Saturday, August 18, 2007
X-Ray the Balance Sheet
Imagine that you were asked to judge a beauty pageant. However, after you accepted, you were told that you would not be able to see any of the women in the pageant. Instead, all you would be able to see were X-rays of their skeletons.
Well, there’s a few things you can tell about beauty from looking at the X-rays. For example, you can check the spine for good posture. In addition, beauty pageant winners tend to be tall and have high cheek bones. You can check for those on the X-rays as well.
However, there are many things the X-rays cannot tell you, such as skin tone and the amount of fat on the contestant. Even more important, X-rays cannot tell you if the contestant has a winsome personality, poise, or a winning smile. You cannot hear them speak or see them walk. It is all of these subtleties which create a true pageant winner.
So the X-rays may be able to eliminate obvious losers, but by themselves are inadequate to determine who the best winner should be. At some point, you have to just narrow the choices and guess.
A lot of business strategy these days revolves around buying and selling companies. In many ways, these courtings between buyers and sellers are a lot like beauty pageants. This has been especially true lately with all of the activity by private equity funds, hedge funds, and the like. These funds look at thousands of companies to find who they want to crown as that beauty they then try to purchase.
How do many of these firms find the time to look at so many different companies? In part, it is done by narrowing the focus to published financials. They pour over hundreds of thousands of numbers, looking for patterns that could lead to easy profits.
Finding the right takeover target just by looking at financials is similar to trying to determine who should win a beauty pageant by only looking at their X-rays. Sure, a balance sheet can tell you how strong an underlying business structure is, just as an examination of a skeleton can tell you how well a person is structured. But true beauty is more than just structure.
The subtleties of a smile, a personality and a walk can overcome a slightly less than perfect skeleton. Similarly, if a balance sheet is examined without looking at the subtleties of the business, you can miss a lot of the features which can truly make a company great (or truly ugly).
The principle here is the risk of an over-reliance on numbers. Over the last year, I have had the opportunity to interact with some of those private equity funds and hedge funds. They all seem to have some of those quantitative geniuses in their organizations—people who are experts at dealing with numbers. It is scary how smart some of these people are, at least when it comes to looking at financials.
When they look at a set of numbers, they can see all sorts of business issues, just like a medical expert can see all sorts of things when looking at an X-Ray. Unfortunately, to many of these quantitative experts, the numbers are really nothing more than abstract concepts. They really do not understand the subtleties behind how the numbers are created. They can see a bad gross margin, but have no idea how to turn it into a good gross margin.
Because they look at so many different kinds of businesses, they often become experts in none of them. It’s all just a bunch of numbers and the trick is to find a combination of numbers which can be easily tweaked for profit, regardless of the industry.
After these firms get done looking at the numbers, some of them then go to management to get “comfort” with all of the subtleties behind the numbers. To me, this is a lot like asking a sleazy used car salesman to give you comfort that his promises about the car he is trying to sell you are true. There is a reason why my wife always takes a used car she is considering purchasing to an auto mechanic she has known and trusted for years. This mechanic has pointed out things the used car dealer was trying to hide, saving my wife from making several mistakes.
Why go to all the trouble to do your numerical homework and then drop the ball on the other aspects of success? This is like getting your act together on how to haggle over price on the used car without knowing whether the engine is in good shape.
In the beginning of the current rush to private equity, knowing just the numbers may have been enough. However, times have changed. There are many more firms bidding up the price and it has gotten a lot harder to find cheap money with which to do a deal. The margin for error has gotten less favorable. It is riskier. Now you cannot “manufacture” enough profits just through clever financials. You also have to “earn” them through superior execution of a sound operating plan.
There are many firms out there that “get it,” including firms like Cerberus. Cerberus employs a lot of operational experts full-time, people who in the past have been successful CEOs of large companies, or bring other types of operational expertise. This allows Cerberus to see beyond just the X-ray of the balance sheet and get to know the full personality of the beauty they are courting.
A similar problem exists in the firms which build those massive mathematical models for stock trading, typically referred to as quant funds. The reasoning was that if you churned through enough numbers quickly enough, you could beat the system. However, as the Wall Street Journal pointed out last Tuesday, these funds have done poorly in the volatility in the market of recent weeks.
According to the WSJ column Ahead of the Tape, the quant funds were playing with some of the same math as the private equity and LBO firms. This doubled the riskiness of what was going on, so that when the credit crunch squeezed the LBO gang, it also busted the math of the quant funds. What the columnist found particularly amazing was that the quant funds were so focused on just the numbers, that they missed the whole concept of how their fate was tied to the LBO boom, something easily seen by those with their heads out of the spreadsheets.
To quote Ahead of the Tape columnist Scott Patterson, “Many quant fund managers now seem to think that their models will start working again soon enough. But if the models proved flawed this time, who’s to say they won’t be proved flawed again?”
Understanding numbers is critical to success in forming business strategy, particularly as it relates to buying and selling companies. However, if one only looks at numbers, one can be deceived about what is going on behind the numbers. A more balanced approach is needed which looks into the subtleties of success. Just as beauty queens are more than just a good skeleton, great strategic deals need to rely on more than just number manipulation.
Mergers typically do not fail because the number gathering was flawed. It isn’t because of a glitch in a formula on a spreadsheet. Instead, mergers typically fail due to people issues, cultural integration issues or an insufficient understanding of the nuances of business acquired. It is the very things that are hard to place on a spreadsheet which can make or break the deal. Why don’t we spend as much time on these other issues as we do on the number gathering?