable financial forecasts over that period than did firms in the metal-mining
industry. One explanation for the differences in industry profitability is the ease of
industry exit. In the retail industry, unprofitable businesses are able to sell their assets
easily for redeployment elsewhere. In the mining industries, where asset redeployment
is much more costly, industry capacity may have dragged down industry profitability.
2
TABLE 5.1 | Most profitable and least profitable U.S. industries: 2005–2014.
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Being within a profitable industry, however, does not ensure superior business
performance. Business performance also depends on the competitive position of the
firm within the industry. Table 5.2 shows the variation of profitability for firms within
the U.S. apparel and accessory stores industry from 2005 to 2014. Despite being one of
the most profitable industries as shown in Table 5.1, there is large variation in
profitability within the industry. All five firms at the bottom of the profitability list
generated median ROAs that were actually negative (Delia’s, Frederick’s, Bakers
Footwear, Pacific Sunwear, and Coldwater Creek). Good forecasting considers the
ability of a business to sustain performance given the structure of its industry and its
competitive position within that industry.
Abnormal profitability is difficult to sustain over time. Competitive pressure tends
to bring abnormal performance toward the mean. To show that effect, we can sort all
U.S. public companies for each year from 2005 to 2015 into five groups (group 1 with
low profits through group 5 with high profits) based on their annual ROAs and sales
growth. We then follow what happened to the composition of those groups over the next
three years. The results of this exercise are captured in Figure 5.1. The ROA
graph shows the mean group rankings for firms in subsequent years. For
example, firms that ranked in group 5 with the top ROA at year 0 tend to have a mean
group ranking of 4.5 in year 1, 4.3 in year 2, and 3.7 in year 3. Firms that ranked in
TABLE 5.2 | Most and least profitable firms within the apparel and accessory stores retail industry:
2005–2014. Rankings in Tables 5.1 and 5.2 are based on all firms from Compustat organized into
industries by 2-digit SIC codes.
group 1 with the lowest ROA at year 0 tend to have a mean group ranking of 1.5 in year
1, 1.7 in year 2, and 2.2 in year 3. There is a systematic drift toward average
performance (3.0) over time. The effect is even stronger vis-à-vis sales growth.
Figure 5.1 provides the transition matrix for average groups sorted by sales growth.
Here we see that, by year 2, the average sales growth ranking for the high-growth group
is virtually indistinguishable from that of the low-growth group.
Figure 5.1 illustrates that business is fiercely competitive. It is naïve to assume that
superior business profitability or growth can continue unabated for an extended period.
Abnormally high profits attract competitive responses that eventually return profits to
their normal levels.
Modeling a Base-Case Forecast that Incorporates
Expectations for Business Strategy
FIGURE 5.1 | Firm-ranking annual transitions by profitability and sales growth. Firms are sorted for
each year into five groups by either annual pretax ROA or sales growth. For example, in the ROA
panel, group 1 comprises the firms with the lowest 20% of ROA for the year; group 5 comprises the
firms with the highest 20% of ROA for the year. The figure plots the mean ranking number for all U.S.
public firms in the Compustat database from 2005 to 2015.
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With a solid understanding of the business’s historical financial mechanics and of the
environment in which the business operates, the forecaster can incorporate the firm’s
operating strategy into the forecast in a meaningful way. All initiatives to improve
revenue growth, profit margin, and asset efficiency should be explicitly reflected in the
financial forecast. The forecast should recognize, however, that business
strategy does not play out in isolation. Competitors do not stand still. A good
forecast recognizes that business strategy also begets competitive response. All
modeling of the effects of business strategy should be tempered with an appreciation for
the effects of aggressive competition.
One helpful way of tempering the modeling of business strategy’s effects is to
complement the traditional bottom-up approach to financial forecasting with a top-down
approach. The top-down approach starts with a forecast of industry sales and then
works back to the particular business of interest. The forecaster models firm sales by
modeling market share within the industry. Such a forecast makes more explicit the
challenge that sales growth must come from either overall industry growth or market
share gain. A forecast that explicitly demands a market share gain of, say, 20% to 24%,
is easier to scrutinize from a competitive perspective than a forecast that simply
projects sales growth without any context (e.g., at an 8% rate).
Another helpful forecasting technique is to articulate business perspectives into a
coherent qualitative view on business performance. This performance view encourages
the forecaster to ground the forecast in a qualitative vision of how the future will play
out. In blending qualitative and quantitative analyses into a coherent story, the forecaster
develops a richer understanding of the relationships between the financial forecast and
the qualitative trends and developments in the enterprise and its industry.
Forecasters can better understand their models by identifying the forecast’s value
drivers, which are those assumptions that strongly affect the overall outcome. For
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example, in some businesses the operating margin assumption may have a dramatic
impact on overall business profitability, whereas the assumption for inventory turnover
may make little difference. For other businesses, the inventory turnover may have a
tremendous impact and thus becomes a value driver. In varying the assumptions, the
forecaster can better appreciate which assumptions matter and thus channel resources to
improve the forecast’s precision by shoring up a particular assumption or altering the
business strategy to improve the performance of a particular line item.
Lastly, good forecasters understand that it is more useful to think of forecasts as
ranges of possible outcomes rather than as precise predictions. A common term in
forecasting is the “base-case forecast.” A base-case forecast represents the best guess
outcome or the expected value of the forecast’s line items. In generating forecasts, it is
also important to have an unbiased appreciation for the range of possible outcomes,
which is commonly done by estimating a high-side and a low-side scenario. In this way,
the forecaster can bound the forecast with a relevant range of outcomes and can best
appreciate the key bets of the financial forecast.
Recognizing the Potential for Cognitive Bias in the
Forecasting Process
A substantial amount of research suggests that human decision making can be
systematically biased. Bias in financial forecasts creates systematic problems in
managing and investing in the business. Two elements of cognitive bias that play a role
in financial forecasting are optimism bias and overconfidence bias. This note defines
optimism bias as a systematic positive error in the expected value of an
unknown quantity, and defines the overconfidence bias as a systematic negative
error in the expected variance of an unknown quantity. The definitions of those two
terms are shown graphically in Figure 5.2. The dark curve shows the true distribution of
the sales growth rate. The realization of the growth rate is uncertain, with a higher
probability of its being in the central part of the distribution. The expected value for the
sales growth rate is g*; thus, the proper base-case forecast for the sales growth rate is
precisely g*. The light curve shows the distribution expected by the average forecaster.
This distribution is biased for two reasons. First, the expected value is too high. The
forecaster expects the base-case sales growth rate to be g’, rather than g*. Such positive
bias for expected value is termed optimistic. Second, the dispersion of the distribution
is too tight. This dispersion is captured by the variance (or standard deviation) statistic.
Because the forecast dispersion is tighter than the true dispersion, the forecaster exhibits
negative variance bias, or overconfidence—the forecaster believes that the forecast is
more precise than it really is.
A description and the implications of an experiment on forecasting bias among MBA
students is provided in an Appendix to this note.
Nestle: An Example
FIGURE 5.2 | Optimism and overconfidence biases in forecasting the sales growth rate.
In 2013, Nestle was one of the world’s largest food and health companies.
Headquartered in Switzerland, the company was truly a multinational organization with
factories in 86 countries around the world. Suppose that in early 2014, we needed to
forecast the financial performance of Nestle for the end of 2014. We suspected that one
sensible place to start was to look at the company’s performance over the past few
years. Exhibit 5.1 provides Nestle’s income statement and balance sheet for 2012 and
2103.
EXHIBIT 5.1 | Financial Statements for Nestle SA (in billions of Swiss francs)
One approach to forecasting the financial statements for 2014 is to forecast Page 99
each line item from the income statement and balance sheet independently. Such
an approach, however, ignores the important relationships among the different line items
(e.g., costs and revenues tend to grow together). To gain an appreciation for those
Note: Although including both turnover and days ratios is redundant, doing so illustrates the two perspectives.
relationships, we calculate a variety of ratios (Exhibit 5.1). In calculating the ratios, we
notice some interesting patterns. First, sales growth declined sharply in 2013, from
7.4% to 2.7%. The sales decline was also accompanied by much smaller decline in
profitability margins; operating margin declined from 14.9% to 14.1%. Meanwhile, the
asset ratios showed modest improvement; total asset turnover improved only slightly,
from 0.7× to 0.8×. Asset efficiency improved across the various classes of assets (e.g.,
accounts receivable days improved in 2013, from 53.0 days to 48.2 days; PPE turnover
also improved, from 2.8× to 3.0×). Overall in 2013 Nestle’s declines in sales growth
and margins were counteracted with improvements in asset efficiency such that return on
assets improved from 6.9% to 7.1%. Because return on assets comprises both a margin
effect and an asset-productivity effect, we can attribute the 2013 improvement in return
on assets to a denominator effect—Nestle’s asset efficiency improvement. The
historical ratio analysis gives us some sense of the trends in business performance.
A common way to begin a financial forecast is to extrapolate current ratios into the
future. For example, a simple starting point would be to assume that the 2013 financial
ratios hold in 2014. If we make that simplifying assumption, we generate the financial
forecast presented in Exhibit 5.2 . We recognize this forecast as naïve, but it provides a
straw-man forecast through which the relationships captured in the financial ratios can
be scrutinized. In generating the forecast, all the line-item figures are built on the ratios
used in the forecast. The financial line-item forecasts are computed as referenced to the
right of each figure based on the ratios below. Such a forecast is known as a financial
model. The design of the model is thoughtful. By linking the dollar figures with the
financial ratios, the model preserves the existing relationships across line items and can
be easily adjusted to accommodate different ratio assumptions.
EXHIBIT 5.2 | Naïve Financial Forecast for Nestle SA (in billions of Swiss francs)
Based on the naïve model, we can now augment the model with qualitative and
quantitative research on the company, its industry, and the overall economy. In early
2014, Nestle was engaged in important efforts to expand the company product line in
foods with all-natural ingredients as well the company presence in the Pacific Asian
region. These initiatives required investment in new facilities. It was hoped that the
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initiatives would make up for ongoing declines in some of Nestle’s important product
offerings, particularly prepared dishes. Nestle was made up of seven major business
units: powdered and liquid beverages (22% of total sales), water (8%), milk products
and ice cream (18%), nutrition and health science (14%), prepared dishes and cooking
aids (15%), confectionary (11%), and pet care (12%). The food processing industry had
recently seen a substantial decline in demand for its products in the developing world.
Important macroeconomic factors had led to sizable declines in demand from this part
of the world. The softening of growth had led to increased competitive pressures within
the industry that included such food giants as Mondelez, Tyson, and Unilever.
Based on this simple business and industry assessment, we take the view
that Nestle will maintain its position in a deteriorating industry. We can adjust
the naïve 2014 forecast based on that assessment (Exhibit 5.3). We suspect that the
softening of demand in developing markets and the prepared dishes line will lead to
zero sales growth for Nestle in 2014. We also expect the increased competition within
the industry will increase amount spent on operating expenses to an operating expenseto-
sales ratio of 35%. Those assumptions give us an operating margin estimate of
12.9%. We expect the increased competition to reduce Nestle’s ability to work its
inventory such that inventory turnover returns to the average between 2012 and 2013 of
5.53. We project PPE turnover to decline to 2.8× with the increased investment in new
facilities that are not yet operational. Those assumptions lead to an implied financial
forecast. The resulting projected after-tax ROA is 6.3%. The forecast is thoughtful. It
captures a coherent view of Nestle based on the company’s historical financial
relationships, a grounding in the macroeconomic and industry reality, and the
incorporation of Nestle’s specific business strategy.
EXHIBIT 5.3 | Revised Financial Forecast for Nestle SA (in billions of Swiss francs)
We recognize that we cannot anticipate all the events of 2014. Our forecast will
inevitably be wrong. Nevertheless, we suspect that, by being thoughtful in our analysis,
our forecast will provide a reasonable, unbiased expectation of future performance.
Exhibit 5.4 gives the actual 2014 results for Nestle. The big surprise was that the effect
of competition was worse than anticipated. Nestle’s realized sales growth was actually
negative, and its operating margin dropped from 14.9% and 14.1% in 2012 and 2013,
respectively, to 11.9% in 2014. Our asset assumptions were fairly close to the outcome,
although the inventory turnover and PPE turnover were a little worse than we had
expected. Overall, the ROA for Nestle dropped from 7.1% in 2013 to 5.3% in 2014.
Although we did not complete a high-side and a low-side scenario in this simple
example, we can hope that, had we done so, we could have appropriately assessed the
sources and level of uncertainty of our forecast.
EXHIBIT 5.4 | Actual Financial Performance for Nestle SA (in billions of Swiss francs)
Appendix
To test for forecasting bias among business school forecasters, an experiment was
performed in 2005 with the 300 first-year MBA students at the Darden School of
Business at the University of Virginia. Each student was randomly assigned to both a
3
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U.S. public company and a year between 1980 and 2000. Some students were assigned
the same company, but no students were assigned the same company and the same year.
The students were asked to forecast sales growth and operating margin for their
assigned company for the subsequent three years. The students based their forecasts on
the following information: industry name, firm sales growth and operating
margin for the previous three years, historical and three-year prospective
industry average growth and margins, and certain macroeconomic historical and threeyear
forecast data (real gross national product [GNP] growth, inflation rates, and the
prevailing Treasury bill yield). To avoid biasing the forecasts based on subsequent
known outcomes, students were given the name of their firm’s industry but not the firm’s
name. For the same reason, the students were not given the identity of the current year.
The responses were submitted electronically and anonymously. Forecast data from
students who agreed to allow their responses to be used for research purposes were
aggregated and analyzed. Summary statistics from the responses are presented in
Figure 5.3.
The median values for the base-case forecast of expected sales growth and
3
FIGURE 5.3 | Median expected and actual financial forecast values for a random sample of U.S.
companies. This figure plots the median forecast and actual company realization for sales growth
and operating margin over the three-year historical period and the three-year forecast period based on
the responses from MBA students in an experiment.
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operating margin are plotted in Figure 5.3. The sales growth panel suggests that students
tended to expect growth to continue to improve over the forecast horizon (years 1
through 3). The operating margin panel suggests that students expected near-term
performance to be constant, followed by later-term improvement. To benchmark the
forecast, we can compare the students’ forecasts with the actual growth rates and
operating margins realized by the companies. We expect that if students were unbiased
in their forecasting, the distribution of the forecasts should be similar to the distribution
of the actual results. Figure 5.3 also plots the median value for the actual realizations.
We observe that sales growth for these randomly selected firms did not improve but
stayed fairly constant, whereas operating margins tended to decline over the extended
term. The gap between the two lines represents the systematic bias in the students’
forecasts. Because the bias in both cases is positive, the results are consistent with
systematic optimism in the students’ forecasts. By the third year, the optimism bias is a
large 4 percentage points for the sales growth forecast and almost 2 percentage points
for the margin forecast.
Although the average student tended to exhibit an optimistic bias, there was
variation in the bias across different groups of students. The forecast bias was
further examined across two characteristics: gender and professional training. For both
sales growth and operating margin, the test results revealed that males and those whose
professional backgrounds were outside finance exhibited the most optimistic bias. For
example, the bias in the third-year margin forecast was 0.7% for those with professional
finance backgrounds and 1.9% for those outside finance; and 2.6% for the male students
and just 0.8% for the female students.
In generating forecasts, it is also important to have an unbiased appreciation for the
precision of the forecast, which is commonly done by estimating a high-side and a lowside
scenario. To determine whether students were unbiased in appreciating the risk in
forecast outcomes, they were asked to provide a high-side and a low-side scenario. The
high-side scenario was defined explicitly as the 80th percentile level. The low-side
scenario was defined as the 20th percentile level. Figure 5.4 plots the median high-side
and low-side scenarios, as well as the expected base-case forecast presented in
Figure 5.3. For the three-year horizon, the median high-side forecast was 4 percentage
points above the base case and the low-side forecast was 4 percentage points below the
base case. The actual 80th percentile performance was 8 percentage points above the
base case and the actual 20th percentile was 12 percentage points below the base case.
The results suggest that the true variance in sales growth is substantially greater than that
estimated by the students. The same is also true of the operating margin. The estimates
provided by the students are consistent with strong overconfidence (negative variance
bias) in the forecast.
FIGURE 5.4 | Median base-case, high-side, and low-side forecasts versus the actual 20th and 80th
performance percentiles for sales growth and operating margin. This figure plots the median basecase,
high-side, and low-side forecasts for sales growth and operating margin over the three-year
forecast period based on the responses from MBA students in an experiment. The low-side and highside
performance levels were defined as the students’ estimate of the 20th and 80th percentile levels.
The actual company 20th and 80th performance percentiles for sales growth and operating margin
are also plotted.

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CASE 6 The Financial Detective, 2016
Financial characteristics of companies vary for many reasons. The two most prominent
drivers are industry economics and firm strategy.
Each industry has a financial norm around which companies within the industry tend
to operate. An airline, for example, would naturally be expected to have a high
proportion of fixed assets (airplanes), while a consulting firm would not. A steel
manufacturer would be expected to have a lower gross margin than a pharmaceutical
manufacturer because commodities such as steel are subject to strong price competition,
while highly differentiated products like patented drugs enjoy much more pricing
freedom. Because of each industry’s unique economic features, average financial
statements will vary from one industry to the next.
Similarly, companies within industries have different financial characteristics, in
part because of the diverse strategies that can be employed. Executives choose
strategies that will position their company favorably in the competitive jockeying within
an industry. Strategies typically entail making important choices in how a product is
made (e.g., capital intensive versus labor intensive), how it is marketed (e.g., direct
sales versus the use of distributors), and how the company is financed (e.g., the use of
debt or equity). Strategies among companies in the same industry can differ
dramatically. Different strategies can produce striking differences in financial results for
firms in the same industry.
The following paragraphs describe pairs of participants in a number of different
industries. Their strategies and market niches provide clues as to the financial condition
and performance that one would expect of them. The companies’ common-sized
financial statements and operating data, as of early 2016, are presented in a
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standardized format in Exhibit 6.1 . It is up to you to match the financial data with the
company descriptions. Also, try to explain the differences in financial results across
industries.

Airlines
Companies A and B are airline companies. One firm is a major airline that flies both
domestically and internationally and offers additional services including travel
packages and airplane repair. The company owns a refinery to supply its own jet fuel as
a hedge to fuel-price volatility. In 2008, this company merged with one of the largest
airline carriers in the United States.
The other company operates primarily in the United States, with some routes to the
Caribbean and Latin America. It is the leading low-cost carrier in the United States.
One source of operating efficiency is the fact that the company carries only three
different aircraft in its fleet, making maintenance much simpler than for legacy airlines
that might need to service 20 or 30 different aircraft models. This company’s growth has
been mostly organic—it expands its routes by purchasing new aircraft and the rights to
fly into new airports.
Beer
Of the beer companies, C and D, one is a national brewer of mass-market consumer
beers sold under a variety of brand names. This company operates an extensive network
of breweries and distribution systems. The firm also owns a number of beer-related
businesses—such as snack-food and aluminum-container manufacturing companies—
and several major theme parks. Over the past 12 years, it has acquired several large
brewers from around the globe.
The other company is the largest craft brewer in the United States. Like most craft
brewers, this company produces higher-quality beers than the mass-market brands, but
EXHIBIT 6.1 | Common-Sized Financial Data and Ratios
nmf = not a meaningful figure
Data sources: S&P Research Insight, Capital IQ, and Value Line Investment Survey.
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production is at a lower volume and the beers carry premium prices. The firm is
financially conservative.
Computers
Companies E and F sell computers and related equipment. One company sells highperformance
computing systems (“supercomputers”) to government agencies,
universities, and commercial businesses. It has experienced considerable growth due to
an increasing customer base. The company is financially conservative.
The other company sells personal computers as well as handheld devices and
software. The firm has been able to differentiate itself by using its own operating system
for its computers and by creating new and innovative designs for all its products. These
products carry premium prices domestically and globally. The company follows a
vertical integration strategy starting with owning chip manufacturers and ending with
owning its own retail stores.
Hospitality
Companies G and H are both in the hospitality business. One company operates hotels
and residential complexes. Rather than owning the hotels, this firm chooses to manage
or franchise its hotels. The company receives its revenues each month based on longterm
contracts with the hotel owners, who pay a percentage of the hotel
revenues as a management fee or franchise fee. Much of this company’s growth
is inorganic—the company buys the rights to manage existing hotel chains and also the
rights to use the hotel’s brand name. This company has also pursued a strategy of
repurchasing a significant percentage of the shares of its own common stock.
The other company owns and operates several chains of upscale, full-service hotels
and resorts. The firm’s strategy is to maintain market presence by owning all of its
properties, which contributes to the high recognition of its industry-leading brands.
Newspapers
Companies I and J are newspaper companies. One company owns and operates two
newspapers in the southwestern United States. Due to the transition of customer
preference from print to digital, the company has begun offering marketing and digitaladvertising
services and acquiring firms in more profitable industries. The company has
introduced cost controls to address cost-structure issues such as personnel expenses.
Founded in 1851, the other company is renowned for its highly circulated
newspaper offered both in print and online formats. This paper is sold and distributed
domestically as well as around the world. Because the company is focused largely on
one product, it has strong central controls that have allowed it to remain profitable
despite the fierce competition for subscribers and advertising revenues.
Pharmaceuticals
Companies K and L manufacture and market pharmaceuticals. One firm is a diversified
company that sells both human pharmaceuticals as well as health products for animals.
This company’s strategy is to stay ahead of the competition by investing in the discovery
and development of new and innovative drugs.
The other company focuses on generic pharmaceuticals and medical devices. Most
of this company’s growth has been inorganic—the growth strategy has been to engage in
highly leveraged acquisitions, and it has participated in more than 100 during the past
eight years. The goal of acquiring new businesses is to enhance the value of the proven
drugs in the company’s portfolio rather than gamble on discoveries of new drugs for the
future.
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Power
Companies M and N are in the power-generation industry. One company focuses on
solar power. This includes the manufacturing and selling of power systems as well as
maintenance services for those systems.
The other company owns large, mostly coal-powered electric-power-generation
plants in countries around the world. Most of its revenues result from power-purchase
agreements with a country’s government that buy the power generated. Some of its U.S.
assets include regulated public utilities.
Retail
Companies O and P are retailers. One is a leading e-commerce company that sells a
broad range of products, including media (books, music, and videos) and electronics,
which together account for 92% of revenues. One-third of revenues are international and
20% of sales come from third-party sellers (i.e., sellers who transact through the
company’s website to sell their own products rather than those owned by the company).
A growing portion of operating profit comes from the company’s cloud-computing
business. With its desire to focus on customer satisfaction, this company has invested
considerably in improving its online technologies.
The other company is a leading retailer in apparel and fashion accessories for men,
women, and children. The company sells mostly through its upscale brick-and-mortar
department stores.
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CASE 7 Whole Foods Market: The Deutsche Bank Report
The latest numbers coming out of Whole Foods Market, Inc. (Whole Foods) in May
2014 took Deutsche Bank research analyst Karen Short and her team by surprise. On
May 6, Whole Foods reported just $0.38 per share in its quarterly earnings report,
missing Wall Street’s consensus of $0.41 and cutting earnings guidance for the
remainder of the year. The company’s share price fell 19% to $38.93 the next day as
Whole Foods’ management acknowledged that it faced an increasingly competitive
environment that could compress margins and slow expansion. The only upbeat news
was the 20% increase in the company’s quarterly dividend, up from $0.10 to $0.12 per
share. Short and her team knew this was not the first time the market believed Whole
Foods had gone stale. In 2006, Whole Foods’ stock had also declined 20% over fears of
slowing growth and increasing competition, but had since bounced back and
outperformed both its competition and the broader market (see Exhibit 7.1 for stock
price performance). Nevertheless, it was time for Short and her team to discuss how the
news altered their outlook for the company in a revised analyst report. The main point
of discussion would certainly be whether Whole Foods still had a recipe for success.
EXHIBIT 7.1 | Share Price Performance of Whole Foods Market Indexed to S&P 500 Index (January
2005 to April 2014)
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The Grocery Industry
The U.S. grocery industry as a whole had historically been a low-growth industry, and,
as a result of fierce competition, had typically maintained low margins. In 2012, the
industry recorded over $600 billion in sales, a 3% increase from the previous year.
Real demand growth was strongly tied to population growth, and consensus estimates
for nominal long-term growth rate were between 2% and 3%. Key segments included
conventional grocers such as Kroger, Publix, Safeway, and Albertsons;
supercenters such as Wal-Mart and Target; natural grocers such as Whole
Data source: Yahoo! Finance, author analysis.
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Foods, Sprouts Farmers Market (Sprouts), and The Fresh Market (Fresh Market); and
wholesalers such as Costco and Sam’s Club. Conventional grocers remained the
primary destination for shoppers, but competition from Wal-Mart, wholesalers, and
other low-price vendors had driven down conventional grocers’ share of food dollars
for over a decade; for example, Wal-Mart was the largest food retailer in the United
States in 2014, with 25% market share. Exhibit 7.2 provides market share information
for the U.S. grocery market. The narrow margins and limited growth opportunities
favored large competitors that could leverage efficiencies in purchasing and distribution
to pass savings on to the consumer. As a result, many small competitors had been
acquired or forced to close. Consumers were extremely price conscious and came to
expect promotions (which were largely funded by manufacturers), and most shoppers
did not have strong attachments to particular retail outlets.
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EXHIBIT 7.2 | Select Market Share Data
Given this environment, companies relentlessly searched for opportunities to
achieve growth and improve margins. Many grocers had implemented loyalty programs
to reward repeat shoppers, and most were trying to improve the in-store customer
experience, for instance by using self-checkout lines and other operational adjustments
to reduce checkout times, a source of frequent complaints. Given the high percentage of
Source:Market Share Reporter (Farmington Hills, MI: Gale, 2014) and author analysis.
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perishable goods in the industry, supply chain management was essential, and
companies were using improved technology to more efficiently plan their inventories.
Grocers also began promoting prepared foods, which could command higher margins
and reach consumers who did not regularly cook their own meals. Finally, most major
grocers offered private-label products, which allowed them to offer low prices while
still capturing sufficient margins.
Despite operating in a competitive and low-growth industry, natural grocers had
grown rapidly over the past two decades. Increasingly health-conscious consumers
were concerned about the source and content of their food, which fueled natural grocers’
sustained growth (over 20% per year since 1990) despite their comparatively higher
prices. In 2012, natural and organic products accounted for $81 billion in total sales in
the United States, a 10% increase from the previous year. Organic products, which
were more narrowly defined than natural products, accounted for about $28 billion of
these sales and were expected to top $35 billion by the end of 2014. Exhibit 7.3
provides growth forecast and share data on the natural and organic segments. As of
2014, 45% of Americans explicitly sought to include organic food in their meals, and
more than half of the country’s 18–29-year-old population sought it out. By specializing
in such products, natural grocers were able to carve out a profitable niche: the three
leading natural grocers (Whole Foods, Sprouts, and Fresh Market) had EBITDA
margins of 9.5%, 7.7%, and 9.1% respectively, whereas Kroger, the leading
conventional supermarket, had an EBITDA margin of only 4.5%. Exhibits 7.4
and 7.5 contain operating and financial information for selected companies in the U.S.
grocery industry.
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EXHIBIT 7.3 | U.S. Store Count Forecast—Natural and Organic Share versus Total Industry
Data source: Deutsche Bank Research; Food Marketing Institute.
EXHIBIT 7.4 | Selected Operating Data for Comparable Companies
Note: “Other natural & organic” is composed of Sprouts and Fresh Market. “Conventional grocer” is
composed of Kroger, Safeway, and SuperValu. “Supercenters and wholesalers” is composed of Wal-
Mart and Costco.
Source: Company SEC filings, 2003–2013.
As expected, the segment’s attractiveness sparked increasing competition from both
new entrants and established players from the other competing segments. Wal-Mart,
Kroger, and others launched organic offerings targeted at health-conscious consumers,
often at a much lower price point than similar products at natural grocers. While Whole
Foods, other natural grocers, independent retailers, and food cooperatives were the
primary source of organic products in the 1990s, by 2006, half of the country’s organic
food was sold through conventional supermarkets. By 2014, organic products were
available in over 20,000 natural food stores and nearly three out of four conventional
grocers.
Even in the face of this competition, Whole Foods maintained a position as the
market leader for the natural and organic industry. As many grocers joined the natural
and organic bandwagon, Whole Foods defended against misrepresentative claims.
Whole Foods had recently introduced a system to rate fresh produce on a number of
criteria, including sustainability and other characteristics important to natural and
EXHIBIT 7.5 | Selected Financial Data for Comparable Companies (in millions of USD, except
percentages, ratios, and per share data; financial statement data as of fiscal year 2013)
Data source: Company SEC filings; Deutsche Bank Research; Food Marketing Institute.
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organic customers. The company’s website listed over 75 substances that were
prohibited in all of its products and published additional measures for meat, seafood,
and produce selection to ensure consumers had insight into the quality of their food.
Whole Foods was the only U.S. retailer that labeled genetically modified foods, an area
of some concern to health-conscious consumers.
Despite its remarkable growth, the natural and organic industry was not without its
critics. Several academic and government studies had concluded that organic products
were not significantly more nutritious than nonorganic goods and claimed that the
inefficiency of organic production could harm the environment. Moreover, the
continuing lack of official legal definitions of terms such as “natural” arguably made
them effectively meaningless: one botanist argued the segment was “99% marketing and
public perception.”
Whole Foods Market
Whole Foods traced its roots to 1978, when John Mackey and Renee Lawson opened a
small organic grocer called SaferWay in Austin, Texas. Two years later, it partnered
with Craig Weller and Mark Skiles of Clarksville Natural Grocery to launch the first
Whole Foods Market, one of the country’s first natural and organic supermarkets. In
1984, the company began expanding within Texas and in 1988 made its first move
across state lines by acquiring the Louisiana-based Whole Foods Company; the next
year it launched its first store in California. The company went public in 1992
and grew rapidly during the 1990s through both new store openings and
acquisitions. Whole Foods launched its first international store in Canada in 2002 and
acquired a natural supermarket chain in the United Kingdom in 2004. The company
had consistently maintained high growth throughout the new century by increasing samestore
sales and expanding its store count; same-store sales grew more than 5% in every
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year except 2008 and 2009, when the global financial crisis brought America into a
severe recession. By 2013, the company’s growth strategy had moved away from
acquisitions, and management saw improving same-store sales and continued new
openings as its primary growth opportunities. Same-store sales—the most important
growth criteria Wall Street used to evaluate retailers—had grown by at least 7% every
year since 2010, far above other established grocers’ growth rates even after it began
expanding its natural and organic offerings. The company had done all of this with no
debt financing. Looking forward, Whole Foods management planned to eventually
operate over 1,000 stores, up from the 362 it operated as of the end of fiscal year 2013.
Exhibit 7.6 contains store count and same-store sales growth history for Whole Foods
and other industry players.
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EXHIBIT 7.6 | Store Growth Statistics for Whole Foods and Other Industry Comparables
Whole Foods positioned itself as “the leading retailer of natural and organic foods”
and defined its mission as promoting “the vitality and well-being of all individuals by
supplying the highest quality, most wholesome foods available.” The company’s sole
operating segment was its natural and organic markets and nearly 97% of its revenues
came from the United States. By 2013, the average Whole Foods store carried 21,000
SKUs and approximately 30% of sales outside the bakery and prepared-food segments
were organic. Whole Foods reported $551 million in net income on $12.9 billion in
sales in 2013, making it the clear leader of natural and organic grocers even though its
numbers were still rather small compared to Kroger’s net income of $1.5 billion on
Data source: Company SEC filings; Deutsche Bank Research; Food Marketing Institute.
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more than $98 billion in sales.
Facing increased competition in the segment, many analysts believed that Whole
Foods’ biggest challenge was its reputation for high prices. For instance, Whole Foods
charged $2.99 for a pound of organic apples, compared to $1.99 at Sprouts and even
less at Costco. Indeed, many consumers derisively described the store as “Whole
Paycheck,” and the company had historically opened its stores in high-income areas. In
response to this image, the company had already begun marketing private labels (365
and 365 Everyday Value), begun competitive price matching and promotional sales, and
launched a printed value guide (The Whole Deal) that featured coupons, low-budget
recipes, and other tips for price-conscious consumers. Additionally, many Whole
Foods supporters often pointed out that they were willing to pay a premium price for a
premium product.
The Research Report
The recent collapse of Whole Foods’ stock price had caught Short and her team
flatfooted. After all, heated competition in the grocery space was nothing new, even for
Whole Foods, but the company had nonetheless maintained both its favorable margins
and high growth rate for years. Short, along with many other analysts across Wall Street,
had been strongly in the bull camp prior to the recent earnings report. Short’s report
from the past month recommended to investors that Whole Foods stock was a “buy” and
worth $60 per share. This argument was based on ongoing gains to expected revenue
growth and EBITDA margins in the coming year (the report built in expectations of
revenue growth of 11% and 14%, respectively, in 2014 and 2015; and EBITDA margins
of 9.4% and 9.8%, respectively, in 2014 and 2015). The main question now facing the
team was whether to adjust its financial forecast for Whole Foods in light of recent
news. Exhibit 7.7 contains a version of the forecast model with the assumptions used
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for Short’s previous report. As an additional benchmark, Exhibit 7.8 reports prevailing
capital market information. As Short reconsidered her position, her team fleshed out the
case for both a bearish and bullish view on Whole Foods.
EXHIBIT 7.7 | Deutsche Bank Model (in millions of USD, except per share figures)
Data source: Company financial reports, Deutsche Bank research, and author estimates.
EXHIBIT 7.8 | Demographic and Capital Markets Data
From the bears’ perspective, the natural and organic market was becoming saturated
as more companies offered organic products at lower cost. This competition would
soon compress Whole Foods’ margins, while at the same time stealing market share and
causing same-store sales to slow or even decline. Several analysts had downgraded
Whole Foods after the company issued its disappointing quarterly results. A report put
out the previous week by another bank noted that 85% of Whole Foods’ stores were
within three miles of a Trader Joe’s—a privately owned natural grocer—up from 44%
in 2005; similar overlap with Sprouts had grown from 3% to 16% and with Fresh
Market from 1% to 14%. Moreover, Whole Foods was running out of dense, highly
educated, high-income neighborhoods to open new stores in, which could either force
the company to rely more on low-price offerings or slow its rapid expansion. Such a
shift in strategy could take the company into uncharted territory and risk its reputation as
a premium brand. Finally, the bears were concerned that the new competitive reality
Data sources: Bloomberg and U.S. Census Bureau.
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would cause the market to fundamentally revalue Whole Foods. The company had long
traded at a substantial premium, at times exceeding Kroger’s market value, despite the
latter company’s substantial size advantage (compared to Whole Foods, Kroger had 7.3
times as many stores that generated 7.6 times as many sales and 3.6 times as much
EBITDA). Such a premium could only be justified if Whole Foods could continue
growing, both at its existing stores and in terms of its overall footprint. The team noted
that even if it cut the price target from $60 to $40, Whole Foods would still
trade at a premium to its competitors in the conventional grocers’ segment.
The bulls believed the combination of Whole Foods’ leadership in natural and
organic offerings, shifting consumer preferences, and organic food’s small but rapidly
growing market provided ample runway for sustained growth at high margins. As the
clear leader in the segment, Whole Foods was well positioned to benefit from
consumers’ increasingly health-conscious decision making. Moreover, Whole Foods
was not just another retailer that offered natural products; it was the standard bearer and
thought leader for the industry, making it top of mind for anyone interested in the type of
healthy products Whole Foods brought into the mainstream. Its competitors were merely
imitating what Whole Foods pioneered and continued to lead, giving the company a
sustainable advantage. While competition could put downward pressure on some of
Whole Foods’ prices, the company had the stature to maintain its margin targets even
with competitive price cuts by driving sales toward higher-margin categories like
prepared foods, where the grocer could more readily differentiate its products.
Moreover, the company’s high prices gave it more room to adjust prices on goods
where it directly competed with lower-cost retailers; past work by Short’s team had
shown that Whole Foods could match Kroger on 10,000 SKUs–equivalent to all the non
private-label nonperishable products the company offered—and still maintain nearly a
35% gross margin, which was within Whole Foods’ target range. Similar analyses
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against other competitors also suggested ample room to selectively compete on prices
while maintaining its overall margin targets. Additionally, Whole Foods had
opportunities to reduce operating expenses, which the bulls thought would offset decline
in revenue from pricing pressure over the next few years. While some analysts were
concerned that Whole Foods’ expansion would take it into lower-income areas that
were distinct from the company’s historical target market, the bulls believed that Whole
Foods private-label products offered a chance to provide similar, high-quality products
at a more accessible price point while protecting margins and providing a promising
new avenue for growth. While the bulls acknowledged that Whole Foods traded at a
premium, they thought the company’s higher growth rates, attractive margins, and
position as a market leader provided ample justification for its higher valuation.
Whole Foods’ CEO John Mackey was firmly in the bull camp. While he
acknowledged that Whole Foods’ best-in-the-industry sales per square foot and margins
would attract competition, he claimed: “We are and will be able to compete
successfully” and that the pricing gap between Whole Foods and the competition would
not disappear. More importantly, he claimed that no competitor offered the quality of
products that Whole Foods could, regardless of how these competitors chose to market
their products. Alluding to the lack of a clear legal definition for natural foods, he
alleged that many competitors marketed standard commercial meat and other
perishable goods under misleading labels, and said that Whole Foods could
more aggressively advertise its superior quality to maintain its differentiation from the
competition. Similarly, the company was making investments to improve the customer
experience, already seen by many as one of its stronger points, by shortening wait times
and offering higher-quality self-service food. Behind the scenes, it was reallocating
support personnel on a regional rather than store-by-store basis in an effort to cut costs.
After hinting at several projects in the pipeline that would help Whole Foods thrive in
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the new reality of stronger competition, he said that Whole Foods “is not sitting still. We
are still very innovative!”
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CASE 8 Horniman Horticulture
Bob Brown hummed along to a seasonal carol on the van radio as he made his way over
the dark and icy roads of Amherst County, Virginia. He and his crew had just finished
securing their nursery against some unexpected chilly weather. It was Christmas Eve
2015, and Bob, the father of four boys ranging in age from 5 to 10, was anxious to be
home. Despite the late hour, he fully anticipated the hoopla that would greet him on his
return and knew that it would be some time before even the youngest would be asleep.
He regretted that the boys’ holiday gifts would not be substantial; money was again tight
this year. Nonetheless, Bob was delighted with what his company had accomplished.
Business was booming. Revenue for 2015 was 15% ahead of 2014, and operating
profits were up even more.
Bob had been brought up to value a strong work ethic. His father had worked his
way up through the ranks to become foreman of a lumber mill in Southwest Virginia. At
a young age, Bob began working for his father at the mill. After earning a degree in
agricultural economics at Virginia Tech, he married Maggie Horniman in 2003. Upon
his return to the mill, Bob was made a supervisor. He excelled at his job and was highly
respected by everyone at the mill. In 2010, facing the financial needs of an expanding
family, he and Maggie began exploring employment alternatives. In late 2012, Maggie’s
father offered to sell the couple his wholesalenursery business, Horniman Horticulture,
near Lynchburg, Virginia. The business and the opportunity to be near Maggie’s family
appealed to both Maggie and Bob. Pooling their savings, the proceeds from the sale of
their house, a minority-business-development grant, and a sizable personal loan from
Maggie’s father, the Browns purchased the business for $999,000. It was agreed that
Bob would run the nursery’s operations and Maggie would oversee its finances.
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Bob thoroughly enjoyed running his own business and was proud of its growth over
the previous three years. The nursery’s operations filled 52 greenhouses and 40 acres of
productive fields and employed 12 full-time and 15 seasonal employees. Sales
were primarily to retail nurseries throughout the mid-Atlantic region. The
company specialized in such woody shrubs as azaleas, camellias, hydrangeas, and
rhododendrons, but also grew and sold a wide variety of annuals, perennials, and trees.
Over the previous two years, Bob had increased the number of plant species grown at
the nursery by more than 40%.
Bob was a “people person.” His warm personality had endeared him to customers
and employees alike. With Maggie’s help, he had kept a tight rein on costs. The effect on
the business’s profits was obvious, as its profit margin had increased from 3.1% in
2013 to an expected 5.8% in 2015. Bob was confident that the nursery’s overall
prospects were robust.
With Bob running the business full time, Maggie primarily focused on attending to
the needs of her active family. With the help of two clerks, she oversaw the company’s
books. Bob knew that Maggie was concerned about the recent decline in the firm’s cash
balance to below $10,000. Such a cash level was well under her operating target of 8%
of annual revenue. But Maggie had shown determination to maintain financial
responsibility by avoiding bank borrowing and by paying suppliers early enough to
obtain any trade discounts. Her aversion to debt financing stemmed from her concern
about inventory risk. She believed that interest payments might be impossible to meet if
adverse weather wiped out their inventory.
Maggie was happy with the steady margin improvements the business had
experienced. Some of the gains were due to Bob’s response to a growing demand for
moremature plants. Nurseries were willing to pay premium prices for plants that
delivered “instant landscape,” and Bob was increasingly shifting the product mix to that
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line. Maggie had recently prepared what she expected to be the end-of-year financial
summary (Exhibit 8.1). To benchmark the company’s performance, Maggie used
available data for the few publicly traded horticultural producers (Exhibit 8.2).
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EXHIBIT 8.1 | Projected Financial Summary for Horniman Horticulture (in thousands of dollars)
Inventory investment was valued at the lower of cost or market. The cost of inventory was determined by accumulating
the costs associated with preparing the plants for sale. Costs that were typically capitalized as inventory included direct
labor, materials (soil, water, containers, stakes, labels, chemicals), scrap, and overhead.
Other current assets included consigned inventory, prepaid expenses, and assets held for sale.
NFAs included land, buildings and improvements, equipment, and software.
Purchases represented the annual amount paid to suppliers.
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EXHIBIT 8.2 | Financial Ratio Analysis and Benchmarking
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Across almost any dimension of profitability and growth, Bob and Maggie agreed
that the business appeared to be strong. They also knew that expectations could change
quickly. Increases in interest rates, for example, could substantially slow market
demand. The company’s margins relied heavily on the hourly wage rate of $10.32,
currently required for H2A-certified nonimmigrant foreign agricultural workers. There
was some debate within the U.S. Congress about the merits of raising this rate.
Bob was optimistic about the coming year. Given the ongoing strength of the local
economy, he expected to have plenty of demand to continue to grow the business.
Because much of the inventory took two to five years to mature sufficiently to
sell, his top-line expansion efforts had been in the works for some time. Bob
was sure that 2016 would be a banner year, with expected revenue hitting a record 30%
growth rate. In addition, he looked forward to ensuring long-term-growth opportunities
with the expected closing next month on a neighboring 12-acre parcel of farmland. But
for now, it was Christmas Eve, and Bob was looking forward to taking off work for the
entire week. He would enjoy spending time with Maggie and the boys. They had much
to celebrate for 2015 and much to look forward to in 2016.
Benchmark figures were based on 2014 financial ratios of publicly traded horticultural 1 producers.
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