Michael Mauboussin E28093 Research Articles and Interviews 2016

Michael Mauboussin – Research, Articles and Interviews (2016)
YYMMDD Title Page #

16-05-03 Thoughts on Dividends and Buybacks: Clearing Up Some Common Misconceptions 2
16-05-19 2016 Thought Leader Forum: What Being Wrong Can Teach You About Being Right 14
16-06-14 Operating Leverage: A Framework for Anticipating Changes in Earnings 85
16-07-08 Form Follows Function: Organizational Structure and Investment Results 111
16-07-09 Global Industry Profit Pools: Visualizing Value Creation for an Industry 123
16-08-04 Thirty Years: Reflections on the Ten Attributes of Great Investors 195
16-10-18 Motley Fool Interview 216
16-10-19 Capital Allocation: Evidence, Analytical Methods, and Assessment Guidance 221
16-11-01 Measuring the Moat: Assessing the Magnitude and Sustainability of Value Creation 296
16-11-15 Capital Allocation Outside the US: Evidence, Analytical Methods & Assessment Guidance 369
Twitter @mjbaldbard mayur.jain1@gmail.com

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Thoughts on Dividends and Buybacks

Clearing Up Some Common Misconceptions
May 3, 2016
Authors 120
S&P 500 Companies
110
Michael J. Mauboussin 100
michael.mauboussin@credit-suisse.com 90
80
Dan Callahan, CFA
70
Number
daniel.callahan@credit-suisse.com
60
Darius Majd 50
darius.majd@credit-suisse.com 40
30
20
10
0
0 0-1 1-2 2-3 3-4 4-5 5-6 6-7 7-8 8-9 9-10 >10
Total Shareholder Yield (Percent)
Source: FactSet and Credit Suisse.
“Our study provides theoretical and empirical evidence for a total payout
(dividends plus buybacks) model of stock returns.”
Philip U. Straehl and Roger G. Ibbotson1
The conventional wisdom that dividends make a crucial contribution to

accumulated capital over time is wrong.
Very few investors actually earn the total shareholder return because it
demands that they fully reinvest all dividends.
You commonly hear complaints that companies buy back stock at prices
that are too high and thus “destroy shareholder value” or “waste money.”
This is a simplistic assessment that confuses two issues.
There is a value conservation principle associated with buybacks. The
value of a firm declines by the amount of capital it disburses. Buying back
shares that are over- or undervalued creates offsetting winners and losers.
If you own the shares of a company buying back stock, doing nothing is
doing something. That something is increasing your percentage
ownership.
FOR DISCLOSURES AND OTHER IMPORTANT INFORMATION, PLEASE REFER TO THE BACK OF THIS REPORT.
May 3, 2016
Introduction
The value of a company is determined by the cash that it pays to its owners over its life. A firm can return
capital to shareholders through dividends, share buybacks, or by selling the company for cash. Ultimately,
value boils down to cash in the pocket. Empirical evidence supports the theory.
Companies in a position to pay a dividend or to buy back stock have to weigh those alternatives against
investing the money back into the business. The idea is that an attractive internal investment will allow the
company to return even more money in the future, adjusted for risk and inflation, and will therefore enrich
current investors. Most investors agree on these points. Appendix A examines the concern that companies
today are underinvesting in their businesses.
The relative merits of dividends, buybacks, and investment are contentious. Share buybacks, in particular,
seem to stir emotion, much of it negative.2 The purpose of this report is to address a handful of
misconceptions:
Dividends are the major contributor to capital accumulation over time;
Buybacks destroy value or waste money;
Shareholders can be passive with regard to share buyback policy.
Price Appreciation and Dividends
Investment managers and pundits often make the claim that dividends are the primary source of total
shareholder return over the long haul.3 But it is crucial to distinguish between the equity rate of return for one
year, which is simply the change in the stock price plus the dividend, and the capital accumulation rate, or total
shareholder return (TSR) over time. The central difference is that total shareholder return incorporates the
reinvestment of dividends. As a result, these are very distinct concepts.4
For example, a stock that has price appreciation (g) of 7 percent with a dividend yield (d) of 3 percent in a
given year has an equity rate of return of 10 percent. But if the g and d remain constant over time, the total
shareholder return is 10.21 percent, based on this formula:
𝑇𝑜𝑡𝑎𝑙 𝑠ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟 𝑟𝑒𝑡𝑢𝑟𝑛 = 𝑔 + (1 + 𝑔)𝑑
Once you appreciate this distinction, you can see that “price appreciation is the sole source of investment
returns that increase accumulated capital.”5 This quotation comes from Alfred Rappaport, a professor emeritus
at the Kellogg School of Management at Northwestern University, and it surprises even experienced investors.
The conventional wisdom is that the income component makes a crucial contribution to accumulated capital
and that its contribution grows over time. This is wrong.
To see why, let’s slow things down and again distinguish between the equity rate of return and total
shareholder return. We’ll use a $100 stock and the same g of 7 percent and d of 3 percent.
If you consider results for one year, it is pretty simple. You start with an investment of $100 and end the year
with a stock worth $107 and $3 in cash. You begin with $100 and end with $110 for a 10 percent return. So
far, so good.
Thoughts on Dividends and Buybacks 2

May 3, 2016
Now let’s go to the total shareholder return case. The TSR calculation makes the crucial assumption that 100
percent of dividends are reinvested in the stock. So if at the end of the year you have a $107 stock and a $3
dividend, you use the cash dividend to buy more stock, getting your investment in the stock back up to $110.
Once you make the decision to reinvest all of your dividends, it becomes clear that capital accumulation
depends entirely on the price change over the time you invest.
The key to understanding TSR is that it is a measure over multiple periods. In year two, the stock rises to
$117.70 and the dividend is $3.30, yielding a total value of $121. The dividend is again reinvested in the
stock, meaning that you have $121 in stock at the end of two periods. The process repeats.
Very few investors actually earn the TSR because it demands that they fully reinvest all dividends. In reality,
many investors choose to spend their dividends. This has utility for those investors, of course, but prevents
them from earning the TSR.
Further, because the government taxes dividends, investors in a taxable account cannot reinvest the full
amount of their dividends. For companies that pay a dividend, only investors who reinvest 100 percent of their
dividends in a tax-free account actually realize the TSR. This is a very small percentage of the investing
population. Indeed, the value of the stock market rises at a lower rate than the market’s TSR as investors and
governments extract value along the way.6
Saving is the act of deferring current consumption in order to consume more in the future. Investors save to
fund retirement, pay for education, or to ensure that an institution such as a university can thrive in the future.
In each case, the investor cares about capital accumulation.
For equities, price appreciation is the only source of investment return that increases accumulated capital. The
reason is that an investor makes an investment decision to reinvest the dividend into the stock. Say you own a
stock that trades at $100 and declares a $3 dividend. The day the dividend is paid, you have a stock worth
$97 and cash of $3.7 You must put the $3 back into the stock to earn the total shareholder return.
The Value Conservation Principle
You commonly hear complaints that companies buy back stock at prices that are too high and thus “destroy
shareholder value” or “waste money.”8 This is a simplistic assessment that confuses two issues.
The first issue is what happens to the value of a firm when it pays out capital. Say a company is worth $1,000
and it chooses to pay out $200 to its shareholders. It should be obvious that the value of the firm following the
disbursement is $800. Indeed, it doesn’t matter whether the company pays a dividend, buys back stock, or
donates the $200 to a charity. The value of the firm adjusts accordingly.
The second issue is the plight of the ongoing versus selling shareholders. If a company buys back stock that is
overvalued, the sellers benefit at the expense of the continuing shareholders. If a company buys back stock
that is undervalued, the ongoing shareholders benefit at the expense of the selling shareholders. All
shareholders are treated the same if a company pays a dividend or buys back stock at fair value.
The important point is that there is a value conservation principle: the winners and the losers offset one
another.9 It is true that ongoing shareholders suffer if a company buys back stock at $50 per share and it
subsequently drops to $30. But you can’t forget that the sellers at $50 made out well.

May 3, 2016
Here is another point to consider if you are a fan of dividends. If you agree that buying back undervalued
shares adds value for ongoing shareholders and you believe your portfolio contains undervalued stocks, why
would you ever want one of your holdings to pay a dividend? As Warren Buffett, chairman and chief executive
officer of Berkshire Hathaway, has written, “Indeed, disciplined repurchases are the surest way to use funds
intelligently: It’s hard to go wrong when you’re buying dollar bills for 80¢ or less.”10
Doing Nothing Is Doing Something
Imagine you were a shareholder of a company that paid a dividend when the stock was at $50 and then it
subsequently dropped to $30. Would you have any complaints about the dividend? Now imagine that you
were a shareholder of a company that repurchased shares at $50 (you did not sell) and then the stock
slumped to $30. How would you feel?
Chances are you would not have any complaints about the dividend. Indeed, the dividend you received might
soften the psychological blow of the steep price decline.11 But you would likely be irritated by the inopportune
buyback. This is despite the fact that you own the stock because you found it attractive at a higher price.
If you rewind the situation with the buyback, it is easy to see that you could have sold a prorated number of
shares that would have resulted in a homemade dividend and the same percentage ownership in the company.
This leads to an important point: if you own the shares of a company buying back stock, doing nothing is
doing something. That something is increasing your percentage ownership in the company.
Some of the misgiving about buybacks is well placed, as companies pursue them with multiple motivations.
The fair value school takes a steady and consistent approach to buybacks. The intrinsic value school seeks to
buy back shares only when management deems them to be undervalued. But perhaps the largest group is the
impure motives school, which seeks to boost accounting numbers or offset dilution from compensation
plans.12 Research shows that there is no correlation between share repurchase intensity, measured as the
difference between the growth in net income and earnings per share, and TSR.13
Investors must be diligent in assessing management’s motivation for its buyback program and need to
recognize the consequences of inactivity when companies do buy back shares.
Conclusion
The value of a business is the present value of future cash flow disbursed to the owners. Appendix B
summarizes the details of buybacks and dividends for the S&P 500 Index in 2015 and shows the long-term
trends in spending. The primary mechanisms to return cash to shareholders are dividends and share buybacks.
Yet there is a great deal of muddled thinking about the role that dividends and buybacks play in building
wealth.
In spite of claims that dividends contribute substantially to long-term TSR, price appreciation is the only source
of investment return that increases accumulated capital. The key is to recognize that TSR is a multi-period
measure that assumes dividends are fully reinvested in the stock. Because investors commonly use dividends
to consume and dividends are frequently taxable, a small minority of shareholders earn the TSR.
There is a value conservation principle associated with buybacks. The value of a firm declines by the amount
of capital it disburses. Buying back shares that are over- or undervalued creates offsetting winners and losers.

May 3, 2016
Only if a stock is at fair value, a nebulous concept itself, do buybacks and dividends have the same impact on
all shareholders (leaving aside tax issues).
Companies buy back stock for a host of reasons, and not all of the motivations are economically sound.
Shareholders must assess management’s reasoning for buybacks. Finally, if you own the shares of a
company buying back stock, doing nothing is doing something. You are increasing your stake in the business
and foregoing the opportunity to create homemade dividends.

May 3, 2016
Appendix A: The Perils of Asset Growth (or Why Paying Out Capital Is Good)
One of today’s concerns is that companies are paying out too much to investors, whether in the form of
dividends or buybacks.14 Companies must find an appropriate balance between investing in the business and
returning cash to shareholders. The extremely low interest rates that prevail today make financial engineering
very attractive, as increases in earnings per share are sure, immediate, and easy to calculate.
But on one point the empirical evidence is quite clear: companies that have rapid asset growth have lower
risk-adjusted TSRs than companies with slow asset growth. Finance scholars studied the topic and conclude,
“The findings suggest that corporate events associated with asset expansion (i.e., acquisitions, public equity
offerings, public debt offerings, and bank loan initiations) tend to be followed by periods of abnormally low
returns, whereas events associated with asset contraction (i.e., spinoffs, share repurchases, debt
prepayments, and dividend initiations) tend to be followed by periods of abnormally high returns.”15 This also
applies to 40 markets outside the U.S.16
There are a couple of theories that may explain this finding. One is that investors underestimate the degree of
empire building. As earnings releases reveal that returns on investment are below expectations, the TSRs for
companies with high asset growth are relatively poor.17
Another theory is that companies pay less attention to their prospective return on investment and more to the
perceived cost of capital.18 Companies invest more when they perceive that the cost of capital is low and less
when they perceive it is high. Assuming that the return on investment is relatively stable, this theory predicts
that asset expansion leads to subpar TSRs.

May 3, 2016
Appendix B: Recent Trends in Dividends and Buybacks
The average buyback yield, defined as gross share buybacks divided by average market capitalization, was 3.2
percent for the S&P 500 Index in 2015. Companies in the index spent $572 billion on buybacks. Exhibit 1
shows the breakdown. Fewer than 20 percent of the companies repurchased no shares at all and just over 20
percent had a buyback yield in excess of 5 percent. The distribution is bimodal.
Exhibit 1: Breakdown of Buyback Yield for the S&P 500 (2015)

120
110
100
90
80
70
Number
60
50
40
30
20
10
0
0 0-0.5 0.5-1.0 1.0-1.5 1.5-2.0 2.0-2.5 2.5-3.0 3.0-3.5 3.5-4.0 4.0-4.5 4.5-5.0 >5.0
Buyback Yield (Percent)
Exhibit 2 shows the breakdown of dividend yields. The dividend yield for the S&P 500 was 2.1 percent in
2015. Companies spent $382 billion on dividends. Roughly 15 percent of companies in the S&P 500 Index
paid no dividend and the modal yield for companies issuing dividends was 2.5 to 3.0 percent.
Exhibit 2: Breakdown of Dividend Yield for the S&P 500 (2015)

120
110
100
90
80
70
Number
60
50
40
30
20
10
0
0 0-0.5 0.5-1.0 1.0-1.5 1.5-2.0 2.0-2.5 2.5-3.0 3.0-3.5 3.5-4.0 4.0-4.5 4.5-5.0 >5.0
Dividend Yield (Percent)

May 3, 2016
Exhibit 3 combines the first two exhibits to show total shareholder yield, defined as gross buybacks plus
dividends divided by average market capitalization. The combined payout was just under $1 trillion. Of the 500
companies in the index, only 20 companies have no yield at all and the modal yield is in the range of 3-5
percent. Finally, nearly 50 companies in the S&P 500 delivered a total shareholder yield in excess of 10
percent.
Exhibit 3: Breakdown of Total Shareholder Yield for the S&P 500 (2015)
120
110
100
90
80
70
Number
60
50
40
30
20
10
0
0 0-1 1-2 2-3 3-4 4-5 5-6 6-7 7-8 8-9 9-10 >10
Total Shareholder Yield (Percent)
Exhibit 4 shows the long-term trend for gross share buybacks and dividend payments as well as the price of
the S&P 500 Index. For nine of the past ten years, buybacks have exceeded dividends in volume. The
exception was 2009, as companies curtailed buybacks during and immediately following the Great Recession.
Exhibit 4: Buybacks and Dividends for the S&P 500 (1999-2015)

Buybacks Dividends
S&P 500 S&P 500
600 2,200 600 2,200
2,000 2,000
500 500
Buybacks ($ Billions)
Dividends ($ Billions)
1,800 1,800
S&P 500 Index
S&P 500 Index
400 400
1,600 1,600
300 1,400 300 1,400
1,200 1,200
200 200
1,000 1,000
100 100
800 800
0 600 0 600
1999 2003 2007 2011 2015 1999 2003 2007 2011 2015
Source: S&P Dow Jones and Credit Suisse.
The exhibit also reveals that dividends are much less cyclical than buybacks. Notwithstanding that dividends
and buybacks are identical under idealized circumstances, executives view them very differently.19
Managements tend to view a dividend as a quasi-contract that has a priority similar to capital expenditures and
research and development investment. A buyback is viewed as a means to deploy residual cash after the
company has met all other obligations and investment needs.

May 3, 2016
Exhibit 5 shows dividend and buyback data, as well as the total shareholder yield, for the S&P 500 Index back
to 1982. The total yield was in excess of 5 percent in 2015, which compares favorably to the U.S. 10-year
Treasury note yield of around 2 percent. The net total shareholder yield is somewhat lower than five percent
because of equity issuance, but remains well above the yield of the 10-year note.
Exhibit 5: Dividends, Buybacks, and Total Shareholder Yield for the S&P 500 (1982-2015)
S&P 500 Total
S&P 500 Dividends + S&P 500 Average Market Dividend Buyback Shareholder
Price Dividends Buybacks Buybacks Market Value Value Yield Yield Yield
1981 863
1982 141 47 8 55 1,015 939 5.0% 0.8% 5.8%
1983 165 50 8 58 1,220 1,118 4.5% 0.7% 5.1%
1984 167 53 27 80 1,217 1,219 4.3% 2.2% 6.6%
1985 211 55 40 95 1,500 1,359 4.0% 2.9% 7.0%
1986 242 63 37 100 1,710 1,605 3.9% 2.3% 6.2%
1987 247 65 45 110 1,736 1,723 3.8% 2.6% 6.4%
1988 278 83 46 129 1,897 1,816 4.6% 2.5% 7.1%
1989 353 73 42 115 2,367 2,132 3.4% 2.0% 5.4%
1990 330 81 39 120 2,195 2,281 3.6% 1.7% 5.3%
1991 417 82 22 104 2,824 2,509 3.3% 0.9% 4.1%
1992 436 85 27 112 3,015 2,919 2.9% 0.9% 3.8%
1993 466 87 34 121 3,306 3,160 2.8% 1.1% 3.8%
1994 459 88 40 128 3,346 3,326 2.6% 1.2% 3.8%
1995 616 103 67 170 4,588 3,967 2.6% 1.7% 4.3%
1996 741 101 82 183 5,626 5,107 2.0% 1.6% 3.6%
1997 970 108 119 227 7,555 6,590 1.6% 1.8% 3.4%
1998 1,229 116 146 262 9,942 8,749 1.3% 1.7% 3.0%
1999 1,469 138 141 279 12,315 11,129 1.2% 1.3% 2.5%
2000 1,160 141 151 292 11,715 12,015 1.2% 1.3% 2.4%
2001 1,147 142 132 274 10,463 11,089 1.3% 1.2% 2.5%
2002 848 148 127 275 8,107 9,285 1.6% 1.4% 3.0%
2003 1,126 161 131 292 10,286 9,197 1.7% 1.4% 3.2%
2004 1,212 181 197 378 11,289 10,788 1.7% 1.8% 3.5%
2005 1,248 202 349 551 11,255 11,272 1.8% 3.1% 4.9%
2006 1,418 224 432 656 12,729 11,992 1.9% 3.6% 5.5%
2007 1,468 246 589 836 12,868 12,799 1.9% 4.6% 6.5%
2008 903 247 340 587 7,852 10,360 2.4% 3.3% 5.7%
2009 1,115 196 138 333 9,928 8,890 2.2% 1.5% 3.7%
2010 1,258 206 299 505 11,430 10,679 1.9% 2.8% 4.7%
2011 1,258 240 405 645 11,385 11,408 2.1% 3.6% 5.7%
2012 1,426 281 399 680 12,742 12,064 2.3% 3.3% 5.6%
2013 1,848 312 476 787 16,495 14,619 2.1% 3.3% 5.4%
2014 2,059 350 553 904 18,245 17,370 2.0% 3.2% 5.2%
2015 2,044 382 572 955 17,900 18,072 2.1% 3.2% 5.3%
Average 2.6% 2.1% 4.7%
Source: Nellie Liang and Steven A. Sharpe, “Share Repurchases and Employee Stock Options and their Implications for S&P 500 Share Retirements
and Expected Returns,” Board of Governors of the Federal Reserve System Finance and Economics Working Paper No. 99-59, November 1999, S&P
Dow Jones Indices, Thomson Reuters Datastream, and Credit Suisse estimates.
Note: All monetary amounts in billions U.S. dollars.

May 3, 2016
Endnotes
1
Philip U. Straehl and Roger G. Ibbotson, “The Supply of Stock Returns: Adding Back Buybacks,” Working
Paper, December 17, 2015.
2
For example, see Barry Ritholtz, “Take Dividends Over Buybacks,” Bloomberg, April 11, 2016; William
Lazonick, “Profits Without Prosperity,” Harvard Business Review, September 2014, 54-55; and Gretchen
Morgenson, “In Yahoo, Another Example of the Buyback Mirage,” New York Times, March 25, 2016.
3
See, for instance Robert D. Arnott and Peter L. Bernstein, “What Risk Premium Is ‘Normal’?” Financial
Analysts Journal, Vol. 58, No. 2, March/April 2002, 64-85; Richard Skaggs, “Dividends: A Timeless
Component of Equity Return,” Advisor Perspectives, April 18, 2012; Aye M. Soe, “Dividend Investing and A
Look Inside the S&P 500 Dow Jones Dividend Indices,” S&P Dow Jones Indices, April 2013; Rupert
Hargreaves, “Dividend Income Accounts for 60% of Equity Returns,” ValueWalk, February 23, 2016.
4
This distinction has a direct analog in money management. If you seek to maximize value over one period,
the proper method is to find the highest arithmetic return. This is where mean-variance maximization is
appropriate. If you are parlaying your capital so that your investment sum at the end of one period becomes
the starting sum of the next, you want to consider geometric mean maximization. See Javier Estrada,
“Geometric Mean Maximization: An Overlooked Portfolio Approach?” Journal of Investing, Vol. 19, No. 4,
Winter 2010, 134-147. For a less technical discussion, see William Poundstone, Fortune’s Formula: The
Untold Story of the Scientific Betting System that Beat the Casinos and Wall Street (New York: Hill and Wang,
2005), 197-201.
5
Alfred Rappaport, “Dividend Reinvestment, Price Appreciation and Capital Accumulation,” Journal of Portfolio
Management, Vol. 32, No. 3, Spring 2006, 119-123.
6
Jeremy J. Siegel, Stocks for the Long Run: The Definitive Guide to Financial Market Returns and Long-
Term Investment Strategies, Fifth Edition (Hoboken, NJ: John Wiley & Sons, 2014), 76.
7
As an empirical matter, the stock price doesn’t go down by the exact amount of the dividend because of the
impact of taxes. The basic equation to determine how much a stock will drop when it goes ex-dividend is as
follows:
Pb – P a = (1-to)
D (1-tcg)
Where Pb is the stock price before the ex-dividend date, Pa is the price after the ex-dividend date, to is the tax
rate on dividend income, and tcg is the tax rate on capital gains. So if the tax rates on dividends and capital
gains are the same (as they are today), then the decline in the stock price is roughly equivalent to the dividend.
If the tax rate on dividends is higher than that on capital gains, which has been true for most of the last half
century, then the decline in stock price will be less than the dividend. See Aswath Damodaran, “Returning
Cash to the Owners: Dividend Policy,” available at
http://pages.stern.nyu.edu/~adamodar/pdfiles/ovhds/ch10.pdf.
8
For example, see David Trainer, “How Stock Buybacks Destroy Shareholder Value,” Forbes, February 24,
2016, and Ritholtz (2016).
9
See exhibit 8 in Michael J. Mauboussin and Dan Callahan, “Disbursing Cash to Shareholders: Frequently
Asked Questions about Buybacks and Dividends,” Credit Suisse Global Financial Strategies, May 6, 2014.
10
Warren E. Buffett, “Letter to Shareholders,” Berkshire Hathaway Annual Report, 2012. See
www.berkshirehathaway.com/letters/2012ltr.pdf.
11
Individual investors commonly use dividends in their mental accounting. See Hersh M. Shefrin and Meir
Statman, “Explaining Investor Preference for Cash Dividends,” Journal of Financial Economics, Vol. 13, No. 2,
June 1984, 253-282.
12
Konan Chan, David L. Ikenberry, Inmoo Lee, and Yanzhi Wang, “Share Repurchase as a Potential Tool to
Mislead Investors,” Journal of Corporate Finance, Vol. 16, No. 2, April 2010, 137-158. Also, Heitor Almeida,

May 3, 2016
Vyacheslav Fos, and Mathias Kronlund, “The Real Effects of Share Repurchases,” Journal of Financial
Economics, Vol. 119, No. 1, January 2016, 168-185.
13
Obi Ezekoye, Tim Koller, and Ankit Mittal, “How Share Repurchases Boost Earnings Without Improving
Returns,” McKinsey Article, April 2016.
14
For example, see the letter from Larry Fink, chief executive officer of BlackRock, to corporate leaders dated
February 1, 2016. He writes: “We certainly support returning excess cash to shareholders, but not at the
expense of value-creating investment.” See www.blackrock.com/corporate/en-in/literature/press-release/ldf-
corp-gov-2016.pdf.
15
Michael J. Cooper, Huseyin Gulen, and Michael J. Schill, “Asset Growth and the Cross-Section of Stock
Returns,” Journal of Finance, Vol. 63, No. 4, August 2008, 1609-1651.
16
Akiko Watanabe, Yan Xu, Tong Yao, and Tong Yu, “The Asset Growth Effect: Insights for International
Equity Markets,” Journal of Financial Economics, Vol. 108, No. 2, May 2013, 259-263.
17
Sheridan Titman, K. C. John Wei, Feixue Xie, “Capital Investments and Stock Returns,” Journal of Financial
and Quantitative Analysis, Vol. 39, No. 4, December 2004, 677-700.
18
Yuhang Xing, “Interpreting the Value Effect Through Q-Theory: An Empirical Investigation,” Review of
Financial Studies, Vol. 21, No. 4, July 2008, 1767-1795.
19
Alon Brav, John R. Graham, Campbell R. Harvey, and Roni Michaely, “Payout Policy in the 21st Century,”
Journal of Financial Economics, Vol. 77, No. 3, September 2005, 483-527.

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Proceedings
May 19, 2016
Tarrytown, NY
Thought Leader
Forum
2016
Table of Contents
Michael Mauboussin, Credit Suisse

Introduction and Welcome .................................................................................................................................3
Bill Gurley, General Partner, Benchmark Capital

How to Miss by a Mile.......................................................................................................................................9
Pedro Domingos, Professor of Computer Science, University of Washington

The Master Algorithm .....................................................................................................................................26
Cade Massey, Professor of Operations, Information and Decisions, University of Pennsylvania

Algorithm Aversion ..........................................................................................................................................48
2
Michael Mauboussin
Introduction
Information and circumstances change constantly in the worlds of investing and business. As a consequence, we
have to constantly think about what we believe, how well those beliefs reflect the world, and what tools we can use
to sharpen our decisions. Because we operate in a world where we can succeed only with a certain probability, we
have to learn from our mistakes. Hence, the theme for the Thought Leader Forum in 2016 was “What Being
Wrong Can Teach You About Being Right.”
This year’s forum featured a venture capitalist, a computer scientist, an economist who focuses on decisions, and a
leading sports executive. Each explored an area of how our thinking and decisions can come up short of the ideal.
We heard about how assumptions deeply shape how you assess a company’s potential and how well-intentioned
incentive systems can go awry. There was an exploration of how computers, through machine learning, can serve
as a new source of knowledge, complementing evolution, experience, and culture. Notwithstanding the potential
benefits of augmenting our intelligence through computers, we discussed why we humans have an aversion to
algorithms and how to overcome it. And then there is the issue of the old and new guard: how can we convince
some who have been successful in an old regime to accept new and better ways of doing things?
The theme of “what being wrong can teach you about being right” has lessons to teach us about naïve realism, man
versus machine, and the role of change. Naïve realism is the sense that our view of the world is the correct one.
But when confronted with reality, we need to revisit our beliefs.
For example, when we face someone who has beliefs different than ours, we tend to adopt one of three attitudes
so that we can perpetuate our position. First, we might assume the other person is merely unequipped with the
facts, so simple sharing will swing them to our side. Next, we believe that even with the facts, the other person
lacks the mental capacity to see the consequences as we do. We can write off those people. Finally, there may be
people who understand the facts as we do but turn their backs on what we perceive to be the truth. We categorize
those people as evil.
Machine learning and artificial intelligence are again hot terms. Google DeepMind’s AlphaGo program, which beat a
human champion in the board game of Go much sooner than most experts had predicted, is emblematic. The
question is how we divide the cognitive work between machines and human judgment. If you are in the information
business—and the chances are good this is true if you are reading this—then you must consider carefully how you
might integrate computers and humans.
All of this implies change, something we are loathe to do. Changing your mind takes time, effort, and humility. This
is especially pertinent when you have been successful in your domain. Strategy in sports is a good analogy. There
are traditional ways to do things, and often those ways are effective. But more careful analysis has revealed
strategies that fly in the face of conventional wisdom that are clearly better. Defensive shifts in baseball are but one
example. Convincing the old guard to change—and eventually, we are all part of the old guard—is a difficult hurdle.
The following transcripts not only document the proceedings, they also provide insights into how you can improve
your own ability to learn from mistakes and improve your odds of being right in the future. Bill Gurley suggested that
the high valuations for some technology startups (so-called “unicorns’) and the low level of liquidity is a balance that
is not tenable. Pedro Domingos explained how computers might be able to complete tasks that are out of the grasp
of humans. Cade Massey showed that we don’t readily embrace algorithms but that there is a way to overcome this
aversion and improve decisions. And Paul DePodesta suggested that the bias against change has less to do with
the game you are playing and more to do with how we humans think.
3
4
Michael Mauboussin
Credit Suisse
Michael Mauboussin is a Managing Director of Credit Suisse in the Global Markets division, based in New York. He
is the Head of Global Financial Strategies, providing thought leadership and strategy guidance to external clients
and internally to Credit Suisse professionals based on his expertise, research, and writing in the areas of valuation
and portfolio positioning, capital markets theory, competitive strategy analysis, and decision making.
Prior to rejoining Credit Suisse in 2013, he was Chief Investment Strategist at Legg Mason Capital Management.
Michael originally joined Credit Suisse in 1992 as a packaged food industry analyst and was named Chief U.S.
Investment Strategist in 1999. He is a former president of the Consumer Analyst Group of New York and was
repeatedly named to Institutional Investor’s All-America Research Team and The Wall Street Journal All-Star survey
in the food industry group.
Michael is the author of The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing, Think
Twice: Harnessing the Power of Counterintuition, and More Than You Know: Finding Financial Wisdom in
Unconventional Places. He is also co-author, with Alfred Rappaport, of Expectations Investing: Reading Stock
Prices for Better Returns.
Michael has been an adjunct professor of finance at Columbia Business School since 1993 and is on the faculty of
the Heilbrunn Center for Graham and Dodd Investing. He is also chairman of the board of trustees of the Santa Fe
Institute, a leading center for multi-disciplinary research in complex systems theory. Michael earned an AB from
Georgetown University.
5
Michael Mauboussin
Credit Suisse
Good morning. For those of you whom I haven’t met, my name is Michael Mauboussin, and I am head of Global
Financial Strategies at Credit Suisse. On behalf of all of my colleagues at Credit Suisse, I want to wish you a warm
welcome to the 2016 Thought Leader Forum. For those who joined us last night, I hope you had a wonderful
evening. We are very excited about our lineup for today.
I’d like to do a couple of things this morning before I hand it off to our speakers. First I want to highlight the levels
at which you might consider today’s discussion about the idea of how being wrong can inform you about being
right. I then want to discuss the forum itself, including what you can do to contribute to its success.
You might listen to today’s discussion at three different levels. Some of the points will span multiple levels, but
these are some of the ideas that we’ll hear about throughout the day.
The first relates to the ideas of naïve realism. In psychology, this is the human tendency to believe that we see the
world around us objectively and that people who disagree with us must be uninformed, irrational, or biased.
The second is man versus machine. This is a theme that is popping up everywhere. What are algorithms good at
and what are humans good at? How do we use algorithms to augment our performance? Why do we struggle to
defer to algorithms in many settings?
The final is the issue of change. Organizational inertia is a huge issue in many firms. How can firms keep up? How
do we integrate new information? What is the psychology of change?
Let’s start with naïve realism. Here’s a cartoon I love: as you can see, there are two armies preparing to square off,
and the quote is: “There can be no peace until they renounce their Rabbit God and accept our Duck God.” The
picture shows that the flags of the competing armies are the exact same. This is based on the rabbit-duck illusion,
an ambiguous picture that can be interpreted either as a rabbit or a duck.
The idea of naïve realism in psychology is that we all think that we have an objective reality of the world. As a
consequence, we have a hard time accepting that others have different points of view. So we all walk around with
beliefs that we think are true. Otherwise we wouldn’t hold onto those beliefs. Things become interesting when
those beliefs confront the world.
Here’s a well-known experiment that demonstrates this point. A psychologist named Elizabeth Newton set up an
experiment whereby there were “tappers” and “listeners.” The tappers were given a list of 25 well-known songs,
such as “Happy Birthday to You,” and were asked to tap the rhythm of the song on the table. The task of the
listener was to identify the song based on the taps.
She ran 125 trials of this. The listeners were able to identify only 3 of the songs, a success rate of about 2.5
percent. But when the researchers asked the tappers what percent they thought the listeners would be able to
identify correctly, the answer was 50 percent! This is related to the curse of knowledge, which is also a huge
impediment to communication. Again, we struggle to understand that others don’t see the world as we do.
So if you see the world one way and others see it a different way, you have to reconcile the views. And as we do
so, we tend to assume one of three things. The first is that the other person simply doesn’t know the facts that you
do, and hence is ignorant. The answer is simply to inform them so that they will then see your point of view. The
second is that the person has the facts, but they are just too stupid to understand them properly. The last
assumption is that people know the facts and can comprehend them, but they just turn their backs on the truth.
Unbelievers in religion are an example.
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Michael Mauboussin
Credit Suisse
Now consider how you assess people who don’t agree with you. Do you evoke one of these assumptions to
reconcile their beliefs with yours?
We now turn to a theme that will spread through the day. I am calling it man versus machine but it may be just as
accurate to say humans versus algorithms. The first point I want to make refers to what I call “the expert squeeze.”
The way to think of it is as a continuum. On one side there are problems that are rules-based and consistent. Here,
experts are often proficient but computers are quicker, cheaper, and more reliable. Today, of course, you have to
point to the success of AlphaGo—Google DeepMind’s program that beat a champion in Go.
At the other side of the continuum are problems that are probabilistic and in domains that change constantly. Here,
the evidence shows that collectives do better than experts under certain conditions. Making sure those conditions
are in place is crucial for a decision maker.
I’m now going to steal a bit of thunder from our second speaker and introduce various approaches to machine
learning. But my point of emphasis is somewhat different. If your organization relies on fundamental research, do
any of these approaches seem familiar?
For example, lots of investors like to appeal to analogies: this investment is like that investment from the past. The
interesting question then becomes: what can we, as fundamental analysts, learn from what’s going on in machine
learning? The next step is considering how we can integrate machine learning techniques into a decision-making
process. If you are relying on quantitative methods, how do you think about the biases built into the algorithms?
The final issue I’ll mention for man versus machine is that we as humans tend to be uneasy letting our fate be
decided by an algorithm, even if there’s abundant evidence that the algorithm is better than a human.
This scene from Moneyball captures the tone: the old timers have a difficult time grasping the signal from the
statistical analysis. This is true for a few reasons. They generalize from their own experience. They overemphasize
recent performance. And they rely on what they see versus cause and effect. We’ll talk today about how to
overcome algorithm aversion, but it’s a huge issue.
The final topic is that of change, which is hard. The first impediment is organizational inertia. Back in the day, I was
a food industry analyst, and I recall a story that captured this well.
When David Johnson took over as CEO of Campbell Soup about 25 years ago, the performance of the company
lagged its peers. So he did a full review to understand how to improve operations.
He noticed that the firm did a huge annual promotion of tomato soup in the fall every year. Tomato soup was one of
their largest and most profitable products. When he asked the executive why they did it, the executive responded, “I
don’t know, we’ve always done it.”
In World War I, Campbell’s strategy was to grow its own tomatoes, harvest them, and them convert them to canned
soup. With inventory up and the soup season still months ahead, Campbell used a promotion to clear its inventory.
But of course the company long ago went to year-round suppliers, eliminating the post-harvest spike in supply. This
evokes a quote from Peter Drucker: “If we did not do this already, would we go into it” now, knowing what we now
know?
Perhaps the most challenging thing to do is to update your beliefs when you receive new information.
Here’s a famous example from Thinking, Fast and Slow by Daniel Kahneman [page 166].
7
Michael Mauboussin
Credit Suisse
“A cab was involved in a hit-and-run accident at night. Two cab companies, the Green and the Blue, operate in the
city. You are given the following data:
 85% of the cabs in the City are Green and 15% are Blue.
 A witness identified the cab as Blue. The court tested the reliability of the witness under the circumstances
that existed on the night of the accident and concluded that the witness correctly identified each one of the
two colors 80% of the time and failed 20% of the time.
What is the probability that the cab involved in the accident was Blue rather than Green?”
The most common response is 80 percent, based on the reliability of the witness. But the correct answer is just a
little over 41percent. In Phil Tetlock’s terrific book, Superforecasting, he has a great line: “Beliefs are hypotheses to
be tested, not treasures to be guarded.” This is really easy to say and very difficult to do in practice. Changing our
minds takes time, effort, in some cases technical skills, and can be embarrassing. Most of us would prefer to keep
believing what we believe.
My final thought is on loss aversion. Everyone in this room deals with decisions that work only with some probability.
We suffer losses more than we enjoy comparable gains. So we tend to stick to conventional ways of doing things
because if we fail, we have lots of company.
There are lots of instances of this in sports. One example is the decision to go for it on fourth down in football. Most
coaches prefer the more conservative route even if it gives them a lower probability of winning, because the
potential pain of getting stopped on fourth down is a lot worse than the upside of a fresh set of downs.
Before I speak about the goal of the forum, I want to mention the talented folks from Ink Factory.
Dusty and Ryan will be graphically recording all of our presenters today. This means they will be synthesizing the
words of our speakers into images and text to capture the key concepts. Their slogan is “you talk. we draw. it's
awesome.” And we think you will agree. Please feel free to take pictures of the artwork and to tweet the images.
And we encourage you to ask them questions—after they are done drawing of course!
Let me end by highlighting what our goals are for the day. First, we want to provide you access to speakers whom
you may not encounter in your day-to-day interactions but who are nonetheless capable of provoking thought and
dialogue. Second, we want to encourage a free exchange of ideas. Note that our speaking slots are longer than
normal. This is in large part because we want to leave time for back-and-forth.
Second, we purposefully call this a “forum” instead of a “conference” precisely for this reason. We want to
encourage an environment of inquiry, challenge, and exchange.
Finally, we want this to be a wonderful experience for you, so please don’t hesitate to ask anyone on the Credit
Suisse team for anything. We will do our best to accommodate you.
8
Bill Gurley
Benchmark Capital
Bill Gurley has spent over 10 years as a General Partner at Benchmark Capital. Prior to Benchmark, Bill was a
partner with Hummer Winblad Venture Partners.
Before entering the venture capital business, Bill spent four years on Wall Street as a top-ranked research analyst,
including three years at CS First Boston focusing on personal computer hardware and software. His research
coverage included such companies as Dell, Compaq, and Microsoft, and he was the lead analyst on the
Amazon.com IPO. In both 1995 and 1996, Bill was a member of Institutional Investor’s All-America Research
Team.
Prior to his investment career, Bill was a design engineer at Compaq Computer, where he worked on products such
as the 486/50 and Compaq’s first multi-processor server. For the past fifteen years, Bill has authored the “Above
the Crowd” blog, which focuses on the evolution and economics of high technology businesses.
Bill is on the advisory board of the McCombs School of Business at the University of Texas and a board member at
KIPP Bay Area Schools. He received his MBA from the University of Texas in 1993 and a BS in computer science
from the University of Florida in 1989.
9
10
Bill Gurley
Benchmark Capital
Michael Mauboussin: I’m very pleased to introduce our first speaker this morning, my good friend and former
colleague, Bill Gurley. Bill is a general partner at Benchmark Capital, one of the world’s leading venture capital
firms. Bill combines a lot of attributes that I admire: he’s wicked smart; intellectually curious; a terrific strategic
thinker; financially savvy; and he doesn’t take himself too seriously. You can find his writings at
abovethecrowd.com, and I recommend reading everything he writes.
In fact, one of Bill’s essays deeply inspired the theme for today’s forum. Here’s the story: one of Bill’s portfolio
companies is Uber. Aswath Damodaran, a professor at NYU (New York University) and valuation expert, suggested
that the company’s value should not exceed a fairly modest amount because it was a substitute for cabs and limos.
Bill’s response—and this was all very civil—was called “How to Miss by a Mile.” Bill reframed the TAM (Total
Addressable Market) for Uber and suggested that Damodaran could be off by a factor of 25 times.
Prior to joining the venture capital world, Bill was a Wall Street analyst. I had the fortune of working with him in his
early days out of business school, where he established himself, in very short order, as a go-to analyst.
Please join me in welcoming Bill Gurley.
Bill Gurley: Before I get started, I want to thank Michael not just for having me here but for being there for me
23 years ago when I started my investment career, and for being a thought leader for the past 23 years. I would
not be where I am today probably if I hadn’t met Michael back then. He was the food analyst and I was the PC
(personal computer) analyst, and somehow he found a way to shape everything I did and have a huge impact on
my career. So, thank you, Michael.
When I first met Michael, we both fell in love with this book, Complexity, by Mitchell Waldrop, about the rise of
the Santa Fe Institute, and I know some of the people in the room have spent a lot of time out there. I tell people
this book has affected how I think more than any other book that I’ve ever read because most of the things we
deal with as investors are complex systems, and I’m going to come back to this at the end, but that’s why I
wanted to point it out here.
Now here’s the professor Michael mentioned. I didn’t know who he was two and a half years ago. It turns out
that he’s a rather thoughtful valuation professor, and here’s the blog post that he published on Uber where I sit
on the board. Not only did he publish this long post, but he did a summary for Nate Silver’s FiveThirtyEight.
The title of this one was “Uber Isn’t Worth $17 Billion,” and he did a lot of work to calculate that he thought the
value should be around $5 billion. He made a number of critical errors in his thinking from my point of view, and
Michael asked me to talk about them today. He said, “Why don’t you talk about ‘How to Miss by a Mile’?” And
he wanted me to incorporate three or four different things that I’ve seen and that we’ve talked about over the
years.
So this is just the first one, but he made a number of errors that I think are interesting and I want to highlight.
The first one was he didn’t theorize that there might be a network effect. This napkin drawing was actually done
by David Sacks, one of the angel investors in Uber. It basically shows that more demand drives more drivers.
More drivers creates more geographic coverage. That leads to less downtime which can lead to lower prices
because you in effect have more utilization, like an airplane. It also leads to faster pickups. Lower prices and
faster pickups drives more demand, and so you have a circle here. He didn’t even consider this, but I don’t even
think that was his biggest mistake.
His biggest mistake related to TAM, total available market. He assumed the market that Uber was attacking was
taxis and black cars. Basically he looked at the revenue for taxis and black cars at the time, and he assumed that
Uber could get some fraction of that. He wrote this two and a half years ago, and just to show you how far off
11
Bill Gurley
Benchmark Capital
he was on that assumption already, the market for taxis and black cars in San Francisco in 2011 was $120
million, and the market for ridesharing in San Francisco right now is $1.2 billion, a 10 times differential and
totally outside of his scope of analysis. It’s still growing, and we’ve only touched 13 percent of the population, so
it’s likely going to be off by more than 10 times, just his TAM assumption.
So how does this happen? What did he miss? He didn’t think about any of these things. He didn’t think about
the fact that the pickup times were much quicker than a taxi. If you’ve ever ordered a taxi in a city like Houston,
it takes 30 minutes for it to show up. Greater coverage density. Uber already has more density in areas where
taxis have never historically served.
Easier payment, higher civility. It’s actually a better experience because of the dual rating and higher trust and
safety. People routinely now rate this experience as way better than taxis from a trust standpoint and, in fact,
there’s numerous blog posts that you can find on the web of people getting their phones back, their keys back,
their money back all through the system.
He made an even bigger mistake for a financial professor which is he didn’t think about price elasticity. Now this
is taught I think in early microeconomics courses. At the time he wrote it, Uber was already about half of taxi
prices in many cities, and these prices were published. So he could have found them, but he didn’t. He didn’t
look at it.
He also didn’t consider new use cases, expanded geographic coverage, a rental car alternative, couples night
out. Uber peaks on Friday and Saturday night and has become a huge DUI deterrent. Where I live near Palo
Alto, a couple in Menlo Park will go out to eat in Palo Alto. They used to drive, but they don’t anymore. They just
take Uber. They don’t have to park. They don’t have to worry about drinking.
Transporting kids, seniors, supplement of mass transit are all other things that he didn’t consider. UberPOOL,
where you share rides in a car, now comprises about 20, 25 percent of rides and is competing with bus and
subway.
Then, a really big one is as an alternative for car ownership, which changes the perspective entirely. The
professor didn’t think about car rental alternatives. The CEO of Hertz didn’t think about it either because he
constantly says that Uber’s a “taxi alternative,” a phrase he uses. This is Hertz’s 12-month stock price.
[Shows video clip of Jim Cramer on CNBC]: Why doesn’t Hertz just own up to Uber? I mean again they
disappointed. Again they said that things had gotten worse this quarter than last quarter. Again they denied
without really saying it’s denial that Uber’s the problem, but I think we all have Uber in our cell phone.
Uber is one of the prestige brands that I talk about. I talk about cosmetics because when you walk outside
you’ve got to be dressed up these days. Put your stuff on. I talk about the iPhone as being a prestige brand and
Uber being a prestige brand.
I think that is directly impacting Hertz. You would think that after all the consolidation in the rental business that
rates would go up, but you know what? They can’t because they’re really competing against Uber.
Bill: I don’t know if any of you have recently used rental cars. I used to go to Seattle and L.A. frequently for
business, and the difference is astounding because with a rental car you’ve got to arrive 30 to 45 minutes
earlier.
You’ve got to get on the shuttle. Ride the shuttle out there. You have to have maps for everywhere you’re going.
You have to know where you’re going to park. You have to get there 15 minutes earlier to get to the parking
structure to get to your car. And by the way, when you get to the hotel you get charged $40 to put it there.
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Bill Gurley
Benchmark Capital
Now Uber’s just completely better, and I would pay three times as much for the experience I get on Uber as I
would for renting a car. If you think about a car ownership alternative . . . oh, wait.
This is expense data that’s now coming out from companies that track corporate expenses. So not only can you
presume that it might affect rental cars, you can actually see it. That top section is Uber, and this blue section
which was at 50 percent but is now at 30 percent is rental cars.
So now there are hard data to support the theory if you will. Now, Michael said it’s okay if I show something
produced by a different investment bank. I want you to contrast someone who thought the TAM was just taxi and
black car with the perspective in this video. This is my last video and then we’ll move on.
[Video Clip]
Bill: I thought that was very clever, but just highlighting a difference. Coming at an approach from the top down
of being a car alternative gets you a vastly different result than if you think about the TAM the way that the
professor did.
Now I think he made a number of errors, and what’s interesting is in his piece he spent a lot of time talking
about judgment errors that investors make. [Laughs]
These quotes which I won’t read to you were all his reasoning as to why the investor group that had valued Uber
had made mistakes. So he thinks about errors in investment judgment. He just didn’t think about them in
himself.
In addition to many biases he may have had, the blog post actually had this disclosure which I think is quite
hilarious. He admitted that he had never used the product. [Laughs] In fact, he lives in New York and only takes
subways and doesn’t own a car. So he didn’t have a great position to make a judgment from.
Let me move on to another example that’s a little more esoteric but relates to investing and compensation. I
wrote the quote from the cartoon here so you can see it larger, and it’s talking about the re-pricing of stock
options, which was a common thing that happened in 2000, 2001. And stock options became vilified for a
number of reasons. Enron and WorldCom were a big part of it. This always pissed me off because this wasn’t
Silicon Valley.
Now admittedly Silicon Valley did some really silly things in ’99, but they didn’t do this. Enron and WorldCom
were outside of Silicon Valley but, as we move through the re-pricing and these two examples, options became
vilified. Here’s The Wall Street Journal. Here’s Harvard Business Review. Even ISS (Institutional Shareholders
Services), who claims to be the champion of the shareholder, came out and said options are bad.
Here are the reasons. The first one was they encourage too much risk-seeking. And so it was felt that it was just
way too potent of a compensation scheme and that it actually causes you to do illegal things. That was one of
them.
They were considered highly dilutive. People were upset about three to four percent a year dilution. They were
routinely re-priced, which was what the cartoon talked about, and then they weren’t properly accounted for.
So these were the four reasons that we decided to get rid of them. In their place we’ve used a new thing called
an RSU, a restricted stock unit, and at least in Silicon Valley the vast majority of these are zero basis stock units.
Typically you look at what you would have given someone in options, run a Black-Scholes comparison, and then
give out an RSU. Starting in 2001 this became common even at the big Microsoft, Intel, Cisco, those types of
companies.
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Bill Gurley
Benchmark Capital
What I’ve done here is I’ve made some assumptions for the Black-Scholes model, but I’m showing you the
comparative payoff for an option holder, or an equivalent value amount in the way they actually move to RSUs
through this math of an RSU.
So the option holder, if the company doesn’t perform, makes no money, it’s worth zero obviously. And this is
what it’s worth if it goes up. The RSU holder has this payout scheme relative to the stock performance.
Now here I’ve said let’s look at what happens when the company just stays even, when the stock price doesn’t
move. The RSU executive makes the same compensation when the stock price doesn’t change as the option
executive makes if the stock went up 50 percent. In all these cases where the stock underperforms, they’re still
getting paid.
So based on this, do you think executives prefer RSUs over options? Yes? No? Absolutely. They love RSUs.
They eat them up. So what has happened? Well, I think this was an error in judgment because I don’t think
everyone thought through the systematic things that would happen afterwards.
First of all, employees don’t hold RSUs, and if you talk to any compensation executive, board member, or CFO
about the companies you’re investing in that use RSUs, they will tell you some number close to 97 percent of
RSUs are sold on the vest date. So they’re not a form of stock ownership. They’re a form of cash
compensation. No one’s holding them, and that’s huge because options were a form of stock ownership and
aligned incentives.
Second, they routinely pay out when shareholders do not see a return, and this is something that I don’t know if
ISS thought about, but I really wish they had. Executives are making way more money in companies that don’t
perform than they did when they were holding options. Way more money.
They dilute all the time. Options were dilutive, but they were only dilutive in upside scenarios. I think we were
more aligned with options than we are with RSUs.
Thirdly, we talked about options maybe creating incentive for too much risk-seeking. I think RSUs create too
much incentive for super-conservative executive behavior, and my mind really understood this when I was
recruiting an executive into one of our startups, and I was competing with a large public company.
I sat down with the executive and said, “Well, show me what package they’re offering you at the other
company,” and he had built a spreadsheet, and he had put in all these different things and the RSU package
they had given him. I said, “Well, what’s this?” And he goes, “Oh, I’m just assuming the stock’s flat for the next
four years.”
So he was accepting a job, thinking about the compensation. He had already decided he didn’t care if the stock
moved or not. For me, that’s just not what you want. I mean you can hold debt if you want that kind of return.
Then the accounting became even worse, which is typical I think in these situations. An in-the-money option
prior to 1999 would have unquestionably been expensed. You just wouldn’t think about it.
Now the majority of stock compensation is through a zero basis, totally in-the-money option, and yet Wall Street
and others still want you to look at non-GAAP (Generally Accepted Accounting Principles) operating income,
which excludes SBC (stock-based compensation) and is even more like cash now than it ever was with options.
Just to highlight a few examples—this isn’t scientifically statistically significant I understand, but I’m going to do it
anyway.
This is Cisco since they went to RSUs in 2000, 15 years ago. If someone were to go and calculate the amount
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of stock-based earnings that Cisco management has gotten via RSUs over this timeframe, it’s going to be, I
don't know, 100 times what they would have gotten from options over this time frame. Some really large
number.
Here’s Intel. Same kind of thing. I’ve been at public investor forums before, and I’ve said to people, “I don’t think
you understand what this compensation scheme looks like. It’s not anything like options were.”
It got even worse, so I’m going to walk you through how a lot of compensation committees make decisions
these days.
First they take an executive. They go run a compensation survey and they say the total target compensation for
this executive should be X, and I use the example here of a CFO. They might say this public CFO should expect
to earn $2 million a year. And so they take the salary, maybe $500,000, and the bonus, $250,000, and they
say the rest should be stock comp. And then they assign that person $1.25 million worth of RSUs, and they do
this every year, and maybe they put it out in front of them.
This has basically led us to where we’re building compensation programs dollar-based not percentage-based. So
what would happen if share prices fell dramatically?
In 2015 many of the mid-cap Internet stocks’ market caps fell dramatically—LinkedIn, Twitter, Yelp—and stock-
based compensation as a percentage of market cap shot up through the roof for some of these companies six to
nine percent a year. So we were worried about options being diluted at three percent a year.
Now we’re at six to nine percent a year, and because it’s a zero-based thing, the option had the cash part that
was coming back. So it’s even worse than this. We wanted to get to a place where there was less dilution, but
we’ve gotten to a place where there’s dramatically more dilution and a misaligned incentive.
I’m a venture capitalist by day, but someone asked me to look at a couple stocks they were thinking about
buying. I literally went and built a few models, and I figured this out. Then I went and downloaded the models
from Wall Street research analysts, and they hadn’t figured it out.
They hadn’t figured out that their share counts didn’t have the incremental dilution in them. I was like. “oh my
god.” Literally two months later reports start flying out where people have figured this out and are starting to look
at how excessive it is.
This is one of my favorite quotes, this [Charlie] Munger quote. He had a list of [25] biases that people bring to
the table around investing, and this is my favorite one. He says his number one is that people don’t think enough
about motivation and compensation. I think the RSU is just a horrible, horrible way to compensate somebody if
you want to align interest with shareholders.
Now I’m going to move on to the birthing of unicorns. This won’t be quite as dramatic as Game of Thrones,
Mother of Dragons, but it’ll be the financial equivalent.
This is how IPOs (Initial Public Offerings) used to work a long time ago in Silicon Valley. Apple went public in
1980 with a $1.8 billion market cap. Microsoft in1986 at $780 million. Cisco went at $224 million.
More recently something different has happened. Google went public at $27 billion and then Facebook waited
until it was worth $100 billion to go public. This is causing anxiety.
These are two people you may or may not know. On this side is Yuri Milner of DST (Digital Sky Technologies).
Yuri invested almost a billion dollars in Facebook at about a $10 billion valuation as a private company. I don’t
know exactly when he got out, but it’s worth $300 billion today, so you run the math.
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This is Scott Shleifer of Tiger [Global Management]. He invested $130 million in JD.com as a private company
and returned about 6 or 7 billion dollars to shareholders.
Now if you’re working for one of these firms and you see companies going public later at $100 billion and you
see people like Yuri and Scott making tons of money by investing in private companies, you have FOMO, fear of
missing out.
It’s a well-studied behavioral science problem that causes misjudgment error, and these firms and many others
and probably many of your firms decided they were going to do what Scott and Yuri did and dive into private
market investing, which created the unicorn. That’s exactly what created the unicorn.
Today there are over 200 private companies that are valued at over a billion dollars, and most of them have
raised over $100 million each.
I call this the great experiment that’s never been done before because we’ve never crammed this much private
capital into immature private companies ever. We’ve put way more money into these companies than was ever
considered in 1999, and there will be consequences.
Let me tell you a little bit about what’s reinforcing this and making it worse than it could possibly be. Venture
Capital has put money in entrepreneurs. They then raise money from late-stage investors and mark up what the
company is worth. That price is then shown to their limited partners (LP) who then give more money to these
guys because they’re doing such a great job.
They even get paid. They get paid on the fact that this guy got this guy to write a check at a higher price, and it’s
measured that way. Now let me show you the most important slide in my entire deck.
My industry has record high IRRs (internal rate of return) right now and almost zero liquidity, no M&A (mergers
and acquisitions), no IPOs. Is anything wrong with this? This is a classic mark-to-market accounting problem,
and it’s going to come unwound. It has already started to come unwound.
You’ve probably read about this. I noticed it’s on the cover of the Wall Street Journal again today. Raise money
at $9 billion. LPs marked it at $9 billion. This is a company called Zenefits. They were doing about $25 million in
revenue and raised money at $4.5 billion.
That $4.5 billion was then marked to the LPs. Not only do they get the bonus. They make distributions based on
these returns. They told people they’d do $100 million in sales in 2015. They did about $60 [million]. They’ve
since had to fire their sales force.
A board member told this guy, Parker Conrad, he wasn’t being ambitious enough. So he wrote a program to
automate filling out compliance exams for their sales force, and there are probably going to be criminal
investigations. It’s not worth $4.5 billion.
Palantir‘s financials leaked a week and a half ago. This company’s raised money at $20 billion, and it’s been
marked that way to the LPs and distributed.
It says they did $400 million in sales in 2015 with a 50 percent growth rate and were unprofitable. Most of their
work is really consultant-like work. So what is a consultancy that’s unprofitable at $400 million growing 50
percent worth?
I asked a group of investors. No one kept their hand up after $1.5 billion. So $1.5 billion marked at $20 billion is
a huge differential. By the way, within the past three months there were secondary trades around $17 billion.
This is what’s happening. This is how it’s coming undone. As a result you’re seeing markdowns across the board
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and across many firms, and then unicorns aren’t so beloved anymore.
What’s interesting once again is that in an attempt to find returns, you get the exact opposite. You get losses.
How does this happen? What did they miss?
First of all, this strategy works great if DST and Tiger are doing it by themselves. But when everybody jumps in
the game, it gets a lot harder, and this is just classic consensus versus non-consensus thinking, contrarian
investing.
Here’s the bigger factor: the money affects the ecosystem. They assume that if you do this, there won’t be any
ramifications, but there are many, many problems. These companies have raised more money than ever.
These companies don’t have capex. They don’t build stores. They don’t build factories. If you give them more
money, they hire more people and they create bigger burn rates, and they get further away from their core unit
economics. It’s hard to know if they’ll ever bring it back together.
One thing I didn’t put on here: a lot of people think that Steve Jobs’s greatest contribution to design was that he
created constraints. He wouldn’t tell the team what to do. He would tell them it has to be this thin or this tall or
weigh this amount, and you go figure it out.
I think the same thing is true with startups. If you have a constraint, you make better decisions. If you have
unlimited constraints, you do everything. You make worse decisions, and I think the quality of execution in these
companies is way worse than it would have been had you not handed out all the money.
Then it creates excess competition, and I think this is now impacting the mid-market public Internet stocks
because there’s just such an excessive amount of money.
So if any of you track the new lending companies, OnDeck’s stock is at $5 and Lending Club’s is at $3. Well,
SoFi and Avalon have raised a billion dollars of private equity, and the SoFi CEO said the reason Lending Club’s
not working is because they’re not ambitious enough.
Now I personally don’t think lending and ambition are two things you want to combine, But the problem is
excessive competition. You can go through almost every vertical and there’s someone out there who’s willing to
lose $200 million, $400 million, in this case $600 million in a year, and it’s very hard to be profitable if your
competitor’s able to do that. So this is just overfunding the category.
Then lastly the IPO process provided immense value that people didn’t think about. Companies prepare for this
event. They take it remarkably serious. They get GAAP compliant. The auditors take it more seriously.
This is probably just an amazingly hard thing to fathom. The auditors try harder when you’re about to go public
than they do when you’re private. I guarantee you. And that’s why you get statements right before you go out
and this kind of thing because they send it to national.
Most of these companies are raising money without audited financials. Some of them, they get the audit. In a
private company you might get audited financials for 2015 done in November of 2016, so no one knows if the
math that’s put on the PowerPoint is even going to be accurate, if it were properly accounted.
The bankers, everyone makes sure you’re ready, and companies and management and boards consider the
weight of being public, and they don’t think about this relative to being private.
Here’s a quote from Mike Moritz who’s one of my peers at Sequoia. He wrote a fabulous article about ”subprime
unicorns.” It’s not very long if you want to read it, it was in the Financial Times. And he says, “It is easier to
conceal weaknesses, present an aura of invincibility and confound investors as a private company that can
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escape by making fewer disclosures than as a publicly traded one.”

I would say that we created a playing field ripe for over-promotion because everyone was being encouraged to
be a unicorn, and people were putting together PowerPoints that were fantastical and didn’t adhere to any of the
same principles that you normally would see in an IPO process. I think you’re going to see a lot more companies
like the three that I highlighted over the next 18 months.
This one’s really short, and then I’ll turn it over to Q&A. This is actually someone I know well, a guy named Nick
Hanauer. He was an early investor in Amazon.com and then invested in this company, Avenue A/aQuantive that
Microsoft bought for $6 billion in ad space.
So he’s done really well for himself. But he’s become a very outspoken person on minimum wage, and he
pushed to have Seattle go to $15. And now he wants Seattle to go to $28. Others have followed suit. You
probably read about New York and California now going to go to $15.
When Nick talks about this, I’ll just highlight one of the things he says is most of the job growth has been in
service jobs, and he says 39 percent is in food. He talks about waiters and waitresses.
I live in Silicon Valley, and I was an investor in OpenTable, and there are some new companies that look a little
bit like OpenTable that often call on me. One of them is called E la Carte, and this is their product called Presto.
and the company’s just been kind of middling along. And this one is in Dallas called Ziosk. These things sit on
tables and replace waitresses and waiters.
I went and visited him two weeks ago, and his inbound leads have never been higher there in Seattle, New York,
and California. I don’t think Nick intended to accelerate the demise of waiters and waitresses, but he may have
in fact done so with his efforts. And these are articles about this technology now taking off. I am highly confident
in low- and mid-service restaurants that these will become pervasive in the next five or ten years.
So here’s my summary on this. In each of these cases, even in the Uber case, I think you had a biased and
passionate advocate who had a problem they wanted to solve that they just felt extremely passionate about.
In the professor’s case, I think he just thought that the investors were being silly, and he wanted to prove that
they were being silly. In the other three cases, I think people felt like either something wasn’t fair or it was a
problem they needed to fix, and so they were looking for a very blunt instrument to fix it.
I think all of these things exist in very complex systems, and that’s why I reference the book Complexity, because
you have interconnected state machines, multiple variables. You have human behavior. And I think you need
systematic thinking to look at these approaches. You have to think through all the inputs. How is A going to
cause B going to cause C? And what are all the ramifications that are going to play out when you move to a new
solution?
I don’t think they did that in any of those last three examples. Then the ultimate irony is in three of the cases you
end up in a worse situation than the problem you intended to fix, which I think happens frequently. Those are my
prepared remarks at 42 minutes, so I'm three minutes under where I was supposed to be.
Question: Thanks very much. You mentioned you’d only heard of Professor Damodaran two and a half years
ago, but what you may not know is among quants he has a tremendous reputation, not because he’s as exciting
a stock picker as Jim Cramer, but because he’s put his valuations online, in spreadsheets, and has
demonstrated that you don’t have to understand the companies a lot. Some fairly simple metrics can give you
good answers.
So I have a hypothetical for you. Let’s say you wanted to know the total value of all private technology
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companies. Would you trust the professor’s calculation or the sum of a survey of the board members of these
companies?
Bill: The professor. Yeah, I would trust the professor. The reason I say that is there’s an amazing amount of
optimism in my industry, and maybe it’s a requirement for the job.
I don’t think if you were just inherently a skeptic you’d do very well in venture capital, but there’s just an inherent
amount of optimism. And this goes in cycles, but in my industry in the past five or ten years, a lot of money’s
been given to people who have never been investors.
They celebrate their operating history, but they don’t reflect whether they have any investing credentials or
credibility, and I don’t think they understand even how capital markets work. That’s part of what’s led to the
problem.
Question: This is really interesting. Thanks. You gave examples where humans got it wrong and missed by a
mile. One of your points in your conclusion was these instances require systematic thinking.
Do you believe that machines would have been better? And in particular in some of the examples you gave, I find
it hard to construct a narrative where we could build a machine that would have figured out what the people
didn’t.
Bill: This is a subject that I think other speakers are going to have a lot more knowledge on than myself. I’m
exposed to it a little bit because my industry tends to get hyper-excited about certain themes and go a little nuts,
and one of them right now is machine learning and AI (Artificial Intelligence), and we’ve studied internally the
types of problems that work well and those that don’t and ones that might be investable or not.
I think that the types of problems that I highlighted would probably be some of the last things that would be
possible just because of all the complexity that I mentioned. Some of these decisions are based on how other
humans react, and that’s constantly changing. It’s just a very complex surface area but, once again, I’d maybe
re-pose the question to someone who knows more.
Michael: Pedro, do you have a thought on that?
Pedro: Boy, do I have thoughts on that. [Laughter] I mean my thought is that, yes, I agree with you. These are
probably some of the harder things for machines to do today.
I think there are a lot of things that a machine learning system might notice that people wouldn’t just because it’s
looking at a lot of signals that people aren’t, that people have forgotten about. Suddenly one of those signals
starts to be really clear, and I think there are cases where that’s happened, and that might be possible with some
of these things.
One advantage that the machines have is that they can look at more of the picture than the humans can. If that
means they get more confused, then it’s bad. It also means that they actually understand what’s going on better.
Your reference to Mitch Waldrop’s book I think is a very interesting one because this is really what it’s all about.
The behavior of the complex system is different from the behavior of the individual parts, and people just look to
model the behavior of the individual parts.
Today most machine learning algorithms are also just modeling the behavior of the individual parts. But the better
algorithms actually start to model systems as a whole. And I think once you do that you can do a lot better.
Bill: Of all of them, I think that compensation would be the one that it could potentially figure out and nail if I’m
right about my thesis.
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Question: How do you see the imbalance on your scale slide playing out, and how does that impact what
you’re doing?
Bill: I think about that every single day. The part I left out in the unicorn story that I think is inherently true is that
the low interest rate environment on a global scale is having a remarkable impact on the amount of money that’s
willing to come into my field and others.
Even today after those stories have blown up, I could probably take 20 meetings with people who want to put
more money in my industry in the next week, and these are inbounds that we’re deferring. A lot of it’s coming
globally, out of Russia, the Middle East, China, looking for global diversification. There’s just vast amounts of
money, and so I don’t know what it will take.
A lot of these companies also have raised so much money that they don’t run out right away. And so this shake-
up started October/November 2015. It’ll probably take a full 18 months after that when people literally run out of
money before you start to see catastrophic effects or behavior change.
Now some of the unicorns I’ve said, though, become zombies. There’s a lot of different metaphors. I think
companies like Zenefits have done massive layoffs of their sales force. What I mean by zombies is they’ve given
up on the growth trajectory that was used to raise the money at the super high valuation, but they have the cash,
and so they downshift, and they’re no longer chasing the gold they once were. That company might stay around
for a very long time.
Another factor that played a role, especially because some of you might be considering joining this wonderful
dance, is a term in private investing called “liquidation preference.”
It basically says that if you want, you can get your money back and not convert to common. And so if a company
sold for less than you paid, you can still get your money back. And that’s how the term works.
Most of the people that came into the market, like many of the names on that chart, thought that it would act
like debt, and so they thought their money was safe. Price doesn’t really matter because I just want an option on
this being the next Google or Facebook.
What they don’t understand is that returns paid out due to liquidation preference are a vast minority. What
happens when these companies stumble is they get recapitalized, and a couple of them like Foursquare and
Jawbone have already been recapped, so your liquidation preference goes away. The board just votes and elects
or the shareholders wipe you out, and most of the terms in these unicorn deals don’t have protection against
that. So it’ll take a while.
I had hoped that it would happen like in 1999 or 2001 because I feel a duty and obligation to perform on those
IRRs that our LPs have already been bonused on. [Laughs] It’s very hard to do payouts in this environment. It’s
very hard to get to liquidity with the weird expectation mismatch, with the ability to raise money at private prices
that are vastly different than public prices. The M&A’s not going to happen until the expectations shift.
Question: Are there things that are underappreciated publicly now about the Lyft/Didi/Uber phenomenon
where you feel highly confident that Uber succeeds? One, and then if could sneak in two, the phenomenon of
WeWork.
Bill: [Laughs] Is that a question?

Question: Yeah.
Bill: [Laughs] All right, we’ll pause for WeWork. The thing that’s happening with Uber’s competition—you
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mentioned Didi in China and Lyft here in North America—is tied to the capital environment that I’m talking about,
and so Lyft was burning.
They made a decision in 2015 to aggressively push the gas, and I don't know what their burn rate was but they
went up to $25 million a month. Then when they got some money from General Motors, they went to $50
million a month.
This is published. It’s out in the press. So there’s a $600 million run rate, and they started what I call renting
market share, buying market share. They might call it earning. I don't know.
What’s going on is if you had a systematic or scale advantage, in a normal company you might have one
company with no profits and one with 30 percent profits, and you say they have a scale advantage or a network
effect.
In this case there’s so much capital available that those things are happening with losses. One company loses
way more money per ride than another company loses per ride. None of this information’s public, so everybody’s
guessing what these numbers are, and you just won’t know.
There’s a famous Buffett quote I think where he says something like, “You don’t know who’s naked until the
water goes out.” And I think that’s the situation we’re in, in this case.
One of the things that’s happened that I think was unpredictable was how many people have come around to the
view in the video as opposed to the professor’s view, and there are lots of interested parties as a result.
On the second one, WeWork. [Laughs] Most of you probably don’t even know who WeWork is. We’re an
investor in a company called WeWork that’s very atypical for us as venture capitalists.
This entrepreneur, who’s really an amazing entrepreneur, named Adam Neumann, decided that we were
undergoing a cultural revolution in how people like to work and live, and that you could restructure office space to
meet that need. He basically rented whole floors of tall buildings, and he retrofitted them with much smaller
individual work units but a lot of glass and common areas and common meeting rooms.
If you ever go into one of these places, and you really have to understand what WeWork is, there’s a totally
different vibe than in a historic shared office space environment. And if you work for a two-person PR firm, you
feel like you’re going to work with a lot of people as opposed to just going in and closing the door and not
knowing anyone else.
There’s a big urban shift with millennials and a lot more people doing independent work And he believes this ties
in to all that. And he’s been quite successful at filling these and extracting a rent per square foot that’s
dramatically above what he paid.
The company gets a lot of questions—about how it should be valued, s it just a leased tenant kind of thing,
should it be valued like that, or should it be valued as a tech company which I think Adam would try and argue.
He recently launched a new product called WeLive that is basically a dorm for post-college people. And if you
look at rents in San Francisco, I think most starting rents are three grand a month. And so he’ll be providing a
product that’ll compete at like $1,100 a month and also will be more social than the others. So I don't know
exactly how to value it. Different people in this room I think even have valued it fairly highly.
Question: A question on this IPO situation because from where I sit it’s actually easier to IPO a company than
it’s ever been. This dichotomy of these companies staying private for as long as possible just doesn’t make
sense. On one hand you have an enormous amount of companies that are staying private, and on the other
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hand, it’s never been easier to go public.

Bill: So look. The change to the Jobs Act, especially the one that allowed the first filing to be private, has been
awesome. And you get two or three iterations with the SEC (Securities Exchange Commission) for those that
aren’t public, like Groupon had and some of these other high-profile ones, and then your window from flip to
price is a lot shorter, which is way positive, all good because there’s less risk in that period.
There are people that started a rhetoric four or five years ago in Silicon Valley that staying private was better. I
think there are certain entrepreneurs who were open to that message. Entrepreneurs who don’t like scrutiny, ,
and think that anything that’s rule-oriented is bureaucratic.
They put a whole narrative around it like it’s harder . . . they blame it on the stock market’s short-term thinking,
saying they want to do long-term things and no one’s letting them. I’d like to highlight that it never stopped Jeff
Bezos or Marc Benioff or Reed Hastings from doing anything.
But I think they’re basically afraid, and they don’t have to be. And some of these Silicon Valley boards, even in
the unicorns that you guys have helped fund, are just printing secondary.
Palantir did a secondary way above $10 billion, and so the entrepreneur’s getting paid, and they don’t have to go
through the scrutiny. I’ve told them, “Look, the minute you took on shareholders and the minute you granted
options to your employees, you were on a course. You have an obligation, and if you don’t feel that way, you
should get out of the chair.” That’s how I feel about it.
Imagine a quarterback who had a great college career saying, just a week before the draft, “You know I’ve
decided I’m not going to play.” And they go, “Why?” And he goes, “Well, the scrutiny on Sunday is going to be
horrible. They’re going to track every play, every pass. They’re going to record every metric. It’s going to be
horrible. I can’t operate. I can’t plan my long-term career with that kind of . . .”
If a quarterback did that, he’d be laughed out of the game. But there are people that are acting that way. And so
it’s been a playground for the past three or four years. And by the way you can go read these articles.
A new CEO went into Evernote and found out they were giving away two days of house cleaning services to
every employee. The perks are off the hook. No one’s looking at profits. No one cares.
Question: To return to the compensation discussion, Charlie Munger said something to the effect of, “Never
before have so many that earn so much earned so little.” And I think it’s one of the things that has changed in
my lifetime in finance. When I first came in, the people who made a lot of money were the partners at the end of
their career who had shown integrity and hard work and developed things. It certainly has benefited my bank
account today where pay for performance in the short-term has become a lot more, and I think through your
discussion it’s really in the tech sector too.
A lot of people got really rich at the end of the century. I think one of the things in our space that we need to
come back to is I think society really respects people who create fantastic organizations: Jeff Bezos, Warren
Buffett, Steve Jobs. But I think there’s this resentment of people who came in at the right place, right time, or
heads I win, tails you lose.
Don’t we need to move the compensation system to ten-year payouts? Turn it so that you’re partners again in
the business, and that you live and die with this business. To that end, you create benchmarks, and people
should be benchmarked to that industry space.
In our space, the benchmarks I think have become much more prevalent. So I was just curious about the
question around compensation.
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Bill: A couple different things I’d say to that. One, in non-tech sectors I’ve noticed from looking at other proxy
statements, which I do occasionally, is that they’ve moved to performance-based RSUs.
The thing about that is there are two problems with performance-based RSUs, although I think they’re better
than just simple RSUs. They requires the board to know what creates stock value, and Michael could lead a
discussion on whether that’s possible or not. Then second, often when they miss the metrics, you’ll see the
board decide to pay it anyway. Those are two problems with that approach.
The problem in Silicon Valley that you have, and maybe it’s a problem with compensation in general, is it’s hard
to go backwards. It kind of only goes forwards. And that’s a competitive thing driven mostly by Google, where
Google is now paying their top executives what I like to call Alex Rodriguez money. And it’s all what they call
GSUs (Google Stock Units), but it’s the same thing.
It’s essentially a cash paycheck of 15 to 20 million dollars a year, and our startups compete for the same talent
with companies that are paying that out. So I don’t know how you correct it. It’s part of another issue in Silicon
Valley with all these competitors having so much money.
We’re in a company called Hortonworks, which is public. Their private competitor, Cloudera, one day raised
$900 million. You say, well, what do you do? The playing field gets messy for everybody.
You can’t choose not to play. If you do, you yield the field and you lose all the customers. The same thing is
happening with this compensation issue. I could be idealistic and try and have a ten-year option period, and I
might not hire anybody in Silicon Valley.
Question: Thank you, Bill. You recently wrote “On the Road to Recap”, where you listed a bunch of challenges.
Two related questions.
One, what pushback or criticism have you received on that from VCs or otherwise?
Two, do you accept the thrust of the premise in some of the stuff you said today in saying you want to hedge
your unicorn exposure or get the other side, other than public market stuff or people who say lease space? Have
you guys thought of . . .
Bill: Thought of hedging?
Question: . . . Hedging, or how do you take the other side?
Bill: I’ve thought about it. [Laughs] I’ve gotten mostly positive feedback on that piece that I wrote. I’ve gotten
some negative feedback from VCs that were out trying to accelerate their fundraising on their paper marks which
is one of the points that I made, and it’s definitely been going on.
Q1 of 2016 had record high new LP money into new venture firms. I’ve even heard some of them are done with
their commitments for the year because they have so many allocations they can do. So there’s a rush to raise
which is just a signal that they know what’s going on. Hedging. Yeah, I’ve thought about it a lot. There are
certain stocks that you could look at that have exposure.
I look at something like Rocket Internet. There’s very little chance that that stock will do well if our companies
don’t do well. But I’ve never actually put anything on, and we’ve never hedged internally.
Some firms have started trying to sell. Founders Fund has sold a few positions. They sold a Lyft position and
Andreessen sold a Lyft position right when GM was buying. It’s not something that’s typically done in our
industry by people that sit on boards, but there are people starting to do it now. The minute everyone starts to do
it, it’ll accelerate the fall. Anyone else?
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Bill Gurley
Benchmark Capital
Michael: I do. What’s exciting? I actually saw an interview you did and you talked a little bit about some work
you did looking at health care. To be more positive, what kinds of things are exciting to you in the next few
years?
Bill: [Laughs] To be more positive. I’m an optimist. Let me just mention the health care sector. So there are
other investors who have spent way more time in it than me, and I probably spent two and a half years looking at
it. I just now feel comfortable making bets, and I’ve actually made a few very early-stage ones.
It’s a segment that’s ripe for technology to add value to. I’ve been involved with other vertical players like Zillow
or GrubHub or OpenTable or Uber, and you say, “Boy, you should be able to use this smart phone and all this
technology and fix this problem.” It’s a ridiculously messed up industry.
I have this theory that democracy and capitalism destroy one another if you give them time, and that decay is
happening most in telecom, health care, and finance where you have the most regulation.
The incumbents are very adept at using the regulation to prevention disruption—things like HIPAA (Health
Insurance Portability and Accountability Act). People think HIPAA is looking after their best interests. HIPAA’s
looking after the incumbent’s best interests. It makes it almost impossible to share data, and all the solutions you
would build to fix the problem require sharing of data, and there’s just all this kind of morass that happens.
I think every entrepreneurial endeavor someone takes on assumes a market-based approach, and our health
care system is not a market-based approach. The people paying for it aren’t the buyers. I think most people are
ignorant of the Recovery Act. We paid doctors to implement electronic health record (EHR) systems, and we
paid them 44 grand each.
It’s like an ERP (Enterprise Resource Planning) for doctors. To think about the ignorance of this decision is just
mind-numbing to me. Forty-four thousand dollars to not the top one percent but the top thousandth of a percent
to put in software that they didn’t want to put in anyway. And the reason they don’t want to put it in is because
they’re not in a competitive environment that requires them to evolve.
Then it gets stupider if that’s a word. The thing you’d worry about is if a doctor was paid to put in something is
that he wouldn’t use it. Right? So two years later they give them $17 thousand if they can prove they’re using
the software you paid them $44K to use. And this came from our federal government. They wrote billions and
billions of dollars of checks to doctors, the downtrodden doctor, to put in software.
By the way, this is how hard it is for a startup to do well. In order for your software to qualify for the EHR
payments, it had to have a certain set of features, and there are Excel spreadsheets you can find on the Internet
where the government lists the product features required for a software solution. Now is there any chance a
disruptive software solution would be built that way? Zero. And that’s how messed up it is.
So it’s just hard to build systems that change when they’re structured that way. I'm enamored with the—talk
about incentives—the Singapore health care system. We’re at say 17, 18 percent of GDP (Gross Domestic
Product). Singapore’s at four. And on any broad-based health metric you can’t find a difference. And what they
do is everyone’s a payer.
The rich pay 80 or 90 percent of their bill. The poor pay 10 to 20 percent of their bill. But no one’s taking on
work that they’re not shopping for. I quite frankly think we need to get the employer out of the game. There’s no
reason the employer’s in the business. There’s all kinds of stuff that needs to happen. It’s difficult.
Michael: Any other areas that are more positive but not health care?
Bill: There’s a company that we’re working with called Stitch Fix that I mentioned last night that is taking a
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Bill Gurley
Benchmark Capital
Moneyball approach to women’s fashion, which is something you wouldn’t think would be possible. Each
customer that comes in fills in a 15-page profile where they talk about their size, their style, their geographic
area, whether they buy clothes more for work or for going out and that kind of thing.
Every item that comes into their inventory we collect 67 metrics on. How wide is the shoulder? How pliable is it?
The colors.
Then we start sending products to people and looking at what they keep and don’t keep. And there are over 60
data scientists in the company. They study the patterns, not only of an individual but also of groups and how they
apply to different things. It’s at the point now where the merchandisers that are creating new products will test
against our algorithms before they even build it.
So that’s an exciting use to me of machine learning in a way that’s applicable. Everybody else is saying that it will
give you an AI bot that you can chat with. It’ll be a lot of fun.
There was this great meme. If you’re into AI and chatbots, there’s this great meme going around Twitter of two
circles that were completely separate, and one of them said, “Things bots do,” and the other one said, “Things
humans need.” [Laughter] There’s no overlap.
Question: At the end you mentioned a little bit about paying attention to labor share and GDP and
technologists, and we’re kind of seeing some folks vote, and obviously that dictates a little bit of policy. How do
you feel that transition evolves over the next five to ten years?
Bill: It’s a question way above my pay grade because of all the different things it involves. I go back to the fact
that a few short couple hundred years ago like 98 percent of our population were farmers, and today it’s less
than one. We made that transition, and I don’t think anyone regrets that we made the transition.
That’s going to happen in a lot of new fields because of automation. I don’t know the solution. I don’t think you
can stop it, and I think if you tried to stop it, you would actually slow progress on a global basis—not for the
individual that’s impacted but for everyone else.
There’s a book that I’m a huge fan of called The Rational Optimist where Matt Ridley talks about the biggest
increases in the standard of living. They’re typically around innovation and the sharing of ideas and open
capitalism.
China’s unlocking for the past 20 years has probably been the biggest impact to standard of living. So slowing
technological change I don’t think helps the global standard of living, but it might help an individual’s situation.
But again that might slow it for everybody else. So it’s a difficult problem.
One thing that we could all do—and there’s actually a group of entrepreneurs out of Seattle that have created a
nonprofit, I think it’s called Code.org—is just promote programming everywhere. [Laughs]
There are engineers being hired into Silicon Valley companies out of university at $175K right now, and there is
a complete undersupply of jobs. China puts 35 percent I think of students into engineering, and we put five or
something.
We’ve created a social and cultural bias, the whole nerd thing. That’s a real problem for our country and for this
issue, and so do everything you can to get coding pushed into middle schools, high schools, that kind of thing.
Michael: I think we’ll call it there. Thank you very much, Bill. Great.
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Pedro Domingos
University of Washington
Pedro Domingos is one of the world’s leading experts in machine learning, artificial intelligence, and big data. He is
a professor of computer science at the University of Washington in Seattle and the author of The Master Algorithm:
How the Quest for the Ultimate Learning Machine Will Remake Our World. He is a winner of the SIGKDD
Innovation Award—the highest honor in data science—and a Fellow of the Association for the Advancement of
Artificial Intelligence. He has received a Fulbright Scholarship, a Sloan Fellowship, the National Science
Foundation’s CAREER Award, and numerous best paper awards.
Pedro is the author or co-author of over 200 research publications, and has given over 150 invited talks at
conferences, universities, and research labs. He received his PhD from the University of California at Irvine in 1997
and co-founded the International Machine Learning Society in 2001. He has held visiting positions at Stanford,
Carnegie Mellon, and MIT. His research spans a wide variety of topics, including scaling learning algorithms to big
data, maximizing word of mouth in social networks, unifying logic and probability, and deep learning.
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Pedro Domingos
Michael Mauboussin: I’m thrilled to introduce our next speaker, Pedro Domingos. Pedro is a professor of
computer science at the University of Washington and a leading expert in machine learning, artificial intelligence,
and big data.
Last fall, I had a series of meetings with senior investment managers in London. What struck me was that in every
conversation, the topic of machine learning came up unsolicited. Determined to learn more about it, I read Pedro’s
book, The Master Algorithm. I found the book useful and illuminating on multiple levels, and recommend it highly.
By the way, the money page is 240. Make a note of that. You’ll hear more about the book in a few moments.
As I mentioned a moment ago, you can listen to Pedro for a primer on machine learning and to get a sense of
where these capabilities may take us. But you can also listen to understand how the various approaches and
challenges in machine learning apply to everyday thinking. Machine learning and AI represent a new and very
exciting means of attaining knowledge.
Please join me in welcoming Professor Pedro Domingos.
Pedro Domingos: Let me start with a question: where does knowledge come from? Until recently, knowledge
came from just three sources. The first one is evolution. That’s the knowledge that’s included in your genes. The
second source of knowledge is experience. That’s the knowledge that’s included in your neurons. And the third
source of knowledge is culture. It’s the knowledge that we acquire by talking with other people, reading books,
and so on.
Now, what’s new in just the last few decades is that there is a new source of knowledge on the planet, and
that’s machine learning. It’s computers. Computers are discovering new knowledge from data.
I noticed that the emergence of each of these new ways of discovering knowledge was a major landmark in the
history of life on Earth. I mean, evolution is life on Earth itself. Learning from experience is what distinguishes
mammals from insects, and culture is what makes humans as successful as they are. It’s what makes us who
we are.
I think that computers as a source of knowledge are going to be every bit as momentous as every one of these
three, and we are just getting started. Already, we see a lot of the impact. Notice also that each of these new
sources of knowledge, operated orders of magnitude faster than the previous sources when they first appeared
on the planet. So learning from experience is orders of magnitude faster than learning from evolution, and
learning from culture by just hearing something that somebody tells you again is a lot faster than learning from
experience.
And learning from computers is going to be even faster. Computers can discover knowledge at a rate that is
unimaginable for human beings. Corresponding to that greater speed, you also discover orders of magnitude
more knowledge with each of these new ways than you did previously.
In fact, Yann LeCun, who is a well-known machine learning researcher and now the Director of AI Research at
Facebook, says that in the future, most of the knowledge in the world will be discovered by computers and will
reside in computers.
So I think we’re at a point where all of us need to understand, not at a necessarily very detailed level, but
conceptually, what machine learning is and what it does. That’s what I am going to try to do in this talk.
Here is machine learning in one slide. In traditional programming, there have really been two stages in the
Information Age. The first stage was where we programmed computers to do things. When we want a computer
to do something, we have to write down an algorithm in painstaking detail explaining how that computer is
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supposed to do it.
And then, this is what happens: there is the computer, in goes the data, in goes the algorithm, and the algorithm
does something to the data to produce the output. For example, in goes an X-ray, in goes an algorithm to
diagnose cancer. Then it says oh, there’s a tumor here, and the output is either, yes, there is a tumor here, or
no, there isn’t one. This is how everything in the Information Age has been built until recently.
Machine learning turns this around. What happens in machine learning is something that is very strange at first
sight but makes a lot of sense. Hopefully it will to you after this talk. The output is actually now going in, and
what comes out is the algorithm. So what we give to the computer is the data that we want it to operate on and
the output that we would like it to produce. The computer figures out how to turn this data into this output, and
then it produces that in the form of an algorithm.
Then that algorithm goes and does its usual job. For example, this might be a bunch of X-rays and this might be
the diagnosis for each of those X-rays. The diagnosis says yes, there was a tumor here, or no, there wasn’t a
tumor here, and the machine learning figures out how to decide whether there is a tumor or not by looking at the
pixels in the image. That goes on and on, and then a bunch of new patients come in and it starts doing this
automatically, at a fraction of the cost of a human pathologist and better. An algorithm that learns to do this in
half-an-hour does better than someone who was in med school for many years.
The amazing thing is that in the old way of doing things, for every different thing that you wanted to do, you
needed to write the new algorithm. If you wanted the computer to do the medical diagnosis, you had to program
it to do the medical diagnosis. If you wanted the computer to drive a car, you had to program it to drive a car.
But in machine learning, the same learning algorithm can do an infinite array of different things depending on
what data you give to it. A learning algorithm is a master algorithm in the sense that it’s an algorithm that makes
other algorithms.
In principle, the same learning algorithm, if it’s powerful enough, can learn absolutely anything that you want it to
learn provided you give it a sufficient amount of the right data. So how does this actually happen? Well, there are
a number of different paradigms in machine learning, a number of different ways of learning new knowledge, of
extracting programs and models from data.
One other thing—machine learning, in addition to being very useful and economically important these days, is
also a lot of fun and very fascinating because the main ideas in machine learning all come from different fields.
In fact, there are five main schools of thought in machine learning. Each one of them has its roots in a different
field, and each one has its own version of how to do things. Each one has its own master algorithm: an algorithm
that if you give it data from any problem, in principle, it can then learn to do what needs to be done for that
particular problem.
The first tribe that we’re going to look at are the symbolists and their origins are in logic and philosophy. They are
the most linked to computer science of the five tribes, and their master algorithm is something called inverse
deduction, which sees induction as being the inverse of deduction.
Then there are the connectionists whose idea is that we’re going to learn by reverse-engineering the human
brain. Your brain is the greatest learning machine on Earth, so let’s figure out how it works and do that on the
computer. They’re called connectionists because it’s all based on this idea that your knowledge is included in the
connections between your neurons, and their master algorithm is something called backpropagation.
Then there are the evolutionaries who say that the master algorithm is not your brain, but rather evolution. They
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want to figure out how evolution works and simulate that on the computer, and their master algorithm is genetic
programming.
Then there are the Bayesians who have their origins in statistics, and their biggest concern is with the uncertainty
of learned knowledge. All knowledge that is learned from data that is the part of induction is necessarily
uncertain, so the idea of Bayesians is to quantify that uncertainty, and so, their master algorithm is probabilistic
inference. It’s computing the probabilities of different hypotheses based on the evidence that you have.
And finally, there are the analogizers who actually have their roots in many different fields. The most important of
these fields is probably psychology. The idea here is that most of the learning and reasoning that we do is by
analogy. It’s by finding similar situations to the ones that we are in now, and then trying to extrapolate from one
to the other. Their most widely used algorithm is something called a kernel machine, also known as a support
vector machine.
So let’s start by visiting the symbolists and seeing what they have to propose. Here are some of the most
prominent symbolists in the world: Tom Mitchell at Carnegie Mellon, Steve Muggleton in the U.K., and Ross
Quinlan in Australia.
The basic idea behind this type of learning, that learning is induction, actually goes back to a 19th century
philosopher and economist named William Jevons. Induction is going from specific facts to general rules
whereas the inverse is deduction, which is going from general rules to specific facts.
Some of us can figure out how to do induction in the same way that mathematicians, for example, figured out
how to do subtraction because it was the inverse of addition, or how to do integration because it’s the inverse of
differentiation, and so on.
In mathematics, this has a very long and distinguished history. So for example, addition gives us the answer to
the question what is two plus two? It’s four, of course. That’s not the deepest thing I’m going to say in this talk.
Subtraction gives us the answer to the inverse question, which is what do I need to add to two in order to get to
four? And so, my idea of inverse deduction is actually to do the same thing but with induction.
For example, deduction gives us the answer to a question such as, “If I know that Socrates is human and that
humans are mortal, than what can I infer about Socrates?” And of course, it’s that Socrates is mortal. We know
how to do this very well. Deduction has been very well understood in logic and computer science and philosophy
for decades or even centuries.
Now, the tricky problem is induction. Induction is the answer to the question, “If I know that Socrates is human,
what else do I need to know in order to be able to infer that he’s mortal?” The answer, of course, is that humans
are mortal.
But you try and figure that out. If you can fill in this gap, now you have a new general rule that you can go and
apply to many other things in combination with other rules to answer questions that you may have never thought
of.
By this process of filling in the gaps in your knowledge using inverse deduction, you build up a knowledge base
of rules that is very powerful. In particular, this idea that you can combine different rules in different ways is
something that only the symbolists can achieve. None of the other schools of machine learning actually have that
capability and it’s a very important one.
Now, I wrote all of this in English. Of course, computers don’t understand natural language, so in a computer,
this is actually usually done using a formal language, such as first order logic. But the idea is the same.
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Symbolist learning is a bit like emulating the scientific method. It’s saying: here’s some data, let me formulate
some hypotheses to explain that data, and then test those hypotheses against new data, and then maybe refine
them or discard them, and so on.
What we’re really doing here is just automating the scientific method, except we’re doing it much faster and on a
much larger scale. And one concrete instantiation of this is what you see in this picture. The biologist in this
picture is actually not the guy in the lab coat. The guy in the lab coat is a machine learning researcher by the
name of Ross King.
The biologist in this picture is actually this machine. This machine is a complete robot biologist in a box based on
the principle of inverse deduction. They started out with a robot named Adam, and now the name of this robot is
Eve. There is only this one in the world so far, but of course, what’s interesting is that once you have a robot like
this, nothing stops you from making millions of them, and it can make progress in science millions of times
faster.
Eve looks at, for example, the biology of a particular cell type. It starts out with data, formulates a hypothesis to
explain that data by inverse deduction, then it designs experiments to test those hypotheses, and then it carries
out the experiments using gene sequencers and DNA microarrays, which is what’s going on here. And then, it
repeats the process. So it really is a complete robot scientist. In 2014, Eve discovered a new malaria drug. So
this is the kind of thing that you can do with this type of learning.
Now, the connectionists are skeptical about all of this. They say this type of learning is too abstract, too clean.
The way most learning happens is not the way a scientist or a logician or even a philosopher works. It’s messier.
It involves making mistakes and being embodied and all sorts of things like that. The idea of the connectionist is
that our competition in machine learning is the human brain, and we are far behind the competition.
So what you do in tech when you’re behind the competition is reverse engineering. You start out by copying it.
You open up their chip and you see what the circuit is, and you figure out how to do the same thing. The
connectionists try to do that with the brain. The brain is inside the skull and it’s got circuits and whatnot, and we
can try to figure out how it works. And this has indeed been a very productive approach to machine learning.
The most famous connectionist in the world is Geoff Hinton. He actually started out as a psychologist in the
’70s, and these days, he’s more of a computer scientist. He actually splits his time between the University of
Toronto and Google.
Jeff believes that the way the brain learns can be captured in a single algorithm, and he has spent the last 40
years trying to discover that algorithm. In fact, he tells the story of coming home from work one day very excited
saying, “I did it! I figured out how the brain works!” And his daughter replied, “Oh, Dad, not again.” [Laughter]
Now, he is the first to say that he’s had his ups and downs, but his quest is starting to pay off. In particular, he is
one of the inventors of this backpropagation algorithm which is used everywhere. Like, if you have an Android
phone, for example, it’s what’s doing the speech recognition, and the variety of things that backprop is used for
is truly mindboggling. One of its killer applications in the ’80s was in finance, predicting stock fluctuations and
foreign exchange fluctuations and whatnot. Two other prominent connectionists are Yann LeCun, who I already
mentioned, and Yoshua Bengio.
So let’s see in a nutshell how this all works. Biologists know roughly how neurons work, and we don’t need to
know more than roughly how they’ll work in order to do what we want. A neuron is a very interesting, it’s a very
unique type of cell; it’s a cell that looks like a microscopic tree. The trunk is called the axon, the branches are
called dendrites, and the roots are also called dendrites.
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The thing that’s interesting about neurons that makes them different from trees is that the branches of one
neuron make contact with the dendrites of other neurons. The points of contact are called synapses, and the
synapses can be more or less efficient.
Neurons build up a charge in their body, or soma. If the charge exceeds the threshold, then the neuron fires
what is called an action potential down the axon, which is quite literally a little lightning bolt. Your brain at work
right now is a symphony of these little lightning bolts going all over the place.
Then the charge goes down the axon and it goes to the synapses, and the more efficient synapses transmit the
charge better using a chemical process that is not important to discuss now, but the point is neuroscientists
believe that everything you’ve ever learned is encoded in how strong the synapses are.
Roughly speaking, when two neurons fire together, the synapse between them grows stronger, meaning that
next time around, the first neuron will have an easier time firing the second neuron. And so, we’re going to build
a mathematical model of a neuron, run it on the computer, build a big network of these neurons, and this is how
we’re going to learn things.
Here’s our mathematical model of a neuron. Notice that there’s a one-to-one correspondence between the
blocks in this diagram and the image of the neuron that I had before. This is the cell body, these are the
dendrites coming in, and this is the axon. So let’s suppose that we have a neuron, and this is your retina right
here. The inputs are just pixels. In general, there could be other layers of neurons, but let’s say they’re pixels.
Now, each one gets multiplied by a weight. Some will get multiplied by a larger weight than others, and these
weights are where the learning is going to happen. Learning in neural networks is basically just twiddling those
weights.
If the sum of these weighted inputs exceeds the threshold, then the output is one. Let’s say I’m looking at an
image of a cat and the neuron is doing its job. Some of the features, which are features of cats, exceed the
threshold so the neuron fires. Otherwise, it says, well, no, this actually doesn’t look like a cat, and the neuron
doesn’t fire.
This part is easy. When things get interesting is when we have a big network of neurons like this. How do we
train it? If you think about it, this is a very hard problem with no obvious answer. I have a huge network of
neurons and there is some little neuron here with some weight and the error is happening at the output. The
network is saying that this is a cat but it’s not a cat. Who is wrong? What weights need to change?
People first thought of neural networks in the ’50s, but they didn’t know how to solve this problem, and so,
things kind of died out.
But in the ’80s, they figured out this backpropagation algorithm, which is in essence a way to solve this problem.
The way backpropagation works is conceptually very simple. All it’s really doing is tweaking each weight in turn
saying if I increase this weight, will the error at the output go down or not?
Let’s say like this was a cat, this should have been firing, it should have been one, but it was just 0.3. So the
error is 0.7, and I need to reduce that error. I need to make the output higher. If I change this weight over here,
if it goes up a little bit, does that make my error go down? Or maybe if this weight goes down a little bit, that will
make the error go down.
Now, of course, doing it like this one weight at a time would be ridiculously inefficient, so what backpropagation
does is handle things in layers. So here is my input, and these purple circles are the neurons. Each neuron
computes its value and then the next layer of neurons can compute their values all the way to the output. When
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we get the output we compare it with what it should have been: did you say that it was a cat and was it a cat?
And then we see by what amount we were wrong and determine how much the weight should change. So what
I do is I propagate the errors, that’s the yellow circles, backwards through the layers, and I compute how much
each weight needs to change.
First I compute how much these weights need to change, and then based on the errors here, I compute how
much these weights need to change all the way back to the beginning. So I’m propagating the errors back
through the network in order to decide how much the weights need to change, and that’s why this algorithm is
called error backpropagation, or backprop for short.
Backprop turns out to be an incredibly powerful way of doing things, and just in the last few years, it’s caused a
revolution in things like, for example, computer vision, object recognition, video understanding, and speech
understanding.
Microsoft has a system, in Skype to be more precise, where it does simultaneous translation for you. You can be
speaking English on the phone with someone in China and they’re hearing Chinese, and vice versa. This is done
by a bunch of neural networks using this type of learning.
Companies like Google, Microsoft, Amazon, and Facebook use these types of networks not just for object and
video recognition but also to choose search results, to choose ads to show you and whatnot. In the press, this is
often called deep learning these days.
Why is it called deep learning? Because it’s training networks with many layers. In the ’80s, people figured out
backprop but they couldn’t really train networks with one so-called hidden layer, which is a layer that’s neither
the input nor the output. But now people actually know how to train networks with more layers.
Perhaps the best-known example of deep learning is what has come to be known as the Google cat network,
which was on the front page of the New York Times a couple years ago. What the Google cat network does is
learn to recognize all sorts of objects from watching YouTube videos. It literally watches hours and hours and
hours of YouTube videos, so maybe it should be called the couch potato network.
Some people actually think that all it recognizes is cat, but no, it recognizes cats and dogs and mice and people
and whatnot. The reason the reporter picked cats as the example is that this is the category on which the
network does best. This is because, I don’t know if you know this, but people really like to upload videos of their
cats. And so, there is more data on cats than on any other entity.
Now, the evolutionaries say, well, sure, backprop might be good for tweaking the weights of the brain, but what
made the brain was evolution. Evolution didn’t just make the brain, it made literally all life on Earth. So evolution,
not backprop, is the master algorithm.
The evolutionaries simulate evolution on the computer except that instead of evolving animals and plants, they
evolve programs. The person who first ran with this was John Hall, and he died actually just last summer. For a
long time, when he started out in the late ’50s, early ’60s, people used to joke that the school of evolutionary
computing consisted of just John and his students and their students. But then in the ’80s, things took off and a
lot of different people started doing evolutionary computing in all sorts of different areas.
And then John Koza actually developed this version of it called genetic programming that we’re going to meet
shortly. And then, Hod Lipson is another person doing very interesting things with this type of learning today that
we will also look at.
This is the basic idea of this type of learning, which John Hall called genetic carbons, because they’re algorithms
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that imitate what genetics does.
At any given time you have a population of individuals, and each of these individuals is defined by a genome.
Except that in our case, the genome isn’t going to be the DNA base pairs, it’s just going to be bits. In some
sense, DNA bits are the DNA of computers, so they’re just going to be bit strengths.
So each of these bit strengths defines a program, and then that program goes out into the world and does its
thing. It tries to perform whatever task we want it to perform, and it gets a fitness score. Again, this is very close
to biology.
The programs that do better get a higher fitness score than the ones that don’t do so well. And then, the fittest
individuals actually get to produce the next generation. You literally do crossover between the genome of a father
program and the mother program and you get genomes of their children.
And then, on top of that, you do random mutations again just like in real evolution, and you have a new
population. The amazing thing is that you can start this process with a population of random individuals and after,
say, a few thousand generations, they’re actually doing very useful and very non-obvious things.
For example, people in this area have been able to evolve things like radios and amplifiers starting literally from
piles of components. And along the way, they’ve actually amassed a lot of patents. They’ve gotten patents for
devices that were invented by genetic algorithms. They have, for example, amplifiers, low pass filters that work
better than the ones that were designed by human engineers.
But John Koza’s idea was that representing programs as bit strings is too low level. When I do crossover, I pick a
random point and then I use one genome up to that point and then the other genome after that point. This is
how nature does things. But it’s very messy. It’s very likely that I have something that is already a pretty good
program and then I cut it at a random place and it doesn’t do anything useful anymore.
So John Koza’s idea was a program. At the end of the day, we’re trying to evolve programs and a program is
really a tree of subroutine calls all the way down to simple things like doing additions and multiplications and
and’s and or’s. So he invented genetic programming to actually use the program tree itself as the genome.
Here is a very simple tree of operations. At the root, there is the multiplication of C by the square root of
something else, and let’s say I have picked the highlighted note from my crossover. One of the child trees is
going to be the tree with the white notes.
That tree is actually one of Kepler’s laws. It’s the law that gives the average duration of a planet’s year as a
function of its average distance from the Sun. It’s actually going to be proportional to the square root of the cube
of the distance.
A genetic algorithm can variously induce this from something like Tycho Brahe’s data that Kepler used, but it can
also induce much, much more complex things. It can induce whole robot routines, and it can induce programs
that do very nontrivial tasks.
And in fact, these days, the evolutionaries are doing things like evolving not just programs but real hardware
robots. This little spider here is actually a mechanical spider from Hod Lipson’s lab that was evolved.
What happens is that the robots start out as random piles of components in simulation. Once they’re doing well
enough, they get 3D-printed and they start to walk and crawl in the real world. There are spiders, there are
dragonflies that fly, there are things that look like nothing that you ever saw before, but they actually crawl and
walk and recover from injury and so forth. And in each generation, the fittest robots get to program the 3D
printer to produce the next generation of robots.
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So this is exciting and maybe also a little scary, right? If the Terminator comes to pass, [Laughter] maybe this is
how it’s going to happen. Of course, these little spiders are not ready to take over the world, but they’ve come a
long way from the random pile of parts that they started out as.
Now, most machine learning researchers actually don’t believe that imitating biology is the way to get to the
master algorithm. So the evolutionaries emulate evolution, the connectionists emulate the brain. But most
machine learning researchers have the attitude that, well, nature did things that way, who knows why and who
knows how good it really is. Let’s just try to figure out from first principles how we can learn optimally. Bayesians
are very much in this paradigm of figuring out what the optimal way to learn is, and as I said Bayesians have a
long history in statistics but also in machine learning.
More recently perhaps, the most famous Bayesian is Judea Pearl, who won the Turing Award, the Nobel Prize
of Computer Science in 2011, for inventing something called Bayesian networks. This is a very powerful type of
Bayesian model that is used for many different things now. Two other prominent Bayesians are David
Heckerman and Mike Jordan.
Bayesians take their names from Bayes’ theorem. Bayesian learning is all based on Bayes’ theorem, and in fact,
Bayesians love Bayes’ theorem so much that there is a Bayesian machine learning startup that actually had a
neon sign of Bayes’ theorem made and hung outside its offices for the whole city to see. So they really, really
believe in Bayes’ theorem.
Bayesians are actually known in the machine learning community as being the most fanatical of the five tribes.
They really have enormous religious attachment to their paradigm and they’re the first ones to say so.
They have to be because for 200 years in statistics, they were a persecuted minority. Statistics was dominated
by Frequentism, and the Bayesians had to get very hardcore in order to survive, and it’s a good thing they did
because they have a lot to contribute. These days with computers and better algorithms, they’re actually in the
ascendant even within statistics.
So what is Bayes’ theorem and Bayesian learning all about? The idea is that Bayesians, above all, are concerned
with the problem of uncertainty. They are obsessed with the fact that nothing I know do I ever know for sure.
Anything that isn’t used from data, I can never be completely sure is right.
So we need to quantify the uncertainty in the way we quantify probability. Then, we have a spate of hypotheses
that we’re considering and as we see evidence, we’re going to update the probabilities of each hypothesis.
Roughly speaking, the hypotheses that are consistent with the data will become more likely, the hypotheses that
are inconsistent with it will become less likely and eventually, there will be a winner. But there may not be a
single winner, and then you just have to average the hypotheses weighted by the confidence that you have in
them.
Bayes’ theorem is really just the little piece of math that tells you how to do this. It’s actually so simple that it’s
barely worth being called a theorem except for the fact that it’s so important. What it does is to help compute the
posterior probability of each hypothesis, which is how much I believe in that hypothesis after seeing the evidence.
But I start with my prior probability, which is how much I believe in each hypothesis before I even see any
evidence. And this is what makes Bayesianism very controversial. Most statisticians, in fact, most scientists will
say, well, you have no basis to make up these prior definitions. You’re just pretending that you’ve quantified
something that you know nothing about.
The Bayesian answer to that, however, is that you have to make those assumptions one way or another. You
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can make them implicitly or you can make them explicitly, and we at least are going to make them explicit, and
that’s healthy.
So you start with the prior, and then as the evidence starts coming in, the question that you ask is if my
hypothesis is true, then how likely am I to see this? And if my hypothesis makes the evidence likely, then
conversely, the evidence makes the evidence likely. My model is likely if it makes the world that I am seeing
likely. This quantity, the probability to the hypothesis of the data given the hypothesis, is called the likelihood and,
it’s also what frequentist statisticians use and what we all learn in Stats 101.
And when you do the product of the two, the prior and the likelihood, you get the posterior probability. There is a
normalization constant to make sure that everything adds up to one, but it’s not too important for our purposes.
You can do all sorts of amazing things with Bayesian learning, one of which is driving cars. Your first self-driving
car is probably going to have a vision network inside it. Google uses a massive vision network with hundreds of
millions of connections to decide which apps to show you.
One application of Bayesian learning that we are all familiar with is spam filters. In a spam filter, the two
hypotheses are: this email is spam or this email is not spam. You start out with a prior probability that, let’s say,
90 percent of emails are spam.
Then, the evidence is the contents of the email. So for example, if the email contains the word “free” in all
capitals, that makes it more likely to be spam. If it contains the word “Viagra,” that makes it even more likely to
be spam. [Laughter] And if it contains “free Viagra” with four exclamation marks, then it’s almost certain to be
spam.
[Laughter]
On the other hand, if it contains the name of your best friend on the signature line, that makes it a lot less likely
to be spam. And so finally, after looking at the evidence, you get a probability that the email is spam or isn’t, and
then you use some threshold of probability to decide whether to throw out the email or put it in the user’s inbox.
David Heckerman had the idea of doing this many years ago, and this was literally a grad student’s summer
project when he interned at Microsoft Research. These days, people use all sorts of different machine learning
algorithms for spam filtering, but vision learning is still one of the most widely used methods and one of the best.
Finally, we have the analogizers, whose idea is that all learning is analogy. The way we learn, the reason we’re
able to do the right thing in new situations is that we notice there are similarities to our previous experiences, and
then, based on what we did or what worked in those experiences, we figure out what to do in this new case. The
analogizers are a less cohesive tribe than the other five. They’re really just a bunch of different people that all do
learning based on this idea. But this is a very central idea in machine learning.
The most important analogizer is probably Vladimir Vapnik. He invented support vector machines, also known as
kernel machines, which until the height of deep learning, were the dominant machine learning algorithms. Even
today support vector machines are still the best method for tackling a lot of problems, not deep learning.
Peter Hart was one of the people who started the very earliest form of analogy-based learning, called the
nearest neighbor algorithm. We’re going to see what that algorithm is shortly. And then, there are famous
analogizers like Douglas Hofstadter, the author of Gödel, Escher, Bach. He actually coined the term analogizer.
He says he’s an analogizer, and Einstein was an analogizer, and that all these great discoveries and things all
happened through reasoning by analogy. So he very much believes that analogy is the master algorithm. In fact,
his most recent book is 500 pages arguing that all of learning, all of intelligence, is just analogy and nothing else.
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Interestingly, Gödel, Escher, Bach is really a book that has more to do with the symbolist type of machine
learning, with logic and whatnot. But the entire book is an extended analogy between Gödel’s theorem, the
music of Bach, and the art of Escher. So the whole learning by analogy was already latent in his thinking, even
back then.
So how does learning by analogy work? Let me explain it by way of proposing a simple puzzle to you. I’m going
to give you a map of two countries, and I’m going to fancifully call them Posistan and Negaland because one is
going to have the positive examples and the other is going to have the negative examples.
So for example, when we’re learning to recognize cats, we call pictures of the cat the positive examples and
pictures of dogs and everything else negative examples. And what I’m going to tell you is where the main cities
in Posistan are on the map. So here’s a Posistan city, here’s another one, there is the capital, Positiville. And the
same thing for the main cities in Negaland.
Another question that I’m going to ask you is where is the border between these two countries? I just told you
where the main cities are, and of course, you can’t know for sure where the boarder is going to be because the
cities don’t determine the border.
But if I give you a piece of paper with these things marked on it, you can probably roughly put down where the
frontier should be. And the nearest neighbor algorithm is really just using the following idea to do this: I am going
to assume that a point on the map is part of Posistan if it’s closer to a city in Posistan than to any city in
Negaland.
So I’m going to break up the map into the neighborhood of each city. The neighborhood of a city is the points
that are closer to it than to any other. For example, the neighborhood of this example, here is this area. And
then, the region of the positive class is just going to be the union of the neighborhood with the positive cities.
Even though it’s a really simple algorithm, notice that at learning time the nearest neighbor algorithm consists of
doing exactly nothing. You do no work. Sometimes this is also known by the name lazy learning. It’s like, oh, I’m
lazy, I’m not going to study for the exam, and then, when I see the questions, I’ll make something up. Like, your
Mom told you that procrastination is bad, but actually, in machine learning it can be very powerful. It can be very
powerful because this frontier that is only implicitly being formed can actually get very, very intricate.
In fact, what Peter Hart did was prove back in the ’60s that you can learn any function in the world just by using
the nearest neighbor. To be more precise, if you give this enough data, it can learn absolutely anything.
Now, the nearest neighbor has a couple of shortcomings, one of which is that if you look at it, this frontier is kind
of jagged. The real frontier is probably smoother than that.
The other is that if you think about it, I’m actually wasting a lot of time and space here by remembering cities that
I don’t need to. For example, if I took out this city and, in fact, if I took out positive itself, if I just erased them
from the map, nothing would change.
The reason nothing would change is that this neighborhood would just get absorbed by the neighborhoods of the
nearby cities and the frontier itself would not change. The only thing that I really need to remember are the
examples that keep the frontier as it is, where it is. For example, if I took this out, then the frontier would move.
Those examples are called the support vectors—vectors because examples in machine learning are usually
represented as vectors, and support vectors because they’re supporting the frontier.
Vladimir Vapnik invented support vector machines, which in essence solve both of these problems. They figure
out exactly which examples you need to keep, and they also learn a smoother frontier. The frontier can come
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from much more general classes of curves than just a piecewise straight line.
The way support vector machines do this is also quite intuitive. Suppose I told you to start on the south end of
the map, and you have to walk all the way to the north, always keeping the positive cities on your left and always
keeping the negative cities on your right.
We know how to do this. We start walking, we go all the way up there. But there is a twist. You have to give all
the cities the widest possible berth. Imagine that the cities were mines and this whole thing was a landmine. You
wouldn’t just walk anywhere. You would stay as far away from the mines as you could while still doing the job.
You would try to maximize your margin of safety, and this is, in fact, how support vector machines work. They try
to maximize the margin between the frontier and the examples of each class. By avoiding going close to here, I
actually avoid going into a region that perhaps actually is negative even though I am not sure.
Analogy-based learning has been used for all sorts of things. It’s one of the oldest and best established types of
learning. But one that we are all familiar with is recommender systems. Netflix, for example, needs to decide
which movies to recommend to you.
In the early days, people tried to recommend things based on the properties of the audience. It says, well, you
like action movies but you don’t like movies with Arnold Schwarzenegger but you like movies with this director,
etc. This turned out to not work very well because taste is subtle. Whether or not you will like a movie is not a
simple function of its properties. Using other people as a resource works much better.
What I need to do to recommend a movie to you is look for people who have similar tastes. And I know that their
tastes are similar to yours because you’ve given similar ratings to movies. If there is someone that gave five stars
when I gave five stars, gave one star when I gave one star, and gave 5 stars to a new movie that I haven’t seen,
the system hypothesizes that I’m going to like it as well. This is really just an application of the nearest neighbor
idea in this particular domain, and it works shockingly well.
Three-quarters of the movies that people watch on Netflix come out of the recommender system. This is how
important it is to their business. And Amazon, of course, also has a recommender system that you’ve all met. A
third of what Amazon sells comes out of the recommender system.
This makes a huge difference to their bottom line and, in particular, how accurate this is makes a huge
difference. Every e-commerce site worth its salt has one of these systems. These days people use all kinds of
different algorithms to do this, but the earliest one was this type of similarity-based learning, and it’s still one of
the best.
Let’s take a step back now. We’ve met the five main tribes of machine learning. We’ve seen that each one of
them has a problem that it can solve better than the others, and each one has an algorithm it uses to solve that
problem.
For symbolists, the problem that they really care about is learning knowledge that they can then compose in
different ways. They can be very flexible that way, and they discover that knowledge through inverse deduction
by filling in the gaps in deductive reasoning.
Connectionists emulate the brain, and the problem that they solve is called the credit assignment problem. It
probably should be called the blame assignment problem because it’s deciding who needs to change when
something goes wrong. Their algorithm for doing that is backprop.
The evolutionaries discover structure. The connectionists have to start with a predefined architecture and then
change the weights, but the evolutionaries actually know how to evolve that structure in the first place. The most
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sophisticated way they do this is via genetic programming.
Then there are the Bayesians, who care about the problem of uncertainty. Their answer to that problem is
probabilistic inference.
And then finally, the analogizers can reason by similarity. As a result, they can function in all sorts of situations
where the others would completely fail. For example, if I just have one positive and one negative example, the
other methods don’t know what to do, but with nearest neighbor, you just put a straight line between them,
which is quite sensible.
They can also generalize farther. For example, Niels Bohr’s original theory of quantum mechanics was based on
an analogy between the atom and the solar system, where the nucleus was the sun and the planets were the
electrons, and so on. So with analogy, you can actually generalize much farther than the other methods can. And
now, each of these tribes very much believes in its own master algorithm.
For example, these days, deep learning is really going like gangbusters and some of the connectionists think
backprop is all they’re going to ever need. But I think the truth is that precisely because each of these problems
is a real problem, none of the tribes has the whole answer. The whole answer is one algorithm that actually
solves all five. That’s when we will truly have a master algorithm.
We need a grand unified theory of machine learning in the same sense that the Standard Model is a grand
unified theory of physics because it unifies the different forces, or the central dogma is a grand unified theory of
biology, and so on.
So what might that look like? I know a lot of us have been doing research on this for a while and we eventually
made a lot of progress and are getting fairly close. The learning algorithms that I describe all look very different,
so it seems very unclear how you could possibly unify them. In fact, some people have argued that it’s
impossible.
But it becomes a lot easier once you notice that all learning algorithms are really composed of the same three
parts. And so, all we have to do is unify each of these parts in turn.
The first part is representation. It’s the choice of language in which you are going to write the program that you
learn. Now, human programmers will use languages like Java and Perl and whatnot. Typically machine learning
people use more abstract languages like, for example, first order logic, but the principle is the same. It could be
differential equations if you’re modeling a physical system where you need to choose that. So that is the choice
of representation.
A natural thing to do here is unify first order logic, which the symbolists already use. But we need to unify that
with what the Bayesians do because we need to handle probability, which logic doesn’t.
We have done that, so now we have this probabilistic logic. For example, the best known one is called a Markov
logic network, which combines first order logic with graphical models. Examples of this are vision networks and
Markov networks.
This language is essentially the same formulas as in first order logic, and a formula is just like a sentence in
English. In fact, sometimes people call them sentences except it’s stated more formally in a way that the
computer can handle. But the twist is that we are now going to attach a weight to each formula. A formula that
has a high weight is a formula that you really believe in, so if the world violates that formula, then its probability
really takes a hit.
So you have all these formulas with all their weights, and the more formulas the world satisfies and the higher
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weight they have, the more likely the world is. And with this, we can represent pretty much anything that we
might want to represent in any field.
Now, the second part is evaluation. We need a score function to tell us how good a candidate program is. One
of the score functions to use is posterior probability, which you already heard about, but more generally, the
evaluation function actually should not be a part of the algorithm. It should come from the user. It’s you, the user,
who should tell the learning algorithm what it’s supposed to be optimizing. So if you’re a company, the evaluation
function might be return on investment.
If you are a consumer, it might be some measure of your happiness. It’s for you to say. And then, finally, what
the algorithm has to do is optimize. Finding the program or the model in that big space defined by the language
achieves the maximum score.
And now here, there’s a very natural combination of ideas from the evolutionaries and from the connectionists.
We need to discover the formulas, but a formula is just a tree of sub-formulas with conjunctions and disjunctions.
We can use genetic programming to evolve our formulas.
Then, we can use backpropagation to learn the weights within the formulas. I have my big chain of reasoning
that I use to explain the data, and with weights within the formulas in various places, I can just backprop through
that to optimize my weights.
So we are actually pretty close to having a complete unification of the five paradigms. And some people say that
or believe that that’s all we’re going to need. My sense, my intuition is that actually that’s not the case. It’s that
even after we have successfully unified these five paradigms, there will still be key new ideas that somebody has
to come up with.
There are some insights that we haven’t had, and in some ways, someone who is not a machine learning
researcher is better placed to have those insights than we in the field. Machine learning researchers are already
thinking along the tracks of a particular paradigm, which makes it hard for them to see outside that paradigm.
One of my secret motivations in writing my book was to get other people interested in the problem because
maybe they’ll have those ideas that we’re not having. So if you figure out how to do this, let me know so I can
publish it.
Let me conclude by just mentioning some of the things that I think will be possible with the master algorithm that
are not possible today. The first one is home robots. We would all like to have robots that do the dishes and do
the cooking and make the beds and maybe even look after the children. Why don’t we have them today?
Well, first of all, everyone agrees that you can’t build a home robot without machine learning. We don’t know
how to program even a car to drive itself let alone a home robot. The second problem is that a home robot, in the
course of an ordinary day, runs into every single one of those five problems, multiple times, which means that no
single one of the five master algorithms is enough. If we unify them, then hopefully we will have what we need.
Here’s another one: all of the major tech companies have a project to turn the worldwide web into a knowledge
base that computers can understand and reason with. Google has the Knowledge Graph, Microsoft has Satori,
et cetera. The idea is that I do not want to just type in keywords and get back pages. What I want to do is ask
questions and get answers.
But for the computer to be able to do that, it has to understand the text that’s out there on the web. It needs to
transform that text into something like first order logic. On the other hand, the knowledge on the web is messy.
It’s ambiguous, contradictory, broken, and incomplete. It’s going to be full of uncertainty, so you need the
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probability as well. And so again at the end of the day, we’re going to need to unify those five paradigms in order
to be able to do this.
A very important problem that we hope computers will be able to solve one day is curing cancer. In a way,
diagnosing disease is a perfect application for machine learning. And indeed, for most diseases, learning
algorithms already do this better than doctors. In a way, what you need to do is recommend a drug for the
patient in the same way that you might recommend a movie or a book except that the problem is much, much
harder.
The reason we haven’t cured cancer is that cancer isn’t one disease. Everybody’s cancer is different and the
same cancer mutates as it goes along, so it’s very unlikely that there will ever be a single drug that cures cancer.
What we really need is a program that takes in the patient’s genome, the tumor’s mutations, the patient’s
medical history, and other relevant information, and then suggests a drug for that particular cancer. Or maybe a
combination of drugs. Or even designs a new drug.
There are already companies that are starting to do this and projects to pull together patient data and whatnot
because without that data of the tumors, the drugs, and the outcomes, we can’t do this. But at the end of the
day, it’s going to take modeling how living cells work, modeling how the gene regulation happens because it’s
when that goes awry that you get cancer.
And so, that’s going to require a lot of data like microarray data and gene sequencing. But again, it’s also going
to require more powerful learning algorithms than the ones that we have today because all of those five problems
keep turning up here.
Let me return once more to recommender systems. Today every company has its own recommender system.
That model is just a little sliver of you based on the data that they have. So Netflix has a model of your movie
tastes based on your movie ratings. Amazon has a model of what you buy based on what you did on their
website. Facebook has a model of you to choose which updates to show you, and Twitter has one for tweets,
and so on.
But this is not what I as a consumer really want to have. What I want to have is a single complete 360-degree
model of me learning from all the data that I ever generate, and then to have this model help me with the
decisions that I have to make at every stage of my life. Not just picking movies or books, but finding jobs,
deciding where to go to college, finding a house, even finding a mate.
Most marriages in the world today, or I should say in America today, start online, and the matchmakers are
learning algorithms, picking a potential list for people based on their profiles. So there are actually children alive
today who wouldn’t have been born if not for machine learning.
But the quality of the process is still very low because you can’t predict whether two people are going to be a
good match just based on their profiles. The more of their life you can see, the better you know them, the better
you’ll be able to do this.
We’re going to need to have that data pulled together, and there are a lot of interesting issues such as who will I
trust to do that? Will I trust one of these companies? What are the privacy considerations, and so forth?
Companies are all in a race trying to do this. Google has Google Now and Microsoft has Cortana. You see all of
these things coming out, but even if you have all that data, the learning algorithms that we have today would
actually not allow us to do this. The master algorithm would. Let me conclude there and take questions.
Question: In the field of empirical finance and historically, the concept is you have a hypothesis and then you
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test it using the data. Some of us historically have used the outputs of that to help make investment decisions.
There is sort of an egregious stand, if you will, that people who are thoughtful users talk about which is called
data mining.
Data mining is derogatory in empirical finance. Among a number of things, it’s overfitting models, it’s reacting to
outliers, it’s looking at datasets that are not representative of the big picture, having nonstationarity that does
process changes over time.
So not being as familiar with machine learning concepts and how that all works, how much of a problem is that in
your world and what are the techniques used to prevent egregious errors based on overfitting?
Pedro: Yes, overfitting is the central problem in machine learning. Every time that you have a powerful type of
learning like all the ones that I have described, this becomes a huge danger. You hallucinate patterns where
there aren’t any. And so you need to figure out ways to avoid hallucinating those patterns. And every one of
these paradigms has their different ways of doing this.
The simplest way is to make sure that you don’t believe your model until it makes correct predictions on data that
it wasn’t trained on. This is a really simple rule and breaking it is the number one mistake made by people who
do machine learning. If you do that, your results will be crap because you can just memorize.
Think of the simple nearest neighbor algorithm. You can memorize the data and it’s always perfectly accurate on
the past, but the problem is when a new patient comes along, or a new situation, will you do the right thing
there?
And so, one way to beat this is with a type of holdout testing or sometimes cross-validation as it’s called,
depending on how you do this. Every learning algorithm usually has at least one parameter that you can tweak to
make a tradeoff between overfitting and being blind to patterns that are there.
You want to be able to see the patterns that are there without hallucinating patterns that aren’t. In the case of
nearest neighbor, there’s a very simple parameter in the number of neighbors that you use. In general, people
don’t just use the single nearest neighbor; they use the k-Nearest Neighbors. For example, I find the k-Nearest
Neighbors to that patient and they vote, and the majority wins. If I increase k, I become less likely to overfit. At
the limit, if I use everybody, then I just predict the most frequent diagnosis.
Question: What is an optimal sample size for something like the nearest neighbor case?
Pedro: Well, it depends. We are in the days of big data. In fact, there are many domains where you have so
much r-sample data that you don’t even use all of it. There are, however, problems where you don’t have a lot of
r-sample data and, in particular, the most difficult problems are the ones where the phenomenon is continually
changing. So if you gather a lot of data, you are outdated, but if you don’t get a lot of data, you don’t learn the
phenomenon.
Those problems are hard and at the limit maybe you can’t solve them, but one way you solve them is by working
at multiple time scales and bringing in other knowledge. You really try to find what the constants are.
A lot of things are changing but some aren’t. And in particular, in cellular biology, the way the cell works actually
doesn’t change. The particular cancer that you’re seeing is new, but we know how to cope with that very well in
machine learning.
Question: I think a lot of the people in this room probably have seen The Matrix, The Terminator, Ex Machina,
etc. When computers reach singularity, this risk is real. What ethical guardrails are taking shape in your world?
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Pedro Domingos
Pedro: Yes, so it is very controversial whether computers will reach the singularity or not. Most computer
scientists do not believe that that will ever happen, but singularity means you have a learning algorithm that can
learn . . . imagine a learning algorithm that makes another learning algorithm. If it makes a learning algorithm that
is better than itself, and that one makes a better one, then we have a runaway intelligence.
This is actually what the concept of the singularity is.

Now, even if this happens, it doesn’t mean that each one is going to get better than the previous one. In fact,
the singularities that you imagine get this exponential growth, can’t actually go to infinity. Like all these
technology curves that look like exponential curves, at some point, you start to see diminishing returns. They
start out growing faster and faster, but then they taper off, and it’s going to be the same thing with intelligence.
Question: Do you see AI advancing to a point where it becomes a danger?
Pedro: No, exactly but let’s suppose that we will have very intelligent machines. Should we worry about them?
Right now, they are a problem to people like Elon Musk and Stephen Hawking who said AI is an existential
danger to humanity, which has gotten a lot of press and whatnot.
I don’t know anybody who is actually an AI expert that takes these ideas seriously. The reason they don’t take
them seriously is that AI, no matter how smart, is still just an extension of us. People have this image of AIs as
being agents that are going to have different goals from us and compete with us or wipe us out, but why would
that happen if we are the ones designing them?
The thing about Terminator and Ex Machina and all these Hollywood movies is that in them, the AIs and the
robots are always humans in disguise, because that’s how you make an interesting movie.
But real AIs, real machine learning algorithms look nothing like humans in disguise. In particular, their goals are
set by us. As long as their goals are set by us, the more intelligence they have, the better. Because if their set
goal is to cure cancer, you want it to be as intelligent and as powerful as possible.
In fact, what we really need to be afraid of is not computers getting too smart but rather them being too stupid.
People worry that computers will get too smart and take over the world, but the real problem is that they’re too
stupid and they’ve already taken over the world.
Computers are already making all these decisions about you and me, like who gets credit and who gets flagged
as a potential terrorist. They’re very fallible because they just lean on datasets and their programming.
So the dangers from AIs come from the EII (Enterprise Information Integration) not knowing enough to do the
right thing: from it not having common sense and misinterpreting what you say. Look what happened to King
Midas, who wanted everything he touched to turn into gold.
The way to avoid these things is to make the computers more intelligent, not less. So this idea that we should
limit the intelligence of computers in order to be safe is exactly backwards. Computers are already flying
airplanes, and soon they’ll be driving cars. The way to be safe is to make them more intelligent, not less.
Question: So maybe a similar question asked differently, what parts of human experience are not reachable
with the five that we have right now?
Pedro: That’s a good question and let me preface my answer with the following. Ten years from now, there will
be a lot more AI in the world than there is now. But the vast majority of that AI will look nothing like people, and
we will be completely unaware of it. It will just be doing its job in some corner of the economy.
A small percentage may look like people because, for example, if I have a home robot, one that’s very cute and
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cuddly and humanlike is likely to sell better than one that’s just a big hunk of metal. So these algorithms by
themselves are not that close to people, but you can imagine some generations forward having algorithms that
for their purposes do the things that people do.
Here the question would be, does that algorithm really have consciousness? This is actually something that
people already ask about some of these bots. Because they look like they’re conscious, people treat them like
they’re human.
And I think ultimately, we’re never really going to know that answer. How do you know that I am conscious? You
just assume that I am conscious because we’re similar enough that since you’re conscious, maybe I am, right?
You’re just doing analogical reasoning.
And people have this amazing ability to project human qualities onto things that behave even slightly humanly, so
the same thing will happen with intelligent robots. We will treat them as being conscious, whether or not they
are. I think it’s an interesting question whether they truly are conscious, but I think that we will never know the
answer to that question.
Question: You started off talking about the analogues between neuroscience and a lot of what we learned in
neuro were from anomalous incidents in history. You know, a guy getting a pole stuck through his brain, and so
on, and then someone discovers something.
There are a lot of positive anecdotes with AI and machine learning. To that, I think people are familiar with, the
Target ad that predicted a teenage girl was pregnant from her buying patterns.
There’s a startup now that is doing visual recognition, identifying images that we would mistake for pornography
that, in fact, are not. Are there examples where the computer is getting the opposite, where they get it
completely wrong?
Pedro: Oh, yes, there are examples galore.
Question: What are we learning from that?
Pedro: This question is closely related to the previous one although it doesn’t seem to be. When we see one of
these learning algorithms do something like, for example, recognize objects, we assume that it’s doing it the
same way that we do.
So for example, a computer learns to tell cats from dogs, and we assume that it kind of knows what a cat or a
dog is, but in reality, it doesn’t. It just picked up on some signal that allows it to distinguish cats from dogs.
One of my colleagues actually did the following experiment. He trained a neural network, one of these deep
models, to discriminate dogs from wolves, and it was 90-something percent accurate, so he was doing a very
good job.
But then they had this way of looking inside the network to try and figure out what it has learned, what parts of
the image that it was keying in on.
Now, what do you think it was keying on? Maybe the snout, maybe the ears? What it was focusing on was long
horizontal white patches in the image. Why was that? Because the images of the wolves were in snow for the
most part, and the images of the dogs were not. So what it really learned was how to classify snow. [Laughter]
And machine learning algorithms have an uncanny tendency to do stuff like this.
Now, one way to look at this is to say, oh my god, the algorithm is so dumb. But a lot of animals in the real world
make mistakes like this, too. If you take a cow and you put a square of calfskin rubbing against its side, the cow
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leaves its calf behind. Shocking, right? It’s that easy to fool a cow, and I know there are more examples like this.
But I would look at this as evolutionarily, nobody was playing pranks like that on the cows, [Laughter]. Cognition
has a cost. Cows use their energy in their intestine, whereas we use it in our brains. But even our brains are
extremely energy-intensive, so using the least amount of energy that will get the job done is fine.
Now if you will always meet wolves in snow and dogs not in snow, then you’re fine. The problem, of course, is
that one day you see a wolf in your backyard and maybe this will get you killed.
Question: Thanks. We heard in Bill Gurley’s talk before you the idea that all of the technological advancement
in AI and so forth might cause disruption for individuals, but be a big positive that creates growth at the level of
society. He cited the idea that 100 years ago, 99 percent of people worked in agriculture, and today, one
percent do. People found jobs doing other things that are better.
Do you feel similarly or are you more concerned that this Fourth Industrial Revolution is a different kind of
technological change that may leave fewer roles for human workers if we can recreate a lot of what humans do?
Pedro: This is actually a raging debate right now. There are the people who say that this is just the next stage
of automation. We’ve seen this story before in every culture, and there is nothing to worry about. It’s always
easier to see the jobs that disappear than the ones that appear.
The biggest effect of automation is that things become cheaper. People are now going to buy other things with
the same money. Or, things that were completely impossible become possible, and you have new jobs.
For example, there are millions of app designers in the world today. That job didn’t exist ten years ago. Farmers
in the 19th century worrying about the destruction of farmers’ jobs couldn’t possibly have imagined that one day
there would be app designers and other things like that, and all of us in this room for that matter.
But now, the counter to that is people who worry that this time is different. And the argument usually runs that
the Industrial Revolution automated manual work, but now we are automating intellectual work, and then there
will be nothing left for the people.
Now, where do I fall on this? I think we really need to distinguish the short to medium term from the long term. In
the short term, and by short term I mean the next decade, I don’t buy the idea that this time is different, because
AI is a very long road.
We’ve come a thousand miles but there are a million more to go, and they’re thinking about this time as going
the other million miles. That million miles will not happen in the near future. In the distant future, maybe we will
have computers and robots that do everything better than people.
I think what’s going to happen in that case is that we’re all going to be independently wealthy. And then, people
are already talking about these things like a universal basic income. But politically right now, it’s impossible to do
something like that because the great majority of us are producing and not receiving unemployment benefits.
But if you get to the point where more than half of the people are unemployed, and the democracy is in place, I
don’t see how people will not vote themselves very generous unemployment benefits and call it lifetime income.
They would have all sorts of very good moral justifications for that stuff. I think that will happen.
In the short term, I think what’s going to happen is there is going to be a lot of displacement. A lot of jobs will
disappear, and this is a real concern. For example, if I was a truck driver, I would be really looking at getting
another job right now because sometime within the next several years—and truck driver is the most frequent
occupation in the U.S.— a lot of these jobs are going to disappear. So we need to worry about what happens
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with the people who lose those jobs. It’s not that we have to retrain those people to be data scientists. Again, the
interesting thing that is happening today is that on the one hand, there are people who don’t have jobs, but on
the other hand, there are all these companies who are desperately short of qualified people.
So we need to train these people to be qualified for those jobs. Bill was saying we need more computer
scientists and more data scientists, but also, I think we need to empower people to retrain themselves and to find
the next job that they’re going to do. The unemployed truck driver isn’t going to become a data scientist.
Say the cost of trucking goes down, the costs of transportation go down, the costs of goods goes down, so a lot
of people have more money. Maybe now they buy better houses so there are more jobs for construction
workers. So maybe the truck driver becomes a construction worker, and construction work is very difficult to
automate.
One of the lessons that we’ve learned in AI painfully and that everybody should be aware of is that we used to
think 30 years ago that the easiest jobs to automate were going to be the blue collar ones. We thought that the
white collar jobs, which require education, were going to be hard to automate.
That has it exactly backwards. The hardest jobs to automate are things like construction work because they
require dexterity, moving around, not stumbling, seeing things that we take completely for granted. These are
tasks that took hundreds of millions of years to evolve.
On the other hand, doctors, lawyers, analysts, engineers, scientists, these are hard because we didn’t evolve to
do them. We have to go to college to learn how to do them. But that also means that the computers can learn
that much more than we can because we are evolving them for that purpose. So there are already a lot of white
collar jobs that have shrunk or disappeared and more of them will.
I think what’s going to happen in this ten-year future is that some jobs will disappear, but the majority of jobs will
not. They’re just going to change.
The way I do my job will change, and what I need to think about in my job is: what in my job can be automated
by machine learning algorithms? Could a machine learn to do what I do by observing me? If it is the case that
everything I do can be automated, then I need to get another job quickly.
But what will be the case for most people and in particular, most white collar jobs, is actually much more
interesting. It’s that some parts of my job can be automated but others can’t.
So what I want to do is I want to automate my job. The way to keep my job safe is to automate it myself, and
then I spend my time doing the higher value things that only I can do on top of what the computer has now
automated. People often frame this in terms of a race between humans and machines, but the real race is
between a human with a machine and a human without a machine.
A very good example of this is when Deep Blue beat Garry Kasparov. People figured computers were now the
world chess champions, end of story. But actually the best chess players in the world today are not computers
because for the time being, humans and machines have different strengths.
What you want to figure out is how do I use the computer to do my job better than I alone could do it or better
than the computer could do it? And I think for most occupations, this is what people should be preoccupied with.
Michael: We’re going to break for lunch, but I do want to ask one thing. Two years ago in this conference the
theme was prediction. And a number of our speakers felt that computers beating humans at Go would take five
to ten years. But in just the last couple months, we saw AlphaGo. Can you explain how AlphaGo works? Were
you surprised by how quickly they were able to do what they did in the game of Go?
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Pedro: Yes, that’s a great question. So indeed, if you had asked me a year ago how long it would take for
computers to beat humans at Go, I would have said I wasn’t sure. I would have thought probably a long time. So
what did DeepMind do that was so amazing?
Demis Hassabis is the guy who created DeepMind, and its initial success was in playing computer games, in
playing Atari games, using these deep learning algorithms that we just saw. Now, what Demis decided to do at
one point was ask why Go was so hard compared to chess or checkers.
Why was chess solved 30 years ago with no machine learning involved, just using search? The problem is that
within Go, the space of possibilities is way larger. And the problem with picking a good Go move is almost more
like a visual pattern recognition problem.
The way most game players work is they have these evaluation functions of the board. They say this is a good
board position because I have a piece advantage, control of the center, etc. I can enumerate those things. And
going back to the ’50s, what people did was they tried these things and they put weights on them. This doesn’t
work for Go. You ask a Go expert why they made that move and they can’t explain.
So Go is almost more of a pattern recognition problem. Pattern recognition is what deep learning is good at:
vision, speech, and whatnot. So DeepMind took these neural networks and plugged them into a classic Go-
playing search process, which again is a little different from the ones that people used before. There is a thing
called Monte Carlo tree search that Go players use to go from being a complete disaster to being as good as a
human amateur. That was already there, but the pattern recognition wasn’t. When you combine the Monte Carlo
tree search with the neural network’s thought by recognition, you get what DeepMind produced.
The other interesting aspect of it is that DeepMind got to where it is by initially learning from a big database of all
the Go games that it could find. That thing spent three months burning thousands of servers just playing against
itself.
And in fact, this is one of the oldest ideas in the whole field: self-play. The first known occurrence, at least
known to me, of the term machine learning is in a paper by a guy at IBM (International Business Machines)
Research in the ’50s called Arthur Samuel. He taught a computer to play checkers by playing against itself until
it was as good as a human being.
At the time, Thomas J. Watson who was the President of IBM, said that when this paper is published IBM’s
stock will go up by 15 percent. And it actually did because people’s perception of what a computer could do
changed. This is what’s happening with companies like Google today. It’s a combination of very new ideas,
semi-new ideas, and very old ideas that actually made this all happen, coupled with a lot of computing power.
Michael: I think on that, we’ll break. Thank you very much, Pedro.
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Cade Massey
University of Pennsylvania
Cade Massey is a Practice Professor in the Wharton School’s Operations, Information and Decisions Department.
He received his PhD from the University of Chicago and taught at Duke University and Yale University before
moving to the University of Pennsylvania. Cade’s research focuses on judgment under uncertainty—how, and how
well, people predict what will happen in the future. His work draws on experimental and “real world” data such as
employee stock options, 401(k) savings, the National Football League draft, and graduate school admissions. His
research has led to long-time collaborations with Google, Merck, and multiple professional sports franchises.
Cade’s research has been published in leading psychology and management journals and has been covered by The
New York Times, The Wall Street Journal, The Washington Post, The Economist, The Atlantic, and National Public
Radio. He has taught MBA and Executive MBA courses for 15 years, receiving teaching awards from Duke, Yale,
and Penn for courses on negotiation, influence, organizational behavior, and human resources. Cade is faculty co-
director of Wharton’s People Analytics Initiative, co-host of “Wharton Moneyball” on SiriusXM Business Radio, and
co-creator of the Massey-Peabody NFL Power Rankings for The Wall Street Journal.
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Cade Massey
Michael Mauboussin: It’s my pleasure to introduce our next speaker, Cade Massey. Cade is a Practice Professor
at the University of Pennsylvania’s Wharton School in the Operations, Information, and Decisions department.
Cade’s work focuses on judgment under uncertainty, including overconfidence, optimism, underreaction, and
overreaction.
First of all, I have to say that I love talking to Cade. If you’re interested in business, sports, or investing, his work
provides countless lessons about how to think better and decide more effectively. What I love about Cade is that he
straddles both the experimental world and the real world. He has also collaborated with some of the largest
companies in the world, such as Google as well as numerous sports franchises.
In many ways, Cade stands at the intersection of all of the discussions today. You’re going to hear about algorithm
aversion, inefficiencies in sports markets, and even ways that we can introduce more rigor to certain processes that
are largely subjective, such as graduate school admissions.
The last thing I’ll mention is that Cade is very involved, as a faculty co-director, in Wharton’s People Analytics
Initiative. I’ve had the pleasure of participating in the annual conference over the last couple of years and the work
is very exciting. Think “Moneyball meets HR (Human Resources).”
Please join me in welcoming Professor Cade Massey.
Cade Massey: Thank you, Michael. Appreciate it. Thank you. I’m delighted to be here. We’ve had our
conference for three years. Michael has made huge contributions in each of the last two, and it is much
appreciated.
So Michael, I took seriously your theme of what being wrong can teach us about being right. I’m going to open
the discussion this afternoon with a little story about being wrong. I also decided to title it a little bit more
poetically, and again consistent with your message: “Accepting Error to Make Less Error.” I didn’t coin that
phrase. You’ll see where that comes from momentarily.
But I want to start with a story about the Massey-Peabody Power Rankings. This is a collaboration with a former
student of mine, Rufus Peabody, who is a professional sports gambler. We publish the football rankings, starting
out just with the NFL (National Football League), and now spanning to college. We’ve done it I think for six
years now in the Wall Street Journal.
When I was at Yale, the Wall Street Journal asked if I would put together a power-ranking system for them, and
I said I would as long as I could get my former student to actually do this with me. They were up for it, and we’ve
been publishing for the last three years.
These days, it’s more easily found online. I’m going to show you various clips from this project. It’s been kind of
a garage project. This is just something we do on the side. Rufus is a full-time gambler. He uses these inputs a
little bit. It’s certainly consistent with what he does in his professional life.
But for me, it’s been a way to learn a little bit more about judgment under uncertainty, and it also gives me a
platform to talk about judgment under uncertainty, because people are generally more interested in hearing
about football than the latest experiment that we’ve run on campus. Lucky for you, you’re going to get both
today.
The system is set up so that we rank teams from 1 to 32. These are NFL teams. And we quantify the ranking,
so this is the number of points we’d expect them to win by or lose by to the average team on a neutral field. In
this ranking, that’s the Broncos at plus eight all the way down to the Jaguars at minus 8.39.
So if these guys were to play each other on a neutral field, we would favor the Broncos over the Jaguars by
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something like 16.4 points. And we built it that way so that you could use it to bet in actual NFL games, if you
wanted to do that. And then, his being a professional gambler and my being a professor, we actually track our
performance.
We want to see how we’re doing, and it has turned out that we’ve done well in this role. We kind of surprised
ourselves in how well we’ve done. Each week, we designate which are our “Big Plays.” Those are the ones
we’re most confident about. The other plays are still bets but they’re not as confident. Then, just to add a little
flavor, we throw a few extra games in there.
We track performance on these Big Plays. In 2014 or so, we had 10-and-a-half games right, five games wrong,
and five-and-a-half games tied. But we track this as we go through the season. So we’re always making sure
we know where people are communicating and how we’re doing.
And then, at the end of the year, we want to track how we’ve done. I’m building up credibility a little bit here, this
is over the first four years. I ran this midseason in 2014 for another talk and the breakeven line in the betting
markets is 52.37. That’s 50 percent plus a little bit of the vig. You have to do better than that to make money.
Across all of our seasons, we’ve been above that breakeven line. We’re calibrated in that our Big Plays do better
than our Other Plays. I can tell you that we didn’t end up 2014 this well. Regression to the mean hurts sports
gamblers as well. This came down some. In 2015, we had a very good year. We were again profitable. We
started doing college football a few years ago and we’ve done really well in that as well.
Let’s do the calibration exercise that says here is the edge and here is our difference with the market—starting
with perfect agreement with the market to increasing difference with the market. This is a three-point difference
with the market. This goes out to six. The histogram here is just frequency of gains, so you see that we very
often agree with the market and in fact generally stay pretty close to the market.
But then, what we want to know is, the more we disagree, do we more often win? And we see this increasing
line, so we’ve got good calibration. This is exactly what you’d hope for. But this is just an aggregate, and of
course there are exceptions. I told you this was a story about being wrong, so I’ll tell you the wrong part of it.
A few years ago, Texas came into their big rivalry game against Oklahoma, and they were having a bad year at
the University of Texas. The previous two years, Oklahoma had beaten them by an average score of 59-to-19,
so Texas fans were hurting and not expecting much better. At the beginning of the year, the futures line on this
game was a pick ‘em, but five weeks into the year, it was a 14-point line.
So at this point, Oklahoma is expected to win by 14. Our model kicks out its predictions for the game. Rufus
sends me the predictions, and we have a Big Play on Texas, which is fine. Four-and-a-half years into the model,
we’ve never changed anything. Trouble is I’m a Texas fan. I’ve lived through those 59-to-19 games the last
couple of years. I feel like I know more about the University of Texas football team than anybody else out there,
and there is no way the Longhorns should be favored even getting 14 points in this game. The system thought
that they would lose by 9 or 10 instead of 14. That’s a Big Play in our world.
I thought Rufus was pulling my leg. I literally thought he was joking with me. I said, no way the model likes Texas
and he says, absolutely, it’s a Big Play. I said, well, we’re not going to run it. [Laughter] And he’s like, we’ve
never overridden the model, ever. [Laughter] I said, we’re going to do it this time.
And so, he said, okay, well, if we’re going to do that, you’re going to have to bet with me. He and I, we had just
done some software work, and so we bet between us the bill for that software work just to make it interesting.
And he said, that’s fine against the line, but what if Texas wins outright? And I’m like, well, whatever you want
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because that’s not happening. And I’m the person who studies overconfidence.
So the bet was that if Texas won outright, that we would be Peabody-Massey for the next week. [Laughter]
None of this Massey-Peabody stuff. It would be Peabody-Massey for a week.
You might guess where this is going. The Longhorns win, they win big, it was a glorious day for Longhorn fans,
and the next week, in all of our outlets—our website, our Twitter account, the Wall Street Journal—we went out
as Peabody-Massey.
It remains the only time we’ve overridden the model. And I feel like this was a lesson learned, and I’m happy to
have paid that small price to learn that lesson of not overriding the model. The wiser way to go is the title from
this Hilly Einhorn paper, which is where I get the title for the talk today: “Accepting Error to Make Less Error.”
Hilly was a researcher at the University of Chicago. He was one of the first behavioral researchers at the
University of Chicago. Before Dick Thaler was there, before Josh Klayman was there, Hilly was there arguing
with all of those new classical economists about the rationality of man.
And I didn’t know Hilly, but I’m told that he was pugnacious and he was a good fighter. He has a ton of great
papers, and he has this very short paper that you guys would all enjoy, “Accepting Error to Make Less Error.”
And the idea is this distinction between clinical judgment and actuarial judgment, and the virtue and supremacy
of actuarial judgment.
But in there is this notion that you have to accept some error in order to have that superior system. In order to
have a superior model, you have to give up on being perfect, essentially. So that’s a nice idea and it’s an elegant
paper, but what does that look like in practice?
It is harder in practice. We’ve gotten a little better over the years, and we’ve had relatively outstanding
performance in this world, but it’s still a very noisy world.
So the trouble with Einhorn’s idea of accepting error to make less errors is you have to accept every one of
those deviations as being as good as you can do. And so, that algorithm is the prediction. You’re not allowed to
deviate from that prediction for any given game. You’re not allowed to chase those errors that you think you
could actually improve.
As you go through the season living that, Einhorn’s idea is nice but it’s tough. And I feel like I have learned that
more from having worked on this Massey-Peabody project for the last six years than I could have ever running
experiments or just talking about things in class.
I assume this is very close to your world. I think my sense is the people who get this kind of thing very well are
sports gamblers and folks who are involved in financial markets because you’ve got some model, you’ve got
some trading strategy, and you don’t always know on any given day whether that model still holds. It’s always
this test of confidence of whether it holds as you see these deviations from the model.
Einhorn is going to strongly come in, and everything I’m going to talk about today is going to talk about the virtue
of staying with that algorithm, and importantly, the psychology of the desire to depart from the algorithm.
Ultimately, we want to get to the question, if people do want to depart from algorithms, what can we do to make
them soften their position? What can we do to make them more amenable to algorithms?
So what I want to do in part two and kind of in the body of the talk is to speak a little bit about whether we have
any research that can inform these questions.
I’ve got a couple of papers and an ongoing project with two co-authors. The first paper was out last year in the
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Journal of Experimental Psychology. Both papers are with Berkeley Dietvorst and Joe Simmons. Dietvorst just
graduated last weekend from our PhD program. He has taken an assistant professor position at the University of
Chicago. I’m very proud of him.
Joe Simmons, a longtime friend and collaborator of mine, has been right at the heart of the replicability crisis in
psychology. So if you guys have read any of that stuff, if you know about the storm that has brewed there over
the last six, seven years, Joe’s paper with Uri Simonsohn and Leif Nelson was one of the key initial papers in
that work.
So we’ve got this initial paper, and then we came in behind that and we’ve got a paper under review now that is
about overcoming algorithm aversion. What I want to do in this section is give you basically the paradigm we’ve
been using, but also two experiments.
There are three experiments in the first paper, four in the second, but I’m just going to give you one from each,
kind of the greatest hits from each of these two papers to give you a sense of what we’re doing in this research.
The idea we’re investigating is that the forecasts of evidence-based algorithms outperform human forecasts. So
algorithms are better than humans. This has been long established.
It goes way back to the psychologist Paul Meehl. Robyn Dawes is famous for it in psychological circles as well.
And in these circles, there is no question that you should be using algorithms. Humans don’t consider things that
the algorithms do, which is one of the four main reasons they do worse than algorithms.
They don’t include everything that they should in the model. They do include things that they shouldn’t. They
don’t know how to weigh each attribute. They don’t know the right weights to put on these things.
And then finally and probably most importantly, whatever they have in the model, they’re not using it consistently.
They’re applying it with one set of weights in the morning and a different set of weights in the afternoon, or with
three factors on Monday and three different factors on Tuesday. They’re not consistent in using whatever
algorithm they’re using implicitly. So this is what we understand about why humans are worse than algorithms.
We haven’t known much about why they are resistant to algorithms. That’s what we wanted to know.
There has been research on the fact that they do resist them. People have run horse races essentially, they have
given people the opportunity to use them, people don’t avail themselves to that opportunity. So we do have
evidence that they don’t use algorithms, but we haven’t had much evidence on why they don’t use these
algorithms.
That’s where we’re coming from. Let me tell you where I’m coming from on the project. My motivation on this
project came again from the NFL. I did some research a few years ago on the NFL draft and because of that,
I’ve gotten pulled into consulting to football, baseball, and basketball organizations. But my main work has been
with the NFL organizations.
And since about 2005, I feel like I have had truth on my side with how teams should allocate their draft capital in
the NFL draft. It’s not that I know which quarterback to pick, but I do have a good sense of the value of the first
pick versus the value of the 32nd pick and what that should mean for their draft strategies.
At this point, we have very robust results, and I’ve got long-term relationships with multiple NFL teams, but it’s a
little depressing how little progress we’ve made with changing decision making in the NFL. Despite having,
quote, truth on my side, and a better regression than the next guy, we don’t move the needle very much.
That experience led to this project. That experience led me to realize we don’t have the tools for opening people
up to algorithms. Even though I’m not selling, I am a little bit selling an algorithm. More generally, I’m selling a
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way of thinking about things that these guys are averse to, and we needed better tools for winning that
argument.
So that’s where I’m coming from, trying to better understand this not just for dry academic reasons, but to
actually make progress. But the more I’ve done this, the more I realize this applies way beyond NFL
organizations. This applies to many of our students who are going out and working in quantitative fields and
trying to get a seat at the table where decisions haven’t historically been made based on quantitative evidence.
So the research questions we’re going to ask are, why do people choose humans over algorithms, and then,
how can we get people to choose algorithms over humans?
We’ve done a number of studies in this area. As you’ve seen, we have a couple of papers. We still feel like
we’re just getting into it. We can say confidently what I’m going to say today, and then what we say beyond that
is still speculative.
We’re continuing this research and we have more hypotheses we want to pursue. These two, I feel like we can
give at least.
So for this first question, the example I would give is one that is common to all of our experiences now,
especially with tools like Waze. Say you’re driving. To what extent do you use algorithms when you drive?
If you decide to change your normal route as you’re driving, and you place yourselves in the middle of a traffic
jam, how do you respond?
You may be unhappy, but I suggest that you don’t lose much confidence in your judgment. It’s probably not very
hard for you to explain away what went wrong on that particular occasion.
What happens on the other hand if Waze or some other GPS (Global Positioning System) tells you to change
route and you end up in the same tracking channel? Very often, it’s a very different attribution. You kind of want
to fire the GPS.
In fact, this was exactly my experience with my wife where I first started trying to get her to use Waze. We had
the misfortune of having a bad experience with Waze right up front and it took probably three more months
before she finally was convinced that it was superior to our judgment.
So this is the idea that we reason about guidance from ourselves differently than we reason about guidance from
algorithms. And in particular, when we see algorithms err, we are much harsher on them than we are on
individuals when we see them err. So why is it that people choose humans over algorithms?
One, they see that it is almost inevitable, and in the domains that we’re studying, it is inevitable that algorithms
are going to make errors. We’re not looking at domains where perfect predictions are possible.
In fancy terms, these are aleatory uncertainties. There is some kind of irreducible uncertainty. If you were going
to ask somebody, “is that coin going to be a head or a tail if I flip it, is that dice going to be a one or a six if we
roll it,” there is no way of knowing for sure. And in those cases, it’s inevitable that an algorithm will err. So that’s
part of the setup. We think that captures many domains.
Second is that people will be more tolerant of errors made by humans and that they’ll lose confidence in
algorithms after seeing it. They will not necessarily lose confidence in humans after seeing it. So that’s where our
hypotheses are. To be clear, see algorithm err, lose confidence in algorithm, choose human instead.
Let me make a confession here. We pursued a number of different hypotheses when we first started studying
this. We discovered in kind of the purest sense that it was this seeing error that is driving things, and I want to
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give you some evidence on that. So let me give you a couple of experimental details. In study 1, we have 361
subjects. These are lab participants. They are estimating the success of MBA students.
We have 115 real MBA students, and we know how they did long-term measured in a number of different ways:
how fancy a company they went to work for, how much money they made, ratings by their peers on graduation,
GPA (Grade Point Average).
We combined all that into student success, and we ask the lab participants to forecast that essentially. How
good given these inputs do you think these MBA students will be long-term?
So the question is whether they want to rely on their own estimates or a statistical model’s estimates. That’s
always going to be the question. You can do this yourself or you can lean on a model to do it.
The model is the algorithm, obviously, and to do this, they’re going to ultimately have ten forecasts. We’re going
to put in incentives where they can earn more money or less money depending on how well they do.
We tell them that they will estimate the actual percentile ranks of real MBA students based on their application, a
statistical model will also estimate this performance, and then we give them a description of variables.
These are what the variables look like. These are the inputs: undergraduate degree, GMATs [Graduate
Management Admission Test], essays, these are basically application materials.
These are things that MBA admissions departments know. In some ways, we’re replicating the admissions
decision. The design is that they’re going to make 15 forecasts with no incentives and they get feedback on
what actually happens.
This is the training set, if we’re going to follow Pedro [Domingos]. They’re going to learn on one set and then
they’re going to be tested on a different set. So this is the learning opportunity, and then what we manipulate
during this learning opportunity is if they themselves make forecasts, and if they have access to the algorithm’s
forecast?
We’re going to cross both of those things, so we have four experimental conditions. You are in one of these four
conditions. Are you making your own forecasts with feedback, yes or no, and are you seeing the model’s
forecast with feedback, yes or no?
Again, this is the training phase. You’re in 14 of these, you’re either making forecasts or not, and you’re either
getting the model’s forecast or not.
We have a human condition which is just making your own forecast and getting feedback; we have a model
condition which is not making your own forecast, just observing the algorithm; and then we have the two
diagonals which is model and human; and then the control condition where you’re not going through the learning
phase at all.
All of the manipulation happens during this learning phase. The subjects are doing 15 trials in one of these
conditions, and it’s just whether or not they’re making predictions and getting feedback and/or whether they’re
doing the same thing with the model.
This is an example of the stimuli they get. Here is an MBA. Here are some basic demographics on the MBA.
How well do you think this person is going to do in their MBA career? You might make this judgment yourself.
What percentile would you put them in? Start cranking it through your own model. You might also think about
your confidence in that model. Would you like the support of a statistical algorithm? I hope most of you would.
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And in this case, the average prediction was the 75 percentile, the model’s prediction was 28, and I mean, the
students’ actual percentile, the answer essentially was two. So that may not be a super representative one. We
naturally sampled this space. You’re going to get some very noisy outcomes.
Just in the example of the stimuli they go through, they get the profile of demographics, they make a prediction
or not, the model makes a prediction or not, and then they get this feedback.
This is an example from the human and model condition. And what I want to show you is what happens
obviously when they are in these different conditions.
So they’re going to get paid a $1 bonus each time the estimate is within five percentile, so they’ve got some
money riding on this. This isn’t a lot of money, obviously, but for our experimental subjects, it adds up, and this is
their basic choice.
After they have done the 15, they face this choice. They’re going to make 10 more of these forecasts, and they
have to decide if they want to use the statistical model or if they want to use their own judgment?
And this is really the most important question for us. They’ve had a chance to learn about this environment,
they’ve had a chance to either exercise their own forecast or observe the model’s forecast. They’ve done this 15
times with no incentives, just a learning trial, and now they’re asked, okay, ten more times for money: do you
want to use yourself or do you want to use the model?
The model in this case is from the same data. In this case, we didn’t do the proper thing and model him on one
dataset and test on another. So it doesn’t have deeper but it does have the same. The model is working in-
sample in this case. We fixed that in the second study.
The outcome is that the participant’s forecasts had 15 percent more error than the model, which is reliably more
error than the model. They would have earned 29 percent more money had they used the model’s forecast.
This is how the students performed. This is how the model performed. The key bit is the percentage who chose
to use the model. I’m breaking it down by the four conditions.
The control condition is where they didn’t do this at all. The first question they got was, okay, you’re doing ten of
these forecasts, do you want to use your own or do you want to use the model? They didn’t have any learning.
What happens? About 65 percent of the time, they want to use the model.
This is a little bit like your experience. Would you rather use the model or your own judgment? This is important
because sometimes our paper gets misconstrued as saying that everybody hates algorithms. We don’t say that
people hate algorithms. In fact, they come in naively here and about two-thirds would actually prefer the
algorithm.
The next one is the human condition, where they made their own judgments, they got feedback, and they never
saw the model do anything. What happens? Again, about two-thirds would actually prefer to use the model. So
they realized they are not perfect in this and would rather use some statistical help.
The other two conditions actually saw the model perform, and I just reported to you how the model performed
relative to how they perform. The model is better. The model is demonstrably better. Everybody who saw it saw it
do better.
But their actual interest in using the model drops dramatically. Only 26 percent of the people who only saw the
model perform chose it. They didn’t have the humility of making their own predictions. So maybe this is the worst
case.
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But in fact, when they saw both, it’s still just a quarter. And I actually oversee this. Because we’re naturally
drawing these 115 and because we have real subjects making real predictions, it’s not the case that everybody
in the study is outperformed by the model.
Some people actually do as well as the model just by chance, but even those who saw the model outperform
themselves, and this is the majority of our people, still prefer to choose their own judgment 69 percent of the
time over the model’s judgment.
You can start to see where we’re getting our conclusion. It’s seeing the model err that leads to the inversion. It’s
not an inborn aversion to the algorithm, it’s that in this world where prediction is tough, error is inevitable. When
people see a model err, they punish the model.
We have some additional measures to give some insight into what’s going on here. For example, we ask about
confidence in the model, and we see that confidence doesn’t change much when they see their own selves
perform. You wouldn’t expect it to. But the confidence gets hurt whenever they see the model perform.
So confidence goes exactly as the choice of model goes, in other words, confidence mediates their choice in the
model. You might ask, well, what about confidence in humans? Did that play a role? That doesn’t play a role.
Confidence in humans is constant across all four conditions. It doesn’t matter whether they saw themselves
perform poorly or not. They don’t lose confidence in themselves. Back to the GPS example. Somehow they
rationalize how their mistake leading to the traffic jam isn’t a permanent feature of their judgment. That
distinction in confidence is one of the clues to what’s going on here.
We have done this in a few different conditions, a few different tests. We have done different tasks. We always
need more of these tasks. There are only so many of these tasks you can run in the experimental setting, but we
have tried forecasting various economic indicators, different kinds of student performance. We have manipulated
the extent to which algorithms outperform the humans.
You might reasonably guess that when the algorithm is only a little bit better than the humans, some algorithm
aversion might be more rational. So we put them in situations where the algorithm is a lot better than the
humans, and yet, this algorithm aversion in the face of error remains robust.
And then we run studies where the choice isn’t between a model and your own judgment, which introduces a lot
of egocentric biases, but between a model and somebody else’s judgment. And we see almost as much
algorithm aversion. It’s mitigated a little bit. There is, it seems a role for egocentric biases, but the bigger effect
still is the aversion to algorithms over just human judgment in general.
So we have some exploratory measures on why this is. We reported these in our first paper and we ask, we
literally just ask, what are some things that you might worry about if you’re trying to compare judgments of
models and humans. What do you think? Do you think humans are better? Do you think models are better?
So for some of these factors, they believe models are better than humans. For some, they believe humans are
better than models. Models are better than humans, according to our subjects, at weighing information
consistently, weighing attributes appropriately, and avoiding obvious mistakes. This is what our participants say.
This is part of the psychology for their preference.
They say that humans are better than models at finding underappreciated candidates, detecting exceptions,
learning from mistakes, and getting better with practice.
So for us, this comports quite a bit with our intuition. It’s this possibility of getting better. It’s the static feature of
at least most algorithms, and laypeople’s impressions of them, and the dynamic feature of humans where we
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can learn and improve over time.
There are also some other interesting details. It isn’t clear to me at all that avoiding obvious mistakes should be
in that category. I’ll give you another example of that later in the talk.
But this idea of detecting exceptions I think is also very close to the heart of it. It goes back to me showing you
that graph of all the NFL games and the line through it, all kinds of exceptions.
Games deviate dramatically from our line. If you could detect those exceptions, fantastic, you could definitely
improve on the algorithm. The trouble is believing you can detect those exceptions. And so, this I think is real
close to the heart of the bias here, a preference for human judgment over the models.
Okay, that’s study one, and the main takeaway is that people are much more likely to abandon an algorithm than
a human after seeing them err. And again, despite the first two words of the title, algorithm aversion, we’re not
saying that people hate algorithms. It’s that when they see algorithms err, which in many domains that we’re
interested in is inevitable, they punish algorithms more than they do humans.
The second paper is more on this question of what can we do about it? Are there ways we can mitigate that?
We have brainstormed many ideas, we’ve run a number of studies, and we’re sure we only have one of the
answers. There are more to be pinned down, but I do want to share what we have on one of those.
So how can we get people to use algorithms? The idea here is that people want to retain some control over their
forecasts. They are not ready to cede forecasts and decision making to these black box algorithms.
The idea is that they’ll be more willing to use an algorithm when they can modify its forecast. Even when the
ability to modify is quite constrained.
You might wonder what difference it would make if you were just given a modicum of control over that algorithm.
Would it make a difference or do you need a lot? You just want a little control or would it be a lot before you
would actually start ceding some decision rights to it? And what is your intuition for how other people will respond
to algorithms? This is what we’re going to investigate here.
So broadly, the setup is going to be the same. We’re going to use a different dataset. We’re going to fix this in-
sample problem I mentioned earlier. We’re going to use some online participants this time instead of lab
participants.
One of the main learnings from the replicability crisis is that psych studies have been underpowered using far too
small a sample. Doing work with Joe Simmons has lead me to use very large samples. Now we try to get 200 a
cell generally, where this is going to be a four-cell experiment.
Eight hundred sixteen online participants, and the task in this case is to estimate students’ standardized math
test performance. We have a real dataset, real high school students, and again, they have to decide for these
estimates, and we’re going to incentivize them. But for these estimates, do they want to rely on their own
judgment or do they want to rely on a model? Broadly the same design as we had before.
Finally and most importantly, the manipulation is how much they’re able to modify the model’s prediction. Here is
the introduction they see: you will estimate the actual percentile ranks of 20 real high school students on a
standardized math test, here are some independent variables, and here is a model that has estimated all
students’ percentiles using the same information you have. Oh, and by the way, the model is wrong by 17 ½
percentiles on average. We’re just telling them upfront this is the model performance.
What we’re saying here is look, it’s hard. We usually say something like “informed, thoughtful statistician” or
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“informed, thoughtful modeler.” We pimp the model a little bit.
But here, we also wanted to give them a truthful take on what the performance is. So we’re saying this is a hard
domain, it’s noisy, the model is imperfect, it’s a good model but it’s imperfect, okay? That’s the setup. And we
ran the training sessions again and then we gave them this choice.
So these are the variables they have, kind of doesn’t matter but just this is what they’re working with. Again, it’s
a challenging task, it’s prima facie challenging. We all kind of thought, why wouldn’t anybody just go straight to
the model? It turns out that they really don’t like to go to the model, but you can see that there is a lot of
similarity to study one.
These are the incentives. We tried to crank it up a little bit though. We were only able to pay one of the four
conditions on this bonus schedule. And then, here is the interesting bit, the four experimental conditions.
They were randomly assigned to one of these four experimental conditions. One is they can’t change the model.
They have to choose between their forecasts or the model, and if they choose the model, they have to go with
the model 100 percent.
The second is that if they choose the model, they can adjust the model by up to ten percentile. So if the model
predicts 37.5, they can move it down to 27.5 or up to 47.5, or adjust by five, adjust by two . . .
They were randomly assigned to one of these two conditions. We were curious how that would impact the take-
up of the model. We’re giving them a fair bit of control, a little bit of control, and almost no control over the
model to see what the impact is on their interest in using the model.
This I think is the most interesting of the paper’s four studies and kind of captures the spirit of it most closely.
This is something that we happened into as we started seeing what they were doing. We were pushing the idea
that they like control, and we wanted to see how little control we could get away with.
You can adjust the model by ten percentiles. Now, you’re going to make a number of predictions. Do you want
to use the model and adjust it or do you want to use your own judgment?
This is what we found. Again, I’m reporting to you what I reported to you for study one, which is the percentage
of people who chose to use the model, and I’m going to show it to you by these different conditions. And for the
can’t-change condition, about 47 percent chose to use the model, so it’s kind of in-between our two conditions
before.
Remember, we told them that it errs, so they haven’t experienced the error firsthand, but they know that it’s
noisy. They know that it has 17.5 percent error. They look at that and about half of them say, yes, I’ll use the
model. About half of them want to use their own judgment.
What happens when you allow them to adjust the model by ten? Significant uptake in their interest in the model.
Now we’re back up there above two-thirds of participants willing to use the model if they can tweak it a little bit.
And then, what happens if you let them tweak it but don’t let them tweak it as much? For 5 percent, it’s 71
percent of participants. And then, most interesting, what happens if you crank it all the way down and you can
only tweak it by two percent, what happens? Sixty-eight percent.
We were really struck by this and this is the main point of the second paper. Yes, it’s kind of intuitive, people will
like the model more when they can move it, but it’s counterintuitive as you don’t have to let them move it very
much to get them to accept the model’s help. So we get dramatic uptake and model usage even though we’ve
tightly constrained them.
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People have demonstrated an inability to improve the model consistently, so we like being able to keep them
very close to the model, so if we can do that without costing us uptake, then we’re ahead of the game.
And so, that’s in fact what we see. These people went about 50 percent with the model and about 50 percent
on their own, and their average error was 22 percentile points.
If you can adjust the model by ten, now we have more than two-thirds of the people using the model. Because
more people are using the model and they’re not all actually adjusting it by that much, they have less error.
Constrain model adjustments by five, you get even less error. Adjust the model by two, less error.
So you get this better performance. There is noise in here so it’d be nice if this were each one improving
because we know that we’re keeping them closer to the model. About the same number of people are using the
model. You would expect this to come down. It’s noisy.
We sampled truthfully, and so, sometimes the Bayesian performance or the model’s performance doesn’t do as
well as it should. But the idea here is that by giving them these adjustment choices, in all cases, they outperform
not giving them the control at all.
If you don’t give them control, if you don’t give them the option of some of the control, they don’t use the model
and they don’t do as well. Give them a little room for control and they’re much more interested in using the
model. When they use it, they don’t push it around that much and they end up performing better.
There are additional downstream consequences. We like this because we’ve made them perform better, but
we’re also really struck by the other downstream consequences. So we collected additional measures.
Things that we have learned are that they are dramatically more satisfied with the process when they can have
some control over it. That’s not terribly surprising.
We have a couple other which are a little more surprising. Being involved with the model, having some control in
the model changes their beliefs about themselves and it changes their beliefs about the model. In particular, they
become less confident in their own ability.
They learn some humility basically by engaging with the model in this way, and kind of profoundly, they get more
confident in the model’s ability.
So if you compared people who didn’t have the chance to work with the model, these are people who were
randomly assigned to these conditions, those who have had a chance to work with the model actually increase
their confidence in the model’s ability.
And then, finally, they are three times more likely to choose model-only. We give them a downstream task where
they again get to choose, and this time, instead of randomly assigning them to these different conditions, we let
them choose which condition they want to be in.
Again, we’re trying to get closer to the real world. We’re trying to get closer to your world where they get to
choose whether or not to use algorithms or not, whether they impose algorithms on their employees. They’re
much more likely to choose the model-only world, which is the optimal world for prediction here, if they’ve had a
chance to play with the model and if they’ve had some control in the earlier rounds.
So people are much more willing to use the model. It doesn’t matter how much you constrained them to the
limit, to our two percent limit even, and there are these positive downstream consequences from using the
model.
Our main takeaway is in deciding whether to choose to use the model, people were insensitive to the amount by
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which they could adjust the algorithm. It seems people want to have some control over the algorithm, not
necessarily greater control.
The research questions we started out with were why do people choose humans over algorithms? And how can
we get people to choose algorithms over humans? Our answers are they are less tolerant of algorithms’
mistakes. This is why.
And then, how can we modify that? We can modify it by letting them modify the algorithm even if just a little bit.
So those are the research parts. I wanted to share those, too. I tried to hew it down to just two experiments, give
you a sense of the spirit of those two papers.
I want to close with a real world example, and I was doing this example concurrently, which is the admissions
process at Wharton. It’s not that we did this research and then I went out and applied it. I’m literally pursuing
these two things concurrently.
How many of you have seen this movie with Tina Fey? I think it’s called Admissions. She is at Princeton. As you
can see from the orange in the background, she’s the Princeton admissions officer. From what I’m told, this is
actually a very representative take on what admissions is like.
A couple of years ago, our dean asked me to get involved with our MBA admissions. And so, for the last two
years, I have worked very closely with those guys trying to bring the best of our world into that office. What
Princeton does is no different than what all the Ivy League schools do, and we think of it as kind of Admissions
1.0.
Some very smart people back in the ’70s decided they were going to improve on the legacy systems that had
been the way people had been admitted for centuries, and they designed this system. It’s been the model for not
just these schools but for everybody in admissions around the country. And it’s a very case-by-case, laborious,
individual, all-the-details-matter kind of process. And we think that there are some ways we can improve it.
So what we’ve tried to do is what we so humbly call Admissions 2.0. Admissions 1.0, the Princeton model as
depicted in that movie, is read the files, debate, and then make an individual decision.
What I mean by that is they are literally sitting around a conference table for a week with the stacks of files, and
they are deciding one-by-one to go through 1,000 up-or-down, and they do this from first thing Monday morning
until Friday afternoon when they’re done.
You might worry about how systematic or how consistent they’re being over that full day, and you might also
wonder how do they make an optimal decision for the portfolio of whatever it is: 500 admitted students, 1,000
admitted students. How do you make the optimal portfolio decision if you’re making sequential one-by-one,
case-by-case decisions, which is what we worried about and which is what we’ve tried to address.
When the Dean first asked me to get involved, I think he thought that I would do some kind of forecasting thing
as I have begun doing with some sports teams. But when I started looking at this, my interest was less in
improving the forecast than it was improving the broader decision process.
So what we do is we do the forecasts up top, and then the key bit is this optimization in the middle. We’re trying
to make a portfolio, we’re trying to optimize the portfolio as you guys would do in seven seconds as opposed to
making case-by-case decisions for four-and-a-half days. And then we are trying, once we have this system, to
evaluate and refine that system based on what we learn each year.
I will say that we’re talking a little bit publicly here or else I wouldn’t be here talking about it, but we’re not
pushing this story out there much right now. We hope to eventually.
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We’ve actually admitted one class on this model. Well, actually, we have a full year of students under this model,
and we’ve just admitted our second class. We will begin talking about it more publicly once we can say we just
graduated the kids that we admitted under this model and it’s actually a working system.
The key part is this portfolio approach. Everything that goes into the model is subjective. Every single input is
subjective. So we’re still using the readers, we’re still using all the admissions experts, but once we have it in the
model, basically we turn the crank and force the optimization to be consistent across everybody.
It’s literally just a maximization model where we’re trying to get as much of our objectives as possible, given the
forecast of all the readers who have read these files. Everything is subjective, everything is human, all the
aggregation happens systematically through the model question.
This is going to take us into more detail than I’m going to actually talk about right now. But we have our
objectives. They’re not very controversial. What we can see right now is what they do in their two years on
campus.
Obviously, what we really care about is long term what they do with their careers, but what we see on campus is
broader than just GPA. So we have a broader set of objectives. And so, we’re going to forecast against those
objectives.
We framed it to all of our readers as if it’s a forecasting task when they read essays and letters of
recommendation. It is a forecasting task. So give us your forecast, and then we have other considerations as
well.
This is an important part of this story. This is Hilly Einhorn’s “Accepting Error to Make Less Error.” We are doing
something at the portfolio level where we’re applying all of our weights consistently, there is no difference
whether you’re the first file read, the 67th file read, or the 670th file read, you’re getting the same weight. If you
came in with an application this year, identically the same application the next year, you’ll be treated the same.
There is much more fairness, consistency. Everything is systematic now.
What we give up is this whole, “Is Joe from Highland Park in Dallas better than Ginny from Menlo Park in
California?” We make that decision but we do it in the model and we do it in a very consistent way.
What we get back is four-and-a-half days where we can be more robust on whether it’s the right portfolio
decision to make. Now we can argue about what’s the right percentage of women to have in the class? Not just
argue about it, we can run sensitivity analysis asking what would happen if we cranked the percentage from this
to that? And any other considerations you want, we can run them all and ask what’s the impact? And what do
we care about?
We have all these policy considerations. On the one hand, we’re just maximizing these forecasts but we’re also
subjecting them to constraints on all other policy considerations. Because we do it this way, now we can talk
about these policies. We can spend our time talking about the policy considerations instead of case-by-case.
The psychologists will tell you and the decision scientists especially will tell you that the biggest flaw on human
judgment isn’t not considering the right factors or even getting the weights right. The decision scientist will say
just give them unit weights. The actual weights don’t matter that much.
What matters the most by far is being systematic, being consistent in applying those same weights day-in, day-
out. That’s what we’ve tried to do here and that’s what we’re a year-and-a-half into exploring.
So what have we learned? I want to emphasize mostly a couple of things. Some of these are basic decision
process stuff, getting the process right, prioritizing relationships, being a good translator. I want to emphasize two
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things, numbers four and five.
Number four: cut decision-maker slack. As I said, I was doing this concurrently with the research on algorithm
aversion. We got much more traction with the admissions office when we told them these aren’t going to be
binding decisions. Each round, we’re going to make 1,000 recommendations to you, 1,200 recommendations to
you. It’s up to you on whether you use them or not.
For every applicant, we’ll give you a one or a zero, admit or not, according to the model. By the way, it’s your
model and it’s your input, so we’re just turning the crank, right? We’re going to give you 600, 1,200 ones and
zeros, you decide what you want to do with them.
And in fact, we have learned that in the optimization, we have to build in the slack, so we don’t actually allocate
all 600 slots. We’ll allocate some fraction of that knowing that we want to give them some room for subjective
changes to it after the fact.
That has been critical. And you could think of it as strategic. It’s our way of getting them to buy in. It’s like the
algorithm aversion experiment where you say you can adjust this model by ten or you can adjust this model by
five. They will be more interested in the model if we give them that slack. But there is another reason: the other
reason is number five, the supervise-your-algorithm reason.
And so, I’ll close with a quick story on being wrong again. See, I’m book-ending it, Michael, with your theme.
The need for supervision is real with these algorithms. And I know this is kind of a low-powered example relative
to some of the things you guys do, but it’s an important example. It affects a lot of people’s lives. And I’ve been
humbled by how dangerous algorithms are. It’s like a power tool that does quick efficient work but you’ve got to
be careful. You can do a lot of damage with the power tool.
So one really brutal example which I’ll probably learn not to give on the record, but I’ll give for the first time on
the record. The first time we did this, this was literally making decisions on who to interview for MBA admissions
round one.
Historically, the admissions folks had a ranking system, and one was the best you could get. You read an essay,
a one is the best, four is the worst. You read a letter of recommendation, one is the best, four is the worst. So
we collect all these data, we build a model, we’re interacting with them all the time, we know that this is the
scale, and yet, when we go to turn the crank, what do we do?
We maximize. We get into the meeting, we’re presenting our results and we’ve got everything showing up, we’re
talking it through, and we are 15, 20 minutes into the meeting before we realize that we haven’t figured out this
distorted worst possible portfolio.
Because we ran the thing in the wrong direction. That’s humbling and that’s also why, playing with a power tool,
you’ve got to have the safety glasses on, got to get the gloves on. It needs a little bit of supervision.
We’ve had a few other moments like that where you realize the beauty of not working with algorithms is that for
all you guys who are going to make idiosyncratic error, you’re unlikely to get one big thing wrong that hurts a lot
of people. With an algorithm, error is not idiosyncratic anymore. You get one big thing wrong, you can take out a
whole bunch of people in one go.
Okay, so I’ll close with just a quick cartoon from “xkcd”, the online comic strip. A lot of you guys probably know
these guys. It’s a clever little continuum of algorithms by degree of complexity, where our favorite cartoonist at
xkcd says, “actually, in the world of complexity, forget anything Pedro [Domingos] does, his deep learning stuff,
the most complicated algorithm is a sprawling Excel spreadsheet built up over 20 years by a church group in
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Nebraska to coordinate their scheduling.”
What I love about this is it doesn’t say that people are averse to algorithms. In fact, they will use algorithms, but
they need to have some involvement in the algorithm. This may not be optimal, but you may be willing to go away
from optimal if they are going to be committed to the algorithm. And I bet those Nebraska churchgoers are
committed to that algorithm. Okay, guys, thank you and happy algorithming.
Question: With respect to your experiment where you allow plus or minus two, five, and ten changes, have you
thought about or looked at instead, allowing the user to incorporate conditioning information, you know, X times
in the trial? So two, five, ten times over the course of the period?
What I’m getting at is in thinking about it with respect to financial models. You like doing algorithms, but if
there’s an OPEC (Organization of the Petroleum Exporting Countries) meeting or there’s a financial crisis or
there’s a terrorist attack, you might evaluate that the calibration of my models are probably inappropriate for this
point in time. And that would help me avoid those really bad outcomes that can come, the errors that can be
really bad. I’d imagine that if you allowed people control, you might see more buy-in.
Cade: It’s a great observation. In fact, in one of our studies, in the first study in that paper, we had two different
conditions. One was you can modify any given recommendation by a certain amount.
The other condition was you can strike any number of them and do your own thing, so it’s closer to what you’re
talking about with the OPEC meeting or whatever. And we get the same comparable levels of uptake. They like
that.
We just thought for further permutation, it was more interesting to play with the other. But as a modeler and a
forecaster, I agree that it’s critical but it’s also just right back to the heart of the problem—when do you know
that exception is okay and when is it not okay?
Question: How do you think about the “broken leg” problem from psychology, where you have the risk of
clinicians overriding the formulas too frequently?
Cade: Right. There are way too many false positive. My collaborator on the NFL draft research is my advisor,
Dick Thaler, who has some experience in the finance industry, and we have been working with the football
teams for 10 or 12 years now. Early on, we had a sit-down with a coach and we were talking about game day
decision making. We try to be humble in these meetings, we really do.
But this one coach in this one situation, we were talking about fourth down, I think, going for it on fourth down,
and there’s just so much data on this and it’s been worked over in so many different ways. We’re talking about
this and the coach asks, what about the wind?
And you know that the wind is going to matter, of course it matters. But it was just that he asked a series of
these questions: What about the wind? What about the left guard? There’s always some other consideration he
wants, he’s never going to accept the model. So it’s like an ongoing joke when we have these conversations
with the “what about the wind type questions.” [Laughter]
Question: I’m just curious on the admissions process if the faculty feels there has been any change in the
composition of the class or the behavior or the capability?
Cade: Yes, yes. So our admissions, the head of admissions, the vice dean of admissions who’s been my
partner in this all along, she came from the trading world, and so, she is pretty sophisticated on these fronts. And
yet, she was a little worried.
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Cade Massey
So we had these events in the Spring, they were admitted over the Winter . . . we have this event in the Spring
for all admittees. They come visit school, we kind of try to sell them on the school. They’re going to our school,
they’re going to other schools, and she went to this first event the first year and she was worried.
She said afterwards she was worried that when she went in, it was going to be like going into the bar scene in
Star Wars. [Laughter] You know, with all the freaks? She thought that’s what we were going to have, which is
misplaced. She’s partly ribbing me but partly serious.
It’s misplaced because all we’ve really done is codified the judgment that we pulled from what they’ve done the
previous three or four years. All we’ve really done is do systematically what they’ve been doing a little less
systematically in previous years.
And this troubled me for a little while because I come from the decision-making world, and we have obsessed for
decades now about bias. And we’re not fixing bias right now. We will move on to that kind of thing. We will
tackle that challenge down the road.
But what we’ve done right now is we have just been more systematic, and my field was not focused on that in
the past. Danny Kahneman has finally started talking about this some and Michael was there in the opening
session of our conference this year.
It’s possible that our field is worried too much about bias and not enough about noise. And this is a great
example of worrying a lot about noise.
There has just been too much noise in the system, but even if we don’t de-bias anything, even if we just codify
what they’ve been doing, we’re wringing a lot of noise out of it and everybody involved feels better about it
because it’s a more fair, just, systematic system. So that’s a long way of saying they’re the same students
basically. We don’t see any changes in class composition right now.
Question: When you gave your different groups different amounts of latitude in adjusting percentiles, did the
ones with more latitude use it or did they not use it much? Were there any patterns of use based on how much
they add?
Cade: So we had ten, five, and two, and you see ten’s use it more than two’s because they have more to use
than two’s, but they don’t use it anywhere near as much as they could. And it varies by case, so they are paying
attention to the details of the case.
I forget the exact averages but it’s going to be something like four [percent], so it’s really only a fraction of the
discretion that they actually had, which was a pretty good clue to us that we could constrain them more. We
ended up constraining them more than they were using. These should have been binding constraints, but they
just didn’t seem to mind very much.
Question: Hi, I have to say great presentation, but I had a visceral negative reaction.
Cade: [Laughter] Excellent.
Question: It feels like what you’re doing is tricking people into accepting bad algorithms. And I want to go back
to the football script which is out there right now. When I see that as a risk manager, what I want to say is, okay,
show me the results conditional on the turnover differential. Show me your prediction, the score, if you replace all
the field goal results with their expected value. I want to take the noise out until I can get to an algorithm that
doesn’t have a lot of noise. Now, there is still a lot of noise here because turnovers are pretty random and field
goals are pretty random . . .
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Cade: Yes. I’m sympathetic to that. I don’t want to trick people into an algorithm until I’m very confident that it’s
the best option. Let me say one last thing on tricking. I am serious when I say that I’m more humble now about
data than I’ve ever been in my life.
And I think the people I know who are best with models and data are actually the most humble. They end up
getting humbled. You’re talking with them a while and then on the other side of that, you actually get humbled
about what data can do.
So I don’t want to trick people. I honestly think it’s better to have a little bit of involvement here and there. But
I’m also in the persuasion game when I’m working with organizations. And so, if it’s helpful then I’ll use whatever
tool is helpful.
The football example is a good one because that model is one that I’ve built over five or six years now, and I’m
not giving up on getting it better. Every offseason, we tweak it a little bit.
But that model is as good a model as there is out there and people aren’t going to beat it, they’re just not. The
odds of someone identifying the exceptions to that model are just exceedingly rare. And so, I’m very happy to
kind of push it because I believe it’s the best judgment. That’s not to say it’s going to be perfect because it’s a
very hard world.
I guess it’s a fine line because I recognize that it can be improved and I want to work every offseason to make it
better, but at the same time, it’s about as good as it gets. I could give you the example from another football
domain—the NFL draft where my early work was done. It’s really hard to pick which quarterback is going to be
better than the next quarterback in the NFL draft. It’s really hard to forecast the performance of these college
kids coming out.
It’s not easy, and if you look at how much this has improved over time, this is a very humbling thing about this
task. It’s a very hard task. Take a correlation between how a player is evaluated coming out of college, say, by
where he is drafted and some measure of his long-term performance: games started, career earnings, whatever,
some correlation, okay? We could pick a lot of different numbers, just give me a correlation and ask how it’s
changed from like the mid-80s to the mid-aughts, 20 years’ worth of work.
With the advent of computers, big data now, how has that correlation changed? Some correlation would be like
0.3. That 0.3 in 1985 is still 0.3 in 2005. There is just a degree of irreducible uncertainty.
So there is a limit to how much we can learn. But you talk about that with good draft guys and they’ll say, yes,
yes, yes, but we’re getting better. And I believe it and I want to hold open that possibility because they are
getting better. They absolutely are getting better. But until we’re better, we need to be really humble and stay
with the model.
Question: Can I ask in terms of the admissions process, one of the things that I like about the process is what
happens to the debate in that it removes the discussion element of it and just in a sense aggregates the
judgments of the individuals.
But what’s the reaction then from the Admissions Committee about the absence of the data? I mean, I guess
you’re saying they do talk about it afterwards, but from my perspective, in some ways, talking actually can bias
the discussion and judgments, assume people are more influential in a group. And if you remove that, it seems
like you get close to kind of the wisdom of crowds. What’s the reaction been in terms of not having those four-
and-a-half days to talk about each individual candidate?
Cade: I think there was skepticism early and there has been broad buy-in having gone through this system,
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even just having gone through it the first round the first year, and it’s because we didn’t remove debate. We just
refocused the debate.
There is still debate on what the criteria are, how you judge that criteria from an essay, there is debate on what
the right weights are across our objectives, there is debate on what’s the right portfolio, the policy constraints,
where we’re pulling students from, and what the right mix of those are, we debate all those things.
There are debates on the exceptions. Whenever we look at that list of ones and zeros, 1,200 ones and zeros,
we look at the people who are on the fence, we look at the people who if you shift the weights one way, they
get out, if you shift the weight the other way, they get in. So for the marginal candidates, we go and look at
them in more detail, and then they get debated. We get much more attention on the right places as opposed to
spending all of this time where it’s just not productive.
Question: I think it’s great how this kind of defies one’s decision making. The concern I have is about the
outcomes. How do we measure the outcome?
Would it make sense to just run a sliver of things the traditional way against a sliver of things within the model
and then you actually have somewhat of a natural experiment where over time, you can see that outcome might
change, and you’ll be able to go back and look?
Cade: Yes. Well, now I’ve got the opposite problem of this gentleman’s instruction up here which is I’m going
to rely on judgment that I know was noisy? Really, do I really want to do that?
Broadly, the spirit of the question, I agree with entirely. We want to run some experiments if at all possible. Back
to the sample size issue, it’s really hard to have enough in any given condition to draw much inference. And so,
we’ve been humbled by what we’re able to do and not do experimentally.
I want to say though about measuring outcomes, we know we’re not getting that right now. And we don’t know,
we don’t have the solution and we fully appreciate the difficulty of the task. The best thing to come of this
process is that we’re having the conversation now, that we’re actually debating exactly how it is that we should
be assessing our students’ performance.
We were partly inspired to pursue this tack by Teach for America. You might not know it, but Teach for America
are the most sophisticated hiring organization I’ve ever been around. They spoke at our first conference, the
People Analytics Conference.
If you think about it, it makes some sense because they have 50,000 or 60,000 applicants every year for the
same job. It’s a homogenous job, more or less—tens of thousands of applications and they’ve been doing it now
15 years. They have really smart, quantitatively sophisticated people in that organization who have been refining
their process for 15 years now.
They said this beautiful thing at our conference the first year. They said we’re never going to be done. It’s not a
project to fix admissions. It’s not a project to fix recruiting. It’s an ongoing process. And they said they had this
model inside, and they’re never going to be done.
And so, Maryellen [Reilly Lamb] and I, the vice dean of admissions, have said that from day one. It kind of
licenses us to say we don’t really know right now how we’re going to measure our outcomes because it’s really
hard, but we’re going to start trying and we’re going to have the conversation. And we’re having the
conversation now that we have never had before because of the process. But that’s a very big and very difficult
question.
Question: Thank you. Just in the first experiment, you were talking about how people have a very adverse
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reaction to negative outcomes from algorithms. I’m curious with your college experiment, let’s say you’re solving
for GPA and Nobel Prizes and wages and things, if that might make sense, but you also could suddenly get
more axe murderers and other characteristics you may not be screening for. Wouldn’t you say, oh, this is a
problem, we can’t do this because we have more people who might go to prison than we can measure.
Cade: [Laughs] I’m not worried about axe murderers per say. That’s not something I’m worried about. But
generally, this idea, I’m aware of something, more aware than anybody else because of the research I’ve done,
I’m greatly privileged in getting this new system going in admissions, helping get it going because we won’t see
the outcomes for a couple of years.
Everything about this research says that people are getting more interested in algorithms if they don’t get
feedback, if they don’t see the algorithm error. And so, it’s like I’ve got this two-year window essentially to get
things going in the most hospitable environment possible, and then, once we’ve started measuring, we’ll learn
that the algorithm is noisy.
We’ll learn that those people that we ranked so highly sometimes don’t turn out so perfectly and that will cause
some people some concern, agreed. I hope we don’t turn up axe murderers, but it will definitely be more
challenging once we have hard outcomes that go against us. And there will be plenty because it’s a hard task.
Question: I’m curious if you spend any time with your colleague, Phil Tetlock?
Cade: Sure.
Question: I mean, obviously, he’s got his superforecasting approach and he’s got all these myriad teams and
some of those teams consistently outperform year after year.
My question is, have you thought about trying to participate and build algorithms to field your own team? And the
second question is, do you think that there are elements of what those successful teams are doing that are
algorithm-like in nature and that kind of coincide with what you’re doing?
Cade: Certainly, I know and I thoroughly enjoy Phil, and Barb [Mellers] as well, and that’s a phenomenal team
and we do talk about these things. In fact, they’ve had a team interested in using data from admissions for one
of their stimuli in some kind of study. So they’re actively engaged in a way with Lyle Ungar, a computer science
guy there.
For the second question, anything in what they’re doing that’s algorithmic is interesting. They don’t very explicitly
go down that road. There may be people who are individual forecasters who are working with algorithms, but
that’s not part of their shtick.
They have discovered some phenomenal things. They’ve discovered some qualities in good forecasters that
differentiate good forecasters from bad forecasters. And probably as profound, have developed some training
techniques that improve people’s judgment under uncertainty.
And again, my field has looked at judgment under uncertainty all the way back to [Paul] Meehl. Really Meehl’s
not my field, but since Danny Kahneman and Amos Tversky did so pretty rigorously, no one has ever really
improved upon it. And these guys have come along and come up with some techniques for actually improving
their judgment. That’s the kind of thing that we need to be incorporating.
We can train our admissions people, for example, using some of those same techniques, and we’d probably see
better forecasts. But we’re lucky to have Phil and Barb doing that work right there.
Michael: Well, we’ll call it there. Thank you, Cade.
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Paul DePodesta
Cleveland Browns
Paul DePodesta has made a career of evaluating, measuring, and assigning value to talent, as documented in
Michael Lewis’s book, Moneyball: The Art of Winning an Unfair Game. The Moneyball methodology has become a
mainstay strategy for business leaders looking for new approaches for overhauling stagnant systems.
Formerly the Vice President of Player Development and Amateur Scouting for the New York Mets, Paul helped
lead the team to the 2015 World Series for the first time since 2000. Mets GM Sandy Alderson said Paul was a
“huge factor” in the Mets’ success.
In January 2016, Paul joined the NFL’s Cleveland Browns as Chief Strategy Officer. In this new role, he is
responsible for assessing and implementing the best practices and strategies that will give the Browns the
comprehensive resources needed to make optimal decisions for their players and team.
Paul is also an Assistant Professor of Bioinformatics at the Scripps Translational Science Institute.
Note: No transcript available.
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Operating Leverage
A Framework for Anticipating Changes in Earnings
June 14, 2016
Value trigger Value factor Value driver Financial leverage Earnings

Authors
Volume
Michael J. Mauboussin
michael.mauboussin@credit-suisse.com Price & mix Operating Financial
Sales Earnings
margin leverage
Dan Callahan, CFA Operating leverage β β
daniel.callahan@credit-suisse.com Economies of scale
Darius Majd
darius.majd@credit-suisse.com
Cost
Cost efficiencies
Source: Alfred Rappaport and Michael J. Mauboussin, Expectations Investing: Reading Stock Prices for
Better Returns (Boston, MA: Harvard Business School Press, 2001), 41.
“Analysts’ usual optimism, their tendency to forecast in a narrow and

comfortable range, and the business cycle prove to be the bane of their
forecasts. Acceleration or deceleration in economic growth tends to catch
analysts off-guard.”
Vijay Kumar Chopra1
Analysts are commonly too optimistic about earnings growth and often
miss estimates by a wide margin.
This report outlines a systematic way to assess earnings revisions with a
specific emphasis on operating leverage.
We cover the drivers of sales growth and then discuss the value factors,
which determine the impact of sales changes on operating profit.
To measure operating leverage, we examine the relationship between the
change in sales and the change in operating profit for the top 1,000
companies from 1950 through 2014. We also examine eight sectors.
Operating leverage and financial leverage together determine earnings
volatility.
Sales growth, profit growth, and value creation do not always go together.
June 14, 2016
Introduction
For a fundamental investor, anticipating revisions in expectations is the key to generating attractive returns. 2
Sources of those revisions include fundamental outcomes (typically earnings revisions) and an assessment of
how the market will value those fundamentals (multiple expansion or contraction). Investors who are able to
forecast earnings in a year’s time that are substantially different than today’s expectations can earn
meaningful excess returns.3
Analysts are commonly too optimistic about earnings growth and often miss estimates by a wide margin.4 This
is especially pronounced for companies that have high operating leverage and surprise the market with weak
sales.5 Buy-side analysts are generally more optimistic and less accurate than sell-side analysts.6
Operating leverage measures the change in operating profit as a function of the change in sales. Operating
leverage is high when a company realizes a relatively large change in operating profit for every dollar of change
in sales. Operating leverage is low when operating profit is mostly unchanged for every dollar of change in
sales. Operating profit is earnings before interest and taxes (EBIT) and is the same as operating income.
This report outlines a systematic way to assess earnings revisions with a specific emphasis on operating
leverage. The goal is to be able to better anticipate revisions in expectations. The issue of operating leverage
does not receive enough attention, in our view, and it can provide insight into excess returns. For instance,
there is empirical evidence that operating leverage can help explain the value premium.7
Exhibit 1 is the roadmap for this analysis. The process starts on the left side with an analysis of the change in
sales. Sales changes, in turn, can be refined using “value factors” to determine the impact on operating profit.
The value factors are based on established microeconomic principles. Consideration of sales changes and the
role of the value factors allows you to calculate operating leverage, or “operating margin beta (β).” You can
then incorporate the degree of financial leverage to determine the variability of earnings.
The main utility of exhibit 1 is to allow you to understand the cause and effect of changes in earnings. The
interaction between sales and operating profit is crucial. Not all sales growth has the same effect on
profitability. Note that you can use the roadmap to analyze the past as well as to anticipate the future.
Exhibit 1: Framework for Assessing Operating Leverage

Value trigger Value factor Value driver Financial leverage Earnings
Volume
Price & mix Operating Financial

Sales Earnings
margin leverage
Operating leverage β β
Economies of scale
Cost
Cost efficiencies
Source: Alfred Rappaport and Michael J. Mauboussin, Expectations Investing: Reading Stock Prices for Better Returns (Boston, MA: Harvard Business
School Press, 2001), 41.
Operating Leverage 2
June 14, 2016
The easiest way to think about operating leverage is as the ratio of fixed to variable costs. Fixed costs are
costs that a company must bear irrespective of its sales level. If sales shrink, fixed costs don’t budge and
profits fall sharply. Conversely, profits rise substantially if sales grow. Theme parks are an example of a
business with high operating leverage. Roughly three-quarters of the costs for that business are fixed, with
labor as the largest component.8
Variable costs are linked to output. These costs rise and fall in tandem with sales. The commissions a
company pays to its sales force is an example of a variable cost. Commissions move together with sales,
limiting the degree of operating leverage.
Exhibit 2 illustrates the impact that sales changes have on operating profit margins for businesses with high
(75 percent) or low (25 percent) fixed costs. The operating profit margin is 20 percent for both businesses
when sales are $10 million. At $25 million of sales, the high-fixed-cost business sees its operating profit
margin soar to nearly 60 percent, while the low-fixed-cost business has an operating profit margin of only
slightly above 30 percent. At $5 million of sales, however, the business with high fixed costs loses money and
records a margin of -40 percent, while the business with low variable costs breaks even.
Exhibit 2: Cost Structure Composition and Operating Profit Scalability

60 75% Fixed / 25% Variable
Operating Profit Margin (Percent)
40
20 25% Fixed / 75% Variable
-20
-40
-60
5 10 15 20 25
Sales ($ Millions)
Source: Credit Suisse.
Note: Cost structure based on $10 million in sales.
Exhibit 3 shows the ratio of fixed assets to total assets by sector. A fixed asset is not sold or consumed during
the normal course of business. Examples include land, manufacturing plants, and acquired intangibles. The
basic idea is that companies that rely on a high ratio of fixed to total assets have high fixed costs. There is a
positive correlation between the ratio of fixed assets to total assets and operating leverage.
June 14, 2016
Exhibit 3: Fixed Assets to Total Assets by Sector

Energy
Materials
Telecommunication Services
Industrials
Information Technology
Consumer Discretionary
Health Care
Consumer Staples
0.0 0.1 0.2 0.3 0.4 0.5 0.6

Fixed Assets to Total Assets
Source: Aswath Damodaran.
Note: Global companies as of January 2015; Fixed-to-total asset ratio for each sector is the average of the industries in that sector.
It is important to underscore that all costs are variable in the long run. While the distinction between fixed and
variable costs is practical and useful for modeling purposes, companies can reduce fixed and variable costs if
sales decline.9 Further, growth eventually dilutes the advantage of an incumbent in a business with high fixed
costs, because the ratio of fixed to variable costs declines as the industry grows.10
Exhibit 4 shows the drivers of operating profit changes for the largest 1,000 global companies, by market
capitalization, for the last 65 years. The sample excludes companies in the financial services and utility
industries. Operating leverage is particularly pronounced in periods of recession and subsequent recovery.
Exhibit 4: Drivers of Operating Profit for Top 1,000 Companies (1950-2014)

50
Change in Operating Margin
40 Change in Sales
Change in Operating Profit
Annual Change (Percent)
30
20
10
-10
-20
1966
1998
1950
1952
1954
1956
1958
1960
1962
1964
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
2000
2002
2004
2006
2008
2010
2012
2014
Source: Credit Suisse HOLT®.

Note: Sample excludes financial services and utilities.
June 14, 2016
The rest of this report has four parts. We start with the drivers of sales growth. We then discuss the value
factors, which determine the impact of sales changes on operating profit. Next we review the empirical results
of our analysis of operating margin β, or how the change in operating profit relates to the change in sales. We
conclude with data on financial leverage. Companies with debt incur interest expense, which serves to amplify
the changes in operating earnings. Companies with high operating and financial leverage have greater swings
in earnings, and hence risk, than those with low operating and financial leverage.11
Sales Growth
We can forecast sales growth using a number of approaches. One logical starting point is overall economic
growth. The left panel of exhibit 5 shows the correlation between annual growth in gross domestic product
(GDP) in the United States and the median sales growth rate for the top 1,000 global companies by market
capitalization from 1950-2014. The right panel is the relationship between growth in industrial production (IP)
in the United States and sales growth, both adjusted for inflation. GDP and IP are highly correlated.
Exhibit 5: Median Sales Growth Is Correlated with GDP and IP Growth (1950-2014)
15 r = 0.65 15 r = 0.73
Annual Real Sales Growth (Percent)
Annual Real Sales Growth (Percent)
10 10
5 5
0 0
-5 0 5 10 -5 0 5 10
-5 -5
Annual Real GDP Growth (Percent) Annual Industrial Production Growth (Percent)
®
Source: Credit Suisse HOLT ; Bureau of Economic Analysis; Board of Governors of the Federal Reserve System.
Naturally, some sectors are more sensitive to overall economic growth than others. Exhibit 6 shows the
correlation between annual U.S. GDP growth and median annual sales growth for eight sectors. The
consumer discretionary and industrial sectors have relatively high correlations with GDP while consumer
staples and health care have correlations that are relatively low.
June 14, 2016
Exhibit 6: Sales Growth versus U.S. GDP Growth by Sector (1950-2014)

Consumer Discretionary Consumer Staples Energy
20 12 25
Annual Sales Growth (Percent)

18 r = 0.77 r = 0.37 r = 0.12
16 10 15
14 8
12 5
10 6
8 4 -5
6
4 2 -15
2 0
0 -25
-2 -2
-4 -4 -35
-4 -2 0 2 4 6 8 10 -4 -2 0 2 4 6 8 10 -4 -2 0 2 4 6 8 10
Annual GDP Growth (Percent) Annual GDP Growth (Percent) Annual GDP Growth (Percent)
Health Care Industrials Information Technology

20 20 50

r = 0.43 r = 0.74 r = 0.55
45
15 15 40
35
10 10 30
25
5 5
20
0 0 15
10
-5 -5 5
0
-10 -10 -5
-4 -2 0 2 4 6 8 10 -4 -2 0 2 4 6 8 10 -4 -2 0 2 4 6 8 10
Annual GDP Growth (Percent) Annual GDP Growth (Percent) Annual GDP Growth (Percent)
Materials Telecommunication Services

25 Annual Sales Growth (Percent) 25
r = 0.53 r = 0.51
20
20
15
10 15
5
10
0
-5 5
-10
0
-15
-20 -5
-4 -2 0 2 4 6 8 10 -4 -2 0 2 4 6 8 10
Annual GDP Growth (Percent) Annual GDP Growth (Percent)
Note: Growth rates are adjusted for inflation. Sector growth rates are calculated using medians. Telecommunication Services includes 1960-2014.
June 14, 2016
Industry growth is the primary factor that analysts consider when they make sales forecasts.12 There are a
number of issues to consider when assessing industry growth.13 The first is where the industry is in its life
cycle.14 Industry growth tends to follow an S-curve, where there is rapid sales growth for a time followed by
flattened sales growth. Industries have different rates of growth as well as variations in growth rates.15
One common analytical mistake is to extrapolate high growth in the middle of an S-curve. One famous
example is the production of color television sets, which were launched in the late 1950s and reached a sales
peak in 1968. The industry grew rapidly in the 1960s, which encouraged manufacturers to add capacity. But
they extrapolated the sharp growth and failed to recognize the top of the S-curve. The result was
manufacturing capacity in the later 1960s of 14 million units and peak unit sales of 6 million units. A sensible
judgment of the number of potential customers multiplied by the revenue per customer informs the
assessment of industry size.
Mergers and acquisitions (M&A) are also important in determining sales growth. One study of the sales growth
of large companies found that M&A accounted for about one-third of total top-line gain.16 Large M&A deals
merit careful analysis because they can change the nature of a company’s operating leverage. However, the
evidence shows it is challenging to create substantial value through M&A.17
Changes in a company’s market share within an industry also influence sales growth rates. Market shares
tend to be volatile in emerging industries, as technological change is rapid and entry and exit is rampant. 18 But
market shares tend to settle down as an industry matures. There is a positive correlation between market
share and profitability. But there is also evidence that corporate objectives focused on competitors, including
market share targets, are mostly harmful to a firm’s profitability.19
There are two basic ways to forecast. One is to gather information and create a bottom-up forecast. The other
is to look at the outcomes of instances in a similar reference class.20 For instance, you might forecast a
beverage company’s sales by estimating the price and volume of future servings. Alternatively, you might
consider the distribution of the sales growth rates for companies of a similar size. In the latter case, you are
considering the commonality with other businesses rather than focusing on the uniqueness of the situation.
Our report, “The Base Rate Book—Sales Growth,” provides the base rates of sales growth for thousands of
companies going back to 1950, offering a reality check for forecasts.21 This research shows that analysts and
companies are commonly too optimistic about sales growth rates, that sales declines occur much more
frequently than forecasts suggest, and that mean and median sales growth rates decline as firm size increases.
Sales growth is the most important value driver for most companies because it is the largest source of cash
and affects four of the value factors. But it is important to emphasize that sales growth, profit growth, and
value creation are distinct. Sales growth only creates value when a company earns a rate of return on
investment that is above the cost of capital. As a result, companies can grow profits without creating value.
Indeed, sales growth destroys value for a company earning a return below the cost of capital.
The threshold margin is the level of operating profit margin at which a company earns its cost of capital.22 To
break even in terms of economic value, a company with higher capital intensity requires a higher operating
profit margin than a company with lower capital intensity. So threshold margin is an analytically sound way to
make the connection between sales growth, profits, and value creation. Appendix A defines threshold margin
and incremental threshold margin. Appendix B shows that the overall rise in operating profit margin has been
driven by companies in the highest margin quintile and documents the history of operating profit margin by
sector.
June 14, 2016
Value Factors
Sales changes can have varying effects on operating profit margins. Careful consideration of the value factors,
including volume, price and mix, operating leverage, and economies of scale, will allow you to sort out cause
and effect. Here’s a quick description of the value factors:23
Volume. Volume captures the potential revision in expectations for the number of units a company sells.
Volume changes lead to sales changes and can influence operating profit margins through operating
leverage and economies of scale.
Price and Mix. Change in selling price means that a company sells the same unit at a different price. If a
company can raise its price in an amount greater than its incremental cost, margins will rise. Warren
Buffett, chairman and chief executive officer of Berkshire Hathaway and one of the most successful
investors in the past half century, argued that “the single most important decision in evaluating a business
is pricing power.” This is not just relevant for established businesses. Marc Andreessen, co-founder and
general partner of the venture capital firm Andreessen Horowitz, recently said “probably the single
number one thing we try to get our companies to do is raise prices.”24
Price elasticity, a measure of the change in the demand for the quantity of a good or service relative to a
change in price, is one way to assess pricing power. Goods or services that are inelastic (e.g., cigarettes
and gasoline) have small changes in demand for a given price change, whereas price changes create
large changes in demand for elastic goods (e.g., leisure airline travel and high-end spirits). One study of
price elasticity for a sample of roughly 370 goods found that a 1 percent change in price would lead to
an average of a 1.76 percent change in demand.25
Price mix captures the change in sales of high- and low-margin products. Goodyear Tire & Rubber is an
example of a company that has had a positive sales mix in recent years. Goodyear’s sales in 2015 were
28 percent lower than those in 2011 and its total unit volume was 8 percent less. Both sales and volume
declined in each year since 2011 with the exception of 2015 for volume. Yet the company’s operating
income rose nearly 50 percent over that period, while its operating profit margin expanded 6 percentage
points. A shift in mix from low-margin commodity tires to high-margin premium tires allowed the company
to increase operating margins.26 Exhibit 7 summarizes these figures.
Exhibit 7: Goodyear Tire & Rubber Change in Sales Mix (2011-2015)

25 14
24 Operating Profit Margin
12
Sales (Billions U.S. Dollars)
23
22 10
21 8
20
19 6
18 4
Sales
17
2
16
15 0
2011 2012 2013 2014 2015
Source: Company reports.
June 14, 2016
Operating Leverage. Businesses almost always invest money before they can generate sales and
profits. These outlays are called “preproduction costs.” For some companies, including those in the
chemical, steel, and utility businesses, the costs relate to physical facilities. These investments are
capitalized on the balance sheet and the accountants depreciate their value on the income statement
over time. Other companies, such as those in the biotechnology or software industries, make huge
investments in research and development or in writing code but expense most of those investments.
Preproduction costs lower operating profit margins in the short run. But as subsequent sales of the good
or service occur, margins rise. Think of it this way: Say a manufacturing company incurs substantial
preproduction costs to build a factory that can produce 100 widgets but only produces 50 today. As
volume rises from 50 to 100 widgets, the incremental investment is small and operating margins rise.
Operating leverage is relevant when you see a company in a position to reap the benefit of its spending
on preproduction costs.
Capacity utilization is one way to assess operating leverage (see exhibit 8). Operating margins tend to
shrink when capacity utilization falls and expand when utilization rises. Exhibit 9 shows this relationship.
Exhibit 8: Capacity Utilization: Total Industry (1967-April 2016)

90
85
Percent of Capacity
80
75
70
65
1997
2000
1967
1970
1973
1976
1979
1982
1985
1988
1991
1994
2003
2006
2009
2012
2015
Source: Board of Governors of the Federal Reserve System (U.S.).

Note: Monthly data.
June 14, 2016
Exhibit 9: Changes in Capacity Utilization and Changes in Operating Margin (1967-2014)

20 r = 0.59
Change in Operating Margin (Percent)

15
10
-5
-10
-15
-20
-15 -10 -5 0 5 10
Change in Capacity Utilization (Percent)
Source: Board of Governors of the Federal Reserve System (U.S.) and Credit Suisse HOLT®.
Note: Annual data.
Economies of Scale. A company enjoys economies of scale when it can perform key activities at a
lower cost per unit as its volume increases. These tasks include purchasing, production, marketing, sales,
and distribution. Economies of scale lead to greater efficiency as volume increases. This is distinct from
operating leverage, where margin improvement is the result of spreading preproduction costs over larger
volumes. Mistaking operating leverage for economies of scale may lead to the incorrect conclusion that
unit costs will decline even as the company expands to meet new demand.
The financial results of Home Depot, the largest home improvement retailer in the United States, are an
example of economies of scale. Home Depot’s gross margins expanded from 27.7 percent in fiscal
1996 to 29.9 percent in fiscal 2001 as it added incremental sales in excess of $30 billion. The company
attributed the improvement in its profitability to the ability to use its size to get better prices from its
suppliers.
Cost Efficiencies. Cost efficiencies can also affect operating profit margin but are unrelated to sales
changes and hence not relevant to a discussion of operating leverage. Still, you must account for
operating margin changes as the result of cost efficiencies. These efficiencies come about in two ways.
A company can either reduce costs within an activity or it can reconfigure its activities.27
The discussion of sales changes and the value factors provides you with a framework to consider operating
leverage, or how operating profit rises or falls as a function of a change in sales. We now turn to an empirical
examination of operating leverage by sector to understand the past and to get a sense of where operating
leverage is most pronounced.
June 14, 2016
Empirical Results for Operating Leverage
We measure operating leverage by examining the relationship between the change in sales and the change in
operating profit in a particular period. Exhibit 10 shows this calculation for the top 1,000 global companies by
market capitalization, excluding financials and utilities, over 1- and 3-year periods from 1950 through 2014.
We call the slope of the least-squares regression line the “operating margin beta (β),” and it is a good proxy
for the degree of operating leverage. The operating margin β for both periods is about 0.10, and is slightly
higher for the one-year change. The way to interpret the β is that for every $1.00 change in sales, operating
profit changes by approximately $0.10.
Exhibit 10: Operating Leverage for the Top 1,000 Global Companies (1950-2014)
2,000 y = 0.11x + 4.06 4,000 y = 0.10x + 4.15
3-Year Change in Operating Income

1,500 3,000
1,000
2,000
500
1,000
0
-5,000 0 5,000 10,000 15,000
0
-500 -10,000 0 10,000 20,000 30,000
-1,000 -1,000
-1,500 -2,000
1-Year Change in Sales 3-Year Change in Sales
®
Source: Credit Suisse HOLT .
Note: All amounts in 2014 U.S. dollars; winsorized at 2nd and 98th percentiles.
Naturally, operating margin β varies by sector and industry given the different economic characteristics of each.
Exhibit 11 shows the data and operating margin β for eight sectors, ranked from highest to lowest leverage.
Exhibit 12 shows the results for each sector for the one- and three-year periods.
Exhibit 11: Operating Margin Beta by Sector (1950-2014)

One-Year Operating Three-Year Operating
Sector Margin Beta Margin Beta
Materials 0.19 0.16
Information Technology 0.17 0.16
Telecommunication Services 0.17 0.19
Energy 0.13 0.10
Health Care 0.12 0.12
Industrials 0.08 0.08
Consumer Discretionary 0.08 0.07
Consumer Staples 0.07 0.07
®
June 14, 2016
Exhibit 12: Operating Margin Beta by Sector (1950-2014)

1,500 y = 0.08x + 8.34 3,500 y = 0.07x + 16.01
3,000

1,000 2,500
2,000
500
1,500
1,000
0
-5,000 0 5,000 10,000 500
-500 0
-5,000 0 5,000 10,000
-500
-1,000 -1,000
Consumer Staples
1,200 y = 0.07x + 23.06 2,500 y = 0.07x + 63.49
1,000
2,000
800
1,500
600
400 1,000
200 500
0
-5,000 0 5,000 10,000 0
-200 -10,000 0 10,000 20,000 30,000
-500
-400
-600 -1,000
Energy
6,000 y = 0.13x - 38.84 12,000 y = 0.10x + 56.12
10,000
4,000
8,000
2,000 6,000
4,000
0
-20,000 0 20,000 40,000 2,000
-2,000 0
-50,000 0 50,000 100,000
-2,000
-4,000
-4,000
-6,000 -6,000
June 14, 2016
Health Care
1,500 y = 0.12x + 39.39 4,000 y = 0.12x + 119.68
3,500

1,000 3,000
2,500
2,000
500
1,500
1,000
0
500
-5,000 0 5,000 10,000
0
-500 -10,000 -500 0 10,000 20,000 30,000
-1,000
-1,000 -1,500
Industrials
1,200 y = 0.08x + 10.43 2,500 y = 0.08x + 10.44
1,000
2,000
800
1,500
600
400 1,000
200 500
0
0
-5,000 0 5,000 10,000
-200 -10,000 0 10,000 20,000
-500
-400
-600 -1,000
-800 -1,500
2,500 y = 0.17x - 12.25 6,000 y = 0.16x - 66.05
2,000 5,000
1,500 4,000
1,000 3,000
500 2,000
0 1,000
-5,000 0 5,000 10,000
-500 0
-10,000 0 10,000 20,000 30,000
-1,000 -1,000
-1,500 -2,000
-2,000 -3,000
June 14, 2016
Materials
2,000 y = 0.19x - 28.83 4,000 y = 0.16x - 87.24

1,500 3,000
1,000 2,000
500 1,000
0 0
-5,000 0 5,000 10,000 -5,000 0 5,000 10,000 15,000
-500 -1,000
-1,000 -2,000
-1,500 -3,000
4,000 y = 0.17x - 32.04 10,000 y = 0.19x - 126.84
8,000
3,000
6,000
2,000
4,000
1,000
2,000
0
-10,000 0 10,000 20,000 0
-1,000 -20,000 0 20,000 40,000
-2,000
-2,000 -4,000
-3,000 -6,000
®
Note: All amounts in 2014 U.S. dollars; winsorized at 2nd and 98th percentiles.
June 14, 2016
Operating margin β has a few practical uses. The error in analyst forecasts tends to be larger in sectors and
industries where the operating margin β is high. For example, earnings surprises are large in the metal industry
but small in the food industry.28 Understanding the full framework for assessing operating leverage is
particularly important for sectors and industries with high operating margin β’s.
Analyst errors tend to be large at peaks and troughs in industrial production. When industrial production
growth accelerates, the errors in analyst forecasts tend to fall. When industrial production decelerates, errors
tend to rise. Analysts, who are normally optimistic, are rewarded when economic conditions are favorable and
miss the mark substantially when conditions are poor.29
Notwithstanding the errors that analysts make when the economy is expanding or contracting, their earnings
forecasts are more accurate than those of management for businesses with high operating margin β.
Management forecasts are better than those of analysts when a firm is dealing with unusual issues such as
losses, inventory increases, and excess capacity. Overall, forecasts by management are more accurate than
analysts about half of the time, suggesting that the information advantage executives have may not be as
significant as macroeconomic factors in determining the accuracy of their forecasts. 30
At this point, we have developed a framework to anticipate changes in operating profit. The process involves
consideration of macroeconomic outcomes and microeconomic factors, informed by empirical results. This
analysis is the basis for “asset beta,” the risk of a company based on the volatility of operating income and
without regard for financial policy. We now introduce the role of financial leverage as a final step to understand
volatility in earnings.
Financial Leverage
Earnings volatility for a company is determined by the combination of volatility in operating profit and financial
leverage. Financial leverage captures the amount of debt a company assumes, net of the cash that it holds.
Lots of debt increases the volatility of earnings because a company has to pay interest expense, which you
can think of as another fixed cost. As a result, financial leverage amplifies changes in operating income. In
exhibit 1, we refer to this as “financial leverage beta (β).”
To illustrate the impact of financial leverage β, consider two companies, A and B, which have the same
scenarios for operating profit next year:
Company A
Operating profit Interest expense Pretax profit
Bullish scenario $120 $0 $120
Base case scenario 100 0 100
Bearish scenario 80 0 80
Since A is free of debt, the variability of pretax profit mirrors that of operating profit. In this case, the highest
profit scenario ($120) is 50 percent greater than the lowest ($80).
Company B
Operating profit Interest expense Pretax profit
Bullish scenario $120 $30 $90
Base case scenario 100 30 70
Bearish scenario 80 30 50
June 14, 2016
B has debt and hence interest expense. The variability of pretax profit for B is much higher than that for A.
The highest profit ($90) is 80 percent greater than the lowest profit ($50). The addition of debt creates more
volatility in earnings and may suggest different values for the businesses.
Exhibit 13 shows the debt-to-total capital ratios by sector. This ratio uses the book value of debt and the
market value of equity. Higher ratios of debt to total capital are consistent with higher financial leverage.
However, the substantial increase in cash holdings distorts this relationship. For example, Apple’s debt-to-
total-capital ratio was approximately 13 percent on March 31, 2016 (debt of $78 billion and market value of
equity of $540 billion). But the company had a cash balance in excess of $200 billion. This means that the
company’s net cash position was in excess of $100 billion even after considering the taxes the company
would pay if it repatriated the money.
Exhibit 13: Debt-to-Total Capital Ratio by Sector
Energy
Materials
Industrials
Consumer Staples
Health Care
0.00 0.05 0.10 0.15 0.20 0.25 0.30 0.35 0.40

Debt to Total Capital
Source: Aswath Damodaran.
Note: Global companies as of January 2015; Debt-to-total capital ratio for each sector is the average of the industries in that sector.
Credit ratings are also a proxy for financial leverage. Exhibit 14 shows the statistics for companies of various
investment ratings, including operating margins, the ratio of operating profit to interest expense, debt to total
capital, and default rates. Companies with high ratings tend to have high margins, low amounts of debt, and
strong interest expense coverage ratios.
June 14, 2016
Exhibit 14: Statistics for Companies with Different Credit Ratings

AAA AA A BBB BB B
Operating income/revenues (%) 28.0 26.9 22.7 21.3 17.9 19.2
EBIT interest coverage (x) 40.8 17.3 10.3 5.5 3.2 1.3
Debt/total capital (%) 2.8 17.2 30.7 41.1 50.4 72.7
Return on capital (%) 30.6 21.6 22.2 14.2 11.1 7.1
Median default rates, 1-Year (%) 0.00 0.00 0.00 0.12 0.71 3.46
Number of companies 4 15 94 233 253 266
Source: Standard & Poor's Ratings Services, Ratings Direct.
Note: Financial ratios are medians for 3-year averages (2011-2013) for U.S companies; default rates are median 1-year global default rates (2014).
Academic research shows that companies with high operating leverage tend to have lower financial leverage.31
Our findings are consistent with this when we measure financial leverage as debt-to-total capital based on
book value. The idea is that companies with high operating margin β will seek low financial leverage so as to
manage overall risk.
Over the past 30 years, the ratio of cash to assets has risen in the United States from 7 percent in 1980 to
about 16 percent today.32 This shift is consistent with the rise in companies that spend a lot of money on
research and development (R&D). As R&D expense is a fixed or quasi-fixed cost, this trend reflects the efforts
by executives to manage overall risk by using a cash buffer to dampen the impact of operating leverage.
Operating leverage and financial leverage together determine earnings volatility. Generally speaking,
executives of companies with substantial operating leverage choose a conservative capital structure so as to
reduce the volatility of the business results.
Conclusion
Making money in markets requires having a point of view about financial results that is different than what the
market reflects. This not only requires understanding the expectations that today’s price embeds, it also
means you must anticipate something that the market does not.
Many financial models that analysts build suffer from linear extrapolation. Quality modelling recognizes the
interactions between sales growth, profitability, and financial leverage. This report offers a systematic
approach to conducting this analysis, fortified with substantial empirical results. While much of our empirical
work is based on analysis by sector, you can use the framework in exhibit 1 for individual companies.
June 14, 2016
Operating Leverage Checklist
Did you consider the relevant macroeconomic variables and their impact on sales growth rates?
Do you understand the breakdown between the company’s fixed and variable costs?
Have you analyzed which value factors have been relevant in determining past results and which will
come into play for future earnings?
Did you determine the impact of cost efficiencies?
Have you calculated the operating margin beta for past results and estimated it to make a thoughtful
forecast?
Did you analyze the balance sheet, including total debt and cash balances, to gauge the effect of
financial leverage?
June 14, 2016
Appendix A: Threshold and Incremental Threshold Operating Profit Margin
Considering the relationship between sales growth, profit growth, and value creation is vital throughout this
analysis. One way to do this is to calculate the threshold margin, or the level of operating profit margin at
which a company earns its cost of capital. To break even in terms of economic value, a company with higher
capital intensity requires a higher margin than a company with lower capital intensity.33
Let’s examine a simple example. Assume a company has the following financial characteristics:
Base sales $100

Sales growth 8.0%
Operating profit margin (base) 8.4%
Operating profit margin (incremental) 8.4%
Incremental fixed capital rate 35%
Incremental working capital rate 25%
Tax rate 35%
Cost of capital 10%
The definitions for sales growth, operating profit margin, tax rate, and the cost of capital are straightforward.
The incremental fixed capital rate captures how much a company will spend on incremental investments in
fixed capital (more formally, capital expenditures minus depreciation) and is measured as a percentage change
in sales.
For example, if sales grow by $10 and the incremental fixed capital rate is 35 percent, the company’s capital
expenditure, net of depreciation, is $3.5. The same idea applies to working capital. For every incremental
dollar in sales, the incremental working capital rate measures the percent a company needs to reinvest in
working capital.
We get these figures if we apply the numbers to five years of free cash flow:
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Sales $100.0 108.0 116.6 126.0 136.0 146.9
Operating income 8.4 9.1 9.8 10.6 11.4 12.3
Taxes 3.2 3.4 3.7 4.0 4.3
Incremental fixed capital 2.8 3.0 3.3 3.5 3.8
Incremental fixed capital 2.0 2.2 2.3 2.5 2.7
Free cash flow 1.1 1.2 1.3 1.4 1.5
We can see that the company is growing modestly. But the question is whether it is creating shareholder value.
We can only assess that by determining whether the company earns a return on its incremental investments
that exceeds the cost of capital.
The answer is that this company is value neutral (see the column “shareholder value added” at the far right
below). It earns its cost of capital on its investments. This demonstrates that growth does not equal value
creation.
June 14, 2016
Free cash Present value of Cumulative present Present value of CUM PV of FCF + Shareholder
Year flow free cash flow value of free cash flow residual value PV of residual value added
1 1.09 0.99 0.99 53.56 54.55
2 1.18 0.97 1.97 52.58 54.55 0
3 1.27 0.96 2.92 51.63 54.55 0
4 1.37 0.94 3.86 50.69 54.55 0
5 1.48 0.92 4.78 49.77 54.55 0
With these parts in place, we can now calculate the incremental threshold margin. This is the margin the
company must achieve on incremental investments in order to earn the cost of capital.
Incremental threshold margin = (incremental fixed + working capital rate) * (cost of capital)
(1 + cost of capital) * (1 – tax rate)
Substituting numbers from above, we can see that the threshold margin is 8.4 percent:
Incremental threshold margin = (0.35 + 0.25) * 0.10 = 0.06 = 0.084

(1.10) * (0.65) 0.715
Given this company’s sales growth, investment needs, tax rate, and cost of capital, it needs to achieve an
incremental profit margin of 8.4 percent just to earn the cost of capital. What the equation also makes clear is
that as a company’s investment needs increase, the business must earn a higher operating profit margin to be
value neutral.
While the incremental threshold margin captures the required margin on new sales, the threshold margin
reflects the overall margin the company must earn to be value neutral.
Here’s the equation:
Threshold margin = (prior year operating income) + (incremental threshold margin * incremental sales)
prior sales + increase in sales
Running the numbers from year 1 to year 2, we see that the threshold margin is also 8.4 percent:
Threshold margin = 9.1 + (0.084 * 8.6) = 9.82 = 0.084

108.0 + 8.6 116.6
Incorporating the concept of threshold margin helps clarify the essential link between growth, profitability, and
value creation.
June 14, 2016
Appendix B: Operating Margins—The Rich Get Richer
Exhibit 15 shows that the aggregate and median operating profit margin for the top 1,000 companies has
been rising since the mid-1980s. The sample excludes companies in the financial services and utility industries.
The aggregate margin is total operating profit divided by total sales for the companies in the sample. The
decline in operating profit margin from 1950 through the early 1980s is the result of increased global
competition in an economy dominated by manufacturing. Since the mid-1980s, the economy has shifted
toward service and knowledge businesses, which tend to have higher operating profit margins.
Exhibit 15: Aggregate and Median Operating Profit Margin (1950-2014)

18
Median
16
14
12
10 Aggregate
8
6
4
2
0
1962
1990
1950
1954
1958
1966
1970
1974
1978
1982
1986
1994
1998
2002
2006
2010
2014
Exhibit 16 shows that much of the expansion in aggregate operating profit margin is attributable to the top
quintile.34 Here, we use operating margin to sort the sample into quintiles in each year. We then see how the
margins change for each of the quintiles over time. This method ensures that the composition of each quintile
changes annually.
Over the full period, the operating margins of the bottom three quintiles remain roughly flat. But the top two
quintiles, and especially the highest one, show substantial margin expansion. For example, the operating
margin for the highest quintile went from 21 percent in 1985 to 33 percent in 2014.
June 14, 2016
Exhibit 16: Operating Profit Margins on the Rise for the Top 20 Percent
45
40
35
30
25
20
15
10
0
1966
2010
1950
1954
1958
1962
1970
1974
1978
1982
1986
1990
1994
1998
2002
2006
2014
Exhibit 17 shows the trend in operating profit margin for all sectors. Note that the relative contribution of
sectors changes over time. For example, the energy, materials, and industrial sectors represented 51 percent
of the market capitalization of the top 1,500 companies in the U.S. market in 1980 but just 19 percent in
2015. During the same time, the healthcare and technology sectors went from 17 to 34 percent of the
market capitalization.
June 14, 2016
Exhibit 17: Operating Profit Margin by Sector (1950-2014)

35 Consumer Discretionary 35 Consumer Staples 35 Energy

30 Mean: 8.2% 30 Mean: 8.3% 30 Mean: 11.7%
25
Median: 8.0% 25
Median: 8.0% 25
Median: 12.1%
StDev: 2.5% StDev: 1.0% StDev: 2.9%
20 20 20
15 15 15
10 10 10
5 5 5
0 0 0
1950
1998
2006
1958
1966
1974
1982
1990
2014
1950
1958
1966
1974
1982
1990
1998
2006
2014
1950
1958
1966
1974
1982
1990
1998
2006
2014
35 Health Care 35 Industrials 35 Information Technology

30 Mean: 15.7% 30 Mean: 7.9% 30 Mean: 13.7%
25
Median: 15.7% Median: 8.3% Median: 13.6%
25 25
StDev: 1.7% StDev: 2.3% StDev: 3.6%
20 20 20
15 15 15
10 10 10
5 5 5
0 0 0
1950
1958
1966
1974
1982
1990
1998
2006
2014
1950
1998
1958
1966
1974
1982
1990
2006
2014
1950
1958
1966
1974
1982
1990
1998
2006
2014
35 Materials 35 Telecommunication Services

30 Mean: 21.6%
Mean: 12.1% 30
Median: 20.6%
Median: 11.7%
25 25 StDev: 5.1%
StDev: 3.7%
20 20
15 15
10 10
5 5
0 0
1990
1950
1958
1966
1974
1982
1998
2006
2014
1950
1958
1966
1974
1982
1990
1998
2006
2014
June 14, 2016
Endnotes
1
Vijay Kumar Chopra, “Why So Much Error in Analysts’ Earnings Forecasts?” Financial Analysts Journal, Vol.
54, No. 6, November/December 1998, 35-42.
2
Alfred Rappaport and Michael J. Mauboussin, Expectations Investing: Reading Stock Prices for Better
Returns (Boston, MA: Harvard Business School Press, 2001).
3
Robert L. Hagin, Investment Management: Portfolio Diversification, Risk, and Timing—Fact and Fiction
(Hoboken, NJ: John Wiley & Sons, 2004), 75-78.
4
Chopra, 1998.
5
David Aboody, Shai Levi, and Dan Weiss, “Operating Leverage and Future Earnings,” Working Paper,
December 7, 2014. Also, Huong N. Higgins, “Earnings Forecasts of Firms Experiencing Sales Decline: Why
So Inaccurate?” Journal of Investing, Vol. 17, No. 1, Spring 2008, 26-33.
6
Boris Groysberg, Paul Healy, and Craig Chapman, “Buy-Side vs. Sell-Side Analysts’ Earnings Forecasts,”
Financial Analysts Journal, Vol. 64, No. 4, July/August 2008, 25-39.
7
Robert Novy-Marx, “Operating Leverage,” Review of Finance, Vol. 15, No. 1, January 2011, 103-134. Also,
Jaewon Choi, “What Drives the Value Premium?: The Role of Asset Risk and Leverage,” Review of Financial
Studies, Vol. 26, No. 11, November 2013, 2845-2875.
8
Salvador Anton Clavé, The Global Theme Park Industry (Wallingford, UK: CABI, 2007), 361.
9
Mark C. Anderson, Rajiv D. Banker, and Surya N. Janakiraman, “Are Selling, General, and Administrative
Costs ‘Sticky’?” Journal of Accounting Research, Vol. 41, No. 1, March 2003, 47-63.
10
Bruce Greenwald and Judd Kahn, Competition Demystified: A Radically Simplified Approach to Business
Strategy (New York: Portfolio, 2005), 43-45.
11
George Foster, Financial Statement Analysis (Englewood Cliffs, NJ: Prentice-Hall, 1978), 268-271. Also,
Baruch Lev, “On the Association Between Operating Leverage and Risk,” Journal of Financial and Quantitative
Analysis, Vol. 9, No. 4, September 1974, 627-641. Also, Gershon N. Mandelker and S. Ghon Rhee, “The
Impact of the Degrees of Operating and Financial Leverage on Systematic Risk of Common Stock,” Journal of
Financial and Quantitative Analysis, Vol. 19, No. 1, March 1984, 45-57.
12
Boris Groysberg, Paul Healy, Nitin Nohria, and George Serapheim, “What Factors Drive Analyst Forecasts?”
Financial Analysts Journal, Vol. 67, No. 4, July/August 2011, 18-29.
13
Michael J. Mauboussin and Dan Callahan, “Total Addressable Market: Methods to Estimate a Company’s
Potential Sales,” Credit Suisse Global Financial Strategies, September 1, 2015.
14
Mariana Mazzucato, ed., Strategy for Business: A Reader (London: Sage Publications, 2002), 78-122.
15
Tim Koller, Marc Goedhart, and David Wessels, Valuation: Measuring and Managing the Value of
Companies, Sixth Edition (Hoboken, NJ: John Wiley & Sons, 2015), 116-118.
16
Patrick Viguerie, Sven Smit, and Mehrdad Baghai, The Granularity of Growth: How to Identify the Sources
of Growth and Drive Enduring Company Performance (Hoboken, NJ: John Wiley & Sons, 2008).
17
Michael J. Mauboussin and Dan Callahan, “Capital Allocation—Updated: Evidence, Analytical Methods, and
Assessment Guidance,” Credit Suisse Global Financial Strategies, June 2, 2015.
18
Mariana Mazzucato, Firm Size, Innovation, and Market Structure: The Evolution of Industry Concentration
and Instability (Cheltenham, UK: Edward Elgar, 2000).
19
J. Scott Armstrong and Kesten C. Green, “Competitor-oriented Objectives: The Myth of Market Share,”
International Journal of Business, Vol. 12, No. 1, Winter 2007, 115-134.
20
Daniel Kahneman, Thinking, Fast and Slow (New York: Farrar, Straus and Giroux, 2011), 245-254.
21
Michael J. Mauboussin, Dan Callahan, and Darius Majd, “The Base Rate Book—Sales Growth: Integrating
the Past to Better Anticipate the Future,” Credit Suisse Global Financial Strategies, February 23, 2016.
22
Alfred Rappaport, Creating Shareholder Value: The New Standard for Business Performance (New York:
Free Press, 1986), 69-75.
23
Rappaport and Mauboussin, 40-46.
June 14, 2016
24
Financial Crisis Inquiry Commission Staff Audiotape of Interview with Warren Buffett, Berkshire Hathaway,
May 26, 2010. See http://dericbownds.net/uploaded_images/Buffett_FCIC_transcript.pdf. Also, Biz Carson,
“Marc Andreessen Has 2 Words of Advice for Struggling Startups,” Business Insider, June 2, 2016.
25
Gerard Tellis “The Price Elasticity of Selective Demand: A Meta-Analysis of Econometric Models of Sales,”
Journal of Marketing Research, Vol. 25, No. 4, November 1998, 331-341.
26
Company reports and presentations. See https://corporate.goodyear.com/documents/events-
presentations/DB%20Global%20Auto%20Presentation%202016%20FINAL.pdf.
27
David Besanko, David Dranove, and Mark Shanley, Economics of Strategy (New York: John Wiley & Sons,
2000), 436.
28
Lawrence D. Brown, “Analyst Forecasting Errors: Additional Evidence,” Financial Analysts Journal, Vol. 53,
No. 6, November/December 1997, 81-88.
29
Chopra, 1998.
30
Amy P. Hutton, Lian Fen Lee, and Susan Z. Shu, “Do Managers Always Know Better? The Relative
Accuracy of Management and Analyst Forecasts,” Journal of Accounting Research, Vol. 50, No. 5, December
2012, 1217-1244.
31
Matthias Kahl, Jason Lunn, and Mattias Nilsson, “Operating Leverage and Corporate Financial Policies,”
Working Paper, November 20, 2014. Also, QianQian Du, Laura Xiaolie Liu, and Rui Shen, “Cost Inflexibility
and Capital Structure,” Working Paper, March 14, 2012. Also, Zhiyao Chen, Jarrad Harford, and Avraham
Kamara, “Operating Leverage, Profitability, and Capital Structure,” Working Paper, November 7, 2014.
32
Juliane Begenau and Berardino Palazzo, “Firm Selection and Corporate Cash Holdings,” Harvard Business
School Working Paper, No. 16-130, May 2016.
33
The appendix relies heavily on Rappaport (1986).
34
Patrick O’Shaughnessy, “The Rich Are Getting Richer,” The Investor’s Field Guide Blog, May 2015. See
www.investorfieldguide.com/the-rich-are-getting-richer. Also, “Profit Margins in a ‘Winner Take All’ Economy,”
Philosophical Economics Blog, May 7, 2015. See www.philosophicaleconomics.com/2015/05/profit-
margins-in-a-winner-take-all-economy.
With respect to the analysis in this report based on the Credit Suisse HOLT methodology, Credit Suisse certifies that (1) the views expressed in this report
accurately reflect the Credit Suisse HOLT methodology and (2) no part of the Firm’s compensation was, is, or will be directly related to the specific views
disclosed in this report.
The Credit Suisse HOLT methodology does not assign recommendations to a security. It is an analytical tool that involves use of a set of proprietary quantitative
algorithms and warranted value calculations, collectively called the Credit Suisse HOLT valuation model, that are consistently applied to all the companies included
in its database. Third-party data (including consensus earnings estimates) are systematically translated into a number of default variables and incorporated into the
algorithms available in the Credit Suisse HOLT valuation model. The source financial statement, pricing, and earnings data provided by outside data vendors are
subject to quality control and may also be adjusted to more closely measure the underlying economics of firm performance. These adjustments provide
consistency when analyzing a single company across time, or analyzing multiple companies across industries or national borders. The default scenario that is
produced by the Credit Suisse HOLT valuation model establishes the baseline valuation for a security, and a user then may adjust the default variables to produce
alternative scenarios, any of which could occur. Additional information about the Credit Suisse HOLT methodology is available on request.
The Credit Suisse HOLT methodology does not assign a price target to a security. The default scenario that is produced by the Credit Suisse HOLT valuation
model establishes a warranted price for a security, and as the third-party data are updated, the warranted price may also change. The default variables may also
be adjusted to produce alternative warranted prices, any of which could occur. Additional information about the Credit Suisse HOLT methodology is available on
request.
Form Follows Function

Organizational Structure and Investment Results
July 8, 2016
Authors
michael.mauboussin@credit-suisse.com
Dan Callahan, CFA

Darius Majd
Source: iStockphoto.
Note: Ironwork designed by Louis Sullivan.
“It is the pervading law of all things organic, and inorganic, of all things
physical and metaphysical, of all things human and all things superhuman, of
all true manifestations of the head, of the heart, of the soul, that the life is
recognizable in its expression, that form ever follows function. This is the law.”
Louis H. Sullivan1
A thoughtful leader carefully considers how his or her firm seeks to add
economic value and builds the organization to do so.
Research suggests that the organization is more important than the
individuals within it.
Teams of three portfolio managers deliver higher gains, adjusted for risk,
than funds managed by a single individual or by teams of other sizes.
Informational diversity has a positive influence on performance and social
category diversity has a modestly negative influence.
Researchers find that funds run by analysts deliver higher returns than
similar funds run by portfolio managers in the same firm.
July 8, 2016
Introduction
Louis Sullivan, a modernist American architect who lived in the late 19th and early 20th century, popularized the
phrase “form follows function.” His point was that an architect should design a building to serve its intended
function. The concept applies to organizations as well. A thoughtful leader carefully considers how his or her
firm seeks to add economic value and builds the organization to do so. Our focus is on investment
management companies.
In simple terms, an investment firm starts with data, which it seeks to refine into information. Analysts and
portfolio managers then evaluate that information and identify securities that appear to be mispriced.
Mispricings are absolute when price differs from value and relative when two securities are mispriced
compared to one another. Portfolio managers then assemble securities in a portfolio. The goal is to generate
attractive returns after considering risk. Organizations can do these tasks quantitatively, qualitatively, or
through some blend of the two. See exhibit 1.
Exhibit 1: Possible Sources of Edge in an Investment Process
Security Portfolio
Data Information
Selection Construction
There are multiple sources of possible edge throughout the process. Firms can gain access to better data
than the competition or have means to refine that data into information that is superior to others. Other firms
may rely on analysis or portfolio management to squeeze out an advantage. Quantitative approaches provide
rigor and consistency. Fundamental approaches can benefit from specialization and identify instances where
the rules-based approaches go wrong.
There are related aspects such as time horizon. Some investment firms seek many little anomalies and trade
frequently to capitalize on them. Think Jim Simons and Renaissance Technologies. Others take a long view
with a belief that large mispricings will evaporate over time. Think Warren Buffett and Berkshire Hathaway.
Both firms have been successful but have radically different organizational structures.
The nature of the client base is also vital. Investors have a tendency to buy high and sell low, which means
that the dollar-weighted rates of return for most funds are well below the time-weighted rates of return.2 The
types of clients an investment firm has and how they add or withdraw funds also has an influence on the
organization and results of the firm.
Here is the main point: You should align every aspect of your organization to support the source of edge you
perceive. Form follows function.
This is important because research shows that the organization is more important than the individuals within
it.3 Klaas Baks, a professor of finance at the Goizueta Business School at Emory University, used a standard
economic model that considered managers and organizations as the factors of production and abnormal
returns as the output. He studied more than 2,000 equity mutual funds and concluded that the organization
explains about 70 percent of the difference between fund results and that the manager was only 30 percent.4
While the relative contribution of the manager and the organization depends on your assumptions, the
manager’s contribution is less than half in nearly all situations.
Form Follows Function 2

July 8, 2016
Further supporting this argument is evidence that the performance of investment professionals drops off
sharply when they switch firms.5 One of the main reasons for this performance degradation is that
professionals leave behind “firm specific human capital”—essentially a set of resources, methods, culture,
informal networks, and talented co-workers—that supports and augments their own capabilities.
Notwithstanding the evidence of the importance of the organization, 85 percent of analysts that researchers
interviewed believed that their performance on the job was independent of their employers and hence
considered their skills to be portable.
Academics have looked carefully at organizational structure and have concluded that it is important in
determining both strategy and performance.6 One dimension researchers studied was hierarchy, defined as
“the distinct number of layers of the structure of the fund.” For example, a fund with a chief executive officer,
a chief investment officer, a head of fixed income, a portfolio manager, and analysts would have five layers.
The research shows that each additional layer an investment firm has reduces average performance.
The rest of this report draws on research to highlight various aspects of organizational structure. We discuss
the role of team size in success in managing portfolios, how team composition affects performance, the
difference in performance between funds run by analysts and portfolio managers within the same firm, and
which sources of input are most useful to portfolio managers. The goal is to prompt an assessment of your
own organization. Where do you create value? Are there changes you can make to align your structure with
your objectives more effectively?
Portfolio Management Team Size
The shift from single- to team-managed equity mutual funds is one of the biggest changes in the money
management business in the U.S. in the last quarter century. Exhibit 2 shows that about 70 percent of equity mutual
funds had a single manager in the early 1990s and that teams manage close to three-quarters of funds today.
Further, the members are anonymous in about 20 percent of funds run by teams.7
From the point of view of a fund company, having a single manager run a fund has pros and cons. The pros are that
it is easier to market a fund with a superstar manager, and indeed the inflows for named managers exceed those of
funds run anonymously. Single managers may also have a greater incentive to perform than a member of a team
because he or she is personally accountable for the fund’s results. Further, funds run by one individual have higher
fees.8 The cons are that single managers seek to capture more of the fund’s economics and take on more risk than
team-managed funds do.

July 8, 2016
Exhibit 2: Mutual Funds Shift from One to Multiple Managers

80
1 Manager
70 2 Managers
3 Managers
Percentage of Mutual Funds
60 4 Managers
5+ Managers
50
40
30
20
10
0
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
Source: Saurin Patel and Sergei Sarkissian, “To Group or Not to Group? Evidence from Mutual Fund Databases,” Journal of Financial and Quantitative
Analysis, Forthcoming, 2016.
Prior studies showed that funds run by teams had returns that were comparable or slightly lower than funds
run by individuals.9 Team-run funds are also generally less risky.10 The difficulty in completing this analysis
properly is the accuracy with which the performance monitoring groups, including Morningstar and The Center
for Research in Security Prices (CRSP), report the data.
New research by Saurin Patel and Sergei Sarkissian, professors of finance, corrected this data issue and then
re-examined the performance of various sizes of teams relative to single-managed funds.11 Exhibit 3
summarizes their findings. They show that the highest gains, adjusted for risk, come from teams of three
members. From there, there is a substantial drop to two-person teams and finally, teams of four. (The
numbers for teams of five or more are similar to those of three, but the researchers found they could draw no
sound conclusions because the sample size was too small.)
It is interesting to note that a team with an odd number of members is at the top of the list. Having three team
members allows sufficient diversity to entertain and vet multiple points of views and has a built-in mechanism
to break ties.

July 8, 2016
Exhibit 3: Team-Managed Funds Relative to Single-Managed Funds (Annual Returns)
Number of Managers Three 58
Two 32
Four 25
0 10 20 30 40 50 60
Risk-Adjusted Gains Relative to
Single-Managed Mutual Funds (Basis Points)
Source: Saurin Patel and Sergei Sarkissian, “To Group or Not to Group? Evidence from Mutual Fund Databases,” Journal of Financial and Quantitative
Analysis, Forthcoming, 2016.
As they examined the data more closely, Patel and Sarkissian realized that only the teams in large
metropolitan areas outperformed the single managers.12 The idea is that larger cities have higher employee
skills and productivity than smaller ones, which create favorable conditions for team results.13 So it is not
simply a team that makes a difference. It is a team that has the requisite characteristics.
The work by Patel and Sarkissian prompts an assessment of the structure of portfolio management teams for
investment firms that rely on a fundamental approach to security selection. Prior research of portfolio manager
results shows that those who attended more selective colleges or universities generated better returns.14 While
the era of the single-managed fund has been fading for decades, only recent work shows that teams deliver
better results than individuals do under certain conditions, as well as which team size is most effective. We
now turn to the topic of how to construct a team to get the highest probability of success.
Team Composition
Groups are effective at making decisions when the views of team members are diverse and there is a
mechanism to aggregate those views.15 Diverse teams have the potential to add value when the members
have different information, the information and models of the members are relevant to the problem at hand,
and there is sufficient communication.16 Promoting diversity within an organization and managing it effectively
are separate tasks. As leading researchers have noted, “To implement policies and practices that increase
the diversity of the workforce without understanding how diverse individuals can come together to form
effective teams is irresponsible.”17
Organizational theorists who study diversity distinguish between social category diversity, which is often what
organizations consider when they assess the issue, and informational diversity.18 Social category diversity
includes differences in gender, age, ethnicity, religion, and sexual orientation. Informational diversity focuses
on variability in education, experience, training, and abilities. Exhibit 4 provides a brief summary of the
variables for each type of diversity.

July 8, 2016
Exhibit 4: Variables and Proxies for Social Category and Informational Diversity
Social category Informational
Variables: Gender Variables: Education
Age Experience
Race Functional knowledge
Ethnicity Expertise
Religion Training
Sexual orientation Abilities
Proxies: Gender Proxies: Education (degree level)

Age Industry tenure
Source: Karen A. Jehn, Gregory B. Northcraft, and Margaret A. Neale, “Why Differences Make a Difference: A Field Study of Diversity, Conflict, and
Performance in Workgroups,” Administrative Science Quarterly, Vol. 44, No 4, December 1999, 741-763. Also, Michaela Bär, Alexandra Niessen, and
Stefan Ruenzi, “The Impact of Work Group Diversity on Performance: Large Sample Evidence from the Mutual Fund Industry,” Center for Financial
Research Working Paper No. 07-16, September 2007.
Informational diversity generally contributes to the team’s ability to add value because the team reveals and
examines different points of view. The role of social category diversity is less clear. Social category diversity
adds value when it is a proxy for informational diversity and when group communication is effective. However,
if social category diversity leads to diminished group communication and members fail to reveal their unshared
information, team performance suffers.
Researchers used this framework to test the impact of each type of diversity on the results for teams that
manage U.S. equity mutual funds.19 Because they could measure neither type of diversity readily, they
developed proxies for each. The researchers used gender and age as proxies for social category diversity and
education level and industry tenure as proxies for informational diversity (see Exhibit 4).
They applied these measures to 2,260 teams from 1996 to 2003. Investment teams are a good test ground
for diversity because the task is clear, there are a large number of decisions that go into managing a portfolio,
and the environment is consistent. They found that informational diversity has a positive influence on
performance and that social category diversity has a modestly negative influence. The drag of social category
diversity is the result of gender diversity, as age diversity had no significant impact. The researchers found, for
example, that a single-gender team would outperform a team consisting of three males and one female by
122 basis points per year.
Gender diversity’s negative impact on portfolio results requires some additional discussion. To begin, it is
important to recognize that globally only 15 percent of portfolio managers are women, with a high of 32
percent in Asia to a low of 11 percent in Latin America.20 The diversity research shows that being a token
within a group, for example one woman among men or one man among women, tends to be
counterproductive.21
Studies of a large number of mutual and hedge funds show no difference in average performance but that
men generally have a higher standard deviation of results than women do and are more overconfident.22
Gender diversity likely fails to add value for a couple of reasons. The first is that women remain
underrepresented in portfolio management and hence face the challenge of critical mass. Second, research
shows that there remains bias against women.23 For instance, women-run funds have lower inflows than their
male counterparts, fail at a higher rate because of an inability to raise funds, and receive less media attention.

July 8, 2016
This discussion underscores the point that promoting diversity in the workplace without instructing employees
how to manage it properly ultimately does a disservice to all. There is nothing magical about a team. You must
assemble it properly, in terms of both size and composition, and manage it effectively to derive the benefits.
Analyst-Run Funds within Fund Families
In most investment management firms that rely on fundamental analysis, analysts evaluate securities and
recommend that portfolio managers buy or sell them. Portfolio managers, in turn, generally share in the
analysis and create portfolios in an effort to deliver excess returns. Analysts are mostly responsible for security
selection, or finding edge. Portfolio managers are mostly responsible for portfolio construction, or figuring out
how best to capitalize on that edge.
The first question is whether buy-side analysts have demonstrated skill. Some studies show that analysts
contribute to excess returns for portfolios and others suggest they do not.24 Much of this research is based on
the data from a single global asset manager.
Gjergji Cici and Claire Rosenfeld, professors of finance, took a novel approach to assess the skill of buy-side
analysts.25 They looked at results for 68 nontraditional funds run exclusively by analysts (roughly half, we
estimate, are Fidelity Select funds) at 14 mutual fund families over a decade. This approach allowed them to
examine actual investment decisions of buy-side analysts rather than just their recommendations.
Cici and Rosenfeld found that the funds run by the analysts delivered higher returns than funds with similar
characteristics run by portfolio managers in the same firm. They labeled a portfolio manager in the same firm
as an “affiliated manager.” Exhibit 5 summarizes their finding. They also found that the analyst-run funds
outperformed comparable unaffiliated managers.
Exhibit 5: Performance of Analyst-Run versus Portfolio Manager-Run Funds

Fund Management
Analyst
Affiliated Manager
Unaffiliated Manager
-10 -5 0 5 10 15
Average Style-Adjusted Monthly Performance
(Basis Points)
Source: Gjergji Cici and Claire Rosenfeld, “A Study of Analyst-Run Mutual Funds: The Abilities and Roles of Buy-Side Analysts,” Journal of Empirical
Finance, Vol. 36, March 2016, 8-29.
What is going on? First, the researchers showed that some mutual fund families have more skilled analysts
than others, leading to better results for the funds run by both analysts and portfolio managers. Second, they
found that portfolio managers who rely on analyst ideas do better than those who do not. It turns out that how
much portfolio managers use analyst recommendations is a function of tenure. The longer a portfolio manager

July 8, 2016
has been around, the less likely he or she is to listen to the analysts. While it is plausible to assume that the
more seasoned managers add value through their experience, the data suggest that they would be better off
sticking to the recommendations of the analysts.
Analyst funds are also smaller on average than manager funds and have lower expense ratios. These factors
also contribute to relative performance.
One element that Cici and Rosenfeld do not emphasize but is worthy of consideration is portfolio construction.
Analyst-run funds are usually sector neutral. Hence, they rely almost exclusively on stock selection for excess
returns. By contrast, manager-run funds commonly have sector tilts. Disaggregating security selection and
portfolio construction in performance attribution is particularly important.
To Whom Should Portfolio Managers Listen?
Portfolio managers get information from their internal analysts as well as external analysts. Sell-side research,
while shrinking, remains a big business. For example, the global budget for sell-side equity research was $8.2
billion in 2007 and is expected to be 40 percent of that amount in 2017.26 How do portfolio managers
balance recommendations from the inside and outside?
Researchers examined this question and found that portfolio managers place an average weight of over 70
percent on buy-side analysts, less than 25 percent on sell-side analysts, and less than 5 percent on
independent research.27 The study considered the decisions of portfolio managers of more than 1,000 funds
over a 3-year span. There is evidence that mutual fund trades follow sell-side recommendations to some
degree and that those recommendations are informative.28
Portfolio managers rely more on their own analysts as the average number of sell-side analysts following a
stock declines, the average error in sell-side forecasts for a company expands, and as the standard deviation
of sell-side analyst estimates rises.
When asked about how they use the sell-side analysts, buy-side professionals suggest that they value
experience following a company, which includes deep industry knowledge and frequent communication with
management.29 However, buy-side analysts generally have a longer time horizon than those on the sell-side.
More than 80 percent of buy-side analysts said their time horizon was longer than one year, and a quarter of
them suggested it was beyond three years. Most sell-side recommendations use one-year target prices.
The reliance on internal versus external sources is relevant to the discussion about form and function. An
investment firm that can secure external sources for data or information that add value and are cost effective
requires fewer resources internally. That said, leaders of investment firms must constantly monitor the trade-
offs between in-house and external input into the investment process.
Conclusion
It is a challenge for active money managers to generate excess returns. Central to developing the skill to do so
is a process that identifies and exploits market mispricings. There are many possible ways of finding edge,
from the short-term signal that Renaissance Technologies gathers to the long-term value that Berkshire
Hathaway seeks. But in all cases, it is essential to align your resources—people, process, and capital—to
serve your source of edge. In other words, consider how you intend to achieve your objective and consider
how to organize your firm to do so most effectively.

July 8, 2016
An honest appraisal of most investment firms reveals at least some mismatch between form and function, if
for no other reason than organizational inertia. This report shares academic research that may shed some light
on what works. Teams of the proper size and construction can outperform single managers. Analyst-run funds
can outperform portfolio manager-run funds, especially if the managers stop heeding the analysts. And the
trade-off between internal and external sources of information relies on what your firm needs and values.

July 8, 2016
Endnotes
1
Louis H. Sullivan, “The Tall Office Building Artistically Considered,” Lippincott’s Magazine, March 1896,
404-409.
2
Ilia D. Dichev, “What Are Investors’ Actual Historical Returns? Evidence from Dollar-Weighted Returns,”
American Economic Review, Vol. 97, No. 1, March 2007, 386-401; Andrea Frazzini and Owen A. Lamont,
“Dumb Money: Mutual Fund Flows and the Cross-Section of Stock Returns,” Journal of Financial Economics,
Vol. 88, No. 2, May 2008, 299-322.
3
Klaas P. Baks, “On the Performance of Mutual Fund Managers,” Working Paper, June 2003.
4
Mark Hulbert, “The Star Manager May Have a Minor Role,” New York Times, July 6, 2003.
5
Boris Groysberg, Chasing Stars: The Myth of Talent and the Portability of Performance (Princeton, NJ:
Princeton University Press, 2010).
6
Massimo Massa and Lei Zhang, “The Effects of Organizational Structure on Asset Management,” Working
Paper, February 1, 2008.
7
Massimo Massa, Jonathan Reuter, and Eric Zitzewitz, “When Should Firms Share Credit with Employees?
Evidence from Anonymously Managed Mutual Funds,” Journal of Financial Economics, Vol. 95, No. 3, March
2010, 400-424.
8
Richard T. Bliss, Mark E. Potter, and Christopher Schwarz, “Performance Characteristics of Individually-
Managed versus Team-Managed Mutual Funds,” Journal of Portfolio Management, Vol. 34, No. 5, Spring
2008, 110-119.
9
Joseph Chen, Harrison Hong, Wenxi Jiang, and Jeffrey Kubik, “Outsourcing Mutual Fund Management:
Firm Boundaries, Incentives, and Performance,” Journal of Finance, Vol. 68, No. 2, April 2013, 523–558;
Michaela Bär, Alexander Kempf, and Stefan Ruenzi, “Is a Team Different from the Sum of Its Parts? Evidence
from Mutual Fund Managers,” Review of Finance, Vol. 15, No. 2, April 2011, 359-396; and Larry J. Prather
and Karen L. Middleton, “Are N+1 Heads Better Than One? The Case of Mutual Fund Managers,” Journal of
Economic Behavior and Organization, Vol. 47, No. 1, January 2002, 103-120.
10
Iordanis Karagiannidis, “The Effect of Management Team Characteristics on Risk-Taking and Style
Extremity of Mutual Fund Portfolios,” Review of Financial Economics, Vol. 21, No. 3, September 2012, 153-
158.
11
Saurin Patel and Sergei Sarkissian, “To Group or Not to Group? Evidence from CRSP, Morningstar
Principia, and Morningstar Direct Mutual Fund Databases,” Journal of Financial and Quantitative Analysis,
Forthcoming, 2016.
12
Saurin Patel and Sergei Sarkissian, “Teams, Location, and Productivity,” Working Paper, April 15, 2016.
13
Luís M. A. Bettencourt, José Lobo, Dirk Helbing, Christian Kühnert, and Geoffrey B. West, “Growth,
Innovation, Scaling, and the Pace of Life in Cities,” Proceedings of the National Academy of Sciences, Vol.
104, No. 17, April 24, 2007, 7301-7306.
14
Judith Chevalier and Glenn Ellison, “Are Some Mutual Fund Managers Better than Others? Cross-Sectional
Patterns in Behavior and Performance,” Journal of Finance, Vol. 54, No. 3, June 1999, 875-899.
15
Scott E. Page, The Difference: How the Power of Diversity Creates Better Groups, Firms, Schools, and
Societies (Princeton, NJ: Princeton University Press, 2007); Michael J. Mauboussin and Dan Callahan,
“Building An Effective Team: How to Manage a Team to Make Good Decisions,” Credit Suisse Global
Financial Strategies, January 8, 2014.
16
Edward P. Lazear, “Globalisation and the Market for Team-Mates,” Economic Journal, Vol.109, No. 454,
March 1999, 15-40.
17
Elizabeth Mannix and Margaret A. Neale, “What Differences Make a Difference? The Promise and Reality of
Diverse Teams in Organizations,” Psychological Science in the Public Interest, Vol. 6, No. 2, October 2005,
31-55.

July 8, 2016
18
Karen A. Jehn, Gregory B. Northcraft, and Margaret A. Neale, “Why Differences Make a Difference: A
Field Study of Diversity, Conflict, and Performance in Workgroups,” Administrative Science Quarterly, Vol. 44,
No 4, December 1999, 741-763.
19
Michaela Bär, Alexandra Niessen, and Stefan Ruenzi, “The Impact of Work Group Diversity on
Performance: Large Sample Evidence from the Mutual Fund Industry,” Center for Financial Research Working
Paper No. 07-16, September, 2007.
20
“Women in the Financial Services Industry,” Oliver Wyman, 2016, 75. A report for the U.S. only shows that
less than 10 percent of fund managers are women. See Laura Pavlenko Lutton and Erin Davis, “Funds
Managed by Women,” Morningstar Research Report, June 2015.
21
Iris Bohnet, What Works: Gender Equality By Design (Cambridge, MA: Belknap Press, 2016); Vicki W.
Kramer, Alison M. Konrad, Sumru Erkut, and Michele J. Hooper, “Critical Mass on Corporate Boards: Why
Three or More Women Enhance Governance,” Directors Monthly, February 2007, 19–22.
22
Alexandra Niessen and Stefan Ruenzi, “Sex Matters: Gender and Mutual Funds,” Center for Financial
Research Working Paper No. 06-01, March, 2006; Rajesh Aggarwal and Nicole M. Boyson, “The
Performance of Female Hedge Fund Managers,” Review of Financial Economics, Vol. 29, April 2016, 23-36;
Richard T. Bliss and Mark E. Potter, “Mutual Fund Managers: Does Gender Matter?” Journal of Business and
Economic Studies, Vol. 8, No. 1, 2002, 1–15; Stanley M. Atkinson, Samantha Boyce Baird, and Melissa B.
Frye, “Do Female Mutual Fund Managers Manage Differently?” Journal of Financial Research, Vol. 26, No. 1,
Spring 2003, 1–18; Brad M. Barber and Terrance Odean, “Boys Will Be Boys: Gender, Overconfidence, and
Common Stock Investment,” Quarterly Journal of Economics, Vol. 116, No. 1, February, 2001, 261-292;
and Christi R. Wann and Bento J. Lobo, “Gender-Based Trading: Evidence from a Classroom Experiment,”
Journal of Economics and Finance Education, Vol. 9, No. 2, Winter 2010, 54-61.
23
Alexandra Niessen-Ruenzi and Stefan Ruenzi, “Sex Matters: Gender and Prejudice in the Mutual Fund
Industry,” Working Paper, May 2013.
24
Boris Groysberg, Paul Healy, and George Serafeim, “The Stock Selection and Performance of Buy-Side
Analysts,” Management Science, Vol. 59, No. 5, May 2013, 1062-1075; Stefan Frey and Patrick Herbst,
“The Influence of Buy-Side Analysts on Mutual Fund Trading,” Journal of Banking and Finance, Vol. 49,
December 2014, 442-458; and Michael Rebello and Kelsey D. Wei, “A Glimpse Behind a Closed Door: The
Long-Term Investment Value of Buy-Side Research and Its Effect on Fund Trades and Performance,” Journal
of Accounting Research, Vol. 52, No. 3, June 2014, 775-815.
25
Gjergji Cici and Claire Rosenfeld, “A Study of Analyst-Run Mutual Funds: The Abilities and Roles of Buy-
Side Analysts,” Journal of Empirical Finance, Vol. 36, March 2016, 8-29.
26
C.R., “Analysts Beware: Regulating Equity Research,” Economist: Schumpeter Blog, May 16, 2014.
27
Yingmei Cheng, Mark H. Liu, and Jun Qian, “Buy-Side Analysts, Sell-Side Analysts, and Investment
Decisions of Money Managers,” Journal of Financial and Quantitative Analysis, Vol. 41, No. 1, March 2006,
51-83.
28
Jeffrey A. Busse, T. Clifton Green, and Narasimhan Jegadeesh, “Buy-Side Trades and Sell-Side
Recommendations: Interactions and Information Content,” Journal of Financial Markets, Vol. 15, No. 2, May
2012, 207-232.
29
Lawrence D. Brown, Andrew C. Call, Michael B. Clement, and Nathan Y. Sharp, “Skin in the Game: The
Inputs and Incentives that Shape Buy-Side Analysts’ Stock Recommendations,” Working Paper, October
2014.

HOLT
Global Industry Profit Pools

Visualizing Value Creation for an Industry
July 2016
Credit Suisse HOLT Credit Suisse Global Financial Strategies

Bryant Matthews Michael J. Mauboussin
+1 312 345–6187 +1 212 538–1931
bryant.matthews@credit-suisse.com michael.mauboussin@credit-suisse.com
David A. Holland Dan Callahan, CFA

CS Senior Advisor +1 212 538–1923
david.a.holland@credit-suisse.com daniel.callahan@credit-suisse.com
credit-suisse.com/holtmethodology Market Commentary

Introduction Automobiles
Count of firms: 94
2015 FY reporting percentage: 73%
Sustainable value creation is of prime interest to 2015
n
investors and corporate executives. The industry is a
M
DAIMLER AG
AI
G
% IC owned by top 10 firms: 66%
TA
Economic Spread %
T
D
W
5
O
O
M
BMW - BAYERISCH
YO
BM
M
M M
H AN
AI
A
TO
G IC
sensible place to begin this analysis. Profit pools are
TOYOTA MOTOR CO
D
S
OTHER
D
SA
N
IS
N
O
U
N
SAIC MOTOR CORP
_p
Y
F
G
W
GENERAL MOTORS
one of the most useful tools available for assessing 0
VO
FORD MOTOR CO
NISSAN MOTOR CO
an industry.1 A profit pool shows how an industry’s -5

HONDA MOTOR CO.
HYUNDAI MOTOR
value creation is distributed at a point in time. 0 10 20 30 40 50 60 70 80 90 100

VOLKSWAGEN AG
Examination of profit pools over time allows 2010
AI
D
H UG
N
AUDI AG
investors and corporate executives to see how the
YU
S
Economic Spread %
N
5 HYUNDAI MOTOR
D G
M
n
O
W
G
BMW - BAYERISCH
N
_p
AI
BM
distribution of economic profits has changed. This
SA
A
G
D
DAIMLER AG
IS
W
M
OTHER
N
VO
G
F
H
FORD MOTOR CO
M
0
handbook shows detailed profit pools for 65 global
TA
VOLKSWAGEN AG
YO
TO
HONDA MOTOR CO.
industries over a ten-year period.

NISSAN MOTOR CO
-5 GENERAL MOTORS
TOYOTA MOTOR CO
0 10 20 30 40 50 60 70 80 90 100
2005
TA O
O NM
M
YO M
NISSAN MOTOR CO
At a glance, a profit pool shows how large
SA
TO DA
Economic Spread %
G
5
IS
N
HONDA MOTOR CO.
AI
F SU
W
N
D
H
BM
N
N
TOYOTA MOTOR CO
YU
companies are (width of the rectangle) and how
H
AUDI AG
n
G
A
EN
AI
_p
FORD MOTOR CO
D
0
much value they create or destroy (height of the
G
W
BMW - BAYERISCH
OTHER
VO
HYUNDAI MOTOR
rectangle). The horizontal axis is the percentage of

DAIMLER AG
-5 RENAULT SA
the industry, typically measured as invested capital

VOLKSWAGEN AG
0 10 20 30 40 50 60 70 80 90 100
or sales, and the vertical axis is the economic profit ----------------------- Percentage of Industry Invested Capital --------------------
*Industry is highly concentrated: 4 firm concentration ratio = 46.4%.
spread, or the return on invested capital minus the A 4-firm concentration ratio of market share below 40% is considered competitive.
Source: Credit Suisse HOLT Data date: June 18, 2016
cost of capital. As a result, the area of each
rectangle—the product of invested capital and
economic profit spread—is the total value added, or The exhibit shows profit pools for the automobile
economic profit, for that industry or company. For industry for 2005, 2010, and 2015, including active
example, a company that has $100 million of and inactive companies.4 The horizontal axis
invested capital and an economic profit spread of 5 represents 100 percent of the capital invested in the
percentage points generates $5 million in economic industry by public companies. The vertical axis
profit ($100 million x 0.05 = $5 million). The total shows a firm’s economic profit spread. We calculate
profit pool for the industry is the sum of the this as Cash Flow Return on Investment (CFROI®)
economic profit of all the companies.2 minus the discount rate.5
To understand the overall profitability of an industry, The exhibit shows the top 10 firms by market
it is useful to analyze the average profitability over a capitalization and the remaining companies are in the
full business cycle, which is generally three to five “Other” category. For example, there were 94
years.3 But average profitability doesn’t reveal how companies in the sample for 2015 and 84
value has migrated over time. Profit pools are companies were in the category of “Other.” The
particularly effective because they allow you to trace automobile industry is highly concentrated, with 4
the increases or decreases in the components of the firms accounting for more than 46% of industry
value-added pie. In this handbook we look at profit sales. When examined by investment, 10 firms
pools from ten years ago, five years ago, and the account for 66 percent of the industry’s total
most recent year to see how results have changed. invested capital.
CLARITY IS CONFIDENCE HOLT

This is market commentary and not a research document. 1
Introduction Automobiles
Count of firms: 94
The industry is clearly cyclical. Most of the 2015
n
G
M
DAIMLER AG
AI
G
automakers, both big and small, destroyed value in
TA
Economic Spread %
T
D
W
5
O
O
M
BMW - BAYERISCH
YO
BM
M
M M
H AN
AI
A
TO
G IC
TOYOTA MOTOR CO
D
S
OTHER
D
SA
N
2010 as the economy was still coming out of a deep
IS
N
O
U
N
SAIC MOTOR CORP
_p
Y
F
G
W
GENERAL MOTORS
0
VO
recession. But the overall picture reveals that the
FORD MOTOR CO
NISSAN MOTOR CO
industry does not define a company’s destiny. Even

HONDA MOTOR CO.
-5 HYUNDAI MOTOR
the industries that create the most value include

VOLKSWAGEN AG
0 10 20 30 40 50 60 70 80 90 100
companies that destroy value, and the industries 2010
AI
D
H UG
N
AUDI AG
YU
S
Economic Spread %
that destroy the most value have companies that
N
5 HYUNDAI MOTOR
D G
M
n
O
W
G
BMW - BAYERISCH
N
_p
AI
BM
SA
A
G
create value. That some companies buck the
D
DAIMLER AG
IS
W
M
OTHER
N
VO
G
F
H
FORD MOTOR CO
M
0
TA
economics of their industry provides insight into the
VOLKSWAGEN AG
YO
TO
HONDA MOTOR CO.
NISSAN MOTOR CO
potential sources of economic performance. -5 GENERAL MOTORS
TOYOTA MOTOR CO
0 10 20 30 40 50 60 70 80 90 100
2005
TA O
O NM
M
YO M
NISSAN MOTOR CO
SA
TO DA
Economic Spread %
Creating a narrative to explain the rise and fall of the
G
5
IS
N
HONDA MOTOR CO.
AI
F SU
W
N
D
H
BM
N
N
TOYOTA MOTOR CO
YU
various competitors can provide important clues
H
AUDI AG
n
G
A
EN
AI
_p
FORD MOTOR CO
D
0
G
W
about what it takes to sustain value creation. The
BMW - BAYERISCH
OTHER
VO
HYUNDAI MOTOR
DAIMLER AG
profit pool of the automobile industry reveals that -5 RENAULT SA
VOLKSWAGEN AG
since 2010 the luxury automakers have 0 10 20 30 40 50 60 70 80 90 100

----------------------- Percentage of Industry Invested Capital --------------------
outperformed automakers that compete in the main *Industry is highly concentrated: 4 firm concentration ratio = 46.4%.
part of the market. For example, Daimler (Mercedes) A 4-firm concentration ratio of market share below 40% is considered competitive.
Source: Credit Suisse HOLT Data date: June 18, 2016
and BMW are creating considerable value and show
up on the left side of the exhibit.
The companies that focus more on the non-luxury Profit pools are a valuable tool for assessing the
segment, including Ford, General Motors, and attractiveness of an industry and how it changes.
Nissan, improved their economic spread but still lag This handbook allows investors and executives to
the luxury automakers. In addition, their share of the assess the attractiveness of 65 industries and to
industry’s total invested capital also declined. Toyota gain some insight into how those industries have
and Hyundai have followed divergent paths. Toyota’s changed over time.
returns improved alongside strength in its luxury
Lexus brand and in the resurgent SUV space,
References:
whereas Hyundai’s results were hurt by exposure to 1 Orit Gadiesh and James L. Gilbert, “Profit Pools: A Fresh
a slowing China. And Volkswagen’s returns Look at Strategy,” Harvard Business Review, May-June 1998,
deteriorated considerably since the company got 139-147; Orit Gadiesh and James L. Gilbert, “How To Map
embroiled in a scandal related to vehicle emissions. Your Industry’s Profit Pool,” Harvard Business Review, May-
June 1998, 149-162.
2 We present HOLT’s economic profit framework, which is
now a standard feature of HOLT Lens®, in this report:

Profit pools also provide a quick view of industry “Introducing HOLT Economic Profit”, September 2014.
concentration. Researchers have shown a reliable 3 Michael E. Porter, “The Five Competitive Forces that Shape
link between industry concentration and profitability. Strategy,” Harvard Business Review, January 2008, 78-93.
4 Industries classified by MSCI GICS 6-digit codes (level 3).
Concentrated industries earn above-average profits 5 We use an adjusted CFROI. See appendix for details.
and less concentrated industries earn below- 6 Kewei Hou and David T. Robinson, “Industry Concentration
average profits.6 and Average Stock Returns,” Journal of Finance, Vol. 61, No.
4, August 2006, 1927-1956.

Table of Contents:
4. Profit Pool Changes 38. Food & Staples Retailing

5. Energy Equipment & Services 39. Beverages
6. Oil & Gas 40. Food Products
7. Chemicals 41. Tobacco
8. Construction Materials 42. Household Products
9. Containers & Packaging 43. Personal Products
10. Metals & Mining 44. Health Care Equipment & Supplies
11. Paper & Forest Products 45. Health Care Providers & Services
12. Aerospace & Defense 46. Health Care Technology
13. Building Products 47. Biotechnology
14. Construction & Engineering 48. Pharmaceuticals
15. Electrical Equipment 49. Life Sciences Tools & Services
16. Industrial Conglomerates 50. Banks
17. Machinery 51. Thrifts & Mortgage Finance
18. Trading Companies & Distributors 52. Diversified Financials
19. Commercial Services & Supplies 53. Consumer Finance
20. Professional Services 54. Capital Markets
21. Air Freight & Couriers 55. Insurance
22. Airlines 56. Internet Software & Services
23. Marine 57. IT Consulting & Services
24. Road & Rail 58. Software
25. Transportation Infrastructure 59. Communications Equipment
26. Auto Components 60. Computers & Peripherals
27. Automobiles 61. Electronic Equip. Instruments & Compon.
28. Household Durables 62. Semi & Semi Equip
29. Leisure Equipment & Products 63. Diversified Telecommunication Services
30. Textiles & Apparel 64. Wireless Telecommunication Services
31. Hotels Restaurants & Leisure 65. Electric Utilities
32. Diversified Consumer Services 66. Gas Utilities
33. Media 67. Multi-Utilities
34. Distributors 68. Water Utilities
35. Internet & Catalog Retail 69. Indep. Power Producers & Energy Traders
36. Multiline Retail 70. Appendix: HOLT Methodology
37. Specialty Retail

Industry profitability changes over past 5 years
Economic Economic
Largest Increase in Profit Spread Profit Spread
Economic Profit Spread 2010 2015 Change
Thrifts & Mortgage Finance -14.2 6.2 20.4
Consumer Finance -1.9 6.3 8.2
Biotechnology 2.6 8.3 5.7
Health Care Technology 2.0 6.7 4.6
Life Sciences Tools & Services 4.0 8.2 4.2
Economic Economic
Largest Decline in Profit Spread Profit Spread
Economic Profit Spread 2010 2015 Change
Internet & Catalog Retail 7.8 6.5 -1.2
Multi-Utilities & Unreg. Power -0.1 -1.2 -1.1
Pharmaceuticals 4.5 3.7 -0.8
Machinery 1.7 1.0 -0.7
Commercial Banks 0.7 0.1 -0.6

Energy Equipment & Services
MSCI GIC: 101010

Count of firms: 325
2015
NATIONAL OILWEL
Economic Spread %
SL FT AMV
10
CO
CAMERON INTERNA
N
I OP OI FMC TECHNOLOGIE
B
EC
SCHLUMBERGER LT
5
AL
S I R
BHIN NA
C S-A
H
HALLIBURTON CO
H
T
TENARIS S.A.
FT
0 OTHER
W
CHINA OILFIELD
SINOPEC OILFIEL
-5 BAKER HUGHES IN
WEATHERFORD INT
0 10 20 30 40 50 60 70 80 90 100
2010
V
O
N
NATIONAL OILWEL
12
Economic Spread %
10 SCHLUMBERGER LT
B
AL
HALLIBURTON CO
SL
TS RL
IG A R
SP I
H
O
SD
I
-
M
I A
SEADRILL LTD
5
BHHIN
FT
W
TENARIS S.A.
R
OTHER
C
TRANSOCEAN LTD
0 CHINA OILFIELD
BAKER HUGHES IN
-5 SAIPEM SPA
WEATHERFORD INT
0 10 20 30 40 50 60 70 80 90 100
2005
BJ SERVICES CO
BH -AR
TS JS

Economic Spread %
10
BV
TENARIS S.A.
N I
SL O
H FT
AL
W
BAKER HUGHES IN
BR
N
R .2
OTHER NATIONAL OILWEL

5
SF
IG
G
SCHLUMBERGER LT
WEATHERFORD INT
0 HALLIBURTON CO
NABORS INDUSTRI
-5 GLOBALSANTAFE C
TRANSOCEAN LTD
0 10 20 30 40 50 60 70 80 90 100
*Industry is considered competitive: 4 firm concentration ratio = 25.5%.
A 4-firm concentration ratio of market share below 40% is considered competitive.

Oil & Gas
MSCI GIC: 101020

Count of firms: 987
2015
BG GROUP PLC
Economic Spread %
10 EXXON MOBIL COR
CHEVRON CORP
T EC
ROYAL DUTCH SHE
5
M G
TO P
Sa
VX
XO B
PL F
SINOPEC CHINA P
.Z
N
D
C
BP P
SI
R
TOTAL SA
I
EN
XY
0 OTHER
O
CONOCOPHILLIPS
BP PLC
-5 ENI - ENTE NAZI
OCCIDENTAL PETR
0 10 20 30 40 50 60 70 80 90 100
LI
2010
C
O
O
N
CNOOC LIMITED
C

Economic Spread %
10 OCCIDENTAL PETR
M EC
SINOPEC CHINA P
N Y
XO OP
SI OX
BP TF
EXXON MOBIL COR

5
Sa
Z
TO
VX
P.
4
D
TR
PL
CHEVRON CORP
C
OTHER
PE
TOTAL SA
0 BP PLC
PETROLEO BRASIL
-5 ROYAL DUTCH SHE
CONOCOPHILLIPS
0 10 20 30 40 50 60 70 80 90 100
2005
D
R
ROYAL DUTCH PET

Economic Spread %
10 CONOCOPHILLIPS
D Z
R P.
Sa
BP F
PL
SHELL TRANSPORT
R FP
T
XO
Sa
TO
VX
EL
D
EXXON MOBIL COR

5 OTHER
C
I
EN
TOTAL SA
BP PLC
0 ELF AQUITAINE S
ROYAL DUTCH SHE
-5 CHEVRON CORP
ENI - ENTE NAZI
0 10 20 30 40 50 60 70 80 90 100

Chemicals
MSCI GIC: 151010

Count of firms: 1048
2015
ELCYB
L
LYONDELLBASELL
Economic Spread %
15 ECOLAB INC
MONSANTO CO
N
O
SYNGENTA AG
10
M
D BA
SAUDI BASIC IND

UN
I
D
SSAYN
n
SF
DU PONT (E I) D
BAPX
D RP
D
5
W
PRAXAIR INC
AI
O
OTHER
BASF SE
0 AIR LIQUIDE
DOW CHEMICAL
0 10 20 30 40 50 60 70 80 90 100
2010
MOSAIC CO
Economic Spread %
15 POTASH CORP SAS
SAUDI BASIC IND

U T. S
A
PRAXAIR INC
10
SAPO O
IB
M
MONSANTO CO
n
SNF
AI N
BASF SE
BMAOX
DN
5
D P
P
DSY
O
R
SYNGENTA AG
OTHER
DU PONT (E I) D
0 AIR LIQUIDE
0 DOW CHEMICAL
0 10 20 30 40 50 60 70 80 90 100
A
IB
2005
D
U
SA
SAUDI BASIC IND

15
Economic Spread %
15 SAUDI ARABIAN F
IA
D
U
PRAXAIR INC
SA
SHIN-ETSU CHEMI
10
TS
DU PONT (E I) D
-E
AKMORP
DOW CHEMICAL
ZON
D N
n
D HXI
5
SF
W
AI
SP
BASF SE
BA
D
OTHER AIR LIQUIDE
0 MONSANTO CO
0 AKZO NOBEL N.V.
0 10 20 30 40 50 60 70 80 90 100

Construction Materials
MSCI GIC: 151020

Count of firms: 307
2015
EM
DANGOTE CEMENT
Economic Spread %
10
G
SIAM CEMENT PUB

N
O
SC DA
ANHUI CONCH CEM

U L UI
AN C
H C
H
MARTIN MARIETTA
R M
5
LTM
C VC
P
EI
F
H
M
LA
ULTRATECH CEMEN
N
LH
OTHER VULCAN MATERIAL

0 CRH PLC
HEIDELBERGCEMEN
-5 LAFARGE S.A.
LAFARGEHOLCIM L
0 10 20 30 40 50 60 70 80 90 100
O M
I C CE
2010
H NG
AN DA
DANGOTE CEMENT
U
Economic Spread %
10 ANHUI CONCH CEM
INDOCEMENT TUNG
C PO
C
FP LT
ULTRATECH CEMEN
C
LA UTP
5
LH H
EX
R
IN
LAFARGE S.A.
EM
EI
N
C
H
OTHER
SC
C
CEMEX SAB DE CV
0 CRH PLC
LAFARGEHOLCIM L
-5 HEIDELBERGCEMEN
SIAM CEMENT PUB
0 10 20 30 40 50 60 70 80 90 100
2005
IN
PO S
R
RINKER GROUP LT
11
EX MA

Economic Spread %
10 YAMAMA SAUDI CE
EMC A
CVM AM
VULCAN MATERIAL
Y
C C
H
CEMEX SAB DE CV
SC
R
FP
5
N
N
H
LH
G
LA
SIAM CEMENT PUB

EI
OTHER
H
CRH PLC
0 LAFARGEHOLCIM L
LAFARGE S.A.
-5 HANSON PLC
HEIDELBERGCEMEN
0 10 20 30 40 50 60 70 80 90 100

Containers & Packaging
MSCI GIC: 151030

Count of firms: 282
2015
SEALED AIR CORP
AM L L.B
BL CC E

Economic Spread %
SE
10 CCL INDUSTRIES
PK C
BALL CORP
C G
SK K
R G
W EX
C
AMCOR LIMITED
5
K
R
PACKAGING CORP
OTHER
IP
CROWN HOLDINGS
0 SMURFIT KAPPA G
REXAM PLC
-5 WESTROCK CO
INTERNATIONAL P
0 10 20 30 40 50 60 70 80 90 100
2010
BALL CORP
Economic Spread %
10 CROWN HOLDINGS
C LL
11
SEALED AIR CORP

S K
B
C
AM BN
A EE
R VY
AVERY DENNISON
5
KL
O EX
V
I
REXAM PLC
W
M
OTHER OWENS-ILLINOIS
IP
0 KLABIN SA
AMCOR LIMITED
-5 INTERNATIONAL P
MEADWESTVACO CO
0 10 20 30 40 50 60 70 80 90 100
2005
BALL CORP
Economic Spread %
10 AVERY DENNISON
A LL
SE VY
SEALED AIR CORP

R E
B
TI C1
KL EX
1
ABMN
REXAM PLC
N
5
M C
C
V
SS
KLABIN SA
W
OTHER AMCOR LIMITED

IP
0 TEMPLE-INLAND I
SMURFIT-STONE C
-5 MEADWESTVACO CO
INTERNATIONAL P
0 10 20 30 40 50 60 70 80 90 100

Metals & Mining
MSCI GIC: 151040

2015
BHP BILLITON LI
Economic Spread %
10
O
GRUPO MEXICO S.
C
IOO I
IP S N
RCEX
P
LE ER N N
SOUTHERN COPPER
5 M S
N O K
BH
VANN POHA
BA GM
SGCM
5
O
RIO TINTO LIMIT
MMC NORILSK NIC

0 OTHER
I
BAOSHAN IRON &

A
KI
BL
NIPPON STEEL &

-5
INNER MONGOLIAN
-10 VALE SA
-57 SOVEREIGN GOLD
0 10 20 30 40 50 60 70 80 90 100
2010
IO O
BHSCCX
C
LEKN
FREEPORT-MCMORA
F
P
13
5

Economic Spread %
VAGM
R
10 SOUTHERN COPPER
XT L .
X
A
PA
BHP BILLITON LI
AAB
A
5
IS
RIO TINTO LIMIT

OTHER
MMC NORILSK NIC
0 VALE SA
BARRICK GOLD CO
-5
ANGLO AMERICAN
-10 XSTRATA PLC
ARCELORMITTAL S
0 10 20 30 40 50 60 70 80 90 100
2005
R P 5
E
BH AL
VALE SA
V

Economic Spread %
PA
IS IO
10
H S
LD
BHP BILLITON LI
E N
O
JF PO
RIO TINTO LIMIT

L
AA
AA
HM
IP
Y
5 OTHER
NE
ARCELORMITTAL S
N
ANGLO AMERICAN
0 NEWMONT MINING
NORSK HYDRO ASA

-5
ALCOA INC
-10 NIPPON STEEL &
JFE HOLDINGS, I
0 10 20 30 40 50 60 70 80 90 100

Paper & Forest Products
MSCI GIC: 151050

Count of firms: 231
2015
I
D
MONDI PLC
N

Economic Spread %
5
PM NV R3
R
FIBRIA CELULOSE
G
B
FI
A
NAVIGATOR COMPA
V DR
ER E .
ST NINFT
1V
UPM-KYMMENE OYJ
PC
W
H B5
U
WEST FRASER TIM

0 LD
C
JI Z
OTHER
O
O SU
NINE DRAGONS PA
STORA ENSO OYJ
EMPRESAS CMPC S
-5
SUZANO PAPEL E
OJI HOLDINGS CO
0 10 20 30 40 50 60 70 80 90 100
2010
A
N R PC M
ME &
LEE & MAN PAPER

CTR EE

A
Economic Spread %
FIIN E
L
3DR
5 SINO-FOREST COR
T
BRE
EMPRESAS CMPC S
I
D
N
M
SINO-FOREST COR
1V
LD
0 NINE DRAGONS PA
PM
V
H
ER
OTHER
U
FIBRIA CELULOSE
JI
ST
O
MONDI PLC
UPM-KYMMENE OYJ
-5
OJI HOLDINGS CO
STORA ENSO OYJ
0 10 20 30 40 50 60 70 80 90 100
2005
ARACRUZ CELULOS
P. 6

G CZ
Economic Spread %
5 GEORGIA-PACIFIC
1
AR
1V PC
PM CMSS
MASISA SA (OLD)
LD
M
P
O
EMPRESAS CMPC S
N ON
H
P
JI
0 UPM-KYMMENE OYJ
SG
IP
O
ER
U
OTHER
N
y
ST
OJI HOLDINGS CO
SE
STORA ENSO OYJ
NIPPON PAPER GR
-5
NORSKE SKOGINDU
-6
SEQUANA
0 10 20 30 40 50 60 70 80 90 100

Aerospace & Defense
MSCI GIC: 201010

Count of firms: 174
2015
P D
U CP
G
GENERAL DYNAMIC
Economic Spread %
15
TX
TN
PRECISION CASTP
R
LM C
UNITED TECHNOLO
T
O
BA F
H
10
SA
RAYTHEON CO
OTHER HONEYWELL INTER

5
R
NORTHROP GRUMMA
AI LOCKHEED MARTIN
0
SAFRAN
-5 BOEING CO
AIRBUS GROUP SE
0 10 20 30 40 50 60 70 80 90 100
2010
BA D P
PRECISION CASTP
GPC

Economic Spread %
U ES
15 GENERAL DYNAMIC
TX
BAE SYSTEMS PLC

T
10
LM
UNITED TECHNOLO
H
OTHER
BA
LOCKHEED MARTIN
R
5
R
HONEYWELL INTER
R
NORTHROP GRUMMA
0
AI
BOEING CO
-5 ROLLS ROYCE HOL
AIRBUS GROUP SE
0 10 20 30 40 50 60 70 80 90 100
2005
BAE SYSTEMS PLC
G ES

Economic Spread %
15
BA
D
GENERAL DYNAMIC
C
TX
UNITED TECHNOLO
O
T
U
10
TN
LM
N
NORTHROP GRUMMA
N
R
BA
H
LOCKHEED MARTIN
OTHER
R
5 RAYTHEON CO
R
AI
HONEYWELL INTER
0
BOEING CO
-5 ROLLS ROYCE HOL
AIRBUS GROUP SE
0 10 20 30 40 50 60 70 80 90 100

Building Products
MSCI GIC: 201020

Count of firms: 317
2015
ASSA ABLOY AB
BLNE b
GALSSA

Economic Spread %
20 ALLEGION PLC
A
E
GEBERIT AG
D ASHSS
15
MFBO
I
A
SMITH (A O) COR
KI
10
AI
R
FORTUNE BRANDS
G
L
B
XI
MASCO CORP
O
5
L
LI
IG OTHER
SG
AH
DAIKIN INDUSTRI
0
AS
COMPAGNIE DE SA
-5 LIXIL GROUP COR
ASAHI GLASS COM
0 10 20 30 40 50 60 70 80 90 100
2010
SA BN
GEBERIT AG
AS GE

Economic Spread %
20
b
ASSA ABLOY AB
DURATEX SA
15
MASCO CORP
IG I
AH IN
D 3
10
L
ASX
AS AIK
DAIKIN INDUSTRI
KC GR
M TE
B
D
ASAHI GLASS COM

5
O
XI
LIC
C
SG
OTHER COMPAGNIE DE SA
0 OWENS CORNING
-5 LIXIL GROUP COR
KCC
0 10 20 30 40 50 60 70 80 90 100
2005
N
EB
GEBERIT AG
G
Economic Spread %
20 MASCO CORP
b
ASSA ABLOY AB
.2 A
15
AS
TT SS
M
TRANE INC
A
IG R
10
O NI
AH G
BPB PLC
L
AS IXIL
SG IKI
B
DPB
LK
A
DAIKIN INDUSTRI
5
L
B
PI
OTHER COMPAGNIE DE SA
0 LIXIL GROUP COR
-5 ASAHI GLASS COM
PILKINGTON P.L.
0 10 20 30 40 50 60 70 80 90 100

Construction & Engineering
MSCI GIC: 201030

Count of firms: 797
2015
CHINA STATE CON
Economic Spread %
10 LARSEN & TOUBRO

ST
C CO
H W A
R
BOUYGUES SA
R
U
A
IN ER
SGU T
IN
R LL
EFY
PO A
O
BOAR
A
VINCI
IN
H
FE ETA
R
C
1
A
C
CHINA RAILWAY C
IN
M
OTHER
H
C
POWER CONSTRUCT
0 CHINA COMMUNICA
CHINA RAILWAY G
-5 METALLURGICAL C
FERROVIAL SA
0 10 20 30 40 50 60 70 80 90 100
2010
FLUOR CORP
Economic Spread %
10 LARSEN & TOUBRO

ALCAR LR
F
ACS ACTIVIDADES
SG OUY A R
IN A
C ST
ET CO
R
C AR
IC
LU
BOHIN
CHINA RAILWAY C
5
A
EF C
AL
IN
H
BOUYGUES SA
H
C
OTHER
M
ORASCOM CONSTRU
0 VINCI
CHINA RAILWAY G
-5 CHINA COMMUNICA
METALLURGICAL C
0 10 20 30 40 50 60 70 80 90 100
2005
ORASCOM CONSTRU
ACFL KACIC

b
Economic Spread %
10
SO
SKANSKA AB
R
FLUOR CORP
BO S
U
YRMAZU
C
EF
SGCC
ACS ACTIVIDADES
5
SC JI MI
F
KAHI
BOUYGUES SA
S
OTHER FOMENTO DE CONS

0 VINCI
SHIMIZU CORPORA
-5 KAJIMA CORPORAT
SACYR SA
0 10 20 30 40 50 60 70 80 90 100

Electrical Equipment
MSCI GIC: 201040

Count of firms: 557
2015
EATON CORP PLC
Economic Spread %
R N
15 ROCKWELL AUTOMA
RD
ET
GK
N
ELMEO
LEGRAND S.A.
SC
SU GH O
BN
BI AI
S
10
IT AN C
AVBW
EMERSON ELECTRI
C
S
SHIDE
SCHNEIDER ELECT
N
5
OTHER VESTAS WIND SYS
M
ABB LIMITED
0
NIDEC CORPORATI
-5 SHANGHAI ELECTR
MITSUBISHI ELEC
0 10 20 30 40 50 60 70 80 90 100
2010
R L
BHARAT HEAVY EL
EM HE

Economic Spread %
15 EMERSON ELECTRI
BN D
ABLEG
ET N
LEGRAND S.A.
H
OI
SU C CHA
10
SC
ABB LIMITED
EG
ID N
S
NHA
BI
SCHNEIDER ELECT
5
S
OTHER EATON CORP PLC

IT
M
SHANGHAI ELECTR
0
EV
AR
NIDEC CORPORATI
-5 MITSUBISHI ELEC
-4 AREVA SA
0 10 20 30 40 50 60 70 80 90 100
2005
EATON CORP PLC
Economic Spread %
15 ROCKWELL AUTOMA
O
C
R N
REC
N
SCHNEIDER ELECT
SCOK
EMIDEL
ET
I
H
10
NBH
O
BN
BHARAT HEAVY EL
AS
AB
NIDEC CORPORATI
PA
BI
5
SU
EMERSON ELECTRI
A
OTHER
IT
EV
M
ABB LIMITED
AR
0
PANASONIC ELECT
-5 MITSUBISHI ELEC
AREVA SA
0 10 20 30 40 50 60 70 80 90 100

Industrial Conglomerates
MSCI GIC: 201050

Count of firms: 176
2015
RP
O
H
R
D
ROPER TECHNOLOG
33
15
Economic Spread %
15 DANAHER CORP
M
M
3M CO
M
E
D H
10
EG
G
R TC
GENERAL ELECTRI
G
SI
JA H U
N
C HG
LT
SU
SIEMENS AG
5
P
K
IC
M
SA
IT
KONINKLIJKE PHI
C
OTHER CK HUTCHISON HO
0
JARDINE MATHESO
-5 CITIC LTD
SAMSUNG C&T COR
0 10 20 30 40 50 60 70 80 90 100
2010
R
DANAHER CORP
H

Economic Spread %
15 3M CO
G M
GENERAL ELECTRI
H UT CH
M
O CH
10
TC HE UT
M
E
SIEMENS AG
n
EG
U CKIM H
G
S K
KONINKLIJKE PHI
SI
IS
PH
5 OTHER
A
CK HUTCHISON HO
IB
SH
H
SIME DARBY BERH

0
TO
CK HUTCHISON HO
-5 HUTCHISON WHAMP
TOSHIBA CORPORA
0 10 20 30 40 50 60 70 80 90 100
2005
R
DANAHER CORP
H
D

Economic Spread %
15 GENERAL ELECTRI
M
M
E
3M CO
G
IN
10
H
SM
SMITHS GROUP PL
C
IB UT
O
SIEMENS AG
IS
TC
n
SH K H
G
5
EG
H
PH
U
TC
OTHER KONINKLIJKE PHI

C
SI
H
U
K
H
HUTCHISON WHAMP
0
TO
CK HUTCHISON HO
-5 TOSHIBA CORPORA
CK HUTCHISON HO
0 10 20 30 40 50 60 70 80 90 100

Machinery
MSCI GIC: 201060

2015
OV
a
W CEB
IT AKTN
KONE OYJ
28
Economic Spread %
15
O
ATLAS COPCO AB
C
O
C
ILLINOIS TOOL W
R
C
C
R
10
IN O TA
U
C
CRRC CORP LTD

AT N
C M BO
E
C A
A N
D
F
KU
DEERE & CO
SH
5
H R
OTHER FANUC CORPORATI
CATERPILLAR INC
0
KUBOTA CORPORAT
-5 MELROSE INDUSTR
CHINA SHIPBUILD
0 10 20 30 40 50 60 70 80 90 100
2010
a
O
HITW TC
ATLAS COPCO AB
C AN I C C I

A
Economic Spread %
15
E N ND
ILLINOIS TOOL W
YU
HYUNDAI HEAVY I
U
LV SU
10
D A
AT D
VO AT
FANUC CORPORATI
M
F
b
C
M
S
KO
DEERE & CO
5 OTHER
CUMMINS INC
SANDVIK AB
0
CATERPILLAR INC
-5 KOMATSU LTD.(C)
VOLVO AB
0 10 20 30 40 50 60 70 80 90 100
2005
C AT W AR
INGERSOLL-RAND
a

ITPC
Economic Spread %
O
IR
15
AT C
PACCAR INC
LV AT O
VO M C C
b SU
ILLINOIS TOOL W
KO U
10
N
DFA
ATLAS COPCO AB
E
CATERPILLAR INC
BI
5 OTHER
SU
FANUC CORPORATI
IT
M
DEERE & CO
0
KOMATSU LTD.(C)
-5 VOLVO AB
MITSUBISHI HEAV
0 10 20 30 40 50 60 70 80 90 100

Trading Companies & Distributors
MSCI GIC: 201070

Count of firms: 481
2015
WTL
WSZ
GFBAN
BUNZL PUBLIC LI
18
10
Economic Spread %
10 FASTENAL CO
S
O
W
GRAINGER (W W)
O
M
WOLSELEY PLC
5
O
C
IT
U
M
SUMITOMO CORPOR
I
N
S
H
R
SU
BE
I&
OTHER
BI
C
AE
O
AERCAP HOLDINGS
SU
SU
U
IT
AR
0
IT
IT
MITSUBISHI CORP
M
M
MITSUI & CO., L
-5 ITOCHU CORPORAT
-4 MARUBENI CORPOR
0 10 20 30 40 50 60 70 80 90 100
2010
GRAINGER (W W)
Economic Spread %
10 NOBLE GROUP LIM

W
G
I
N
MMTC LTD
C
BE
ITMM BG
G
CC
S
H
N
U
ITOCHU CORPORAT
I&
OT
BI
O
5
O
ELSU
AR
IT
SU
N
SU
M
AD M
M
SUMITOMO CORPOR
IT
IT
SU
SA
OTHER
M
MITSUBISHI CORP
0 MITSUI & CO., L
MARUBENI CORPOR
-5 SAMSUNG C&T
ADANI ENTERPRIS
0 10 20 30 40 50 60 70 80 90 100
O
2005
TW
O W STNE
SK NETWORKS
G FSAK

Economic Spread %
10 FASTENAL CO
S
W
H T
SU U C
W
O TA
GRAINGER (W W)
O
IT YO
I
C
N
BI
WOLSELEY PLC
O
I&
5
TO
BE
IT
SU
OTHER
M
TOYOTA TSUSHO C
IT
AR
SU
IT
M
ITOCHU CORPORAT
0 MITSUBISHI CORP
SUMITOMO CORPOR
-5 MITSUI & CO., L
MARUBENI CORPOR
0 10 20 30 40 50 60 70 80 90 100

Commercial Services & Supplies
MSCI GIC: 202010

Count of firms: 606
2015
L
C
SR
STERICYCLE INC
Economic Spread %
TY B P JIN S
G
15 CINTAS CORP
BBXIC EI TA
B C
BEIJING ORIGINW
O
10
C
C
.
SOCIETE B I C S
SGN
M
RC
W
O
M
BRAMBLES LIMITE
C
W
5 OTHER
SE
TYCO INTERNATIO
WASTE CONNECTIO
0
REPUBLIC SERVIC
-5 WASTE MANAGEMEN
SECOM CO., LTD.
0 10 20 30 40 50 60 70 80 90 100
2010
K
GL
GC
ASR
STERICYCLE INC
23
15
Economic Spread %
15 AGGREKO PLC
R XB S
G4S PLC
B F
10
G
O
SG
BRAMBLES LIMITE
C M
TY CO
REPUBLIC SERVIC
M
5 OTHER
SE
P
W
P
IP
WASTE MANAGEMEN
AN
N
PP
AI
SECOM CO., LTD.

0
D
TO
TYCO INTERNATIO
-5 DAI NIPPON PRIN
TOPPAN PRINTING
0 10 20 30 40 50 60 70 80 90 100
2005
CINTAS CORP
I U S
Economic Spread %
PSBE TA
15
b
SECURITAS AB
C
C
PITNEY BOWES IN
TO IP O
10
N C
PP P
AN
BRAMBLES INDUST
D OM
BX Bq
W B
BX
C
C
AI
M
BRAMBLES LIMITE
OTHER
SE
TY
5 WASTE MANAGEMEN
TYCO INTERNATIO
0
SECOM CO., LTD.
-5 DAI NIPPON PRIN
TOPPAN PRINTING
0 10 20 30 40 50 60 70 80 90 100

Professional Services
MSCI GIC: 202020

Count of firms: 275
2015
EXPERIAN PLC
VR FX N

E P
PI SK
Economic Spread %
EX
EQUIFAX INC
35 VERISK ANALYTIC
C
EN IT
30
AD RU
CAPITA PLC
25
EC
BV N
RECRUIT HOLDING
S
R
20
TW
D
SG
I
AN
ADECCO GROUP AG
15 OTHER
R
TOWERS WATSON &

10
5 SGS SA
0 BUREAU VERITAS
RANDSTAD HOLDIN
0 10 20 30 40 50 60 70 80 90 100
2010
EX PI RSK
VERISK ANALYTIC
Economic Spread %
C V
37 CAPITA PLC
35
IH N
EXPERIAN PLC
P
S
30 IHS INC
25 BUREAU VERITAS
SN
20
I
D
BV
EN
SG
AN
SGS SA
15
AD
R
OTHER
AN
RANDSTAD HOLDIN
10
MHI
R
5 ADECCO GROUP AG
0 ROBERT HALF INT
MANPOWERGROUP
0 10 20 30 40 50 60 70 80 90 100
2005
CHOICEPOINT INC
1

Economic Spread %
D F PS.
EQUIFAX INC
E C
35 DUN & BRADSTREE

C NBX
PI
30 CAPITA PLC
25 ROBERT HALF INT
20
AD N
SG I
H
EN
M D
S
R
SGS SA
AN
15
AN
OTHER
R
ADECCO GROUP AG
10
VN
5 RANDSTAD HOLDIN
0 MANPOWERGROUP
NIELSEN COMPANY
0 10 20 30 40 50 60 70 80 90 100

Air Freight & Couriers
MSCI GIC: 203010

Count of firms: 123
2015
W
R
H
C
C H ROBINSON WO
32
Economic Spread %
30 EXPEDITORS INTL
25 UNITED PARCEL S
PD
EX
20 ROYAL MAIL PLC
H
OI
ATDA
15 BOLLORE
MN
n
PS
YAYU
G
FD F
D L
BO G
PW
10
M
L
U
DEUTSCHE POST A
H
M
X
EP
R
OTHER
5 FINANCIERE DE L
0 FEDEX CORP
-5 HYUNDAI GLOVIS
YAMATO HOLDINGS
0 10 20 30 40 50 60 70 80 90 100
2010
W
R
H
C H ROBINSON WO
C

Economic Spread %
30 EXPEDITORS INTL
25 POSTNL
I
3 DA
20
EC HY TNPD
U O U L
HYUNDAI GLOVIS
H
PS R N
PEX
O
15
AT
ECORODOVIAS INF
n
YA LL
G
M
PW
10
BO
UNITED PARCEL S
X
D
OTHER
FD
5 DEUTSCHE POST A
0 FEDEX CORP
-5 BOLLORE
YAMATO HOLDINGS
0 10 20 30 40 50 60 70 80 90 100
2005
W
C H ROBINSON WO
R

H
Economic Spread %
30
C
EXPEDITORS INTL
25 UTI WORLDWIDE I
L D
N IW P
20 POSTNL
PT UETX
15
n
UNITED PARCEL S
O
PS
AT
PWL
DTO
10
U
FD L
M
X
TOLL HOLDINGS L
EX
YA
OTHER
5 DEUTSCHE POST A
0 EXEL PLC
-5 FEDEX CORP
YAMATO HOLDINGS
0 10 20 30 40 50 60 70 80 90 100

Airlines
MSCI GIC: 203020

Count of firms: 86
2015
I
V NA
LU RYPAA
JAPAN AIRLINES
JA

Economic Spread %
86
AL
RYANAIR HOLDING
5
D
AG
SOUTHWEST AIRLI
IN SO
IN N
AL
EA
IC
I
L
H
DELTA AIR LINES
AA
U
A
C
A
R
H
AI UNITED CONTINEN
H
C
OTHER
C
0 AMERICAN AIRLIN
INTERNATIONAL C
AIR CHINA LIMIT
-5 CHINA SOUTHERN
CHINA EASTERN A
0 10 20 30 40 50 60 70 80 90 100
2010
P
LATAM AIRLINES
AY

Economic Spread %
EA
SO
CATHAY PACIFIC
ATN
H
D INA N
D
C LA
5
AL A
C CH
AG OL
SI IN
CHINA EASTERN A
H
H
AL
H
C
AI
SINGAPORE AIRLI
AN
V
LH
LU
AIR CHINA LIMIT
0 OTHER CHINA SOUTHERN
DELTA AIR LINES
ANA HOLDINGS IN
-5 DEUTSCHE LUFTHA
SOUTHWEST AIRLI
0 10 20 30 40 50 60 70 80 90 100
2005
RYANAIR HOLDING
Economic Spread %
YA
CATHAY PACIFIC
LUALY P
R
5
D
SIHA
AG OL
SINGAPORE AIRLI
Q V
IC N
IC H
AT
AG
A
AG
A
SOUTHWEST AIRLI
C
AN
F
LH
R
AI
QANTAS AIRWAYS
0 OTHER INTERNATIONAL C
ANA HOLDINGS IN
INTERNATIONAL C
-5 DEUTSCHE LUFTHA
AIR FRANCE KLM
0 10 20 30 40 50 60 70 80 90 100

Marine
MSCI GIC: 203030

Count of firms: 190
2015
KUEHNE UND NAGE
IN

Economic Spread %
KN
10 KIRBY CORP
MISC BERHAD
A SH
AE ISXC
AP MOELLER MAER
O
5
MKE
SU A O
b
C
H A
SK
I O SH
IT IN T
C HIN
CHINA SHIPPING
M CH IEN
Y
IN
R
N
C
R
PO
CHINA COSCO HOL
M
0 O
IP
NIPPON YUSEN KA
N
OTHER
ORIENT OVERSEAS
-5 CHINA SHIPPING
MITSUI O.S.K. L
0 10 20 30 40 50 60 70 80 90 100
2010
KUEHNE UND NAGE
Economic Spread %
LA NIN
10 HAPAG-LLOYD AG
K
G
ORIENT OVERSEAS
SK O
I O SH
b
N H
PO A S
RT
AEEN
H
IT SCNA
Y
AP MOELLER MAER
5
N HIN
O
M RI
M MI H I
C
O
CHINA SHIPPING
C
SU
C
A
IP
IN
NIPPON YUSEN KA
OTHER
H
C
0 CHINA SHIPPING
MISC BERHAD
-5 MITSUI O.S.K. L
CHINA COSCO HOL
0 10 20 30 40 50 60 70 80 90 100
2005
KUEHNE UND NAGE
Economic Spread %
10 NEPTUNE ORIENT
E IN
N KN
I
M PS
MISC BERHAD
AK
AS
L C
b
R TX
P&O NEDLLOYD NV
Y
IS
SK
5
IO
TE
M MYN
W
AE A
N
KA
OTHER
BO
SU
PO
MATSON INC
N
IT
IP
M
AP MOELLER MAER
0 KAWASAKI KISEN
MITSUI O.S.K. L
-5 NIPPON YUSEN KA
BOLLORE
0 10 20 30 40 50 60 70 80 90 100

Road & Rail
MSCI GIC: 203040

Count of firms: 210
2015
DAQIN RAILWAY C
U . RA

Economic Spread %
AL
N IN
CANADIAN NATION
TR
T RP
C Q
5
R
P
A
SX
EN
P
ES CO
UNION PACIFIC C
N
D
JA
P
C
SC
C
JA
P.
TR
CENTRAL JAPAN R
C
ST
M
W
OTHER
EA
CANADIAN PACIFI
0 CSX CORP
NORFOLK SOUTHER
EAST JAPAN RAIL
-5 MTR CORPORATION
WEST JAPAN RAIL
0 10 20 30 40 50 60 70 80 90 100
2010
3RA
LL MOIN
AL RUAQ
DAQIN RAILWAY C
P
Economic Spread %
6
R
RUMO LOGISTICA
O
5
C
AL
ALL AMERICA LAT

N R
N .
X
R
U MT
TR
S
SC
N
P
C
C
P
JA
MTR CORPORATION
EN
ST
C
UNION PACIFIC C
EA
0 OTHER CSX CORP
CENTRAL JAPAN R
CANADIAN NATION
-5 NORFOLK SOUTHER
EAST JAPAN RAIL
0 10 20 30 40 50 60 70 80 90 100
2005
AVIS BUDGET GRO
AR
Economic Spread %
CENTRAL JAPAN R
BR C OR
C
P O
5
AL
JA U C
S C
MTR CORPORATION
TR
N TR
ST KY
EN
NORFOLK SOUTHER
.
EA TO
K3
SX
C
N
C
OTHER
C
BURLINGTON NORT
P
N
0
U
TOKYU CORPORATI
EAST JAPAN RAIL
CANADIAN NATION
-5 UNION PACIFIC C
CSX CORP
0 10 20 30 40 50 60 70 80 90 100

Transportation Infrastructure
MSCI GIC: 203050

Count of firms: 196
2015
I
AB YD ANGB HA
HP
SHANGHAI INTERN
S SHIN T G
AI

AO AN
GO
Economic Spread %
AIRPORTS OF THA
SH
5
N
NINGBO PORT COM

A
AE P
ADL
N
TC
E
SHANGHAI INTL A
OTHER
L
SYDNEY AIRPORT
AT
0 ABERTIS INFRAES
TRANSURBAN GROU
AEROPORTS DE PA
-5 AENA SA
ATLANTIA SPA
0 10 20 30 40 50 60 70 80 90 100
AI
2010
C E E GH
PL AP HAN
SHANGHAI INTERN
Economic Spread %
5
CU S
M
TCH O3
ADANI PORTS AND

5
A
R
N
PLUS EXPRESSWAY
LI
C
E P
CCR SA
R
AB D
R
A
AP
CHINA MERCHANTS
OTHER
L
0
AT
TRANSURBAN GROU
AEROPORTS DE PA
ABERTIS INFRAES
-5 AUTOROUTES PARI
ATLANTIA SPA
0 10 20 30 40 50 60 70 80 90 100
2005
INTOLL GROUP
O

IT
Economic Spread %
10 ABERTIS INFRAES
5 PENINSULAR AND
E
AB
L O
BA BR AG
ATLANTIA SPA
AT P
EF
A I
FR
R
SN
AUTOROUTES DU S
R
F
AS
AP
0 OTHER FRAPORT AG FRAN
BRISA-AUTO ESTR
BAA PLC
-5 SANEF
AUTOROUTES PARI
0 10 20 30 40 50 60 70 80 90 100

Auto Components
MSCI GIC: 251010

Count of firms: 554
2015
H
LP
DELPHI AUTOMOTI
D
Economic Spread %
10 CONTINENTAL AG
N
O
T
ES I
I
G A
C
JC
ID ND
JOHNSON CONTROL
C I
BRYU .
SO TA
G
SE
M
MAGNA INTERNATI
O
EN YO
5
P
H
N
IC
OTHER
TO
SI HYUNDAI MOBIS
M
AI
BRIDGESTONE COR
D
0 COMPAGNIE GENER
TOYOTA INDUSTRI
-5 DENSO CORPORATI
AISIN SEIKI CO.
0 10 20 30 40 50 60 70 80 90 100
AI
2010
D
N
YU
H
HYUNDAI MOBIS
15
Economic Spread %
10 JOHNSON CONTROL
T
CONTINENTAL AG
ES
O
M G
M
C I
E N MI E
JC
MAGNA INTERNATI
N
ID
I
SO TO
5
SU N S
P
TA
O
BR.
G
O
IC
YO
BRIDGESTONE COR
SI
M
OTHER
AI
TO
COMPAGNIE GENER
0
D
AISIN SEIKI CO.
SUMITOMO ELECTR
-5 DENSO CORPORATI
TOYOTA INDUSTRI
0 10 20 30 40 50 60 70 80 90 100
AI
2005
D
N
YU
H
HYUNDAI MOBIS
12
Economic Spread %
10 JOHNSON CONTROL
SO EST
TA O
CONTINENTAL AG
O
G
YO OM
M NG
IC SE
C
ID
I
C I
JC
MAGNA INTERNATI
O
TO MIT
BR.
5
G
M N
P
SI
EN
SU
BRIDGESTONE COR
AI
D
OTHER DENSO CORPORATI

0 AISIN SEIKI CO.
COMPAGNIE GENER
-5 SUMITOMO ELECTR
TOYOTA INDUSTRI
0 10 20 30 40 50 60 70 80 90 100

Automobiles
MSCI GIC: 251020

Count of firms: 94
2015
n
G
M DAIMLER AG
AI

TA
Economic Spread %
T
D
O
O
M
BMW - BAYERISCH
YO
BM
M
M M
H AN
I
A
TO
G IC
A
TOYOTA MOTOR CO
D
S
OTHER
D
SA
N
IS
N
O
VO YU
N
SAIC MOTOR CORP
_p
F
G
W
GENERAL MOTORS
0 FORD MOTOR CO
NISSAN MOTOR CO
HONDA MOTOR CO.
-5 HYUNDAI MOTOR
VOLKSWAGEN AG
0 10 20 30 40 50 60 70 80 90 100
2010
AI
D
H UG
N
AUDI AG
YU

S
Economic Spread %
5 HYUNDAI MOTOR
D G
M
n
O
W
BMW - BAYERISCH
M
N
_p
AI
BM
SA
A
G
DAIMLER AG
IS
W
OTHER
N
VO
G
F
FORD MOTOR CO
M
0
TA
VOLKSWAGEN AG
YO
TO
HONDA MOTOR CO.
NISSAN MOTOR CO
-5 GENERAL MOTORS
TOYOTA MOTOR CO
0 10 20 30 40 50 60 70 80 90 100
2005
TA O
O NM
M
YO M
NISSAN MOTOR CO
SA
TO DA

Economic Spread %
5
IS
HONDA MOTOR CO.

AI
F SU
W
N
D
H
BM
N
TOYOTA MOTOR CO
YU
H
AUDI AG
n
G
A
EN
AI
_p
FORD MOTOR CO
D
0
G
R
W
BMW - BAYERISCH
OTHER
VO
HYUNDAI MOTOR
DAIMLER AG
-5 RENAULT SA
VOLKSWAGEN AG
0 10 20 30 40 50 60 70 80 90 100

Household Durables
MSCI GIC: 252010

Count of firms: 526
G LE
R
EA E
2015
ID E
M RE
G
GREE ELECTRIC A
16
Economic Spread %
15 MIDEA GROUP CO
NEWELL BRANDS I
M NHH L
S JA W
10
SU
N
D HK
JARDEN CORP
KI
R
SEI
H
STEINHOFF INTER
I
N
5
C
OTHER
Y
AS
MOHAWK INDUSTRI
N
N
SO
PA
D R HORTON INC
0
SEKISUI HOUSE,
-5 SONY CORPORATIO
PANASONIC CORPO
0 10 20 30 40 50 60 70 80 90 100
2010
EA
ID
GD MIDEA HOLDIN
M

Economic Spread %
15
G
EL
GREE ELECTRIC A
EE
ELECTROLUX AB
R
C CT O
10
G
N LE N C
NIKON CORPORATI
LG IK b
N X
O
O UI
R
EL
LG ELECTRONICS
U
PA S O
I
O
N
A S IS
5
EL
C
E
YO
N K
P
OTHER SONY CORPORATIO

E
Y
AR
N
SA
SO
SH
SHARP CORPORATI
0
SEKISUI HOUSE,
-5 PANASONIC CORPO
SANYO ELECTRIC
0 10 20 30 40 50 60 70 80 90 100
2005
CENTEX CORP
Economic Spread %
15 LENNAR CORP
N.
LETX
D R HORTON INC
O
C
10
SH ECI
C
U
ELISb
ELECTROLUX AB
LSGE UX
R
EL I
H
R
K
O
D
SEKISUI HOUSE,
C
5
O
Y
OTHER
N
AS
LG ELECTRONICS
SO
M
N
PA
PH
SHARP CORPORATI
0
SONY CORPORATIO
-5 PANASONIC CORPO
-4 PULTEGROUP INC
0 10 20 30 40 50 60 70 80 90 100

Leisure Equipment & Products
MSCI GIC: 252020

Count of firms: 132
2015
R
G
A
I
PI
O
POLARIS INDUSTR
17
AS P
AN

Economic Spread %
H AL
15 ALPHA GROUP
IM
SH
HASBRO INC
10
N
C
N S
AT
C
SHIMANO INC.(C)
BC
YA AI
BA EA
O
AH
M
D
AM
KY
BRUNSWICK CORP
M
5
N
OTHER
SA
MATTEL INC
AMER SPORTS OYJ

0
BANDAI NAMCO HO
-5 YAMAHA CORPORAT
SANKYO CO., LTD
0 10 20 30 40 50 60 70 80 90 100
2010
POLARIS INDUSTR
Economic Spread %
15 HASBRO INC
AS
H II
P
AT
MATTEL INC
C
M
10
G NO
M
KY
SANKYO CO., LTD

SA
SE A
N
N
N BE
IM
SA
SA
AI
SHIMANO INC.(C)
SH
BA H
5
ER
D
C
C
SEGA SAMMY HOLD

OTHER
IV
AH
N
U
M
BENETEAU
0
YA
BANDAI NAMCO HO
-5 YAMAHA CORPORAT
UNIVERSAL ENTER
0 10 20 30 40 50 60 70 80 90 100
M
2005
SA
A
G
SEGA SAMMY HOLD

SE
AS YO

Economic Spread %
15
SA PII
POLARIS INDUSTR
K
N
AN I C
AT
SANKYO CO., LTD

A
SH ND
O
M
H
10
BC
HASBRO INC
BA
IM
C
N
MATTEL INC
A
AI
5
AH
D
OTHER BRUNSWICK CORP

N
M
BA
YA
BANDAI CO., LTD

0
SHIMANO INC.(C)
-5 BANDAI NAMCO HO
YAMAHA CORPORAT
0 10 20 30 40 50 60 70 80 90 100

Textiles & Apparel
MSCI GIC: 252030

Count of firms: 861
2015
HERMES INTERNAT
Economic Spread %
25 VF CORP
KE S
NIKE INC
20
N FRCM
VH
LUXOTTICA GROUP
PR UX
15
L
LV TP
KERING
H
M
R n
FR
H G
IO
LVMH MOET HENNE

10
U DS
D
OTHER
C
A
CHRISTIAN DIOR
5 RICHEMONT (COMP
0 ADIDAS AG
THE SWATCH GROU
0 10 20 30 40 50 60 70 80 90 100
N
2010
U
H &F
C LI
LI & FUNG LIMIT

27
Economic Spread %
25
O
COACH INC
HERMES INTERNAT
20
NIKE INC
PR E S
15
K M
LV TP
KERING
IN
NHR
R
M
RE
IO
FR
H L
LVMH MOET HENNE

10
D
U EL
C
B
CHRISTIAN DIOR
5 OTHER
RICHEMONT (COMP
0 BELLE INTERNATI
THE SWATCH GROU
0 10 20 30 40 50 60 70 80 90 100
2005
H
COACH INC
O

C
Economic Spread %
25 HERMES INTERNAT
NIKE INC
20
ADIDAS AG
AD E S
M n
15
KM
LV X G
LUXOTTICA GROUP
NHR
LU S
R
IO
U R
LVMH MOET HENNE

10
TP
D
F
PRHR
C
CHRISTIAN DIOR
5 OTHER RICHEMONT (COMP
0 THE SWATCH GROU
KERING
0 10 20 30 40 50 60 70 80 90 100

Hotels Restaurants & Leisure
MSCI GIC: 253010

Count of firms: 803
2015
PG
C
COMPASS GROUP P
27
Economic Spread %
20 STARBUCKS CORP
YUM BRANDS INC

H
15
LVA M X
SANDS CHINA LIM

YU BU
S
H SND
S
LAS VEGAS SANDS

L
TA
10
S
D
MLT
L N
HILTON WORLDWID
C
C IE
L
C
ROR
C
MCDONALD'S CORP
5 OTHER
CARNIVAL CORP/P
0 ORIENTAL LAND C
ROYAL CARIBBEAN
0 10 20 30 40 50 60 70 80 90 100
2010
PG
COMPASS GROUP P
Economic Spread %
20 YUM BRANDS INC
GENTING SINGAPO
15 MCDONALD'S CORP
H
D S
L T C
STARBUCKS CORP
MGEM
C N
C ENR DS
10
GMAANUX
YU
SANDS CHINA LIM

SB
S
S
LV
MARRIOTT INTL I
5
C
OTHER GENTING BERHAD
0 CARNIVAL CORP/P
LAS VEGAS SANDS
0 10 20 30 40 50 60 70 80 90 100
2005
R
PA
O
GREEK ORGANISAT
64
Economic Spread %
20 MARRIOTT INTL I
LAS VEGAS SANDS
15 YUM BRANDS INC

CVUSM R
YL A
CARNIVAL CORP/P
M
10
C UX
C
M SB T
O
STARWOOD HOTELS
H
P
AC R
C
STARBUCKS CORP
5
Z
OTHER
C
MCDONALD'S CORP
0 CAESARS ENTERTA
ACCOR
0 10 20 30 40 50 60 70 80 90 100

Diversified Consumer Services
MSCI GIC: 253020

Count of firms: 208
2015
V
ERAA
ASA
AA PLC
56
45
Economic Spread %
B 3
30
T
SERVICEMASTER G
H O
KR
25 KROTON EDUCACIO
R
20
M
BLOCK H & R INC

ZH FA
H E
15
I JIA
M S
B
BE C
H ES
BRIGHT HORIZONS
SC E
C
10
G
OTHER ZHEJIANG YASHA

5
SERVICE CORP IN
0
-5 GRAHAM HOLDINGS
-5 BENESSE HOLDING
HOUGHTON MIFFLI
0 10 20 30 40 50 60 70 80 90 100
2010
APTW TRA
STRAYER EDUCATI
Economic Spread %
W S
30
L
WEIGHT WATCHERS
O
25 APOLLO EDUCATIO
H MC
G
C JI E
V
G ZH SS
D
20
AN
ED
DEVRY EDUCATION
E
R
BE ID
15
N
H E
B
EDUCATION MANAG
10 OTHER
BLOCK H & R INC
5
SOTHEBY'S
0
-5 BENESSE HOLDING
ZHEJIANG YASHA
GRAHAM HOLDINGS
0 10 20 30 40 50 60 70 80 90 100
2005
APOLLO EDUCATIO
W OL

Economic Spread %
30
SE TW
AP
WEIGHT WATCHERS
C ESI 6B
59 RV
25
4
SERVICEMASTER G
C SS
H O
G NE .2
20
EC
BE UR
SERVICEMASTER C
R
15
LA
ITT EDUCATIONAL
H
10 OTHER CAREER EDUCATIO

5
BLOCK H & R INC
0
-5 LAUREATE EDUCAT
BENESSE HOLDING
GRAHAM HOLDINGS
0 10 20 30 40 50 60 70 80 90 100

Media
MSCI GIC: 254010

Count of firms: 748
2015
FO WX P N
T WP E L
R
RELX NV
21
Economic Spread %
20
X
WPP PLC
TIME WARNER INC

15
IS
SA
TWENTY-FIRST CE
M E
D
C TC
C
10
Jn
OTHER DISNEY (WALT) C
A
VN
VNIP
C
ALTICE SA
5
TW
COMCAST CORP
0 TIME WARNER CAB
-5 NASPERS LIMITED
VIVENDI SA
0 10 20 30 40 50 60 70 80 90 100
2010
AB
VI
VIACOM INC
21
Economic Spread %
20 TIME WARNER INC

VI TV . Jn
D TRPINX
NW
NASPERS LIMITED
15
T
THOMSON-REUTERS
V
D X
10
FO
IS
DIRECTV
SA
OTHER
C
VIVENDI SA
5
M
C
C
TW
TWENTY-FIRST CE
0 DISNEY (WALT) C
-5 COMCAST CORP
TIME WARNER CAB
0 10 20 30 40 50 60 70 80 90 100
2005
THOMSON-REUTERS
Economic Spread %
20
I.
VIVENDI SA
TR
RELX NV
15
TWBSLN
CBS CORP
V
D X A
VI
Z
CE
10
FOTR
R
TIME WARNER INC

OTHER
IS
SA
S
C TV
C
STARZ
5
D
M
TWENTY-FIRST CE
0 DISNEY (WALT) C
-5 DIRECTV
COMCAST CORP
0 10 20 30 40 50 60 70 80 90 100

Distributors
MSCI GIC: 255010

Count of firms: 184
2015
POOL CORP
L

Economic Spread %
QO
15
LKPO
I LKQ CORP
YCO I X
H
PC
JC FA HU
C
GENUINE PARTS C
A N MA
IN
G
C N
10
A
INCHCAPE PLC
Z
O
AN
ANHUI XINHUA ME
G
5 C
IN
OTHER
C
CFAO
N
U
AO
W
JARDINE CYCLE &
0
LI
CANON MARKETING
-5 WUCHAN ZHONGDA
-11 LIAONING CHENG
0 10 20 30 40 50 60 70 80 90 100
2010
JARDINE CYCLE &
YC
Economic Spread %
15 LKQ CORP
JC
IN I
G
N IX
C Q
GLIANH O
CFAO
PCO U
LK
A A
10
F
ANHUI XINHUA ME
H
A
TB
LIAONING CHENG
IN
IE
5
N
L
IP
OTHER GENUINE PARTS C

AN
C
D'IETEREN S.A
0
INCHCAPE PLC
-5 IMPERIAL HOLDIN
CANON MARKETING
0 10 20 30 40 50 60 70 80 90 100
2005
IN LK BG OL
POOL CORP
P PO

Economic Spread %
15 PACIFIC BRANDS
C Q
JC H
LKQ CORP
YC
10
PC
INCHCAPE PLC
G
G
N
L
D
IP
TB
JARDINE CYCLE &

AN
5
IE
OTHER
C
GENUINE PARTS C
IMPERIAL HOLDIN
0
D'IETEREN S.A
-5 CANON MARKETING
MEDION AKTIENGE
0 10 20 30 40 50 60 70 80 90 100

Internet & Catalog Retail
MSCI GIC: 255020

Count of firms: 121
2015
PRICELINE GROUP
Economic Spread %
EXPEDIA INC
LN
35
TR PE
PC
TRIPADVISOR INC
30
EX
SO IP
,
N
25 ASOS PLC
FL TE
ZNS
20
N KU
AMAZON.COM INC
AM
15
W AG
A
P
R
YN L
RAKUTEN, INC.(C
A
10 OTHER
Z
5 NETFLIX INC
0 ZALANDO SE
-5
YOOX NET-A-PORT
-16
WAYFAIR INC
0 10 20 30 40 50 60 70 80 90 100
2010
PC E
EXPEDIA INC
P
LN

EX
Economic Spread %
PRICELINE GROUP
,
N
35
TE
ASOS PLC
30
R LOXS
U
AK
25
ZN
NAS
NETFLIX INC
F
3
AM
20
H OW
I
BTSN
RAKUTEN, INC.(C
G
15
E
AN
H
10 OTHER AMAZON.COM INC

D
O
5 HSN INC
0 B2W COMPANHIA D
-5
HOME RETAIL GRO
E-COMMERCE CHIN
0 10 20 30 40 50 60 70 80 90 100
2005
PE
EXPEDIA INC
EX

Economic Spread %
570 NUTRISYSTEM INC

35
ZN RI
AMAZON.COM INC
30
AM NT
PCFL UL O
O
25
N K SH
CJ O SHOPPING
BE LX C
N NA
20
,
AS O
N
BWLLU
ASKUL CORPORATI
G
N
TE
J
15
C
NETFLIX INC
10 OTHER
AK
5
R
PRICELINE GROUP
0 BELLUNA CO., LT
-5
N BROWN GROUP P
RAKUTEN, INC.(C
0 10 20 30 40 50 60 70 80 90 100

Multiline Retail
MSCI GIC: 255030

Count of firms: 150
2015
XT
N
NEXT PLC
12
LC

Economic Spread %
LI G
10
T EPO
DOLLAR GENERAL
D
TG V
EL PUERTO DE LI
D N
FA R
S B
JW
LT
M
KS LA
KS
TARGET CORP
5 M
MACY'S INC
OTHER NORDSTROM INC
0 DOLLAR TREE INC
FALABELLA S.A.C
-5 KOHL'S CORP
MARKS AND SPENC
0 10 20 30 40 50 60 70 80 90 100
2010
DOLLAR GENERAL
F G
B

D
JW ALA
Economic Spread %
10
LC
FALABELLA S.A.C
A
O
G
KS N
EP
NORDSTROM INC
IN H
SE
TGS
T
SHE S
M LIV
KOHL'S CORP
5
TT
KS
LO
M
TARGET CORP
OTHER
EL PUERTO DE LI
0 MACY'S INC
MARKS AND SPENC
-5 LOTTE SHOPPING
SHINSEGAE
0 10 20 30 40 50 60 70 80 90 100
2005
T LAB
FALABELLA S.A.C
Economic Spread %
10
TG FA
TARGET CORP
KSWN
R
M S
U A
IG
LD AR EG
NORDSTROM INC
JC S
J
P
K
M INS
KOHL'S CORP
5
SH
M
MARKS AND SPENC

OTHER
SH
PENNEY (J C) CO
0 MACY'S INC
SHINSEGAE
-5 MARUI GROUP CO.
SEARS HOLDINGS
0 10 20 30 40 50 60 70 80 90 100

Specialty Retail
MSCI GIC: 255040

Count of firms: 518
2015
AUTOZONE INC
Economic Spread %
HOR ZO
15
Y
O'REILLY AUTOMO
A
DL
IT X T
HOME DEPOT INC

LRBO b
TJ S
M
H
H & M HENNES &

10
X
ET
ROSS STORES INC

R
W
ST
LO
L BRANDS INC
FA
5 TJX COMPANIES I
OTHER
INDITEX
0 LOWE'S COMPANIE
FAST RETAILING
0 10 20 30 40 50 60 70 80 90 100
2010
H & M HENNES &
Economic Spread %
15
b
INDITEX
M
H
TJX COMPANIES I
IN E T
BEST BUY CO INC

10
C
X
H SU S T R
IT
G
BB X
G ASLS
S Y
STAPLES INC
TJ
FP
D N
P
FAST RETAILING
5
W
GAP INC
OTHER
LO
SUNING COMMERCE
0 HOME DEPOT INC
LOWE'S COMPANIE
0 10 20 30 40 50 60 70 80 90 100
2005
H & M HENNES &
Economic Spread %
15 HOME DEPOT INC

H Mb
D
H
INDITEX
LOPL Y
S YB
BBBBX
WS
IT
BED BATH & BEYO

10
D
X
BEST BUY CO INC

A
TJ
AD
PS
STAPLES INC
M
G
YA
5 OTHER LOWE'S COMPANIE
TJX COMPANIES I
0 GAP INC
YAMADA DENKI CO
0 10 20 30 40 50 60 70 80 90 100

Food & Staples Retailing
MSCI GIC: 301010

Count of firms: 322
2015
X
CVS HEALTH CORP

BA T F E
VS

W OSCU M
Economic Spread %
10
CAN AL
C
WALMEX - WAL-MA
W
ALIMENTATION CO
M B
W EDS.
COSTCO WHOLESAL
WT
T
A
WALGREENS BOOTS
&
5 N ALIMENTATION CO
VE
KR
SE
WESFARMERS LIMI
OTHER
WAL-MART STORES
0 KROGER CO
SEVEN & I HOLDI
0 10 20 30 40 50 60 70 80 90 100
2010
EX
M
WALMEX - WAL-MA
AL

Economic Spread %
10
W
WAL-MART STORES
C OW
T
WOOLWORTHS LIMI
VS
M
W
CVS HEALTH CORP

W ES
C ST
C BA
W
WESFARMERS LIMI
TS O
5
&
O
WALGREENS BOOTS
VE
R
AR
SE
COSTCO WHOLESAL
OTHER
C
TESCO PLC
0 CARREFOUR S.A.
SEVEN & I HOLDI
0 10 20 30 40 50 60 70 80 90 100
2005
Y
SY
SYSCO CORP
13
EX
Economic Spread %
10
T
WAL-MART STORES
C BA LM
M
W
W WA
WALMEX - WAL-MA
O L
E
S O S
CEV ST
TS RN-
C V
WALGREENS BOOTS
ARE
&
C
CVS HEALTH CORP

5
N
VE
COSTCO WHOLESAL
SE
SEVEN-ELEVEN JA
OTHER
CARREFOUR S.A.
0 TESCO PLC
SEVEN & I HOLDI
0 10 20 30 40 50 60 70 80 90 100

Beverages
MSCI GIC: 302010

Count of firms: 230
2015 W
I 3
O
AMBEV - COMPANH
ABBEV
AB E ICH

Economic Spread %
25 ANHEUSER-BUSCH
A
D WE
B 3
SA V
G
E
K
KWEICHOW MOUTAI
20
BD
DIAGEO PLC
N AU
KO
15
EI S
P
AMBEV S.A
H EM
PE
F
SABMILLER PLC
10 OTHER
COCA-COLA CO
5 PEPSICO INC
0 FEMSA - FOMENTO
HEINEKEN NV
0 10 20 30 40 50 60 70 80 90 100
2010
W
O
3CH
KWEICHOW MOUTAI
EEVI

Economic Spread %
AKBW
25 AMBEV - COMPANH
AB E
I
G
BD
DIAGEO PLC
D
20
U
P SA
ANHEUSER-BUSCH
KO
P
PEM
FE B
15
R
SA
COCA-COLA CO
PE
SABMILLER PLC
10
N
OTHER
EI
H
FEMSA - FOMENTO
5 PEPSICO INC
0 PERNOD RICARD
HEINEKEN NV
0 10 20 30 40 50 60 70 80 90 100
2005
COCA-COLA CO
KO
Economic Spread %
25 DIAGEO PLC
PEPSICO INC
20
PE E
P
G
B D
D
ALLIED DOMECQ P
C
SA LL
I 3
LO
15
AB EV
A
H MO 3
SABMILLER PLC
G EV
N E
AB
EI D
AB
AMBEV - COMPANH
10
OTHER ANHEUSER-BUSCH
5 AMBEV S.A
0 GRUPO MODELO S.
HEINEKEN NV
0 10 20 30 40 50 60 70 80 90 100

Food Products
MSCI GIC: 302020

2015
MGIS RL C
KH
KRAFT HEINZ CO
18
Economic Spread %
15
ES Z
HORMEL FOODS CO
H
N
N DL
O
AN
GENERAL MILLS I
D
MONDELEZ INTERN
10
ABK N
NESTLE S.A.
TS
F
DANONE SA
5
M
OTHER TYSON FOODS INC

AD
KELLOGG CO
0 ASSOCIATED BRIT
ARCHER-DANIELS-
0 10 20 30 40 50 60 70 80 90 100
2010
GENERAL MILLS I
Economic Spread %
DK IS
15 KRAFT HEINZ CO
G
ES O
N AHNC
N
LZ
DANONE SA
D
Y
M
BR
NESTLE S.A.
10
CK
MONDELEZ INTERN
W BF
KELLOGG CO
AD L
A
M
LI
5 CADBURY PLC
OTHER
ASSOCIATED BRIT
0 WILMAR INTERNAT
ARCHER-DANIELS-
0 10 20 30 40 50 60 70 80 90 100
2005
LZ Y Y
M WW B R
CADBURY PLC
C

Economic Spread %
15 WRIGLEY (WM) JR
D
GK
N SHSY
H H IS
MONDELEZ INTERN
N
ES
KELLOGG CO
O
10
AN
GENERAL MILLS I
D
HERSHEY CO
M
5
AD
HILLSHIRE BRAND
OTHER
NESTLE S.A.
0 DANONE SA
ARCHER-DANIELS-
0 10 20 30 40 50 60 70 80 90 100

Tobacco
MSCI GIC: 302030

Count of firms: 37
2015
ALTRIA GROUP IN
O

M
Economic Spread %
59
B
IMPERIAL BRANDS
IM
AI
55
R
50 REYNOLDS AMERIC
45
PM
PHILIP MORRIS I
TS
40
Z3
IT RUSP
TO
BA
35 BRITISH AMERICA
CM
N
30
PA
25 HANJAYA MANDALA
JA
&G
20 OTHER SOUZA CRUZ SA
KT
15
10 ITC LTD
5 JAPAN TOBACCO I
KT&G
0 10 20 30 40 50 60 70 80 90 100
2010
IMPERIAL BRANDS
B
IM

Economic Spread %
69 LORILLARD INC
55
50 PHILIP MORRIS I
O SP
PM O
45
L
M M
HANJAYA MANDALA
40
H
TS
Z3
AI
35
R
BA
TO
ALTRIA GROUP IN
R
30
C
25 REYNOLDS AMERIC
C
PA
IT
20
JA
OTHER BRITISH AMERICA

15
10 SOUZA CRUZ SA
5 ITC LTD
JAPAN TOBACCO I
0 10 20 30 40 50 60 70 80 90 100
2005
IMPERIAL BRANDS
B
IM

Economic Spread %
LORILLARD INC
55
50 UST INC
45
R LH T.1
GALLAHER GROUP
40
LO
G US
35 REYNOLDS AMERIC
AI
TS
30
TO
O
25
BA
M
ALTRIA GROUP IN
T
JA C
N
AL
20
IT
PA
15 OTHER BRITISH AMERICA
10 ALTADIS SA
5 ITC LTD
JAPAN TOBACCO I
0 10 20 30 40 50 60 70 80 90 100

Household Products
MSCI GIC: 303010

Count of firms: 69
2015
VR
B
N
R
U
RECKITT BENCKIS
45
Economic Spread %
40 UNILEVER INDONE
LL
35
H
HINDUSTAN UNILE
30
_p
COLGATE-PALMOLI
KG
25
L
C
HENKEL KGAA
M
H
20
PG
KM LX
R
Ab HA
PROCTER & GAMBL
C
15
SC IC
OTHER CLOROX CO/DE
10
N
U
5 KIMBERLY-CLARK
0 UNICHARM CORPOR
SVENSKA CELLULO
0 10 20 30 40 50 60 70 80 90 100
2010
VR
B
N
R
RECKITT BENCKIS
42
U

Economic Spread %
40 UNILEVER INDONE
35 HINDUSTAN UNILE
30
L L
COLGATE-PALMOLI
C HL
25
LX
_p
PROCTER & GAMBL

PG
20
R
C
KG
B HA
CLOROX CO/DE
N
15
KM IC
H
HENKEL KGAA
10
Ab
U
OTHER
SC
5 UNICHARM CORPOR
0 KIMBERLY-CLARK
0 SVENSKA CELLULO
0 10 20 30 40 50 60 70 80 90 100
2005
RECKITT BENCKIS
Economic Spread %
40 UNILEVER INDONE
35
R
HINDUSTAN UNILE
L L V
B
C HL UN
R
30 COLGATE-PALMOLI
25
PG LX
CLOROX CO/DE
20
C
A
_p
Ab ER
PROCTER & GAMBL

15
KG
B
SC MB
KM
KIMBERLY-CLARK
10
KI
H
OTHER
5 HENKEL KGAA
0 KIMBERLY-CLARK
0 SVENSKA CELLULO
0 10 20 30 40 50 60 70 80 90 100

Personal Products
MSCI GIC: 303020

Count of firms: 182
2015
COTY INC
N Y
Economic Spread %
U OT
20 UNILEVER N.V.
c
C
EP
SE
L'OREAL
R
O
EN E C
AN C
15
IG OU
H OR PA
G PA
EL
LAUDER (ESTEE)
I
BE G H
E
AMOR
LG HOUSEHOLD &
P
L
10
R
AM
OTHER
O
BEIERSDORF AG
C
O
KA
AMOREPACIFIC
5
AMOREPACIFIC GR
0 HENGAN INTERNAT
KAO CORPORATION
0 10 20 30 40 50 60 70 80 90 100
2010
NATURA COSMETIC
3

U
Economic Spread %
U AT
20 UNILEVER N.V.
N
c
L'OREAL
N
I
EP
AN
15
R
HENGAN INTERNAT
PG
O
AVEN
AVON PRODUCTS
H
10
IGE3
EL
P
O
R
OTHER
BEYP
KA EID
LAUDER (ESTEE)
O
C
H
IS
HYPERMARCAS SA
O
5
SH
BEIERSDORF AG
0 SHISEIDO COMPAN
KAO CORPORATION
0 10 20 30 40 50 60 70 80 90 100
2005
3
U
AT
NATURA COSMETIC
N

P _p
Economic Spread %
20
AV DG
WELLA AG
EP
A
R
W
AVON PRODUCTS
O
15
N
L'OREAL
U
IG .1
UNILEVER N.V.
BE V
EL
O
R
10
AC
D
O
EI
LAUDER (ESTEE)
C
OTHER
IS
O
SH
KA
ALBERTO-CULVER
5
BEIERSDORF AG
0 KAO CORPORATION
SHISEIDO COMPAN
0 10 20 30 40 50 60 70 80 90 100

Health Care Equipment & Supplies
MSCI GIC: 351010

Count of firms: 445
2015
ESSILOR INTERNA
Economic Spread %
20 ZIMMER BIOMET H
ISS HI
INTUITIVE SURGI
ZB S
ES
BSTJ G
15
R
ST JUDE MEDICAL
M X
T
AB K
D
BOSTON SCIENTIF
SY
10
T
X MEDTRONIC PLC
BD
X
BA OTHER STRYKER CORP
5
ABBOTT LABORATO
0 BECTON DICKINSO
BAXTER INTERNAT
0 10 20 30 40 50 60 70 80 90 100
2010
ALCON INCORPORA
Economic Spread %
20 ST JUDE MEDICAL
L
AC
ABBOTT LABORATO
AB TJ
15
T
S
SYNTHES INCORPO
M KT
SYYS
I
E V
D
BD SS
STRYKER CORP
S
BA
10
C
MEDTRONIC PLC
X
OTHER
BAXTER INTERNAT
5
COVIDIEN PLC
0 ESSILOR INTERNA
BECTON DICKINSO
0 10 20 30 40 50 60 70 80 90 100
2005
R
ZIMMER BIOMET H
O
BSBH

Economic Spread %
20 BOSTON SCIENTIF
Z
ST L A
AC OY
HOYA CORPORATIO
J
H
15
M YK
T
ALCON INCORPORA
D
S
ST JUDE MEDICAL
10
T
X
AB
BA
STRYKER CORP
T
OTHER
D
G
MEDTRONIC PLC
5
ABBOTT LABORATO
0 BAXTER INTERNAT
GUIDANT CORP
0 10 20 30 40 50 60 70 80 90 100

Health Care Providers & Services
MSCI GIC: 351020

Count of firms: 393
2015
UNITEDHEALTH GR
Economic Spread %
30 AETNA INC
ES T
N
X
AE
U
25 EXPRESS SCRIPTS
CIGNA CORP
20
M I
K
FR TM
C
ANAH
C
MCKESSON CORP
C
EG
15 CARDINAL HEALTH
M
A
10
C
OTHER
H
ANTHEM INC
5 FRESENIUS SE &
0 HCA HOLDINGS IN
HUMANA INC
0 10 20 30 40 50 60 70 80 90 100
2010
X
R
ES
EXPRESS SCRIPTS
61
Economic Spread %
30 UNITEDHEALTH GR
N
U
25 AETNA INC
M T
C M
ANHS
AE
MEDCO HEALTH SO
20
FR CK
I
ANTHEM INC
EG
M
15
C EG
CIGNA CORP
FM
AH
10 OTHER MCKESSON CORP
5 FRESENIUS SE &
0 FRESENIUS MEDIC
CARDINAL HEALTH
0 10 20 30 40 50 60 70 80 90 100
2005
HX
NR
UES
EXPRESS SCRIPTS
46
Economic Spread %
30 UNITEDHEALTH GR
T
AE
25 AETNA INC
TM
CIGNA CORP
ANI
20
C
M H
ANTHEM INC
M K
15
A
C
H HS 1
C
M X.
CARDINAL HEALTH
10
C
OTHER
A
MCKESSON CORP
C
5 CAREMARK RX INC
0 MEDCO HEALTH SO
HCA HOLDINGS IN
0 10 20 30 40 50 60 70 80 90 100

Health Care Technology
MSCI GIC: 351030

Count of firms: 77
2015
.
C
S
IN
IM
IMS HEALTH HOLD

31
VE 3,

Economic Spread %
30
C WI DA V
M3, INC.(C)
E
S
25
G
VEEVA SYSTEMS I
N IN
M
20
N
ER N
MEDASSETS INC
N
IN SO
X
15
M V
R
AT
D
O
WINNING HEALTH
D
M
10 OTHER CERNER CORP
5
ATHENAHEALTH IN
0
-5 MEDIDATA SOLUTI
INOVALON HOLDIN
ALLSCRIPTS HEAL
0 10 20 30 40 50 60 70 80 90 100
2010
.
C
AS N
D ,I
M M3
M3, INC.(C)
Economic Spread %
30 MEDASSETS INC
I
3
EMSI
25
.
X
Q
QUALITY SYSTEMS
R
ER HN Y
AT MS
D
20
M
EMDEON INC
H
15
PM
N
ALLSCRIPTS HEAL
M
10
D
C
C
HMS HOLDINGS CO
5 OTHER
C
ATHENAHEALTH IN
0
-5 CERNER CORP
CEGEDIM
COMPUGROUP MEDI
0 10 20 30 40 50 60 70 80 90 100
2005
M3, INC.(C)
Economic Spread %
.
C
30 QUALITY SYSTEMS
S II, IN
25
IMQMS3
D GE
IMS HEALTH HOLD

C MR
20
ER M
MERGE HEALTHCAR
15
G
FB LP
CEGEDIM
IX
10
TZ
AG EC
C
OTHER CERNER CORP

IO
5
TRIZETTO GROUP
0
-5 ECLIPSYS CORP
-7 AGFA-GEVAERT N.
ISOFT GROUP PLC
0 10 20 30 40 50 60 70 80 90 100

Biotechnology
MSCI GIC: 352010

Count of firms: 479
2015
D
IL
G
GILEAD SCIENCES
C LX GN
34
R P

EL N
Economic Spread %
SH
E
20
G
SHIRE PLC
IB
A
AB SL
BV
BI
C REGENERON PHARM
15
N
G
ALEXION PHARMAC
AM
10 CELGENE CORP
TX
VR
BIOGEN INC
5 OTHER
CSL LIMITED
0 ABBVIE INC
-5 AMGEN INC
VERTEX PHARMACE
0 10 20 30 40 50 60 70 80 90 100
2010
D
IL
G
GILEAD SCIENCES
20
Economic Spread %
20
EL
CELGENE CORP
C
IB N
SL
CSL LIMITED
BI L
15
AT
C
P
N
SH
ACTELION AG
G
Z N
10
AM
EN X
BIOGEN INC
G AL
SHIRE PLC
5
TX
VR
OTHER AMGEN INC

0 ALEXION PHARMAC
-5 GENZYME CORP
-5 VERTEX PHARMACE
0 10 20 30 40 50 60 70 80 90 100
2005
AMGEN INC
Economic Spread %
20
G
GILEAD SCIENCES
AM
BI LD
BIOGEN INC
IB
15
G HP
SE NZ
I
G
O
E
S
E LG
SHIRE PLC
A
N
M CE
10
C DI
D
GENZYME CORP
IR
H
MERCK SERONO S.
5
GENENTECH INC
0 OTHER CELGENE CORP
-5 MEDIMMUNE INC
-4 CHIRON CORP
0 10 20 30 40 50 60 70 80 90 100

Pharmaceuticals
MSCI GIC: 352020

Count of firms: 581
2015
b
N VO
AGNO
NOVO NORDISK AS
18
Economic Spread %
15 ALLERGAN PLC
JOHNSON & JOHNS
ROCHE HOLDING A
10
J
JN
PF Gn
G
BAYER AG
O
VN
R
N Y
BA
SY
BM
K
PFIZER INC
O
R
OTHER
SA
5 M BRISTOL-MYERS S
NOVARTIS AG
0 MERCK & CO
SANOFI S.A.
0 10 20 30 40 50 60 70 80 90 100
2010
NOVO NORDISK AS
Economic Spread %
15 ROCHE HOLDING A
b
G O
JOHNSON & JOHNS

O V
R NO
ASTRAZENECA PLC
10
J
SY
N
JN
VN
SK
AZ
K
SA
SANOFI S.A.
R
O
PF
G
OTHER GLAXOSMITHKLINE
YG
5
BA
MERCK & CO
PFIZER INC
0 NOVARTIS AG
BAYER AG
0 10 20 30 40 50 60 70 80 90 100
2005
JOHNSON & JOHNS
Economic Spread %
15
J
PFIZER INC
JN
SANOFI S.A.
PF
SY
GLAXOSMITHKLINE
VN
10
SK
AZ E
SA
N
Y
K
O
G
R
W
WYETH
N
Y
M
LL
G
O
ASTRAZENECA PLC
R
5 OTHER NOVARTIS AG
MERCK & CO
0 LILLY (ELI) & C
ROCHE HOLDING A
0 10 20 30 40 50 60 70 80 90 100

Life Sciences Tools & Services
MSCI GIC: 352030

Count of firms: 114
2015
O
TM
THERMO FISHER S
24
Economic Spread %
20 M I
IL IV
QUINTILES TRANS
Q
N
TD
D
M
DIVI S LABORATO
15 ILLUMINA INC
METTLER-TOLEDO
AT
10
W I
A
PK
FI
AGILENT TECHNOL
N
EU
N
OTHER
LO
PERKINELMER INC
5
WATERS CORP
0 EUROFINS SCIENT
LONZA GROUP AG
0 10 20 30 40 50 60 70 80 90 100
2010
O
TM
THERMO FISHER S
Economic Spread %
20 LIFE TECHNOLOGI
.3
FE
ILLUMINA INC
15
LI
WATERS CORP
W MN
M T
TD
A
IL
METTLER-TOLEDO
10
I
PP D
D
COVANCE INC
V
C
LO KI
N
PHARMACEUTICAL
P
5
A
OTHER AGILENT TECHNOL
0 PERKINELMER INC
LONZA GROUP AG
0 10 20 30 40 50 60 70 80 90 100
2005
FISHER SCIENTIF
Economic Spread %
20 LIFE TECHNOLOGI
.2
.3
H
WATERS CORP
FE
FS
15
PPAT
O I
LI
PHARMACEUTICAL
W
THERMO FISHER S
10
TM
MILLIPORE CORP
AB .2
FX
I.3
I
IL
PK
A AF
APPLIED BIOSYST
M
5 OTHER
PERKINELMER INC
0 AFFYMETRIX INC
-1-1 AGILENT TECHNOL
0 10 20 30 40 50 60 70 80 90 100

Banks
MSCI GIC: 401010

2015
COMMONWEALTH BA
Economic Spread %
20 JPMORGAN CHASE
BA
C
WELLS FARGO & C

15
U CO
CHINA CONSTRUCT
LT
F
R RI
IN NA
O
AG ST
10
C FC
BA CU
WM
C K
INDUSTRIAL & CO
I
JP
A
C
H
N
I
SB
D
BA
AGRICULTURAL BA
5
H
OTHER
BANK OF AMERICA
0 BANK OF CHINA
-5 CITIGROUP INC
HSBC HOLDINGS P
0 10 20 30 40 50 60 70 80 90 100
2010
CHINA CONSTRUCT
Economic Spread %
20 AGRICULTURAL BA
IT M TRLT
JP DUICUCO
INDUSTRIAL & CO
15
IN R A
S
AGHIN
JPMORGAN CHASE
F
O
C
10
BA C 4
K
B
ITAU UNIBANCO H
N
U
F
BA BA
W
C C
WELLS FARGO & C

S
5 OTHER
H
BANK OF CHINA
0 HSBC HOLDINGS P
-5 BANK OF AMERICA
CITIGROUP INC
0 10 20 30 40 50 60 70 80 90 100
2005
BANK OF AMERICA
C
WC

C F
Economic Spread %
3
BA
WBS
20
F
B.
WELLS FARGO & C

JP A O
R
H
SB U
CITIGROUP INC
15
H IZ
SA M
M
S
N
ROYAL BANK OF S
BI
OTHER
SU
10 WACHOVIA CORP
IT
M
MIZUHO FINANCIA
5
HSBC HOLDINGS P
0 JPMORGAN CHASE
-5 BANCO SANTANDER
MITSUBISHI UFJ
0 10 20 30 40 50 60 70 80 90 100

Thrifts & Mortgage Finance
MSCI GIC: 401020

Count of firms: 186
2015
INDIABULLS HOUS
D F

H NB
Economic Spread %
FC
HOUSING DEVELOP
N TG
I
R B
AF H T
YC
LIES N
15 SL R
M
W CN
D
TF VDE
MGIC INVESTMENT
OTHER
10
E
NEW YORK CMNTY

5 RADIAN GROUP IN
0 ESSENT GROUP LT
-5
LIC HOUSING FIN
-10
-15 WASHINGTON FEDE
-20 EVERBANK FINANC
TFS FINANCIAL C
0 10 20 30 40 50 60 70 80 90 100
2010
HOUSING DEVELOP
Economic Spread %
N FC
H ICCH B
NEW YORK CMNTY

LI C
D
Y
H
15
BGL N
C .
LIC HOUSING FIN

PB S F
BK
TF CF
M
10 GENWORTH MI CAN
5 HUDSON CITY BAN
0
TG G
PF
CAPITOL FEDERAL
-5
D
TFS FINANCIAL C
-10
M
OTHER
-15 DEUTSCHE PFANDB
-20 DEPFA DEUTSCHE
-19 MGIC INVESTMENT
0 10 20 30 40 50 60 70 80 90 100
2005
.3 C
HOUSING DEVELOP
Q
FC F

C HD
Economic Spread %
AM
17 COUNTRYWIDE FIN
W
A
M RK
W
FNTG
D
YG
15
BK
G
N
WASHINGTON MUTU
EH
FM HC
10 OTHER
GOLDEN WEST FIN
C
5
C
NORTHERN ROCK P
0 MGIC INVESTMENT
-5
FANNIE MAE
-10
-15 HYPOTHEKENBANK
-20 HUDSON CITY BAN
FREDDIE MAC
0 10 20 30 40 50 60 70 80 90 100

Diversified Financials
MSCI GIC: 402010

Count of firms: 320
2015
N
FSDB MC COEN ME GI
KO
IH C SP
S&P GLOBAL INC

54
R 1G O G

Economic Spread %
40 CME GROUP INC
35 HONG KONG EXCHA

30
n
INTERCONTINENTA
25
b R
20 MOODY'S CORP
VE O
B
IN IX C
15
K.
DEUTSCHE BOERSE
BR
R
10
O
FIRSTRAND LIMIT
5 OTHER BERKSHIRE HATHA
0
-5 ORIX CORPORATIO
INVESTOR AB
0 10 20 30 40 50 60 70 80 90 100
N
2010
KO
F3 3
MMNEFG
CME GROUP INC

BBVHCVOM

Economic Spread %
40 HONG KONG EXCHA
35 BM&F BOVESPA S.
30
b n
VE 1G
BOLSA DE MERCAD
25
IN DB
B FI
20 DEUTSCHE BOERSE
K. N
BRSRBO
15 INVESTOR AB
B
FFU
BL
10 OTHER
G
FUBON FINANCIAL
5 FIRSTRAND LIMIT
0
-5 BERKSHIRE HATHA
GROUPE BRUXELLE
0 10 20 30 40 50 60 70 80 90 100
2005
O
C
M
MOODY'S CORP
62
Economic Spread %
40 INVESTOR AB
b
VE
35
O
CME GROUP INC

IN
CR
30
R CRO
OAASM GE
S&P GLOBAL INC

I
FSRIXEPE
25
SCPM
20 AMP LIMITED
B
15
BL
B
OTHER ASEER COMPANY F

K.
10
BR
ORIX CORPORATIO
5 FIRSTRAND LIMIT
0
-5 BERKSHIRE HATHA
GROUPE BRUXELLE
0 10 20 30 40 50 60 70 80 90 100

Consumer Finance
MSCI GIC: 402020

Count of firms: 190
2015
G
PF
PROVIDENT FINAN
33
Economic Spread %
30 AMERICAN EXPRES
P
25
AX
SANTANDER CONSU
SC
20
FS
IN
DISCOVER FINANC
F
D
.
F
O
SY
15
OF
C
F
LY N
COM
SYNCHRONY FINAN
AL EO
M
10 OTHER
O
A
AC
ONEMAIN HOLDING
5
CAPITAL ONE FIN
0
-5 AEON FINANCIAL
-4 ALLY FINANCIAL
ACOM CO., LTD.(
0 10 20 30 40 50 60 70 80 90 100
2010
TO
R
T A
AV TR O P
BANCO COMPARTAM
N SR GD OM

Economic Spread %
30 GREEN DOT CORP

C
25 SHRIRAM TRANSPO
20
I
NAVIENT CORP
S
.
FI
15
AC DIT
C
P
AMERICAN EXPRES
AX
FS O
10
E
D AE
F
O
R
O
OTHER CAPITAL ONE FIN

C
5
C
AEON FINANCIAL
0
-5 DISCOVER FINANC
-77 CREDIT SAISON C
ACOM CO., LTD.(
0 10 20 30 40 50 60 70 80 90 100
2005
KR VI
B
A
N
NAVIENT CORP
32
AX

Economic Spread %
30 MBNA CORP
IS
25
F B
AMERICAN EXPRES
O U
FU IT
C ITS
20
AI ED
MITSUBISHI UFJ
O
M
JI
L
C
R
15
E
FU
C
IS
M
CAPITAL ONE FIN

OTHER
KE
O
10
AC
O
TA
CREDIT SAISON C
PR
5
AIFUL CORPORATI
0
-5 ACOM CO., LTD.(
TAKEFUJI CORPOR
PROMISE CO., LT
0 10 20 30 40 50 60 70 80 90 100

Capital Markets
MSCI GIC: 402030

Count of firms: 994
2015
K
BL
BLACKROCK INC
34
Economic Spread %
25 CITIC SECURITIE
BANK OF NEW YOR

20
SE
UBS AG
IC
IT
15
C
SCHWAB (CHARLES
N
n
W
GOLDMAN SACHS G
10
G
BS
N
OTHER
BK
SH
BK
SG
G
U
GC
BS
UBS GROUP AG
D
S
5
U
S
M
DEUTSCHE BANK A
0 MORGAN STANLEY
-2 CREDIT SUISSE G
0 10 20 30 40 50 60 70 80 90 100
2010
K
BL
BLACKROCK INC
32
Economic Spread %
25 FRANKLIN RESOUR
GOLDMAN SACHS G
N
20
BE
BANK OF NEW YOR
15
n
N
STATE STREET CO
SG
C T
BK
S
BK
ST
G
G
N
D
CREDIT SUISSE G
10
BS
BS
U
OTHER DEUTSCHE BANK A

M
5 UBS AG
0 UBS GROUP AG
MORGAN STANLEY
0 10 20 30 40 50 60 70 80 90 100
2005
N
UBS AG
G
S G MQ
BS

BS
Economic Spread %
25
H
U
UBS GROUP AG
N
U
LE
BA Gn A H
LEHMAN BROTHERS
S
C
BK R
20
G
D MU
CREDIT SUISSE G
S
.2
O
M
15
N
GOLDMAN SACHS G
BK
OTHER MORGAN STANLEY

10
NOMURA HOLDINGS
5 DEUTSCHE BANK A
0 MERRILL LYNCH &
BANK OF NEW YOR
0 10 20 30 40 50 60 70 80 90 100
*Industry is considered competitive: 4 firm concentration ratio = -0.0%.

Insurance
MSCI GIC: 403010

Count of firms: 441
2015
N U
IN AN
AX G RO PA
PI PR
PRUDENTIAL PLC
G
20
A

Economic Spread %
15 PING AN INSURAN
AI CH
V G
CHINA PACIFIC I
10
AL A
M AF
AIA GROUP LIMIT

OTHER
G N
ET
5
ZU
PO
ALLIANZ SE
N
AI
AXA SA
0
PA
JA
METLIFE INC
-5 ZURICH INSURANC
-10 AMERICAN INTERN
JAPAN POST HOLD
0 10 20 30 40 50 60 70 80 90 100
2010
U
G G AN RO
AL IN IA G
AIA GROUP LIMIT

Economic Spread %
P A
15 PING AN INSURAN
V G
AF A
ALLIANZ SE
AX RANP
10
C TI
M AS
E
ZIUN
ASSICURAZIONI G
H
5 OTHER METLIFE INC

.
FC
M
CHINA PACIFIC I
0
G
AI
ZURICH INSURANC
-5 AXA SA
-10 AMERICAN INTERN
MANULIFE FINANC
0 10 20 30 40 50 60 70 80 90 100
2005
P A S
AGEAS SA
AX GE
M RU F

Economic Spread %
15
V .
AXA SA
AL FC
G G
G I
AI AS
ET
PRUDENTIAL FINA
10
M
V
TRLL
MANULIFE FINANC
A
OTHER
5 ALLIANZ SE
ASSICURAZIONI G
0
AMERICAN INTERN
-5 METLIFE INC
-10 ALLSTATE CORP
TRAVELERS COS I
0 10 20 30 40 50 60 70 80 90 100

Internet Software & Services
MSCI GIC: 451010

Count of firms: 439
2015
TENCENT HOLDING
Economic Spread %
FACEBOOK INC
35 NAVER
T
EN
30
U R
BAIDU INC
LN Y JA
C
D VE
25
N
L
G
A OO
TE
FB
BINA
ALPHABET INC
O
20
O
EBAH
ON
G
YAHOO JAPAN COR
YSHH D
15
OI I
LE K
OTHER EBAY INC
10
5 LINKEDIN CORP
0 LESHI INTERNET
-1 YAHOO INC
0 10 20 30 40 50 60 70 80 90 100
2010
BAIDU INC
Economic Spread %
TENCENT HOLDING
TE BID
T
YA ALVIB EN
35
OAI O .
GM HOERBA
ALIBABA.COM LIM
C
JA
N
30
A
NAVER
25
L
A
G
N
OL
YAHOO JAPAN COR

AY
20
EB
OM
MAIL.RU GROUP
15
O
YHKA
OTHER ALPHABET INC

A
10
5 EBAY INC
0 AKAMAI TECHNOLO
YAHOO INC
0 10 20 30 40 50 60 70 80 90 100
2005
JA
ERO
AV O
YAHOO JAPAN COR

N AH

Economic Spread %
37 NAVER
35
AY
EBAY INC
W
30
EB
G MW
MONSTER WORLDWI
L
G
25
O
N
O
ALPHABET INC
R
IA RS
O
YH
20
O
V
YAHOO INC
C
15
VE
n
VERISIGN INC
10
IG
LI
OTHER
TO
5 IAC/INTERACTIVE
0 T-ONLINE INTERN
0 LIVEDOOR CO., L
0 10 20 30 40 50 60 70 80 90 100

IT Consulting & Services
MSCI GIC: 451020

Count of firms: 618
2015
MASTERCARD INC
VA
Economic Spread %
4140 VISA INC

N
AC
35 ACCENTURE PLC
IB S
30
TC
TATA CONSULTANC
M
W FY H
25
C DP
IN T S
INTL BUSINESS M
A
20
PL R
PY IP
AUTOMATIC DATA
15 OTHER
COGNIZANT TECH
10
5 INFOSYS LIMITED
0 WIPRO LIMITED
PAYPAL HOLDINGS
0 10 20 30 40 50 60 70 80 90 100
2010
VISA INC
Economic Spread %
MASTERCARD INC
V
TC MA
35 TATA CONSULTANC
S
30
IN CN
ACCENTURE PLC
25
MSH
IB T Y
A
F
INFOSYS LIMITED
W DP
X R
20
C
IP
A
COGNIZANT TECH
15 OTHER
XR
INTL BUSINESS M
10
5 AUTOMATIC DATA
0 WIPRO LIMITED
XEROX CORP
0 10 20 30 40 50 60 70 80 90 100
2005
TATA CONSULTANC
Economic Spread %
FIRST DATA CORP

P D S
F TC
AWCI INFAY C
35
AD NPR Y X
PAYCHEX INC
30 INFOSYS LIMITED
25 WIPRO LIMITED
20
IB P
TS A
M
JI AT
ACCENTURE PLC
15
U
FU T D
10 OTHER AUTOMATIC DATA

T
N
5 INTL BUSINESS M
0 NTT DATA CORPOR
-1 FUJITSU LIMITED
0 10 20 30 40 50 60 70 80 90 100

Software
MSCI GIC: 451030

Count of firms: 770
2015
PG
SAP AG
Economic Spread %
SA
20 INTUIT INC
O MW U
VINT
VMWARE INC -CL

C
SF E
M DBVI
15 T
R
DA M
AT
ORACLE CORP
A
E R
T
C
AS
ACTIVISION BLIZ
10 OTHER
ADOBE SYSTEMS I
MICROSOFT CORP
5
SALESFORCE.COM
0 ELECTRONIC ARTS
DASSAULT SYSTEM
0 10 20 30 40 50 60 70 80 90 100
2010
T
SF
M
MICROSOFT CORP
L
20
C

Economic Spread %
20
PG E
O
ORACLE CORP
SA DB
A
ACTT TW
ADOBE SYSTEMS I
U
VXI S
INM
15
V
SAP AG
M
VMWARE INC -CL

R
10 OTHER
O
C
INTUIT INC
N
TE
CITRIX SYSTEMS
5
IN
N
ACTIVISION BLIZ
0 SALESFORCE.COM
NINTENDO CO., L
0 10 20 30 40 50 60 70 80 90 100
2005
L
C
R
M YM SK
O
SF C
ORACLE CORP
20
S AD

T
Economic Spread %
BE
20 AUTODESK INC
AD
SYMANTEC CORP
PG
15
O
TE G
D
MICROSOFT CORP
SAA
IN N
N
C
N KO
ADOBE SYSTEMS I
10 CA INC
EA
OTHER SAP AG
5
KONGZHONG CORPO
0 NINTENDO CO., L
ELECTRONIC ARTS
0 10 20 30 40 50 60 70 80 90 100

Communications Equipment
MSCI GIC: 452010

Count of firms: 366
2015
G
IN
IJ
BEIJING XINWEI
BE

Economic Spread %
15 HARRIS CORP
O
C RS
SC
CISCO SYSTEMS I
H
IC RP
N PNRW
A
10
KI
ER CO
PALO ALTO NETWO
JPNA
O
b
SI
E
OTHER JUNIPER NETWORK
ZT
5 M
A
U
NOKIA CORP
AL
MOTOROLA SOLUTI
0
ZTE CORP
-5 TELEFONAKTIEBOL
ALCATEL-LUCENT
0 10 20 30 40 50 60 70 80 90 100
2010
CNP FIV
F5 NETWORKS INC
J F
Economic Spread %
O
S CR
15 JUNIPER NETWORK
b RP
CISCO SYSTEMS I
10
IC O
ER E C
ZTE CORP
ZT
TELEFONAKTIEBOL
KI
Iq
5
O
A R
N
U SIT
NOKIA CORP
OTHER
I.3
SI
MOTOROLA SOLUTI
0
M
M
AL
SITRONIKS AO
-5 ALCATEL-LUCENT
-5 MOTOROLA MOBILI
0 10 20 30 40 50 60 70 80 90 100
2005
JUNIPER NETWORK
Economic Spread %
15
SC R
CISCO SYSTEMS I
O
CJNP
A
KI
NOKIA CORP
O
10
IC S.1
N
ER HRFA
MOTOROLA SOLUTI
SI
M
SCIENTIFIC-ATLA
5
A
U
HARRIS CORP
AL
OTHER
T.
LU
TELEFONAKTIEBOL
0
N
ALCATEL-LUCENT
-5 NORTEL NETWORKS
-5 LUCENT TECHNOLO
0 10 20 30 40 50 60 70 80 90 100

Computers & Peripherals
MSCI GIC: 452020

Count of firms: 275
2015
APPLE INC
Economic Spread %
PL
EMC CORP/MA
AA
25 HP INC
20
LM H
FU E IN
H C
WESTERN DIGITAL
FI C
G
EM
M DK
BO N
JI TE
PQ
N
15
H DC
PE
O
SU
SA SN HEWLETT PACKARD
AN
W
10
C
OTHER SANDISK CORP
5
SAMSUNG ELECTRO
0
-5 CANON INC.(C)
BOE TECHNOLOGY
FUJIFILM HOLDIN
0 10 20 30 40 50 60 70 80 90 100
2010
P
R
PL CO
HTC CORPORATION
AA BT.C

Economic Spread %
BH
34 BLACKBERRY LTD
PQ L
25
H EL
APPLE INC
D
20
G
SA T C
M AP
DELL INC
N
EM
IN
SU
15
N
HP INC
N
LM
10
O
AN
FI
EMC CORP/MA
OTHER
JI
5
C
FU
NETAPP INC
0
-5 SAMSUNG ELECTRO
CANON INC.(C)
FUJIFILM HOLDIN
0 10 20 30 40 50 60 70 80 90 100
2005
L
DELL INC
EL

Economic Spread %
35 APPLE INC
25 HP INC
LM O
IN
20
FI H C
N
EMC CORP/MA
PQ L
SU
H AP
15
FU ICO
C C
AN
M
A
EM
CANON INC.(C)
EC A
SA
10
R
O
JI
JA
OTHER SAMSUNG ELECTRO

C
5
RICOH COMPANY,
0
N
-5 FUJIFILM HOLDIN
-4 SUN MICROSYSTEM
NEC CORPORATION
0 10 20 30 40 50 60 70 80 90 100

Electronic Equipment Instruments & Components
MSCI GIC: 452030

U
O
ZH
2015
G
HKE EX PAHN
AH
HANGZHOU HIKVIS
21
N EN Ab

Economic Spread %
15
AI E
AMPHENOL CORP
H C
M
H
LW ATA
HEXAGON AB
OY
10
R
KEYENCE CORPORA
ML
A
U
TE
ER
HON HAI PRECISI
C
I,
G
5
O
H
OTHER
AC
KY
TE CONNECTIVITY
IT
H
MURATA MANUFACT
0
CORNING INC
-5 HITACHI, LTD.(C
KYOCERA CORPORA
0 10 20 30 40 50 60 70 80 90 100
2010
DELTA ELECTRONI
EL
Economic Spread %
15 HON HAI PRECISI

TA
EL
KEYENCE CORPORA
KY W E
LYE AI
D
L C
10
TKEE H
H RA
G N
TE CONNECTIVITY
P M
N
AC CE
O
IS A
LU L
H
D AT
O
CORNING INC
I,
5
X
LGUR
OTHER KYOCERA CORPORA

M
IT
O
H
HITACHI, LTD.(C
IN
0
MURATA MANUFACT
-5 LG DISPLAY
-8 INNOLUX CORP
0 10 20 30 40 50 60 70 80 90 100
BI
2005
O
M
H
FI
FIH MOBILE LTD

AI CE
18
Economic Spread %
15 KEYENCE CORPORA
YE
H KE
C TR M
H
HON HAI PRECISI

ER O
N
O P TA
10
KYU ORARP
AC IS A
O
CORNING INC
A UO
H PL
MC
TDK CORPORATION
TD W
K
5
IT D
L
I,
G
OTHER
H G
MURATA MANUFACT
L
AU OPTRONICS CO
0
KYOCERA CORPORA
-5 LG DISPLAY
HITACHI, LTD.(C
0 10 20 30 40 50 60 70 80 90 100

Semi & Semi Equip
MSCI GIC: 453010

Count of firms: 691
2015
N GO O
TX AV VG
A
AVAGO TECHNOLOG
31
Economic Spread %
20 BROADCOM LTD
M
TEXAS INSTRUMEN
B X L
O
N SM
15
C
TARC PII
QUALCOMM INC
Q
XP
A
AN
IW M
N
ASML HOLDING NV
10
TC
NXP SEMICONDUCT
IN
NXP SEMICONDUCT
5 OTHER
BROADCOM CORP
0 TAIWAN SEMICOND
INTEL CORP
0 10 20 30 40 50 60 70 80 90 100
2010
K
TE
IA
MEDIATEK INCORP
ED
Economic Spread %
20 MARVELL TECHNOL
M
TAXSRCVL
M
BROADCOM CORP
M
Q NL
S
BMR
M
O
15
AN
C
ASML HOLDING NV
IW
TC
TA
AT
IN
TEXAS INSTRUMEN
IX
10
AM
YN
QUALCOMM INC
H
SK
INTEL CORP
5 OTHER TAIWAN SEMICOND
0 APPLIED MATERIA
SK HYNIX
0 10 20 30 40 50 60 70 80 90 100
2005
MARVELL TECHNOL
Economic Spread %
20 BROADCOM CORP
OM L
CC V
M
BRMR
QUALCOMM INC
15
Q
TEXAS INSTRUMEN
A NS
TC
INTEL CORP
N
IX
AM A
10
TX
IW
IN
M N
AM T
TAIWAN SEMICOND
ST HY
TA
SK D
APPLIED MATERIA
5
OTHER ADVANCED MICRO
0 SK HYNIX
0 0 STMICROELECTRON
0 10 20 30 40 50 60 70 80 90 100

Diversified Telecommunication Services
MSCI GIC: 501010

Count of firms: 217
2015
SINGAPORE TELEC
EL

Economic Spread %
ST
VERIZON COMMUNI
5 TELSTRA CORPORA
TE AN
BT
S
VZ
TL
TE
F
BT GROUP PLC
O
n
G
T
TE
IN
OTHER ORANGE SA
N
H
T
PO
C
0 TELEFONICA SA
IP
N
AT&T INC
DEUTSCHE TELEKO
-5 CHINA TELECOM C
NIPPON TELEGRAP
0 10 20 30 40 50 60 70 80 90 100
2010
EL
SINGAPORE TELEC
ST
Economic Spread %
ORANGE SA
TTLEL N
5
A
TE S IA
R
TELIA COMPANY A
TE
O
A
VZ
TELSTRA CORPORA
IN
TE
H
T
T
D
TELEFONICA SA
OTHER
N
0
PO
VERIZON COMMUNI
IP
N
AT&T INC
DEUTSCHE TELEKO
-5 CHINA TELECOM C
NIPPON TELEGRAP
0 10 20 30 40 50 60 70 80 90 100
2005
E
AN I T
R SUD
SAUDI TELECOM C
TSLA

Economic Spread %
18 TELSTRA CORPORA
5
O
ORANGE SA
n
F
S
G
TE
IT
BL
TE
TL
TELEFONICA SA
D
OTHER
VZ
TELECOM ITALIA
N
PO
T
0 DEUTSCHE TELEKO
IP
N
VERIZON COMMUNI
BELLSOUTH CORP
-5 AT&T INC
NIPPON TELEGRAP
0 10 20 30 40 50 60 70 80 90 100

Wireless Telecommunication Services
MSCI GIC: 501020

Count of firms: 87
2015
KDDI CORPORATIO
Economic Spread %
10 AMERICA MOVIL S
XL O
C
O
AM DI
ROGERS COMMUNIC
O
C
M
KD
O
BA
A
CHINA MOBILE LI
D
H .B
TT I
IN
N RT
FT
C CI
S
B
U
SOFTBANK GROUP
R
SO
U
A
D
TM
IN
OTHER
VO
BHARTI AIRTEL L
H
0
C
NTT DOCOMO, INC
VODAFONE GROUP
-5 CHINA UNITED NE
T-MOBILE US INC
0 10 20 30 40 50 60 70 80 90 100
2010
K
N
AM TNP
H S A
VIMPELCOM LIMIT
O
XL
MVI
C TS B

M FT
Economic Spread %
10
A
MTN GROUP LIMIT

SO
O
IN
VO I C
AMERICA MOVIL S
D
KD
TI
D
BR
SOFTBANK GROUP
O
5
C
O
MOBIL'NYE TELES
D
OTHER
TT
CHINA MOBILE LI
N
0 KDDI CORPORATIO
VODAFONE GROUP
-5 BHARTI AIRTEL L
NTT DOCOMO, INC
0 10 20 30 40 50 60 70 80 90 100
2005
O
VO XL
AMIM
M
D
TELECOM ITALIA
T
18
A

IN
Economic Spread %
10
H
AMERICA MOVIL S
M
IC
C
TE
O
D
K
C
KD
VODAFONE GROUP
AN
O
OTHER
D
M B
CHINA MOBILE LI
TT
O T
5
O OF
N
TELEFONICA MOVI
S
S
KDDI CORPORATIO
0 NTT DOCOMO, INC
SPRINT CORP
-5 SOFTBANK GROUP
O2 PLC
0 10 20 30 40 50 60 70 80 90 100

Electric Utilities
MSCI GIC: 551010

Count of firms: 202
2015
NEXTERA ENERGY
Economic Spread %
5 SOUTHERN CO
SO EE
PG&E CORP
N
A CG
O
IBEP
EN UK
KE C
E
PC AMERICAN ELECTR
EX
P
D
EI
IBERDROLA S.A.
0
F
ED
OTHER DUKE ENERGY COR
ENEL SPA
EXELON CORP
-5 KEPCO
ELECTRICITE DE
0 10 20 30 40 50 60 70 80 90 100
2010
FORTUM OYJ
Economic Spread %
5 EXELON CORP
ED CE C 1V
M
F ZP
CEZ A.S
EFXU
IB UK
D E
ELO
EN E
ELECTRICITE DE
S
EI
EL
SOUTHERN CO
0 OTHER
O
KY
ENDESA SA
TO
DUKE ENERGY COR
IBERDROLA S.A.
-5 ENEL SPA
TOKYO ELECTRIC
0 10 20 30 40 50 60 70 80 90 100
2005
DUKE ENERGY COR
Economic Spread %
5 EXELON CORP
L
C
EN O Bt
EXK
IE
SELC
U
ELECTRABEL
D
D
ED S I
E
F U
SOUTHERN CO
EL
A
E
ELE
IB
OTHER ENEL SPA

KY
0
TO
SAUDI ELECTRICI
ELECTRICITE DE
IBERDROLA S.A.
-5 ENDESA SA
TOKYO ELECTRIC
0 10 20 30 40 50 60 70 80 90 100

Gas Utilities
MSCI GIC: 551020

Count of firms: 90
2015
CHINA GAS HOLDI
A

G
Economic Spread %
10
S A
PETRONAS GAS BE
AP GA HIN
APA GROUP
P C
A
O
G
G GK
KA
HONG KONG AND C
G
5 TO AS
SRON
H A
SA
G
KY
AS
SNAM SPA
L
O
AI
G
OTHER
G
GAS NATURAL SDG
0 AGL RESOURCES I
TOKYO GAS CO.,
-5 OSAKA GAS CO.,
GAIL INDIA LIMI
0 10 20 30 40 50 60 70 80 90 100
2010
AS
PERUSAHAAN GAS
PG
Economic Spread %
10
KO
HONG KONG AND C

PG IL G
GAIL INDIA LIMI

G ON
N AG
H
PETRONAS GAS BE
G S
A
5
A
SR A
A
AS FG
EN
SNAM SPA
O
KA
KY
OTHER
SA
ENAGAS SA
TO
G
0 NATIONAL FUEL G
GAS NATURAL SDG
-5 TOKYO GAS CO.,
OSAKA GAS CO.,
0 10 20 30 40 50 60 70 80 90 100
2005
Ty
N
IS
KO
DISTRIGAZ
D

Economic Spread %
ST IL G
10 HONG KONG AND C

N
O
H
GAIL INDIA LIMI

A
AG
G
G R
QUESTAR CORP
A
5
A
GS
EN
AS
G
SRGA
KA
GAS NATURAL SDG

P
KY
SA
OTHER
TO
PETRONAS GAS BE
O
0 SNAM SPA
ENAGAS SA
-5 TOKYO GAS CO.,
OSAKA GAS CO.,
0 10 20 30 40 50 60 70 80 90 100

Multi-Utilities
MSCI GIC: 551030

Count of firms: 49
2015
CENTRICA PLC
Economic Spread %
5 D E NATIONAL GRID P
N A
PUBLIC SERVICE
ED
SR
N
G
W E
EC
PE
C
CONSOLIDATED ED
IE
D
G SEMPRA ENERGY
EN
0 OTHER
DTE ENERGY CO
n
G
WEC ENERGY GROU
N
EO DOMINION RESOUR
-5 ENGIE SA
E. ON SE
0 10 20 30 40 50 60 70 80 90 100
2010
A
N
C
CENTRICA PLC
5
Economic Spread %
5
G
PUBLIC SERVICE
PE
G E
N SR
SEMPRA ENERGY
ED
VI
IE
D
EG
G
NATIONAL GRID P
EN
n
W
OTHER
G
R
VEOLIA ENVIRONN
EO
0 CONSOLIDATED ED
DOMINION RESOUR
ENGIE SA
-5 RWE AG
E. ON SE
0 10 20 30 40 50 60 70 80 90 100
2005
PE RE A
CENTRICA PLC
N

Economic Spread %
5 SEMPRA ENERGY
E
LY GI
S
N G
PUBLIC SERVICE
n
EN
G
G
N
VI
EO
NATIONAL GRID P
OTHER
D
EG
VEOLIA ENVIRONN
0
W
ENGIE SA
R
SUEZ
E. ON SE
-5 DOMINION RESOUR
RWE AG
0 10 20 30 40 50 60 70 80 90 100

Water Utilities
MSCI GIC: 551040

Count of firms: 71
G QI N ON
2015
AN G E D
U N DG
D N
N
G HOUNAN
GUANGDONG GOLDE
C SO U

G
Economic Spread %
19 SOUND ENVIRONME
5
WING
AW TR
CHONGQING WATER
IJ
BE
GUANGDONG INVES
OTHER
T
N
BEIJING ENTERPR
U
SV
PN
0 U AQUA AMERICA IN
AMERICAN WATER
SEVERN TRENT PL
-5 UNITED UTILITIE
PENNON GROUP PL
0 10 20 30 40 50 60 70 80 90 100
3 GQ ON
2010
IN
SP N GD
SB HO AN
GUANGDONG INVES
C U

G
Economic Spread %
6 CHONGQING WATER
N /A
5
PN AS
S
SABESP - COMPAN
U
AG
AG
AW TR
AGUAS DE BARCEL
W
OTHER
K
AGUAS ANDINAS S
SV
0
U
PENNON GROUP PL
AQUA AMERICA IN
AMERICAN WATER
-5 SEVERN TRENT PL
UNITED UTILITIE
0 10 20 30 40 50 60 70 80 90 100
2005
/A
AS
AGUAS ANDINAS S
U

N
Economic Spread %
AG
AGUAS DE BARCEL
D
5
T NG
S
GUANGDONG INVES
AG
SV A
N
U TR
U
PN
G
SEVERN TRENT PL
OTHER
G
PENNON GROUP PL
U
G
W
AW
0
KE
N
AQUA AMERICA IN
UNITED UTILITIE
NORTHUMBRIAN WA
-5 KELDA GROUP PLC
AWG PLC
0 10 20 30 40 50 60 70 80 90 100

Independent Power Producers & Energy Traders
MSCI GIC: 551050

Count of firms: 231
2015
CHINA YANGTZE P
G

EEGJI YA
Economic Spread %
EN
N
U WG
5 ZHEJIANG ZHENEN
IA
H PN
A
AN
TP A N R
A
ZH IN
N E
A ENEL GREEN POWE
H
H W
A N WE
C
C PO
I
HUANENG POWER I
AT O
G
I
D
D P
C
G
N
HUADIAN POWER I
OTHER
G
0
N
C
GD POWER DEVELO
CHINA NATIONAL
NTPC LIMITED
-5 CGN POWER CO LT
DATANG INTERNAT
0 10 20 30 40 50 60 70 80 90 100
2010
A
CHINA YANGTZE P
TB DC Y

Economic Spread %
EN INA
5
PW
ENDESA - EMPRES
EGLE3
H
C
TRACTEBEL ENERG
N R OL
C
AN G
R
I
IPRP
TP
IB
AT N
ENEL GREEN POWE

G
D NE
A
IBERDROLA RENOV
U
0 OTHER
H
RELIANCE POWER
INTERNATIONAL P
NTPC LIMITED
-5 HUANENG POWER I
DATANG INTERNAT
0 10 20 30 40 50 60 70 80 90 100
2005
YA
A
CHINA YANGTZE P
IN

Economic Spread %
5
C
AES CORP
C NG
N AN S
C
U N
S
TP E
ENDESA - EMPRES
H SO
AE
EN
IC
EG
EDR
I
TR
A
ENERGY FUTURE H
IP
C
33
EC
00
CONSTELLATION E
EL
0 OTHER INTERNATIONAL P
EDISON SPA
HUANENG POWER I
-5 NTPC LIMITED
ELECTRIC POWER
0 10 20 30 40 50 60 70 80 90 100

Appendix: HOLT Methodology
A short tutorial on CFROI is provided at the HOLT Lens website located at:
http://holtlens.csintra.net/lens/Welcome.action An extract is provided below.
CFROI: The HOLT Measure of Return on Capital
CFROI emphasizes a company’s cash producing ability, by taking accounting information and converting it to cash.
Cash flows generated from a firm’s activities are the best way to measure its underlying economics, telling you
whether a company is creating wealth or destroying it.
Typically, when companies undertake a specific project such as an acquisition or an expansion into a new business
line, they prepare an economic profile which factors in the forecast amounts and timing of all cash outflows and
inflows over the estimated project life. An internal rate of return can then be calculated, which is simply compared
to the firm’s hurdle rate to decide whether or not to proceed with the project.
HOLT expands on this premise, applying it not only to a specific project, but to an entire company. CFROI translates
the ratio between investments and cash flows into an internal rate of return by recognizing the finite economic life
of assets that depreciate such as buildings, and the residual value of assets that don’t necessarily depreciate, such
as land and cash. Like the IRR calculation of a project, the CFROI metric is a proxy for the company’s economic
return.
This provides a consistent, holistic approach that can be used to compare performance across a portfolio, a market
or a global universe of companies.
Definitions
EROI (Economic Return on Investment) is the return on total invested capital after deducting a charge that accounts
for the replacement of depreciating assets.
Economic Spread is the difference between EROI and a firm’s cost of capital. Firms that earn a return on invested
capital in excess of the cost of capital generate economic profit. Firms with a negative economic return generate an
economic loss and erode shareholder value. Because economic profit is a single-period measure, it is important to
understand a firm’s history of wealth creation, as any single year may be anomalous.
Economic Profit equals Economic Spread x Invested Capital: (EROI-DR) x IC.
Invested Capital is measured as total inflation adjusted gross investment, which includes a firm’s total gross assets,
as well as capitalized assets such as R&D, operating leases, intangible operating assets, etc. Invested Capital does
not include acquisition Goodwill.
Economic Profit Pools, sorted by market capitalization
This analysis focuses on the largest 10 firms per industry by market cap. This is purely an arbitrary decision. Other
samples are also interesting: largest firms by market enterprise value, largest firms by invested capital, etc.
Regardless of sampling choice, our measure of industry concentration will show the same result since we tally up
the percentage of market share (by sales) held by the four largest firms:
Concentration ratio = Revenue % (firm 1) + Revenue % (firm 2) + Revenue % (firm 3) + Revenue % (firm 4)

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Past performance should not be taken as an indication or guarantee of future performance, and no representation or warranty, expressed or implied is
made regarding future performance. Backtested, hypothetical or simulated performance results have inherent limitations. Simulated results are
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Investment principal on securities can be eroded depending on sale price or market price. In addition, there are securities on which investment
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HOLT Disclaimer
The HOLT methodology does not assign ratings or a target price to a security. It is an analytical tool that involves use of a set of proprietary
quantitative algorithms and warranted value calculations, collectively called the HOLT valuation model, that are consistently applied to all the
companies included in its database. Third-party data (including consensus earnings estimates) are systematically translated into a number of default
variables and incorporated into the algorithms available in the HOLT valuation model. The source financial statement, pricing, and earnings data
provided by outside data vendors are subject to quality control and may also be adjusted to more closely measure the underlying economics of firm
performance. These adjustments provide consistency when analyzing a single company across time, or analyzing multiple companies across industries
or national borders. The default scenario that is produced by the HOLT valuation model establishes a warranted price for a security, and as the third-
party data are updated, the warranted price may also change. The default variables may also be adjusted to produce alternative warranted prices, any
of which could occur. The warranted price is an algorithmic output applied systematically across all companies based on historical levels and volatility
of returns. Additional information about the HOLT methodology is available on request
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Thirty Years
Reflections on the Ten Attributes of Great Investors
August 4, 2016
Authors
Dan Callahan, CFA

Darius Majd
Source: iStockphoto.
“Perhaps the single greatest error in the investment business is a failure to

distinguish between the knowledge of a company’s fundamentals and the
expectations implied by the market price.”
The world of investing and business has seen a great deal of change in
the past 30 years.
This report shares thoughts on the ten attributes of great fundamental
investors.
Accounting is the language of business and you need to understand it to
appreciate economic value and to assess competitive positioning.
Investors face a slew of psychological challenges. Perhaps the most
difficult is updating beliefs when new information arrives.
Position sizing and portfolio construction still do not get the attention they
warrant.
The substantial shift from active to passive management has profound
implications for the investment industry.
August 4, 2016
Introduction
I started on Wall Street 30 years ago today. It has been a fascinating three decades, which is undoubtedly
true of all periods of similar length. Notable events include the stock market crash of 1987, the fall of the
Berlin Wall and unwinding of communism, the introduction of the Internet and the ensuing dot-com bubble,
and a painful financial crisis and a subsequent recovery.
Exhibit 1 shows a contrast between then and now. The indices for equity markets are roughly 10 times higher
than they were in 1986, unadjusted for inflation and dividends, and the yield on the U.S. 10-year Treasury
note is one-fifth of what it was. Of the top 10 companies by market capitalization in 1986, only General
Electric, AT&T, and Exxon Mobil remain in the group today. Google, Amazon.com, and Facebook were not
even dreams. In 1986, Microsoft, Oracle, Adobe, and Sun Microsystems went public.
I have spent roughly two-thirds of my career on the sell-side and a third on the buy-side. Both experiences
have been deeply gratifying and incredible learning opportunities. In this report, I offer what I believe to be the
ten attributes of a great fundamental investor, as well as some thoughts on where we go from here. Before I
do so, I provide some personal background and note the influences on my thinking. Feel free to skip directly
to the attributes section on page six.
Exhibit 1: August 4: 1986 and 2016 (based on the closing price the previous business day)
1986 (inflation adjusted) 2016
DJIA 1,763.54 3,878.47 18,355.00
S&P 500 234.91 516.63 2,163.79
NASDAQ 370.66 815.17 5,159.74
Yield on U.S. 10-year Treasury note 7.34% 1.54%
Dividend yield S&P 500 3.5% 2.1%
Cyclically adjusted price-earnings (CAPE) ratio 13.9x 26.2x
Gold $361 $794 $1,356
Oil $12 $26 $41
Cost of storage ($/MB) $71 $0.0000633
Cost of computing (100 calculations) $1 $0.000001
Equity mutual fund AUM $0.15 trillion $8.15 trillion
Passively-managed assets <1% 35%
Top 10 stocks IBM Apple
Exxon Alphabet (Google)
General Electric Microsoft
AT&T Exxon Mobil
Royal Dutch Amazon.com
General Motors Berkshire Hathaway
DuPont Johnson & Johnson
BellSouth Facebook
Philip Morris General Electric
Merck AT&T
Source: FactSet, U.S. Energy Information Administration, Robert Shiller (see: www.econ.yale.edu/~shiller/data.htm),
http://ns1758.ca/winch/winchest.html (cost of storage).
Note: Gold=NYMEX:GC in dollars per ounce; Oil=Cushing, OK WTI spot price in dollars per barrel; CAPE ratio as of July 2016.
Thirty Years 2
August 4, 2016
Background
My first job was as a member of a training program at Drexel Burnham Lambert. (How I got the job is a funny
story, which I recount in The Success Equation.1) Drexel was a hot firm at the time in large part because of
Michael Milken. The program was ideal for a novice. We spent the first few months in classroom training and
then rotated through more than a dozen departments, including various trading desks, equity research,
investment banking, and operations. If you didn’t know who you were professionally, the exposure to each of
the firm’s businesses was an excellent way to find out.
We were being trained to become retail brokers, or what we call “financial advisors” today, and we launched in
January 1988. I was an abject failure. Granted, the environment was not ideal in the wake of the stock market
crash of 1987 and Drexel’s legal woes. But I was not cut out for that work and it was apparent from the start.
Fortunately, I learned a great deal at Drexel, not the least of which is what I am bad at.
I was a government major in college so came to Wall Street unencumbered with any business knowledge. (My
senior year I did take “Principles of Accounting” for non-business majors at my father’s urging and earned a
“C+” out of the generosity of the professor’s heart.) I was comfortable with numbers—my college counselor in
high school encouraged me to apply to engineering schools—but had little or no exposure to business and
finance. But a liberal arts background did expose me to lots of disciplines and cultivated critical thinking.
I believe my lack of business education was an asset because it encouraged me to ask a lot of questions and
to think from first principles. I recall going to an equity research morning call and hearing the utility industry
analyst suggest the slow-growing companies under his coverage deserved price-earnings (P/E) multiples in
the high teens and the tobacco industry analyst imply that his fast-growing companies should trade at P/E’s in
the mid-teens. How does that make sense? I was dropped into a world of rules-of-thumb, old wives’ tales,
and intuitions. William James, the famous professor of psychology, suggested that upon entering the world a
baby “feels it all as one great blooming, buzzing confusion.”2 That captured it pretty well.
My first breakthrough occurred when a classmate in my training program handed me a copy of Creating
Shareholder Value by Alfred Rappaport.3 Reading that book was a professional epiphany. Rappaport made
three points that immediately comprised the centerpiece of my thinking. The first is that the ability of
accounting numbers to represent economic value is severely limited. Next, he emphasized that competitive
strategy analysis and valuation should be joined at the hip. The litmus test of a successful strategy is that it
creates value, and you can’t properly value a company without a thoughtful assessment of its competitive
position.
The final point is that stock prices reflect a set of expectations for future financial performance. A company’s
stock doesn’t generate excess returns solely by the company creating value. The company’s results have to
exceed the expectations embedded in the stock market.
With my failure as a broker and with Creating Shareholder Value as my guiding light, I set off to get a job in
equity research. My first real opportunity came as a junior analyst supporting two senior analysts, one following
food, beverage, and tobacco companies and the other capital goods. I worked hard and read extensively
during that period. For example, I read Competitive Strategy and Competitive Advantage by Michael Porter.
Bennett Stewart’s The Quest for Value, as well as McKinsey’s Valuation, came out then as well. The
wonderful thing about that time was I could learn ideas on the weekend and apply them on Monday morning.
The opportunity to meld theory and practice was crucial.
Thirty Years 3
August 4, 2016
The consumer analyst basically told me that I was to be available to support him during business hours but that
if I wanted to launch coverage of any new companies—with his name on the top of the report—I was free to
work nights and weekends to do so. I leapt at the opportunity, and decided to write about Ralston Purina. I
was very familiar with Ralston because it had been covered by one of Drexel’s best analysts. The report I
wrote was full-blown Rappaport, with a focus on strategy and economic value and a dismissal of superficial
accounting measures.
The senior analyst, cut from a more traditional cloth, didn’t like the report much but didn’t prevent me from
publishing it. Shortly thereafter, I received a call from the office of the chairman and chief executive officer, Bill
Stiritz, indicating that he appreciated the approach and that he would like to discuss it in more detail. Stiritz,
one of the executives featured in Will Thorndike’s excellent book The Outsiders, was considered one of the
shrewdest executives in the consumer staples industry. Receiving his imprimatur was a huge boost.4
I landed the job as the senior packaged food analyst at First Boston (which later merged with Credit Suisse)
not too long after that. After a few months, one of our technology analysts, Charlie Wolf, knocked on my door
and asked if we could discuss brands. Charlie, beloved by all who knew him, was a tenured professor at
Columbia Business School who took a sabbatical year on Wall Street in the early 1980s and never went back.
We chatted and I shared some of my research.
The next day he returned to my office and suggested that I teach at Columbia Business School. Columbia and
First Boston had a close association, and a number of the analysts had taught as adjunct professors. For most,
it was a course or two and they were done. I had guest lectured for another one of our analysts, and agreed to
teach Security Analysis in the summer of 1993.
I have now taught that course for 24 years in a row (in 1995 I started teaching in the spring term). That
experience has been a deep influence. When people ask me about what it is like to teach, I suggest they think
about what it would be like to deliver 20 hours of lectures on what they do all day. At first you might think that
is a pretty easy task, until you realize that articulating what you do forces you to think about what you do. As a
natural consequence, you are likely to question whether there are better ways to do what you do.
Teaching imposes a discipline of understanding and communication that few other activities can—save
perhaps writing. Inspirational teachers are also diligent students. So a commitment to teaching at a high level
demands constant learning and consolidation of knowledge. There is the additional benefit of being around
young people who are bright and challenging.
In 1996, I was sitting at a Baltimore Orioles baseball game with a hot dog in one hand and a beer in the other.
My host was the well-known money manager, Bill Miller. That night, he suggested I make a trek to New
Mexico to visit the Santa Fe Institute. I had been reading widely, especially at the intersection of economics
and biology, so I was primed for his message.
The Santa Fe Institute (SFI) was founded in 1984 by a handful of eminent scientists, including a number of
winners of the Nobel Prize, who believed that many of the most vexing problems in the world lie at the
intersection of disciplines. Universities, on the other hand, are largely structured in silos based on academic
discipline. That means that the biologists talk to the biologists, the physicists to the physicists, and the
economists to the economists. But there’s little discussion across boundaries. At SFI, researchers from all
disciplines work together to tackle problems. One of the early seminars brought together economists,
physicists, biologists, and others to discuss the economy as an evolving complex system.
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I followed Bill’s advice and went to a meeting in the fall of 1996 and was immediately enthralled. The people
drawn to the institute are naturally intellectually curious and expansive. And given that many of the institute’s
founders came from the hard sciences, there is an insistence on rigor. I have learned many lessons from the
researchers at SFI, including those about markets as complex adaptive systems, network theory, increasing
returns, power laws, and diversity. The exposure to substantive and non-mainstream work has deeply
animated my thinking.
For the last 20 years or so, I have spent most of my time thinking about investment process. This includes
topics such as market efficiency (where and how pockets of inefficiency manifest), valuation, competitive
strategy analysis, and decision making. What we know about each of these areas today is substantially greater
than what we did in 1986, and yet we have an enormous amount to learn. As I like to tell my students, this is
an exciting time to be an investor because much of what we teach in business schools is a work-in-progress.
As a strategist and a student of investing, I have had the opportunity to meet or study many great investors. I
will now share the attributes that I believe distinguish them from the rest. The reason for the background is to
reveal my bias. I believe in economic value, the importance of constant learning and teaching, and that diverse
input combined with rigor can lead to insight. This is all very consistent with what Charlie Munger, the vice
chairman of Berkshire Hathaway, calls the “mental models” approach.5
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Ten Attributes of Great Fundamental Investors
Here are the top ten attributes that I believe great fundamental investors share:
1. Be numerate (and understand accounting). To be a successful investor, you have to be comfortable

with numbers. There are rarely complicated calculations but a feel for figures, percentages, and
probabilities is essential.
One of the main ways numeracy comes up is in financial statement analysis. Accounting is one of the
main languages of business. Great investors are adept at financial statement analysis, which allows them
to understand how a business has done in the past and gives some sense of how it will do in the future.
There are a handful of excellent books on accounting that are worth reading carefully.6 The goals of
financial statement analysis are twofold. The first is to translate financial statements into free cash flow,
the lifeblood of corporate value.
You calculate free cash flow by starting with cash earnings and subtracting the investments a company
makes to generate future earnings. Investments include increases in working capital, capital expenditures
above and beyond what is needed to maintain plant and equipment, and acquisitions. Free cash flow is
what is left over after investments have been subtracted from cash earnings. It is also the sum that a
company can return to its claimholders in the form of interest payments, dividends, and share buybacks,
without jeopardizing a company’s value creation prospects.
Earnings are the most widely used metric of corporate performance. But it is easy to show that growth in
earnings and growth in value are distinct. Companies can increase earnings and simultaneously destroy
value if the investments the company makes don’t earn an appropriate rate of return. By focusing on the
present value of future free cash flow, a thoughtful investor translates financial statements into what
determines value.
The second goal of financial statement analysis is to make a link between a company’s strategy and how
it creates value. One simple way to do this is to compare, line by line, two companies that are in the same
business. Are their expenses comparable? Do they use capital in a similar way? Noticing differences in
how companies spend money and allocate investment resources offers insight into their competitive
positions.
You can do a simpler analysis just by looking at the path to return on invested capital (ROIC). You can
break ROIC into two components: profitability (net operating profit after tax/sales) and capital velocity
(sales/invested capital). Companies with high operating profit margins and low capital velocity are
generally pursuing what Michael Porter, a professor of economics, calls a “differentiation” strategy.
Companies with low operating profit margins and high capital velocity are following a “cost leadership”
strategy.7 The analysis of how a company makes money spills directly into an assessment of how long the
company can sustain its advantage (if ROICs are attractive) or what the company has to do to improve its
economic profits.
Understanding a business requires understanding the numbers. The task has become more challenging in
recent years as companies are investing more in intangible assets and less in tangible assets. For example,
in fiscal 2016 Microsoft spent about one-and-a-half times as much on research and development, which it
expensed on the income statement, as it did on capital expenditures, which were capitalized on the
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balance sheet. This shift means that traditional accounting measures are less useful but does not abdicate
the responsibility to understand a business’s current economics and prospects.8
2. Understand value (the present value of free cash flow). The landscape of investing has changed a
great deal in the past three decades. It is interesting to consider what about investing is mutable and what
is immutable. The truth is that much is mutable. The average half-life of a public company is about a
decade, which means that the investable universe is in flux.9 Conditions are always shifting because of
unknowns including technological change, consumer preferences, and competition. But one concept that
is close to immutable for an investor is that the present value of future free cash flow determines the value
of a financial asset. This is true for stocks, bonds, and real estate. Valuation is challenging for equity
investors because each driver of value—cash flows, timing, and risk—are based on expectations whereas
two of the three drivers are contractual for bond investors.
Great fundamental investors focus on understanding the magnitude and sustainability of free cash flow.
Factors that an investor must consider include where the industry is in its life cycle, a company’s
competitive position within its industry, barriers to entry, the economics of the business, and
management’s skill at allocating capital.
A corollary to this attribute is that great investors understand the limitations of valuation approaches such
as price/earnings and enterprise value/EBITDA multiples.10 Indeed, multiples are not valuation but a
shorthand for the valuation process. No thoughtful investor ever forgets that. Shorthands are useful
because they save you time, but they also come with blind spots. As Al Rappaport says, “Remember, cash
is a fact, profit is an opinion.”11
3. Properly assess strategy (or how a business makes money). This attribute has two dimensions. The
first is a fundamental understanding of how a company makes money. The idea is to distill the business to
the basic unit of analysis. For example, the basic unit of analysis for a retailer is store economics. How
much does it cost to build a store and fill it with inventory? What revenues will it generate? What are the
profit margins? Answers to these and other questions should allow an investor to assess the economic
profitability of a store, which he or she can then roll up to understand the overall company.
The basic unit of analysis varies by industry. What you need to understand to assess a subscription
business, customer lifetime value, is different than a business dependent on research and development
such as a biotechnology company. Great investors can explain clearly how a company makes money, have
a grasp on the changes in the drivers of profitability, and never own the stock of a company if they do not
understand how it makes money. You can think of this as the micro dimension of understanding strategy.
The second dimension is gaining a grasp of a company’s sustainable competitive advantage. A company
has a competitive advantage when it earns a return on investment above the opportunity cost of capital
and earns a higher return than its competitors. The classic approach is to analyze the industry and how the
company fits in, and the common tools include the five forces that shape industry attractiveness, value
chain analysis, assessment of the threat from disruptive innovation, and firm-specific sources of
advantage.12
The key to strategy is to understand trade-offs. Michael Porter makes a distinction between strategy and
operational effectiveness that executives and investors commonly blur. Strategy is about deliberately being
different than competitors and requires making tough choices about what activities to do and not do.
Operational effectiveness relates to the activities that all businesses need to do and hence does not entail
choice.
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Great investors can appreciate what differentiates a company that allows it to build an economic moat
around its franchise that protects the business from competitors. The size and longevity of the moat are
significant inputs into any thoughtful valuation. As Al Rappaport emphasized years ago, strategy and
valuation need to go together. This is the macro dimension of understanding strategy.
4. Compare effectively (expectations versus fundamentals). Comparing is a critical element of

investing. Investors compare all day: stocks versus bonds, active versus passive, value versus growth,
stock A versus stock B, and now versus later. Humans are quick to compare but not very good at it.
Perhaps the most important comparison an investor must make, and one that distinguishes average from
great investors, is between fundamentals and expectations. Fundamentals capture a sense of a
company’s future financial performance. Value drivers including sales growth, operating profit margins,
investment needs, and return on investment shape fundamentals. Expectations reflect the financial
performance implied by the stock price.
Making money in markets requires having a point of view that is different than what the current price
suggests. Michael Steinhardt called this a “variant perception.”13 Most investors fail to distinguish between
fundamentals and expectations. When fundamentals are good they want to buy and when they are poor
they want to sell. But great investors always distinguish between the two.
One vivid analogy is pari-mutuel betting. Horse racing is a good example. The amount bet on a horse gets
reflected in the horse’s odds, or probability, of winning the race. The goal is not to figure out which horse
will win but rather which horse has odds that are mispriced relative to how it will likely run the race.14
Fundamentals are how fast the horse will run, and expectations are the odds. You need to consider those
elements separately.
One of the basic challenges in comparing well is a concept that psychologists call “coherent arbitrariness,”
which says that we struggle to understand the absolute value of a good but are effective at understanding
the relative value.15 You may not know the proper value of a pharmaceutical company, but you can rank
them in order of your preference. Unless you solely engage in arbitrage, absolute values ultimately matter.
Humans tend to think by analogy, which can create some cognitive trouble. One issue is that a single
analogy, or even a handful of analogies, may fail to reflect a full reference class of relevant cases. For
example, rather than asking whether this turnaround is similar to a prior turnaround, it is useful to ask for
the base rate of success for all turnarounds. Psychologists have shown that properly integrating the
outcomes from an appropriate reference class improves the quality of forecasts.
Another challenge with using analogies is that we see similarities when we focus on similarities and see
differences when we focus on differences. The emphasis of the comparison colors the outcome. For
example, Amos Tversky, a psychologist known for his collaboration with Daniel Kahneman, asked subjects
which pair of countries they deemed more similar, West Germany and East Germany or Nepal and Ceylon
(the study was done in the early 1970s and Ceylon changed its name to Sri Lanka in 1972). Two-thirds
of the subjects selected West Germany and East Germany.
Tversky then asked subjects which pair of countries they deemed more different. Logic suggests an
answer that is the complement of the first response, hence two-thirds finding Nepal and Ceylon more
different. But that’s not what Tversky found. Seventy percent of the subjects rated West Germany and
East Germany more different than the other pair. What you are looking for dictates what you see.16
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A final challenge is considering causality from the point of view of attributes versus circumstances.
Attributes are features that allow for categorization. For instance, animals with wings and feathers can fly.
Circumstances capture causal mechanisms. Since the physics of lift causes flight, animals or objects that
can create lift will fly, including most birds and airplanes, and those that can’t create lift won’t fly. To learn
from history, you need to understand causality.17 We commonly limit our comparisons to attributes and
hence miss essential insights. Great investors compare well without falling for the common traps.
5. Think probabilistically (there are few sure things). Investing is an activity where you must constantly
consider the probabilities of various outcomes. This requires a certain mindset. To begin, you must
constantly seek an edge, where the price for an asset misrepresents either the probabilities or the
outcomes. Successful operators in all probabilistic fields dwell on finding edge, from the general managers
of sports franchises to professional bettors.
When probability plays a large role in outcomes, it makes sense to focus on the process of making
decisions rather than the outcome alone. The reason is that a particular outcome may not be indicative of
the quality of the decision. Good decisions sometimes result in bad outcomes and bad decisions lead to
good outcomes. Over the long haul, however, good decisions portend favorable outcomes even if you will
be wrong from time to time. Time horizon and sample size are also vital considerations. Learning to focus
on process and accept the periodic and inevitable bad outcomes is crucial.
Great investors recognize another uncomfortable reality about probability: the frequency of correctness
does not really matter (batting average), what matters is how much money you make when you are right
versus how much money you lose when you are wrong (slugging percentage). This concept is very difficult
to put into operation because of loss aversion, the idea that we suffer losses roughly twice as much as we
enjoy comparably sized gains. In other words, we like to be right a lot more than to be wrong. But if the
goal is grow the value of a portfolio, slugging percentage is what matters.
There are three ways of coming up with probabilities. The first is subjective probability, a figure that
corresponds with a state of knowledge or belief. For instance, you might assign a subjective probability to
the likelihood that two countries go to war. Second is propensity, which is generally based on physical
properties of the system. For example, you would estimate the probability of a die coming up four in a
single roll as one out of six based on the fact that the die is a perfect cube and the toss is without bias.
The final approach is frequency, which considers the outcomes of a proper reference class given the
situation under deliberation.
You are well served to use the frequency approach to anticipate measures of corporate performance such
as sales and profit growth rates. Subjective probabilities, which require frequent updating, can also be very
useful. But there are realms where attaching probabilities to outcomes can be treacherous.18 Here, both
the probabilities and outcomes are largely unknowable. This is the territory of “black swans,” outcomes
that are “outside the realm of expectations,” have a large impact, and are explained after the fact. If you
are going to participate in this area, the goal here is to gain exposure to positive black swans.
Warren Buffett, chairman and chief executive officer of Berkshire Hathaway, summed up this attribute
well: “Take the probability of loss times the amount of possible loss from the probability of gain times the
amount of possible gain. That is what we’re trying to do. It’s imperfect, but that’s what it’s all about.”19
6. Update your views effectively (beliefs are hypotheses to be tested, not treasures to be
protected).20 Most people prefer to maintain consistent beliefs over time, even when the facts reveal their
beliefs to be wrong. Further, we commonly expect others to be consistent. For example, politicians who
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change their views are derisively called “flip-floppers.”21 The need for consistency tends to grow with age.
The idea that many older people are set in their ways is grounded in truth.22
We all walk around with views of the world that we believe are correct. You are compelled to change your
mind only when you confront reality that disconfirms your beliefs. The easiest way to avoid the sensation
of being wrong is to fall for the confirmation bias. With confirmation bias, you seek information that
confirms your view and interpret ambiguous information in a way that is favorable to your belief.
Consistency allows you to stop thinking about an issue and to avoid change as a consequence of reason.
But great investors do two things that most of us do not. They seek information or views that are different
than their own and they update their beliefs when the evidence suggests they should. Neither task is
easy.
The trait of seeking alternative views is called being “actively open-minded,” a term coined by a professor
of psychology at the University of Pennsylvania named Jonathan Baron. Actively open-minded is defined
as “the willingness to search actively for evidence against one’s favored beliefs, plans or goals and to
weigh such evidence fairly when it is available.”23 Research shows that actively open-minded people
perform well in forecasting tasks that demand collecting information. The trait of being actively-open
minded can offset confirmation bias.24
Great investors also update their views as new information arrives. The idea is that you can represent your
degree of belief about something by a probability. When new information arrives, you update that
probability. The formal way to do this is to use Bayes’s Theorem, which tells you the probability that a
theory or belief is true conditional on some event happening.25
The practical challenges are to avoid overreacting to information that appears to explain causality on the
surface but in fact does not, as well as to detect information that does matter but that does not appear to
be causal. In addition, while it is often clear to shift your degree of belief up or down, the magnitude of the
shift is also important.
The best investors among us recognize that the world changes constantly and that all of the views that we
hold are tenuous. They actively seek varied points of view and update their beliefs as new information
dictates. The consequence of updated views can be action: changing a portfolio stance or weightings
within a portfolio. Others, including your clients, may view this mental flexibility as unsettling. But good
thinking requires maintaining as accurate a view of the world as possible.
7. Beware of behavioral biases (minimizing constraints to good thinking). Keith Stanovich, a

professor of psychology, likes to distinguish between intelligence quotient (IQ), which measures mental
skills that are real and helpful in cognitive tasks, and rationality quotient (RQ), the ability to make good
decisions. His claim is that the overlap between these abilities is much lower than most people think.
Importantly, you can cultivate your RQ.
Warren Buffett captures this idea when he distinguishes between an engine’s horsepower (IQ) and output
(RQ):
“I always look at IQ and talent as representing the horsepower of the motor, but that the output—the
efficiency with which that motor works—depends on rationality. A lot of people start out with 400-
horsepower motors but only get a hundred horsepower of output. It’s way better to have a 200-
horsepower motor and get it all into output.”26
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Two areas of research, heuristics and biases and prospect theory, merged economics and psychology in
the last half century. While many of the ideas had been around for a long time, Daniel Kahneman and
Amos Tversky did a great deal to formalize the thinking.
The heuristics and biases literature notes that we tend to operate with rules of thumb (heuristics), which
are generally correct and save us lots of time. But these heuristics have associated biases that can lead to
departures from logic or probability. Examples of heuristics include availability (rely on information that is
available rather than relevant), representativeness (placing people or objects in categories that are
inaccurate), and anchoring (placing too much weight on an anchor figure). There is now a long list of
heuristics and biases, and great investors are those who not only understand these concepts but take
steps to manage or mitigate behavioral biases in their investment process.
Prospect theory shows how the decisions by individuals depart from normative economic approaches in
risky situations. Loss aversion, which says that individuals tend to suffer more from losses than
comparable gains, is a good example. While there may be a persuasive evolutionary explanation for loss
aversion, it is not good for money management.27
Epistemic rationality, or the degree to which your beliefs map accurately to the world, is an essential
ingredient to RQ. People who score well on RQ are well calibrated, which means that the probabilities they
assign to particular outcomes tend to be accurate over a large sample of judgments. One way to improve
calibration is to keep score. You can track your forecasts and grade them based on outcomes.
The ability to sidestep behavioral biases is likely part disposition, part training, and part environment. Great
investors are those who are generally less affected by cognitive bias than the general population, learn
about biases and how to cope with them, and put themselves in a work environment that allows them to
think well.
8. Know the difference between information and influence. In classic markets for goods or services,
prices are a highly informative mechanism. In microeconomics, the equilibrium price is one that balances
supply and demand. A higher price creates more supply than demand, and hence excess supply. A lower
price creates more demand than supply, and hence excess demand. The equilibrium price is also known
as the market clearing price because it clears away excess supply or demand. Supply and demand curves
may shift, but price is a very useful source of information about the market.
Prices also provide useful information in capital markets. The main value is as an indication about
expectations for future financial performance. (This is less true for derivatives, which may be efficiently
priced even if the asset from which its price is derived is inefficiently priced.) As we saw in a prior point,
great investors are adept at translating between expectations and fundamentals, and keep them separate
in decision making. Further, arbitrageurs serve to close aberrant price gaps. Arbitrage is negative
feedback, pushing prices that have drifted from fair value back toward their correct level.
Yet investing is an inherently social exercise. As a result, prices can go from being a source of information
to a source of influence. This has happened many times in the history of markets. Take the dot-com
boom as an example. As internet stocks rose, investors who owned the shares got rich on paper. This
exerted influence on those who did not own the shares and many of them ended up suspending belief and
buying as well. This fed the process. The rapid rise of the dot-com sector was less about grounded
expectations about how the Internet would change business and more about getting on board. Negative
feedback ceded to positive feedback, which pushes a system away from its prior state.
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One of the best models for thinking about this type of behavior is the threshold model from Mark
Granovetter, a professor of sociology at Stanford University.28 Imagine 100 potential rioters milling around
in a public square. Each individual has a “riot threshold,” the number of rioters that person would have to
see in order to join the riot. Say one person has a threshold of 0 (the instigator), one has a threshold of 1,
one has a threshold of 2, and so on up to 99. This uniform distribution of thresholds creates a domino
effect and ensures that a riot will happen. The instigator breaks a window with a rock, person one joins in,
and then each individual piles on once the size of the riot reaches his or her threshold. Substitute “buy dot-
com stocks” for “join the riot” and you get the idea.
The point is that very few of the individuals, save the instigator, think that rioting is a good idea. Most
would probably shun rioting. But once the number of others rioting reaches a threshold, they will jump in.
This is how the informational value of stocks is set aside and the influential component takes over.
Great investors don’t get sucked into the vortex of influence. This requires the trait of not caring what
others think of you, which is not natural for humans. Indeed, many successful investors have a skill that is
very valuable in investing but not so valuable in life: a blatant disregard for the views of others. Success
entails considering various points of view but ultimately shaping a thesis that is thoughtful and away from
the consensus. The crowd is often right, but when it is wrong you need the psychological fortitude to go
against the grain. This is much easier said than done, especially if it entails career risk (which is often the
case).
9. Position sizing (maximizing the payoff from edge). Puggy Pearson was a cigar-chomping gambling
legend who won the World Series of Poker and was one of the world’s best pool players. When asked
about his success, Pearson said, “Ain’t only three things to gambling: Knowin’ the 60-40 end of a
proposition, money management, and knowin’ yourself.”29 Great investors take to heart all three of
Pearson’s points, but money management is the one that gets the least attention in the discourse on
investment practice.
The book Bringing Down the House by Ben Mezrich tells the story of a half dozen students from MIT who
deployed a card counting system to make lots of money in Las Vegas. Their system had two parts. The
first was the method for counting cards. Here, members of the team fanned out to different tables and
developed a signal to indicate when the odds looked good. But the second part of the system is
commonly overlooked. The team members knew exactly how much to bet given the odds at the table and
the size of their bankroll.
Similarly, success in investing has two parts: finding edge and fully taking advantage of it through proper
position sizing. Almost all investment firms focus on edge, while position sizing generally gets much less
attention.
Proper portfolio construction requires specifying a goal (maximize sum for one period or parlayed bets),
identifying an opportunity set (lots of small edge or lumpy but large edge), and considering constraints
(liquidity, drawdowns, leverage). Answers to these questions suggest an appropriate policy regarding
position sizing and portfolio construction.
The most common approaches are based on mean-variance (maximize return for a given level of risk) and
the Kelly Criterion (maximize a portfolio’s geometric mean return).30 Which approach makes most sense
for you depends a great deal on how you answer the questions about goals, opportunities, and constraints.
But the broad point is that most investors do a poor job with position sizing and great investors are more
effective at it.31
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Ed Thorp is one of the best investors of the last half century. In the early 1960s, he wrote the book, Beat
the Dealer, which explained card counting in blackjack as a means to gain edge as well as a betting
strategy based on the Kelly Criterion in order to take advantage of that edge. The MIT team was his
intellectual progeny.
His returns as an investor are extraordinary. For the nearly 30 years ended in the late 1990s, Thorp’s
investments had grown at a 20 percent annual rate with a 6 percent standard deviation.32 Thorp has been
among the most thoughtful and thorough in explaining the benefits, drawbacks, and practical
considerations of the Kelly Criterion.33
Astute investors understand that finding edge and betting on it appropriately are both essential to long-
term success.
10. Read (and keep an open mind). Every year, Columbia Business School sends a group of students to
Omaha, Nebraska to meet with Todd Combs, a graduate of the school (and former student), and Warren
Buffett (also a graduate), at Berkshire Hathaway. After one of those trips, I asked the students for their
impression of the meetings. The students, in somewhat of a state of disbelief, said that Combs suggested
that they read 500 pages a day. In a world of endless meetings, blinking Bloomberg terminals, and
demanding emails, this goal seems inconceivable.
Berkshire Hathaway’s Charlie Munger said that he really liked Albert Einstein’s point that “success comes
from curiosity, concentration, perseverance and self-criticism. And by self-criticism, he meant the ability to
change his mind so that he destroyed his own best-loved ideas.”34 Reading is an activity that tends to
foster all of those qualities.
Munger has also said, “In my whole life, I have known no wise people (over a broad subject matter area)
who didn’t read all the time–none, zero.”35 This may be hyperbolic, but seems to be true in the investment
world as well.
Great investors generally practice a few habits with regard to their reading. First, they allocate time to it.
Warren Buffett has suggested that he dedicates 80 percent of his working day to reading.36 Note that if
you are spending time reading, you are not doing something else. There are trade-offs. But many
successful people are willing to make reading a high priority.
Second, good readers tend to take on material across a wide spectrum of disciplines. Don’t just read in
business or finance. Expand the scope into new domains or fields. Follow your curiosity. It is hard to know
when an idea from an apparently disparate field may come in handy.
Finally, make a point of reading material you do not necessarily agree with. Find a thoughtful person who
holds a view different than yours, and then read his or her case carefully. This contributes to being actively
open-minded.
Research shows that successful people read a lot and do so more for education than for entertainment.37
Reading is their primary means to continue their education. This habit is particularly important for investors,
who must synthesize a huge number of inputs into actionable ideas.
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What Next?
It is harder than ever to generate excess returns in the investment management business. The main
explanation for the rising difficulty is an idea we call the “paradox of skill.” The paradox says that in some
activities, as skill increases luck becomes more important in determining outcomes. The key insight is
differentiating between absolute and relative skill.
Absolute skill in investing, which includes bright investors working hard using vast amounts of data and
incorporating ideas from the latest research, has never been higher. Relative skill, on the other hand, appears
to be narrowing. The difference between the best and the average is less today than it was a generation or
two ago. We see this clearly when we examine the standard deviation of excess returns for mutual funds,
which has declined steadily for a half century.
The massive shift in asset allocation away from active investing toward passive investing exacerbates this
effect. Thirty years ago, index funds were less than one percent of assets under management, and today they
(along with other passive vehicles such as exchange-traded funds) are about one-third. Think of it this way:
For you to have positive alpha, the industry’s term for risk-adjusted excess return, someone has to have
negative alpha of the same amount. By definition, alpha for the market must equal zero (before fees).
So you want to compete against less-skilled investors because they are your source of alpha. It is
disadvantageous for you if the weak players flee the market (selling their stocks and buying index funds), or if
the least capable professional investors lose assets to passive funds, because it means that only the smartest
investors remain in the active game. The truth is that weak players, whom the strong players require to
generate excess returns, are fleeing at a record pace.
Still, here are a couple of suggestions for active managers to contemplate.
The first is to consider carefully where your skill will be most valuable. More than 25 years ago, Richard
Grinold spelled out the “fundamental law of active management.”38 The non-technical interpretation says that
excess returns equal skill times opportunity. All the skill in the world is for naught unless you have an
opportunity to apply it. Before figuring out how you will win the game, figure out which game to play.
Second, there is a still a lot of upside in properly building an investment firm. In the past 30 years, we have
learned a substantial amount about how our minds work, the value of diversity, and the role of training.
Take a look at exhibit 2, which considers the factors that contribute to peak performance as an investor. The
box on the left starts with selecting the right people to be analysts and portfolio managers. The next pair of
boxes place emphasis on proper training through deliberate practice and the thoughtful application of
technology. Then the organization has to manage cognitive bias. Only then can an individual in a firm reach
peak performance.
Thirty Years 14
August 4, 2016
Exhibit 2: Achieving Peak Performance in an Investment Organization
Deliberate
Practice
Managing Peak
Selection
Mental Bias Performance
Technology/
Innovation
Here are some thoughts on each:
Selection. Both Keith Stanovich’s work on IQ and RQ and Phil Tetlock’s work on superforecasting
strongly suggest that there’s more to good decision making than traditional smarts measured through IQ.
Qualities such as active-open mindedness, thinking probabilistically, an ability to update views frequently
and accurately, and persistence are not well captured in tests. Even proxies for intelligence, such as
graduating from an elite university, do not do the job.39
Stanovich, along with some colleagues, will publish a book on rational thinking in September 2016 that
includes the CART (Comprehensive Assessment of Rational Thinking), a test analogous to the IQ test.40
The cognitive reflection test (CRT) and extended CRT are simple tests that likely capture the same
dimensions of thinking.41
Progressive investment organizations will extend their selection process to including screening for
rationality, which will likely improve results.
Deliberate practice. The next step toward peak performance is the application of deliberate practice,
which has a number of elements.42 Done properly, deliberate practice is designed with a specific
objective, requires timely and accurate feedback from a coach or teacher, entails substantial repetition,
and is only viable for students who are motivated. Deliberate practice is not fun, but it is gratifying
because the performance improvements are tangible.
There is no straightforward way to map the elements of deliberate practice to the world of investing.
Designed practice with a specific objective may involve exercises in probability judgments, including
learning how to establish prior beliefs, how to update views, and how to distinguish between
fundamentals and expectations.
Feedback is a challenge. Your first inclination is to use the market as a source of feedback, but the
problem is that market moves, especially in the short term, are very noisy. A better approach is to break
down an investment thesis in components, each of which you can measure and track. This allows you to
keep score and provide feedback. The Brier score is an established way to assess the accuracy of
probabilistic forecasts.43
The way to achieve repetition is to constantly work on similar types of problems that may not be directly
related to the portfolio. Handicappers talk of “action bets” and “prime bets.” Action bets are small bets
that serve to keep the handicapper engaged and sharp. The stakes are low but the handicapper gets
feedback to help his bigger bets. Prime bets are the big bets. If action bets are the warm up, prime bets
are the main event. In order to gain repetition, the investor should think about everything relevant in
probability terms and sharpen his or her ability to do so.
Thirty Years 15
August 4, 2016
Motivation in cognitive tasks shows up as active open-mindedness, a need for cognition, and
competitiveness. When the best forecasters in a tournament were asked why they participated in the first
place, they cited “wanting to be among the top forecasters” as the primary reason. Investing entails
ongoing learning, so motivation to learn and stay involved is essential. Reading is probably the best
indication of this motivation.
Technology and innovation. Here is a provocative thought: if you compete against a computer, you are
highly likely to lose. If you compete with a computer to augment your performance, you are more likely to
win. The question is how this plays out in the investment business.
One model we can examine is chess. Machine beat man when Garry Kasparov lost to Deep Blue in
1997. Since then, a new type of play called freestyle chess has become more popular. In freestyle chess,
humans make the moves but can avail themselves of whatever aids they want, including chess programs
and other humans. While it is close, it appears that freestyle teams are the best chess players in the
world, easily surpassing humans by themselves and narrowly beating the best chess programs.44
You need to sort what the computer is good at and what you can do. Then you have to let the computer
do its thing while you do yours. Computers are good at applying base rates, crunching numbers, and
casting a wide net. Humans can add value by understanding causality in a more nuanced way,
recognizing regime changes, and applying more granular knowledge.
It is hard to be at the cutting edge of innovation, but there is a great deal to gain from simply applying
available ideas or principles. For example, it is still surprising how few fundamental investors use
simulation in their work. You can buy a Monte Carlo simulator off the shelf for a reasonable price, and it
will generate substantial insight. Is your organization set up in the best possible way? For example, are
your teams the proper size, of the ideal composition, and managed well? Finally, fundamental firms
should keep an eye on academic research to see if any of the ideas apply.
Managing mental bias. At this point, most investors are familiar with the basic ideas from the literature
on heuristics and biases and prospect theory. (If you are not, you should learn about the ideas right away).
The challenge today is to implement methods to manage and mitigate behavioral biases.
There are a few techniques that can be helpful. One example is the use of checklists, which come in two
forms. A DO-CONFIRM checklist allows an investor to do his or her job as they see fit but prompts
pauses to make sure the job has been done thoroughly. Our experience is that checklists can be
effective for the routinized aspects of investing, for instance making sure that the analyst has done a
competitive strategy or return on invested capital analysis properly. A READ-DO checklist is useful in
periods of high stress. One case is when a stock you own drops sharply versus the market. A checklist
can lay out the protocol to ensure the best possible decision.45
Another technique is an explicit effort to improve choice architecture. Research in psychology

demonstrates that how choices are presented influences behavior. Nudges are structures that encourage
positive behaviors without limiting options.
Having an organization with a high level of cognitive diversity, people with different training experience,
personalities, and skills, is perhaps the most powerful antidote to bias. But cultivating cognitive diversity is
not enough. You must manage diversity. “Psychological safety” is the single factor that best predicts
good performance for a team. This means that people feel free to voice their views and are willing to take
appropriate risks.46
Thirty Years 16
August 4, 2016
Some Influential Books along the Journey
1980s
Michael E. Porter, Competitive Strategy: Techniques for Analyzing Industries and Competitors (New York:
Free Press, 1980).
Robert Cialdini, Influence: The Psychology of Persuasion (New York: William Morrow, 1984).
Michael E. Porter, Competitive Advantage: Creating and Sustaining Superior Performance (New York: Free
Press, 1985).
Alfred Rappaport, Creating Shareholder Value: The New Standard for Business Performance (New York: Free
Press, 1986).
Richard Dawkins, The Blind Watchmaker (New York: W.W. Norton & Company, 1986).
Max H. Bazerman, Judgment in Managerial Decision Making (New York: John Wiley & Sons, 1986).
1990s
Michael Rothschild, Bionomics: Economy as Ecosystem (New York: Henry Holt, 1990).
Tom Copeland, Tim Koller, and Jack Murrin, Valuation: Measuring and Managing the Value of Companies
(New York: John Wiley & Sons, 1990).
G. Bennett Stewart III, The Quest for Value: A Guide for Senior Managers (New York: Harper Business,
1991).
Peter Bernstein, Capital Ideas: The Improbable Origins of Modern Wall Street (New York: John Wiley & Sons,
1992).
M. Mitchel Waldrop, Complexity: The Emerging Science at the Edge of Order and Chaos (New York: Simon &
Schuster, 1992).
Kevin Kelly, Out of Control: The Rise of Neo-Biological Civilization (New York: Addison Wesley, 1994).
Daniel C. Dennett, Darwin’s Dangerous Idea: Evolution and the Meanings of Life (New York: Simon &
Schuster, 1995).
Peter Bernstein, Against the Gods: The Remarkable Story of Risk (New York: John Wiley & Sons, 1996).
Steven Pinker, How the Mind Works (New York: W.W. Norton & Company, 1997).
E.O. Wilson, Consilience: The Unity of Knowledge (New York, Alfred A. Knopf, 1998).
Carl Shapiro and Hal R. Varian, Information Rules: A Strategic Guide to the Network Economy (Boston, MA:
Harvard Business School Press, 1999).
2000s
Michael Lewis, Moneyball: The Art of Winning an Unfair Game (New York: W.W. Norton, 2003).
James Surowiecki, The Wisdom of Crowds: Why the Many Are Smarter than the Few and How Collective
Wisdom Shapes Business, Economies, Societies, and Nations (New York: Random House, 2004).
Eric D. Beinhocker, The Origin of Wealth: Evolution, Complexity, and the Radical Remaking of Economics
(Boston: Harvard Business School Press, 2006).
Daniel Kahneman, Thinking, Fast and Slow (New York: Farrar, Straus and Giroux, 2011).
Philip E. Tetlock and Dan Gardner, Superforecasting: The Art and Science of Prediction (New York: Crown
Publishers, 2015).
Thirty Years 17
August 4, 2016
Endnotes
1
Michael J. Mauboussin, The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing
(Boston, MA: Harvard Business Review Press, 2012), 1-2.
2
William James, The Principles of Psychology, Volume 1 (New York: Henry HOLT and Company, 1890), 488.
3
Free Press, 1986).
4
William N. Thorndike, Jr., The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint
for Success (Boston, MA: Harvard Business Review Press, 2012).
5
Peter D. Kaufman, ed., Poor Charlie’s Almanack: The Wit and Wisdom of Charles T. Munger (Virginia
Beach,VA: PCA Publication, 2005).
6
Some of my favorites include Howard M. Schilit and Jeremy Perler, Financial Shenanigans: How to Detect
Accounting Gimmicks & Fraud in Financial Reports, 3rd Edition (New York: McGraw Hill, 2010); Charles W.
Mulford and Eugene E. Comiskey, Creative Cash Flow Reporting: Uncovering Sustainable Financial
Performance (Hoboken, NJ: John Wiley & Sons, 2005); Charles W. Mulford and Eugene E. Comiskey, The
Financial Numbers Game: Detecting Creative Accounting Practices (Hoboken, NJ: John Wiley & Sons,
2005); and Kathryn F. Staley, The Art of Short Selling (New York: John Wiley & Sons, 1997).
7
Free Press, 1980).
8
Baruch Lev and Feng Gu, The End of Accounting and the Path Forward for Investors and Managers
(Hoboken, NJ: John Wiley & Sons, 2016).
9
Madeleine I. G. Daepp, Marcus J. Hamilton, Geoffrey B. West, and Luís M. A. Bettencourt, “The Mortality of
Companies,” Royal Society Interface, Vol. 12, No. 106, May 6, 2015; Michael J. Mauboussin and Dan
Callahan, “Why Corporate Longevity Matters: What Index Turnover Tells Us about Corporate Results,” Credit
Suisse Global Financial Strategies, April 16, 2014.
10
Stanley Block, “Methods of Valuation: Myths vs. Reality,” The Journal of Investing, Winter 2010, 7-14.
EBITDA stands for earnings before interest, taxes, depreciation, and amortization.
11
Alfred Rappaport, Creating Shareholder Value: A Guide for Managers and Investors (New York: Free Press,
1998), 15.
12
Michael J. Mauboussin and Dan Callahan, “Measuring the Moat: Assessing the Magnitude and Sustainability
of Value Creation,” Credit Suisse Global Financial Strategies, July 22, 2013.
13
Michael Steinhardt, No Bull: My Life In and Out of Markets (New York: John Wiley & Sons, 2001), 129.
14
Steven Crist, “Crist on Value,” in Beyer, et al., Bet with the Best (New York: Daily Racing Form Press,
2001).
15
Dan Ariely, George Loewenstein, and Drazen Prelec, “‘Coherent Arbitrariness’: Stable Demand Curves
Without Stable Preferences,” Quarterly Journal of Economics, Vol. 118, No 1, February 2003, 73-106.
16
Amos Tversky, “Features of Similarity,” Psychological Review, Vol. 84, 1977, 327-352. Reprinted in Eldar
Shafir, ed., Preference, Belief, and Similarity: Selected Writings, Amos Tversky (Cambridge, MA: MIT Press,
2004).
17
Paul R. Carlile and Clayton M. Christensen, “The Cycles of Theory Building in Management Research,”
Harvard Business School Working Paper Series, No. 05-057, 2005. Also, see the chapter, “History, The
Fickle Teacher,” in Duncan J. Watts, Everything Is Obvious*: *Once You Know the Answer (New York: Crown
Business, 2011), 108-134.
18
Nassim Nicholas Taleb, The Black Swan: The Impact of the Highly Improbable, Second Edition (New York:
Random House, 2010), 365.
19
Warren E. Buffett, Berkshire Hathaway Annual Meeting, 1989.
20
The phrase “beliefs are hypotheses to be tested, not treasures to be protected” comes from Philip E.
Tetlock and Dan Gardner, Superforecasting: The Art and Science of Prediction (New York: Crown Publishers,
2015), 191.
Thirty Years 18
August 4, 2016
21
Robert B. Cialdini, Influence: The Psychology of Persuasion (New York: William Morrow, 1993).
22
Stephanie L. Brown, Terrilee Asher, and Robert B. Cialdini, “Evidence of a Positive Relationship Between
Age and Preference for Consistency,” Journal of Research in Personality, Vol. 39, No. 5, October 2005,
517-533.
23
Christopher Peterson and Martin E. P. Seligman, Character Strengths and Virtues: A Handbook and
Classification (Oxford: Oxford University Press, 2004), 144.
24
Uriel Haran, Ilana Ritov, Barbara A. Mellers, “The Role of Actively Open-Minded Thinking in Information
Acquisition, Accuracy, and Calibration,” Judgment and Decision Making, Vol. 8, No 3, May 2013, 188-201.
25
For a layman’s discussion of Bayes’s Theorem, see Nate Silver, The Signal and the Noise: Why So Many
Predictions Fail—But Some Don’t (New York: The Penguin Press, 2012), 243-248. To solve for the new
probability, you need three quantities. First, you need a prior probability (x). Second, you need an estimate of
the probability as a condition of the hypothesis being true (y). Finally, you need an estimate conditional on the
hypothesis being false (z).
Bayes’s Theorem = xy
xy + z(1-x)
For an example, see Michael J. Mauboussin and Dan Callahan, “Cultivating Your Judgment Skills: A
Framework for Improving the Quality of Decisions,” Credit Suisse Global Financial Strategies, May 7, 2013.
26
Brent Schlender, “The Bill & Warren Show,” Fortune, July 20, 1998.
27
Rose McDermott, James H. Fowler, and Oleg Smirnov, “On the Evolutionary Origin of Prospect Theory
Preferences,” Journal of Politics, Vol. 70, No. 2, April 2008, 335–350.
28
Mark Granovetter, “Threshold Models of Collective Behavior,” American Journal of Sociology, Vol. 83, No. 6,
May, 1978, 1420-1443.
29
David Spanier, Easy Money: Inside the Gambler’s Mind (New York: Penguin, 1987).
30
Javier Estrada, “Geometric Mean Maximization: An Overlooked Portfolio Approach?” Working Paper,
January 2010.
31
Leonard C. MacLean, Edward O. Thorp, Yonggan Zhao, and William T. Ziemba, “How Does the Fortune’s
Formula Kelly Capital Growth Model Perform?” Journal of Portfolio Management, Summer 2011, 96-111.
32
William Poundstone, Fortune’s Formula: The Untold Story of the Scientific Betting System that Beat the
Casinos and Wall Street (New York: Hill and Wang, 2005), 320.
33
Edward O. Thorp, “The Kelly Criterion in Blackjack, Sports Betting, and the Stock Market,” in Handbook of
Asset and Liability Management, Volume 1: Theory and Methodology, S.A. Zenios and W. T. Ziemba, eds.,
(Amsterdam: North-Holland, 2006), 385-428.
34
“Berkshire Hathaway’s Warren Buffett & Wesco Financial’s Charlie Munger,” Outstanding Investor Digest,
Vol. 19, No. 3 &4, December 31, 2004, 52.
35
Berkshire Hathaway Annual Meeting, 2004 per Tren Griffin, Charlie Munger: The Complete Investor (New
York: Columbia Business School Press, 2015), 104.
36
Drake Baer, “Nine Books Billionaire Warren Buffett Thinks Everyone Should Read,” Business Insider,
September 2, 2014.
37
Libby Kane, “What Rich People Have Next to Their Beds,” Business Insider, June 17, 2014.
38
Richard C. Grinold, “The Fundamental Law of Active Management,” Journal of Portfolio Management, Vol.
15, No. 3, Spring 1989, 30-37; Richard C. Grinold and Ronald N. Kahn, Active Portfolio Management: A
Quantitative Approach for Producing Superior Returns and Controlling Risk, Second Edition (New York:
McGraw Hill, 2000), 147-169; Roger Clarke, Harindra de Silva, and Steven Thorley, “The Fundamental Law
of Active Portfolio Management,” Journal of Investment Management, Vol. 4, No. 3, Third Quarter 2006, 54-
72.
39
Barbara Mellers, Eric Stone, Terry Murray, Angela Minster, Nick Rohrbaugh, Michael Bishop, Eva Chen,
Joshua Baker, Yuan Hou, Michael Horowitz, Lyle Ungar, and Philip Tetlock, “Identifying and Cultivating
Thirty Years 19
August 4, 2016
Superforecasting as a Method of Improving Probabilistic Predictions,” Perspectives on Psychological Science,

Vol. 10, No. 3, May 2015, 267-281.
40
Keith E. Stanovich, Richard F. West, and Maggie E. Toplak, The Rationality Quotient: Toward a Test of
Rational Thinking (Cambridge, MA: MIT Press, 2016).
41
Shane Frederick, “Cognitive Reflection and Decision Making,” Journal of Economic Perspectives, Vol. 19,
No. 4, Fall 2005, 25-42.
42
Anders Ericsson and Robert Pool, Peak: Secrets from the New Science of Expertise (New York: Houghton
Mifflin Harcourt, 2016).
43
Glenn W. Brier, “Verification of Forecasts Expressed in Terms of Probability,” Monthly Weather Review, Vol.
78, No. 1, January 1950, 1-3.
44
Kevin Kelly, “The Three Breakthroughs That Have Finally Unleashed AI On the World,” Wired, October 27,
2014.
45
Michael J. Mauboussin, Dan Callahan, David Rones, and Sean Burns, “Managing the Man Overboard
Moment: Making an Informed Decision After a Large Price Drop,” Credit Suisse Global Financial Strategies,
January 15, 2015; Michael J. Mauboussin, Dan Callahan, Darius Majd, Greg Williamson, and David Rones,
“Celebrating the Summit: Making an Informed Decision After a Large Price Gain,” Credit Suisse Global
Financial Strategies, January 11, 2016.
46
Julia Rozovsky, “The Five Keys to a Successful Google Team,” November 17, 2015. See
https://rework.withgoogle.com/blog/five-keys-to-a-successful-google-team/.
Thirty Years 20
Limited, Credit Suisse Securities (Thailand) Limited, Credit Suisse Securities (Malaysia) Sdn Bhd, Credit Suisse AG, Singapore Branch, and elsewhere in the
world by the relevant authorized affiliate of the above.
Motley Fool - Michael Mauboussin Interview
Interview with Michael Mauboussin company has no debt or a lot of debt, its ROIC
Oct 18, 2016 at 4:47PM is the same. That's a useful feature.
Motley Fool analyst John Rotonti interviews John Rotonti: When you calculate ROIC or
Michael Mauboussin about returns on invested return on equity (ROE), do you prefer to
capital (ROIC), valuation, and behavioral keep goodwill in or take it out?
finance.
Michael Mauboussin: There are a host of
John Rotonti: How do you define a high- practical issues that you need to deal with
quality business? when you calculate ROIC, including the
treatment of goodwill. The simple answer is
Michael Mauboussin: A high-quality that I like to see it calculated both ways. For
business is one that is profitable, typically as a some companies, the difference is huge. For
result of high margins, has relatively low debt, example, in fiscal 2016, Cisco's (NASDAQ:
a very capable management team, and a CSCO) ROIC excluding goodwill is roughly 3
business that is unlikely to change abruptly in times higher than it is including goodwill.
the near term. So essentially it is a business
with a high return on invested capital and The longer answer is if a company has been
stable prospects. acquisitive and I would expect them to remain
so, I would lean toward leaving in goodwill. If
John Rotonti: How do you define a high- the company did a huge deal, is saddled with a
quality management team? lot of goodwill, and is not active in M&A, I
would lean toward removing it. The basic idea
Michael Mauboussin: All roads in behind excluding it is that you get a better
managerial evaluation lead to capital sense of the underlying economics of the
allocation. A high-quality management team is business.
one that knows how to take resources,
including capital and people, and put them to John Rotonti: I have found that in a lot of
their best and highest use. Quality executives cases, a business's high ROIC is driven by
are ethical, open-minded, thoughtful, judicious either high net operating profit after tax
risk-takers, transparent, and long-term (NOPAT) margins or high invested capital
oriented. turnover (sales/invested capital). What does
it say about a business if its high ROIC is
John Rotonti: Do you have a preferred driven by both high NOPAT margins and
measure for the returns a business is high capital efficiency? Are these businesses
generating? Return on assets? Return on of higher quality?
equity? Or return on invested capital?
Michael Mauboussin: Generally speaking,
Michael Mauboussin: All of these measures companies that achieve a high ROIC through
have limitations, but return on invested capital high margins and moderate to low capital
is my favorite of that group for a couple of velocity are associated with what Michael
reasons. First, there is a little less room for Porter calls a "differentiation" strategy. A high
manipulation when you use ROIC, which is ROIC through low margins and high turnover
net operating profit after tax, or NOPAT, is consistent with a "cost leadership" strategy.
divided by invested capital. NOPAT is cash Very few companies have both high margins
earnings before financing costs. You can and high turns, but you can certainly say they
calculate invested capital from the left or right have an enviable strategic position.
side of the balance sheet, which can provide
insight into the efficiency of asset utilization My colleague at Columbia Business School,
as well as financing choices. Bruce Greenwald, wrote a book called
Competition Demystified in which he
Second, ROIC is financing neutral. All of discusses three sources of competitive
those other measures can be manipulated by advantage: consumer advantage (akin to
changes in capital structure. So whether a differentiation), production advantage (cost
Page 1 of 5
leadership), and economies of scale. The high- commensurate rise in research and
margin, high-turn businesses have all three development as a percentage of sales.
sources of advantage working for them. Information-technology and health-care
companies, which rely more on intangible
John Rotonti: U.S. companies are assets, have margins that are higher than those
generating a lot of excess free cash flow of industrial, energy, and material companies
right now because ROICs are high but that use more tangible assets.
reinvestment is low. Could you explain
intelligent capital allocation? Should John Rotonti: In your opinion, is one source
companies invest every penny they can of competitive advantage stronger and
internally at high rates of return before more sustainable than another?
returning cash to shareholders through
dividends and buybacks? Michael Mauboussin: This is a tough
question to answer. The closest thing I've seen
Michael Mauboussin: First you have to to an empirical study of this question is the
answer the basic question of what the work by Michael Raynor and Mumtaz Ahmed,
company is trying to achieve. Assuming that consultants at Deloitte, that was discussed in
its goal is to build long-term value per share, I their book, The Three Rules. They analyzed
would say that capital allocation is all about thousands of companies going back to the
finding the opportunities with the best and 1960s and suggested that superior
highest use. Certainly I would have a bias performance, results that are above and
toward organic investments, such as capital beyond what luck allows, is the result of
expenditures. But there may be instances when companies following two rules. The first rule
repurchasing shares creates more value per is "better before cheaper." In other words, do
share than a capital expenditure does. The not compete on price. The second rule is
right answer to all capital allocation questions "revenue before cost." Successful companies
is "it depends." Specifically, it depends on the focus on increasing sales rather than cutting
relationship between price and value. costs. The title suggests a third rule, which,
irritatingly, is that there are no other rules.
A strong empirical finding is that companies
with rapid asset growth tend to have poor total Those rules seem closer to a differentiation
shareholder returns and companies with slow, strategy than a cost leadership strategy.
or even contracting, asset growth have good
returns. This tells you that it's hard to grow John Rotonti: For companies with high
rapidly and create a lot of value at the same ROIC, do you think it's useful to
time. Also, actions such as divestitures, spin- incorporate enterprise value/invested
offs, and buybacks can add value. capital as a valuation metric? I have
sometimes found that companies that have
John Rotonti: You recently pointed out that high ROIC and are trading at lower
the current cash flow return on investment multiples of invested capital (let's say
(CFROI) of U.S. companies is 9%, which is EV/invested capital less than 3) tend to also
50% higher than the long-term average of look attractive using other valuation
6%. What is driving such high returns? Is methodologies.
this sustainable?
Michael Mauboussin: Researchers
Michael Mauboussin: I don't know, but one established the relationship between return on
likely explanation is the shift in the nature of invested capital and price to book a while ago.
our economy. A generation or two ago, most This is what Warren Buffett has called the "$1
businesses invested primarily in tangible test." The basic idea is simple: If you invest so
assets. Think large factories capturing as to earn above the cost of capital, $1
economics of scale. But in recent years the deployed in the business is worth more than $1
economy has shifted toward intangible assets. in the market.
We see this in the 35-year fall in capital
expenditures as a percentage of sales and a
Page 2 of 5
I don't think it's a particularly good valuation part to address this potential scenario.
metric for a couple of reasons. First, unless Economic profit reflects the magnitude of the
you make a lot of adjustments, it is hard to get investment spread as well the amount of
comparable figures. Take the example of two capital invested.
retailers. One leases its stores and the other
buys them. The companies will have very To tie it back into my comment in question, it
different accounting figures on the surface, but turns out maximizing economic profit is what
would be much more similar if you capitalized maximizes the difference between enterprise
leases for the first one. So comparability is value and invested capital.
tricky.
John Rotonti: I know that no one metric is
Second, the ratio does not take growth into appropriate for all businesses. But do you
consideration. Imagine you have a pair of have a particular measure of cash flow that
businesses that have the same positive return you prefer when analyzing most businesses?
spread in excess of the cost of capital, but one Operating cash flow less capital
of the businesses is growing much faster than expenditures? EBITDA less capital
the other. The faster-growing business will expenditures? Net income plus depreciation
have a justifiably higher ratio of enterprise and amortization? Owner earnings?
value/invested capital.
Michael Mauboussin: I believe one of the
My preferred way to value all business is a constants in our industry is that the value of a
discounted cash flow (DCF) model. You can business is the present value of free cash flow.
use multiples to supplement the core DCF It doesn't matter what kind of business it is.
model, but I think DCF should be at the center Businesses have different paths to generating
of valuation. free cash flow, but that's the universal source
of value.
John Rotonti: In 1995 you wrote,
"Although our analysis firmly suggests that Free cash flow (FCF) is technically defined as
the market appreciates high-return net operating profit after tax (NOPAT) minus
businesses, it is incorrect to conclude that a investments in future growth. You can think of
manager's sole objective is to maximize NOPAT as the cash profit a company would
returns on invested capital. In fact, have if it had no financial leverage.
management's prime goal should be to Investments include changes in net working
maximize the difference between enterprise capital, capital expenditures (commonly
value and invested capital." Does your expressed as net of depreciation), and mergers
recent research still suggest this to be the and acquisitions.
case?
Some of the measures you mentioned are
Michael Mauboussin: Right, this is an proxies for FCF, but there's no reason not to
extension of the prior point. Value creation calculate the correct number instead of using
requires that a company invests above the cost proxies.
of capital. Once a company earns appropriate
returns, growth amplifies value creation. John Rotonti: Is there a single best measure
or proxy for growth of intrinsic value?
Here's how the issue might arise. Imagine that
a company sets up an incentive program for Michael Mauboussin: I have never used a
executives that rewards simply the spread proxy for this concept, but it would be a
between ROIC and the cost of capital. combination of ROIC and growth. The basic
Executives at that company may be tempted to idea is that for companies earning an ROIC
only accept very high ROIC projects and similar to the cost of capital, growth does not
indeed to reject value-creating projects that matter much. But as the spread becomes a
diminish the spread of ROIC to the cost of larger positive, the importance of growth is
capital. The measure of economic value added, amplified.
a version of economic profit, was developed in
Page 3 of 5
John Rotonti: How do you evaluate a
company's balance sheet? Do you look for a Operating unit heads should be paid on key
particular coverage or debt ratio? value drivers of their business — typically
sales growth, operating profit margins, and
Michael Mauboussin: First, it is important to capital intensity. Finally, front-line employees
make sure that you properly recognize all of should get paid on the metric they can control.
the liabilities. Leases, underfunded pensions, For example, you might offer an incentive for
and equity compensation are some examples an accounts receivable clerk to collect money
of items that you need to capture. more efficiently.
From there, I don't do anything fancy. I mostly In each case, the overarching goal is to match
look at coverage ratios and the volatility of the compensation with what the employee can
cash flows. The ratings agencies also have control.
very good base rate data on the rate of default
by rating, so that can be a helpful input into John Rotonti: What is one question you
the thinking. think investors should ask of each
management team?
John Rotonti: Some high ROIC businesses
have shareholder deficits (negative book Michael Mauboussin: I'm not sure there is
value) because of large share repurchases. one question that all investors should ask. But
Are businesses that lack book equity value I think there are three things that you should
inherently riskier investments? bear in mind when you meet management.
Michael Mauboussin: No. The value of a First, how can you have a conversation that is
business is the present value of the future free different than the conversations of other
cash flow, and the accounting for book value investors? If you just let management walk
has little bearing on that. The only caveat is if through their slide deck, you will not hear
a company has commitments or instruments anything novel.
with covenants tied to measures such as book
value. But from an economic point of view, Second, you should be aware that we all have
negative book value is not a concern. a tendency to be optimistic about things that
are important to us. So executives are typically
When I started out as an analyst, I followed overly optimistic. Recognize that. At the same
Ralston Purina, a company that was aggressive time, most people are pretty accurate in
in buying back shares. I documented the evaluating those around them. So ask
growing disparity between book value, which management about suppliers, competitors, and
was going down, and market value, which was customers, and you may get more accurate
going up. answers than if you ask them about
themselves.
John Rotonti: Do you have any
performance metrics that you prefer Finally, I always try to understand how
management compensation be based on? management thinks about capital allocation
decisions. I'm less interested in the details of
Michael Mauboussin: Expectations Investing, what they might do, although that's important,
a book I co-authored with my mentor Al and am more interested in how they think
Rappaport, has a chapter dedicated to this about the topic in general.
topic. We argue that C-level executives can be
compensated with equity but that the options John Rotonti: Which qualities lead to share
or restricted stock units should be indexed to outperformance over a long period of time?
the market or an appropriate peer group. The
idea is that you should be willing to pay dearly Michael Mauboussin: There is no formula.
for superior relative performance, rather than The excess returns for high ROIC businesses
let the vagaries of the market determine the are not exceptional, because the market knows
bulk of the pay. they are high ROIC businesses.
Page 4 of 5
John Rotonti: Is there a question about
The best answer is that a stock starts off with investing that I should be asking you that
low expectations and then consistently I've missed?
delivers results better than what the market
anticipated. Not very helpful but accurate. Michael Mauboussin: The work I'm excited
by now has to do with reference-class
John Rotonti: What step(s) should investors forecasting. Danny Kahneman has popularized
take to try avoid value traps? this with the idea of the "inside" versus
"outside" view. The basic idea is that we
Michael Mauboussin: Value traps are usually naturally try to forecast by gathering
the result of a business that is structurally information that we combine with our own
disadvantaged. So the best advice is to think input. That's the inside view. Think of a
deeply about sustainable competitive college student considering when she will
advantage. Research also shows that analysts complete a term paper. She will think about
tend to miss estimates more on the downside how hard the assignment appears to be, will
than on the upside, and that's important to bear consider her schedule, and project a date that
in mind. she will be done.
John Rotonti: What do you think is the The outside view, by contrast, considers the
most important lesson investors should problem as an instance of a larger reference
learn from the field of behavioral finance? class. It basically asks the question, "what
happened when other people were in this
Michael Mauboussin: There are really two situation before?" It is an unnatural way to
threads. The first is the work on heuristics and think because you have to discount your
biases. The basic idea is that we all tend to use personal information and then find and appeal
heuristics, or rules of thumb, which save us a to a base rate. So in the case of our college
great deal of time and are generally quite student, she would ask "when other students
accurate. But these heuristics come with had a similar paper due, how long did it take
associated biases, which can lead to poor them to complete it?"
decisions. There is a very long list of biases,
but some of the most important ones for Perhaps it will come as no surprise that the
investors include overconfidence, outside view commonly provides a more
confirmation, framing, recency, and accurate, and pessimistic answer, than the
anchoring. inside view.
The second thread is on prospect theory, Investors can incorporate the outside view in
which shows that our decisions in risky many aspects of their jobs, from modeling
settings are less than optimal. A classic corporate performance to assessing M&A. I
example is loss aversion, the idea that we think it's a really powerful tool that is
suffer losses roughly twice as much as generally underutilized.
comparably sized gains.
John Rotonti: What do you think is the

most common behavioral bias?
Michael Mauboussin: I don't know which is

most common, but confirmation bias is a
dangerous one because it prevents us from
appropriately updating our views when new
information arrives. It is very hard to sidestep
as an investor.
Page 5 of 5
Capital Allocation
Evidence, Analytical Methods, and Assessment Guidance
October 19, 2016
Authors
Dan Callahan, CFA

Darius Majd
Capital allocation is a senior management team’s most fundamental

responsibility. The problem is that many CEOs don’t know how to allocate
capital effectively. The objective of capital allocation is to build long-term
value per share.
Capital allocation is always important but is especially pertinent today
because return on invested capital is high, growth is modest, and
corporate balance sheets in the U.S. have substantial cash.
Internal financing represented more than 90 percent of the source of total
capital for U.S. companies from 1980-2015.
M&A, capital expenditures, and R&D are the largest uses of capital for
operations, and companies now spend more on buybacks than dividends.
This report discusses each use of capital, shows how to analyze that use,
reviews the academic findings, and offers a near-term outlook.
We provide a framework for assessing a company’s capital allocation
skills, which includes examining past behaviors, understanding incentives,
and considering the five principles of capital allocation.
October 19, 2016
Table of Contents
Executive Summary ....................................................................................................................... 3
Introduction ................................................................................................................................... 4
Groundwork: Where Does the Money Come From and Where Has It Gone? ........................................ 6
Sources of Capital.............................................................................................................. 7
Uses of Capital .................................................................................................................. 9
Recent Trends in Cash Flow Return on Investment and Asset Growth .................................... 15
Capital Allocation Alternatives ....................................................................................................... 18

Mergers and Acquisitions .................................................................................................. 18
Capital Expenditures ......................................................................................................... 25
Research and Development............................................................................................... 29
Net Working Capital ......................................................................................................... 31
Divestitures ..................................................................................................................... 34
Dividends ........................................................................................................................ 36
Share Buybacks............................................................................................................... 40
Assessing Management’s Capital Allocation Skills ........................................................................... 45

Past Spending Patterns .................................................................................................... 45
Calculating Return on Invested Capital and Return on Incremental Invested Capital.................. 47
Incentives and Corporate Governance ................................................................................ 49
Five Principles of Capital Allocation .................................................................................... 52
Conclusion .................................................................................................................................. 54
Acknowledgment ......................................................................................................................... 55
Checklist for Assessing Capital Allocation Skills .............................................................................. 56
Endnotes .................................................................................................................................... 57
References ................................................................................................................................. 65
Books ............................................................................................................................. 65
Articles and Papers .......................................................................................................... 67
Capital Allocation 2
October 19, 2016
Executive Summary
Capital allocation is the most fundamental responsibility of a senior management team of a public
corporation. The problem is that many CEOs, while almost universally well intentioned, don’t know how to
allocate capital effectively. The proper goal of capital allocation is to build long-term value per share. The
emphasis is on building value and letting the stock market reflect that value. Companies that dwell on
boosting their short-term stock price frequently make decisions that are at odds with building value.
Capital allocation is always important but is especially pertinent in the United States today given the high
return on invested capital, modest growth, and substantial cash on corporate balance sheets. Companies
that deploy capital judiciously have a significant opportunity to build value.
Internal financing represented more than 90 percent of the source of total capital for U.S. companies from
1980-2015. This is a higher percentage than that of other developed countries including the United
Kingdom, Germany, France, and Japan.
Mergers and acquisitions (M&A), capital expenditures, and research and development (R&D) are the
largest uses of capital for operations. In the past 35 years, capital expenditures are down, and R&D is up,
as a percentage of sales. This reflects a shift in the underlying economy. M&A is the largest use of capital
but follows the stock market closely. More deals happen when the stock market is up.
The amount companies have spent on buybacks has exceeded dividends for the past decade, except for
2009. Buybacks did not become relevant in the U.S. until 1982, so you should treat comparisons of
yields before and after 1982 with caution. Research shows that the overall proclivity to return cash has not
changed much over the decades, but the means by which the payout occurs has shifted.
Academic research shows that rapid asset growth is associated with poor total shareholder returns.
Further, companies that contract their assets often create substantial value per share. Ultimately, the
answer to all capital allocation questions is, “It depends.” Most actions are either foolish or smart based on
the price and value.
Divestitures are substantial and generally create value. If the buyers tend to lose value, it stands to reason
that the sellers gain value. Selling or spinning off poor performing businesses can lead to addition by
subtraction.
Past spending patterns are often a good starting point for assessing future spending plans. Once you
know how a company spends money, you can dig deeper into management’s decision-making process.
Further, it is useful to calculate return on invested capital and return on incremental invested capital.
These metrics can provide a sense of the absolute and relative effectiveness of management’s spending.
Understanding incentives for management is crucial. Assess the degree to which management is focused
on building value and addressing agency costs.
The five principles of value creation include: zero-based capital allocation; fund strategies, not projects; no
capital rationing; zero tolerance for bad growth; and know the value of assets and be prepared to take
action.
October 19, 2016
Introduction
Capital allocation is the most fundamental responsibility of a senior management team of a public corporation.
Successful capital allocation means converting inputs, including money, things, ideas, and people, into
something more valuable than they would be otherwise. The net present value (NPV) test is a simple,
appropriate, and classic way to determine whether management is living up to this responsibility. Passing the
NPV test means that $1 invested in the business is worth more than $1 in the market. This occurs when the
present value of the long-term cash flow from an investment exceeds the initial cost.
Why should value determine whether a management team is living up to its responsibility? There are two
reasons. The first is that companies must compete. A company that is allocating its resources wisely will
ultimately prevail over a competitor that is allocating its resources foolishly. The second is that inputs have an
opportunity cost, or the value of the next best alternative. Unless an input is going to its best and highest use,
it is underperforming relative to its opportunity cost.
The process of making inputs more valuable has a number of aspects. A logical starting point is a strategy.
Properly conceived, a strategy requires a company to specify the trade-offs it will make to establish a position
in the marketplace that creates value. A strategy also requires a company to align its activities with its
positioning and to execute effectively.1
Since a company’s strategy is often already in place when a new chief executive officer (CEO) takes over,
capital allocation generally becomes his or her main responsibility. While a proper and comprehensive
discussion of capital allocation requires a consideration of intangible and human resources, our focus here is
on how companies spend money.
The problem is that many CEOs, while almost universally well intentioned, don’t know how to allocate capital
effectively. Warren Buffett, chairman and CEO of Berkshire Hathaway, describes this reality in his 1987 letter
to shareholders. He discusses the point of why it is beneficial for Berkshire Hathaway’s corporate office to
allocate the capital of the companies it controls. Buffett is worth quoting at length:2
This point can be important because the heads of many companies are not skilled in capital
allocation. Their inadequacy is not surprising. Most bosses rise to the top because they have excelled
in an area such as marketing, production, engineering, administration or, sometimes, institutional
politics.
Once they become CEOs, they face new responsibilities. They now must make capital allocation
decisions, a critical job that they may have never tackled and that is not easily mastered. To stretch
the point, it’s as if the final step for a highly-talented musician was not to perform at Carnegie Hall but,
instead, to be named Chairman of the Federal Reserve.
The lack of skill that many CEOs have at capital allocation is no small matter: After ten years on the
job, a CEO whose company annually retains earnings equal to 10% of net worth will have been
responsible for the deployment of more than 60% of all the capital at work in the business.
CEOs who recognize their lack of capital-allocation skills (which not all do) will often try to compensate
by turning to their staffs, management consultants, or investment bankers. Charlie [Munger] and I
have frequently observed the consequences of such “help.” On balance, we feel it is more likely to
accentuate the capital-allocation problem than to solve it.
In the end, plenty of unintelligent capital allocation takes place in corporate America. (That's why you
hear so much about “restructuring.”)
October 19, 2016
Intelligent capital allocation requires understanding the long-term value of an array of opportunities and
spending money accordingly. It also includes knowing the value of a firm’s individual assets and being willing
to sell them when they are worth more to others.
We believe that long-term growth in value per share should guide capital allocation decisions. A necessary
corollary is that there is a time when shrinking the business is the most beneficial course for ongoing
shareholders. In some cases, for instance, buying back shares is a wiser choice than expanding by means of
capital expenditures or acquisition.
Capital allocation is a dynamic process, so the correct answer to most questions is, “It depends.” Sometimes
acquiring makes sense and other times divesting is the better alternative. There are times to issue equity and
times to retire it. Because the components that determine price and value are changing constantly, so too
must the assessments that a CEO makes. As Buffett says, “The first law of capital allocation—whether the
money is slated for acquisitions or share repurchases—is that what is smart at one price is dumb at another.”3
Buffett also discusses what he calls the “institutional imperative,” a force that is also pertinent.4 The force has
multiple aspects as he describes it, but a pair of them are relevant here. One is that subordinates will readily
create spreadsheets and studies to support the business craving of the leader. Another is that companies will
“mindlessly” imitate one another, whether in M&A or executive compensation.
The message here should be clear. A decision isn’t good just because someone in the organization can justify
it or because some other company is doing it. Proper capital allocation requires a sharp analytical framework
and independence of mind.
In our experience, very few CEOs, and chief financial officers for that matter, have what we call the “North
Star of value.” The North Star is not the brightest star, but it doesn’t move much throughout the night or year.
As a result, it provides a reliable sense of direction. Likewise, companies that have a North Star of value have
an unwavering view of value no matter what is going on. It is common for executives to solicit input from a
range of stakeholders, hear varying points of view, and walk away confused and unsure about the proper
course of action. This doesn’t happen to executives with the North Star of value, especially since they may
have better information about their company’s prospects than the market does.
Incentives are another barrier to proper capital allocation. An executive who is paid to deliver a target based on
short-term earnings per share may well act very differently than an executive who is focused on building long-
term value per share. In assessing management, ask a fundamental question: If there is a conflict between
maximizing a reward based on the incentive plan and creating long-term value per share, which route will the
executive select?
William Thorndike’s excellent book, The Outsiders: Eight Unconventional CEOs and Their Radically Rational
Blueprint for Success, deeply inspired this report.5 Thorndike shares the stories of eight CEOs who created
tremendous value per share during their tenures. One theme that comes out clearly in the book, and is explicit
in the subtitle, is that these CEOs appeared out of step with conventional wisdom as they were building value.
The North Star of value guided their decisions, and they had the independence of mind to make the best
choices.
October 19, 2016
This report has three parts:
1. Groundwork. This part starts by showing the sources of capital. It then specifies capital allocation
options, shows how companies have allocated capital in the past 35 years, and explains why this issue
of capital allocation is particularly relevant today.
2. Capital allocation alternatives. This section documents how much money companies have allocated
to each alternative over time, offers an analytical framework for judging value creation, summarizes the
academic research on the payoffs to such investments, and provides a brief outlook for spending.
3. Assessing a company’s capital allocation skills. This part discusses methods to assess past
capital allocation choices, how to evaluate incentives, and the five principles of capital allocation.
Groundwork: Where Does the Money Come From and Where Has It Gone?
If the job of management is to deploy capital so as to add value, it makes sense to start with a discussion of
where capital comes from and how management teams have spent it in the past. The sources of capital
include the cash the business generates and access to the capital of claimholders, including debtors and
shareholders. A company can also sell an asset, which is a one-time realization of the cash flow the asset is
expected to generate over its life.
Businesses that grow rapidly generally require a sizable amount of investment. For example, imagine a
restaurant concept that is highly successful. To satiate demand that firm must build lots of restaurants and
hence invest a substantial sum in expansion. The rate of return on incremental capital is the maximum growth
rate in operating profit a business can reach without external financing. By extension, a company with a return
on invested capital (ROIC) greater than its growth rate will generate surplus capital.6
Companies that cannot fund their growth internally must access cash externally, either by borrowing or selling
equity. The pecking order theory is an idea in corporate finance that says that managers of companies will
typically choose to fund investments first with cash that the company generates internally, next with debt, and
finally with equity.7 One essential tenet of thoughtful capital allocation is that all capital has an opportunity cost,
whether the source is internal or external.
The uses of capital are where money goes. Executives can invest in the business through capital expenditures,
increases in working capital, research and development, or mergers and acquisitions. These investments allow
a company to grow. But growth, in and of itself, is never the goal of a thoughtful capital allocator. The proper
metric of success is an increase in long-term value per share.
A company can also return cash to debt and equity holders. Debt repayment, a return of some or all principal
and interest a company owes, is straightforward. A company can return cash to shareholders either by paying
a dividend, where all holders receive the same amount, or by buying back stock. In a buyback, shareholders
sort themselves. Those who want cash sell their shares and those who want to increase their stake in the
company hold their shares. A dividend treats all shareholders the same no matter what the stock price.
In a buyback, selling shareholders benefit at the expense of ongoing shareholders if the stock is overvalued,
and ongoing shareholders benefit at the expense of selling shareholders if the stock is undervalued. All
shareholders are treated uniformly only if the stock price is at fair value.8
October 19, 2016
Exhibit 1 summarizes the sources and uses of financial capital. These follow closely the alternatives and
choices that Thorndike specifies in The Outsiders.
Exhibit 1: Sources and Uses of Financial Capital

Capital sources Capital allocation
Capital expenditures
Operational cash flow Working capital
Business Business
Asset sales Mergers/acquisitions
Research & development
Cash dividends
Access cash Equity issuance Return cash
Share buybacks
from claimholders Debt issuance to claimholders
Debt repayment
Sources of Capital. Exhibit 2 shows the sources of capital for companies in the U.S. from 1980 through
2015. Internal financing, or the cash generated by the businesses, represented more than 90 percent of the
total source of capital during this period. If we extend this analysis back to include all of the years following
World War II, internal funding is still more than 80 percent of the total source of capital. Issuance of new debt
is the next most significant source of capital. Equity has been a negative source of capital, which means that
companies have bought back more shares than they have issued.
Exhibit 2: U.S. Sources of Capital, 1980-2015

Internal Financing
140% New Debt
New Equity
120%
100%
80%
60%
40%
20%
0%
-20%
-40%
-60%
1985
2005
1980
1990
1995
2000
2010
2015
Source: Board of Governors of the Federal Reserve System, Division of Research and Statistics, Flow of Funds Accounts Table F.103.
October 19, 2016
Internal financing represents a larger percentage of the total source of capital for companies in the U.S. than
for companies in other developed countries. For example, internal financing has been about 70 percent of the
total source for the United Kingdom, 66 percent for Germany, 55 percent for France, and 50 percent for
Japan.9 The ratio of internal financing to the total source of capital tends to correlate with the underlying return
on invested capital. A country with a high ROIC can fund a greater percentage of its investments with
internally generated cash than a country with a low ROIC.
There are pros and cons to having internal financing represent a high percentage of investment funding. The
pro is that companies are earning high returns on capital in general and need not rely on capital markets to
fund their growth. The con is that companies can deploy internally generated funds into value-destroying
investments. The need to raise money from the capital markets creates a check on management’s spending
plans.
Indeed, Peter Bernstein, the renowned financial historian and economist, once suggested that all companies
should be required to pay out 100 percent of their earnings and then appeal to the markets when they want
funds for investment. He argued that markets are more effective than companies at allocating capital, and as
a result the overall effectiveness of capital allocation would improve if left to the devices of the market.10
The choice of debt or equity as a source of funding also determines capital structure. Exhibit 3 shows the
debt-to-total capital ratio for the largest companies in the U.S. from 1950 through 2015. We define the debt-
to-total capital ratio as the book value of debt divided by the sum of the book value of debt and the market
value of equity. The ratio is currently 19 percent, just below the long-term average of about 20 percent. The
availability and cost of debt, along with the appetite for debt and the general level of stock prices, determine
this ratio.
Exhibit 3: U.S. Debt-to-Total Capital, 1950-2015

40%
35%
30%
25%
Average
20%
15%
10%
5%
0%
1950
1955
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
2010
2015

Note: For data back to 1920, see John R. Graham, Mark T. Leary and Michael R. Roberts, “A Century of Capital Structure: The Leveraging of
Corporate America,” Journal of Financial Economics, Vol. 118, No. 3, December 2015, 658-683.
October 19, 2016
Uses of Capital. Exhibit 4 shows how the top 1,500 companies in the U.S., excluding companies in the
financial services and regulated utility industries, deployed capital in 2015. While just a snapshot for a
particular year, the ranking reasonably reflects how companies in the U.S. have allocated capital over time.
Exhibit 4: U.S. Capital Deployment, 2015

Total Dollar Amount ($ Billions) Total as a Percentage of Sales
Mergers & Acquisitions Mergers & Acquisitions
Capital Expenditures Capital Expenditures
Gross Buybacks Gross Buybacks
Divestitures Divestitures
Dividends Dividends
Research & Development Research & Development
Change in Net Working Capital Change in Net Working Capital
-400 0 400 800 1,200 1,600 2,000 -5% 0% 5% 10% 15% 20%
Source: Credit Suisse HOLT and Thomson Reuters.

Note: Data for R&D, capital expenditures, working capital, buybacks, and dividends exclude financial companies and regulated utilities; data for mergers
& acquisitions and divestitures include all industries.
Exhibit 5 shows the breakdown of spending by source from 1980-2015.
Exhibit 5: U.S. Capital Deployment, 1980-2015

100% Change in net working capital
Gross buybacks
90%
80%
Dividends
70%
Divestitures
60%
50%
40%
30%
20% Mergers & acquisitions
10%
0%
1980
1985
1990
1995
2000
2005
2010
2015

Note: Data for R&D, capital expenditures, working capital, buybacks, and dividends exclude financial companies and regulated utilities; data for mergers
& acquisitions and divestitures include all industries.
October 19, 2016
Similar to 2015, mergers and acquisitions (M&A) and capital expenditures are the largest uses of capital over
time. An examination of the changes from 1980 through 2015 reveals some noteworthy patterns:
M&A is by far the largest use of capital, but it is very cyclical, ranging from a low of less than 1 percent of
sales in 1980 to almost 30 percent at its peak in the late 1990s. M&A activity tends to be greatest when
the economy is doing well, the stock market is up, and access to capital is easy. As a result, companies
frequently do deals when they can, rather than when they should.
Capital expenditures went from roughly 10 percent of sales to approximately 6 percent over this period.
The simplest explanation is that the composition of the economy has changed, with businesses that
require less capital investment replacing those that require more. (See Exhibits 6 and 7.) For example,
the energy, materials, and industrial sectors represented 50 percent of the market capitalization of the
top 1,500 companies in the U.S. market in 1980 but just 19 percent in 2015. During the same time, the
healthcare and technology sectors went from 18 to 34 percent of the market capitalization. This shift also
helps explain the increase in cash holdings.11 Another possible cause of the dip in capital expenditures is
that public companies are now investing too little. Academic research suggests that public companies
invest less than comparable private companies because they want to maximize short-term earnings.12
Share buybacks went from being virtually nonexistent in 1980 to a large use of capital in the last decade.
In 1982, the Securities and Exchange Commission defined rules that created a safe harbor for
companies to repurchase shares, eliminating the threat of stock manipulation and opening the floodgates
for buybacks. Over the past 30 years, companies have shifted their payouts from mostly dividends to a
combination of dividends and buybacks. Research shows that the propensity to distribute cash to
shareholders has held remarkably steady after accounting for firm characteristics including size, age, and
profitability.13
Research and development (R&D) expenditures have risen steadily, growing from 1.3 percent of sales in
1980 to 2.7 percent in 2015. The shift in the composition of the economy that accounts for the decline
in capital expenditures also explains the rise in R&D (see Exhibits 6 and 8). Further, companies that rely
on R&D tend to hold more cash than companies that are less reliant on R&D. This partially accounts for
the swell of cash on corporate balance sheets.
October 19, 2016
Exhibit 6: U.S. Sector Composition, 1980-2015

100%
90% Financials
80% Utilities
Telecom
70%
60%
50% Healthcare
40% Consumer Staples
30%
20%
Industrials
10%
Materials
Energy
0%
1980
1985
1990
1995
2000
2005
2010
2015
Source: Credit Suisse HOLT.
Exhibit 7: U.S. Capital Expenditures by Sector, 1980-2015

100% Utilities
Telecom
90%
80%
Healthcare
60%
50%
Industrials
40%
Materials
30%
20% Energy
10%
0%
1980
1985
1990
1995
2000
2005
2010
2015
October 19, 2016
Exhibit 8: U.S. R&D Spending by Sector, 1980-2015

100% Telecom
90%
80%
70%
60%
50%
Healthcare
40%
20% Consumer Discretionary
10% Industrials
Materials
0% Energy
1980
1985
1990
1995
2000
2005
2010
2015
Exhibit 9 shows a detailed history of capital deployment from 1980-2015, adjusted for inflation. It is worth
noting that the standard deviations of the growth rates, which appear in the bottom row, are small for R&D,
dividends, and capital spending relative to those of buybacks, M&A, and divestitures. Standard deviation is a
measure of how much something varies from an average. These standard deviations provide a glimpse into
how managers think about each use of capital. The lower the standard deviation, the more sacrosanct
management deems that investment. Exhibit 10 represents the same deployment numbers as a percentage of
sales.
October 19, 2016

Total Amount (2015 U.S. Dollars)
Mergers & Capital Research & Net Working Gross
Acquisitions Expenditures Development Capital Buybacks Divestitures Dividends
1980 50,253 520,088 71,993 53,889 14,814 1,521 116,637
1981 225,381 535,670 75,389 29,533 12,405 25,301 117,228
1982 141,179 488,507 80,637 -20,946 22,322 27,259 118,820
1983 242,876 409,811 85,940 47,519 20,049 77,761 123,750
1984 432,992 432,518 96,678 43,126 58,173 107,366 123,384
1985 420,956 449,881 100,102 11,726 87,281 110,364 121,425
1986 478,144 405,798 106,112 35,233 73,544 165,118 129,918
1987 461,134 370,220 108,061 75,116 91,665 160,599 130,690
1988 683,271 413,880 116,515 72,474 91,304 224,691 144,549
1989 553,739 428,250 120,284 229,262 79,220 177,805 139,242
1990 295,383 431,375 121,259 -5,211 64,057 122,457 134,137
1991 212,445 412,048 126,159 -5,887 40,124 83,928 133,087
1992 237,390 401,240 131,563 15,384 48,380 125,253 135,096
1993 378,627 405,027 134,359 53,161 60,386 136,471 133,051
1994 523,395 421,951 134,075 19,195 59,425 219,842 134,194
1995 766,489 472,148 153,712 65,064 103,342 346,251 143,091
1996 878,719 512,665 160,048 55,453 119,630 265,616 148,451
1997 1,288,698 570,647 180,472 78,888 173,504 461,206 149,023
1998 2,211,845 571,514 195,959 -58,454 222,428 382,228 153,364
1999 2,096,708 583,005 195,966 137,396 220,897 497,837 152,342
2000 2,250,465 642,519 214,058 -26,512 205,321 465,041 149,768
2001 985,141 611,609 223,344 83,590 168,343 413,595 141,818
2002 567,655 476,106 211,652 56,163 162,106 226,265 141,566
2003 711,817 450,099 215,801 159,293 168,725 285,682 150,398
2004 946,576 479,226 219,677 213,068 270,130 309,075 164,195
2005 1,329,986 521,592 224,934 13,320 386,924 425,874 181,276
2006 1,705,809 611,430 252,409 1,288 519,635 516,336 197,417
2007 1,613,404 651,015 247,862 41,035 622,232 590,845 209,102
2008 993,147 689,575 248,657 -25,491 441,422 309,937 219,827
2009 813,603 514,902 218,910 213,845 170,067 281,834 203,868
2010 866,109 570,059 239,529 192,518 323,887 300,931 213,699
2011 1,009,828 677,709 253,902 102,394 456,780 401,076 234,980
2012 791,509 727,572 267,333 221,022 399,896 379,758 263,139
2013 993,971 741,901 274,193 193,479 485,084 375,795 296,421
2014 1,377,516 793,966 294,884 -5,214 557,870 472,373 327,354
2015 1,795,752 709,394 299,654 135,221 572,826 491,768 354,687
CAGR 10.8% 0.9% 4.2% 2.7% 11.0% 18.0% 3.2%
St. Dev. 67.0% 10.2% 5.2% 737.6% 45.0% 265.0% 5.3%
Source: Credit Suisse HOLT; Thomson Reuters; Credit Suisse.
Note: All figures in 2015 U.S. dollars (millions); R&D, capital expenditures, working capital, buybacks, and dividends is the top 1,500 “industrials” (ex-
financials and regulated utilities), whereas M&A and divestitures include all industries.
October 19, 2016

As a Percentage of Sales
Mergers & Capital Research & Net Working Gross
Acquisitions Expenditures Development Capital Buybacks Divestitures Dividends
1980 0.9% 9.7% 1.3% 1.0% 0.3% 0.0% 2.2%
1981 4.2% 10.1% 1.4% 0.6% 0.2% 0.5% 2.2%
1982 2.8% 9.7% 1.6% -0.4% 0.4% 0.5% 2.4%
1983 4.8% 8.2% 1.7% 0.9% 0.4% 1.5% 2.5%
1984 8.4% 8.4% 1.9% 0.8% 1.1% 2.1% 2.4%
1985 8.3% 8.9% 2.0% 0.2% 1.7% 2.2% 2.4%
1986 9.8% 8.3% 2.2% 0.7% 1.5% 3.4% 2.7%
1987 9.2% 7.4% 2.2% 1.5% 1.8% 3.2% 2.6%
1988 12.9% 7.8% 2.2% 1.4% 1.7% 4.2% 2.7%
1989 10.2% 7.9% 2.2% 4.2% 1.5% 3.3% 2.6%
1990 5.3% 7.7% 2.2% -0.1% 1.2% 2.2% 2.4%
1991 3.8% 7.4% 2.3% -0.1% 0.7% 1.5% 2.4%
1992 4.2% 7.1% 2.3% 0.3% 0.9% 2.2% 2.4%
1993 6.5% 6.9% 2.3% 0.9% 1.0% 2.3% 2.3%
1994 8.5% 6.8% 2.2% 0.3% 1.0% 3.6% 2.2%
1995 11.7% 7.2% 2.3% 1.0% 1.6% 5.3% 2.2%
1996 12.6% 7.4% 2.3% 0.8% 1.7% 3.8% 2.1%
1997 17.3% 7.6% 2.4% 1.1% 2.3% 6.2% 2.0%
1998 29.6% 7.7% 2.6% -0.8% 3.0% 5.1% 2.1%
1999 26.8% 7.4% 2.5% 1.8% 2.8% 6.4% 1.9%
2000 26.7% 7.6% 2.5% -0.3% 2.4% 5.5% 1.8%
2001 11.7% 7.3% 2.7% 1.0% 2.0% 4.9% 1.7%
2002 7.0% 5.8% 2.6% 0.7% 2.0% 2.8% 1.7%
2003 8.2% 5.2% 2.5% 1.8% 1.9% 3.3% 1.7%
2004 9.9% 5.0% 2.3% 2.2% 2.8% 3.2% 1.7%
2005 13.3% 5.2% 2.2% 0.1% 3.9% 4.3% 1.8%
2006 16.1% 5.8% 2.4% 0.0% 4.9% 4.9% 1.9%
2007 15.2% 6.1% 2.3% 0.4% 5.9% 5.6% 2.0%
2008 9.0% 6.2% 2.2% -0.2% 4.0% 2.8% 2.0%
2009 8.4% 5.3% 2.3% 2.2% 1.8% 2.9% 2.1%
2010 8.2% 5.4% 2.3% 1.8% 3.1% 2.8% 2.0%
2011 8.7% 5.9% 2.2% 0.9% 4.0% 3.5% 2.0%
2012 6.8% 6.2% 2.3% 1.9% 3.4% 3.2% 2.2%
2013 8.4% 6.3% 2.3% 1.6% 4.1% 3.2% 2.5%
2014 11.2% 6.5% 2.4% 0.0% 4.5% 3.8% 2.7%
2015 15.3% 6.1% 2.6% 1.2% 4.9% 4.2% 3.0%
Source: Credit Suisse HOLT; Thomson Reuters; Credit Suisse.
Note: R&D, capital expenditures, working capital, buybacks, and dividends is the top 1,500 “industrials” (ex-financials and regulated utilities), whereas
M&A and divestitures include all industries.
The issue of judicious capital allocation is certainly nothing new. Henry Singleton, the CEO whom William
Thorndike holds up as the standard for excellence, started his company, Teledyne, more than 50 years ago.
And Buffett’s quote about capital allocation is more than a quarter century old. Still, the issue feels particularly
pressing today.
October 19, 2016
Recent Trends in Cash Flow Return on Investment and Asset Growth. Larry Fink, the chairman and
CEO of BlackRock, Inc., an investment firm with more than $5.1 trillion in assets under management,
captured the current zeitgeist in a letter dated February 1, 2016. Addressed to the leaders of large global
corporations, the letter argued that many companies are shying away from investments with long-term payoffs
in favor of returning cash to shareholders via dividends and buybacks. In effect, Fink argued that the chiefs of
industry are misallocating capital.14
Let’s turn to some concepts and numbers to quantify Fink’s assertion. The maximum earnings growth rate a
company can achieve through internal funding is a function of its ROIC and payout ratio. High ROICs and low
payout ratios allow for greater achievable growth rates than low ROICs and high payout ratios. Low ROIC or
high payout businesses can certainly grow but need to access debt or equity capital to do so.
Here are the numbers. Cash flow return on investment (CFROI®) remains high in the U.S. (see Exhibit 11).
CFROI measures the cash returns a business earns on the investments it makes. Since CFROI is also
adjusted for inflation, it is an ideal tool for comparing results over time. The current level of 9.2 percent is well
above the historical average of approximately 6.6 percent from 1951-2015. The number is even higher
excluding the excess cash parked on the balance sheets of many companies. The current levels of ROIC and
CFROI suggest that companies today can fund substantial growth through internally-generated funds.
Exhibit 11: U.S. CFROI, 1951-2015

12
10
8
Average
Percent
0
1975
2015
1951
1955
1959
1963
1967
1971
1979
1983
1987
1991
1995
1999
2003
2007
2011

Note: U.S. industrial firms, weighted by net assets.
®

CFROI is a registered trademark in the United States and other countries (excluding the United Kingdom) of Credit Suisse
Group AG or its affiliates.
October 19, 2016
Exhibit 12 shows the annual rate of asset growth, adjusted for inflation, from 1951-2015. In 2015, spending
was very weak relative to the long-term average, a point that is particularly pronounced given that CFROIs are
high. It’s hard to know exactly why companies remain so reticent to invest, but executives commonly point to
political and economic uncertainty.15
Exhibit 12: U.S. Real Asset Growth Rate, 1951-2015

12
10
8
Percent
6
Average
0
1951
1955
2007
2011
1959
1963
1967
1971
1975
1979
1983
1987
1991
1995
1999
2003
2015
Note: U.S. industrial firms, weighted by gross investments.
The combination of high return on investment and modest growth means that businesses are generating
sizable sums of cash. For example, companies in the S&P 500, excluding the financial services, transportation,
and utilities industries, had a balance of cash and marketable securities of $1.4 trillion as of June 30, 2016,
roughly 8 percent of the market capitalization of the index. This cash balance is even more remarkable
considering that companies in the S&P 500 disbursed $975 billion to their shareholders through buybacks
and dividends in the 12 months ending June 30, 2016.
Cash balances are high today, and it is common to hear market commentators say that we are at all-time
highs. But we are by no means in uncharted waters if you measure cash as a percentage of assets. Exhibit 13
shows that at 11 percent, today’s cash as a percentage of assets is well below the levels in the post-World
War II period. Further, a sizable sum of today’s cash balance is offshore, and companies cannot repatriate it
without incurring an additional tax burden. So between the shift in the composition of the economy and tax
policy, some increase in cash holdings should come as no surprise.
October 19, 2016
Exhibit 13: U.S. Cash as a Percentage of Total Assets, 1950-2015

30%
25%
20%
15%
Average
10%
5%
0%
1950
1955
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
2010
2015
Note: Top 1,500 U.S. industrial firms.
We can summarize the discussion so far as follows:
Internal financing represents the vast majority of the source of capital for U.S. companies. Internal
financing supplies less capital to companies in other developed countries, in part because those countries
have lower ROICs.
The primary uses of capital include M&A and capital expenditures, although M&A is very cyclical. Over
the last 35 years spending on capital expenditures and dividends has declined as a percentage of sales,
while R&D and share buybacks have increased as a percentage of sales. These changes reflect the shift
in the structure of the underlying economy.
ROIC is high in the U.S., and the rate of investment is middling. As a consequence, companies are
generating strong free cash flow, and capital allocation is more important than ever.
Before delving into each of the specific uses of capital, it is worth considering what the academic research
says about capital allocation. The findings are easy to condense: “Asset growth rates are strong predictors of
future abnormal returns.” This is true in both U.S. and international markets.16
More specifically, firms with low asset growth rates earn substantially higher shareholder returns, after
adjusting for risk, than firms with high asset growth rates. Further, companies that contract their assets tend
to generate higher shareholder returns than companies that expand their assets.
High returns to shareholders tend to follow events such as spin-offs, dividend initiations, share buybacks, and
debt prepayments, whereas low returns to shareholders generally follow events such as acquisitions and stock
and debt issuance.
The academic research supports the notion that capital allocation is challenging and that growth is not
inherently good. But we must keep in mind that context is very important. Recall that the correct answer to
almost every capital allocation question is, “It depends.” We need to look beyond base rates, as informative as
they are, to understand what truly drives or impedes value creation. We now turn to the details of the major
uses of capital.
October 19, 2016
Capital Allocation Alternatives
For each alternative, we will consider four aspects: the trend in spending, how to think about the alternative
from an economic standpoint, the empirical research, and the outlook for future spending.
Mergers and Acquisitions. M&A is by far the largest source of redistribution of corporate resources of all
the alternatives. For many companies, M&A is the most significant means to pursue strategic goals and the
most costly way to do so. And if M&A volume continues to average 9 percent of the equity market
capitalization of the U.S., as it has since 1980, nearly all companies and investment portfolios will feel the
effect of M&A at some point.
Exhibit 14 shows the dollar amount of M&A as well as M&A as a percentage of sales from 1980 to 2015.
M&A tends to follow the stock market closely, with more M&A activity when the stock market is up.17 It comes
as no surprise that companies that act early in an M&A cycle tend to generate higher returns than those that
act later. The first movers in an M&A wave enjoy the benefits of a larger pool of acquisition targets and
cheaper valuations than companies that acquire later in the cycle. Later acquirers are encouraged to act based
on bandwagon effects, or what Buffett calls the institutional imperative, and an accommodating environment
for financing.18
Exhibit 14: U.S. Mergers and Acquisitions, 1980-2015

Dollar amount
2,500,000 35%
As a percentage of sales
30%
As a percentage of net sales

2,000,000
25%
1,500,000
$ Millions
20%
15%
1,000,000
10%
500,000
5%
0 0%
1980
1985
1990
1995
2000
2005
2010
2015
Source: Thomson Reuters and Credit Suisse HOLT.

Note: Dollar amounts are not inflated. U.S. announced domestic mergers; excludes debt tender offers, equity carve-outs, exchange offers, loan
modifications, and open market repurchases.
Private equity has also played an increasingly prominent role in M&A (see Exhibit 15). Private equity rose from
essentially nothing to seven percent of deal volume at the peak of the leveraged buyout boom in the 1980s. In
the early 2000s, private equity’s percentage of M&A rose steadily, reaching a peak in 2007 at 37 percent of
the volume. There was a substantial drop-off in participation through the financial crisis, but private equity is
back to an average of about 10-15 percent of volume in recent years.
October 19, 2016
Exhibit 15: Private Equity Percentage of M&A Volume, 1980-2015

Private Equity
Corporate
100
90
80
Percentage of Total
70
60
50
40
30
20
10
0
1980
1985
1990
1995
2000
2005
2010
2015
Source: Thomson Reuters; Credit Suisse; Amy Or, “Private Equity Firms Were Busy in 2015, but Not as Much as Corporates,” Wall Street Journal,
January 5, 2016.
Note: U.S. deal activity; corporate M&A includes announced domestic mergers and excludes debt tender offers, equity carve-outs, exchange offers,
loan modifications, and open market repurchases.
How should companies assess the merit of an M&A deal? Mark Sirower, a consultant at Deloitte, suggests
that acquirers use the following formula:19
Net present value of the deal = present value of the synergies – premium
Simply stated, the formula says that a deal is good if the acquirer gets more than it pays for. The underlying
premise is that the target’s stock price, pre-deal, accurately reflects the present value of the company’s future
free cash flow. So the deal creates value for the buyer only if the synergy from putting the businesses
together exceeds the premium for control the acquirer must pay to close the deal. This equation is more
fundamental than superficial metrics such as accretion to earnings per share, which doesn’t appear to factor
into the market’s reaction.20 As a result, the formula provides much more insight into a deal’s economic virtue.
Let’s take a closer look at the terms in the equation. Exhibit 16 shows the results of a survey of corporate
executives that McKinsey, a consulting firm, conducted regarding synergy. There is a clear difference between
cost synergies, the cost the companies can save by removing redundancies, and revenue synergies, the
anticipated increase in sales from combining businesses. Other forms of synergies have historically played a
less substantial role.21
October 19, 2016
Exhibit 16: Cost Synergies Are More Reliable Than Revenue Synergies
Cost Synergies Revenue Synergies
40 40
Percentage of Companies
Percentage of Companies
30 30
20 20
10 10
0 0
<30 30-50 51-60 61-70 71-80 81-90 91-100 >100 <30 30-50 51-60 61-70 71-80 81-90 91-100 >100
Percentage of Anticipated Synergies Captured after Merger Percentage of Anticipated Synergies Captured after Merger
Source: Scott A. Christofferson, Robert S. McNish, and Diane L. Sias, “Where Mergers Go Wrong,” McKinsey on Finance, Winter 2004, 1-6.
Cost synergies are much more reliable than revenue synergies. About one-third of the executives surveyed
said that their company achieved all or more of the anticipated cost synergy, while one-quarter of the
companies overestimated their cost synergy by 25 percent or more. But roughly 70 percent of mergers fail to
deliver the anticipated revenue synergy. The most common challenges companies cite for synergy realization
include delays in implementing planned actions, underestimation of costs and complexities, and flat-out
overestimation of synergies.22
Exhibit 17 shows the average deal premium, with each deal receiving an equal weight. The premium is the
difference between the price a buyer is willing to pay and the prevailing market price prior to any anticipation of
a deal. For example, if a stock is trading at $100 and a buyer offers $140, the premium is 40 percent
($40/$100). While the premium is generally straightforward to calculate for a particular transaction, the series
of premiums over time is difficult to aggregate. The current average premium is 48 percent, not far from the
long-term norm.
Exhibit 17: U.S. Average Deal Premium, 1980-2015

70%
60%
50%
Average
40%
30%
20%
10%
0%
1980
1985
1990
1995
2000
2005
2010
2015
Source: Patrick A. Gaughan, Mergers, Acquisitions, and Corporate Restructurings – Sixth Edition (Hoboken, NJ: John Wiley & Sons, 2015), 605;
FactSet; Thomson Reuters; Credit Suisse.
October 19, 2016
Any analysis of M&A should focus on the difference between the synergy and the premium. Succeeding at
M&A is not easy for a number of reasons. First, if the premium is too large a company cannot recoup its
investment, no matter how strategic the deal. Second, often competitors can replicate the benefits of a deal or
take advantage of a company’s lack of focus as it goes through an integration process. Third, M&A requires
payment up front for benefits down the road, which creates legitimate skepticism for investors. Finally, M&A
deals are generally costly to reverse.23
The empirical evidence on M&A underscores the challenges that buyers face.24 Over time, it appears that a
majority of acquirers see their stock prices decline following the announcement of a deal. Research by
McKinsey concluded that about one-third of deals create value for acquirers, and the other two-thirds are
value neutral or value destructive.25 That said, you must recognize that M&A creates value when you consider
both the buyer and the seller. Exhibit 18 shows a measure that McKinsey calls “deal value added,” which is
the percentage increase in the combined market capitalizations of the buyer and seller. This has averaged
about 6 percent over the past 19 years, with the only negative year in 2000 at the peak of the dot-com
bubble. M&A creates substantial value but most of that value goes to the sellers, not the buyers.
Exhibit 18: Average Deal Value Added, 1997-2015

14%
12%
Average
10%
8%
6%
4% Average
2%
0%
-2%
-4%
-6%
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
Source: Richard Dobbs, Marc Goedhart, and Hannu Suonio, “Are Companies Getting Better at M&A?” McKinsey on Finance, Winter 2007, 7-11;
David Cogman, “Global M&A: Fewer Deals, Better Quality,” McKinsey on Finance, Spring 2014, 23-25; David Cogman, McKinsey & Company.
Note: DVA is McKinsey’s calculation of the combined (acquirer and target) change in market capitalization relative to the market from two days prior to
two days after the announcement, as a percentage of transaction value.
One comment we hear consistently from management is that the market is short-term oriented and fails to
recognize the virtue of the announced deal. Mark Sirower and his colleague, Sumit Sahni, studied this
assertion. Exhibit 19 summarizes their findings, which are based on an analysis of more than 300 deals.26
The first observation is that about one-third of the deals (103/302) result in a stock price for the buyer that is
initially higher, net of the market’s change. This is consistent with past studies. Next, there is a clear
correlation between the premium the buyer paid (the column on the right) and the announcement return (the
column in the middle). Smaller premiums yielded positive returns, and higher premiums generated negative
returns. This is consistent with Sirower’s formula to determine a deal’s net present value for the buyer.
October 19, 2016
Exhibit 19: The Stock Market Takes a Long-Term View When It Judges M&A
Announcement One-Year
Stock Reaction # of Deals Return Return Premium
Persistent positive 52 5.6% 33.1% 25.8%
Initial positive 103 5.7% 4.9% 30.7%
Full sample 302 -4.1% -4.3% 35.7%
Initial negative 199 -9.2% -9.0% 38.4%
Persistent negative 133 -10.3% -24.9% 40.5%

Source: Mark L. Sirower and Sumit Sahni, “Avoiding the ‘Synergy Trap’: Practical Guidance on M&A Decisions for CEOs and Boards,” Journal of
Applied Corporate Finance, Vol. 18, No. 3, Summer 2006, 85.
Sirower and Sahni then wanted to see if the market’s initial reaction was accurate. So they checked on the
deals one year later. Those that were initially positive remained positive overall, with a one-year total
shareholder return of 4.9 percent. More than half of the initial positive deals were persistently positive.
Deals that were initially negative remained so on average, with a total shareholder return of -9.0 percent. Two-
thirds of the negative deals were persistently negative. This research suggests that while the market’s initial
read of a deal isn’t perfect, there does not appear to be a bias. Indeed, if there is a bias it is that the market is
too optimistic, as one-half of the positive deals turned negative but only one-third of the negative deals turned
positive.
The story for buyers should not come across as too dour. There are ways to shade the odds of a deal to be
more favorable. One empirical finding is that not all types of deals have the same chances of success. Peter
Clark and Roger Mills, finance experts who focus on M&A, found substantially different success rates for
varying categories of deals. Exhibit 20 summarizes their analysis.
October 19, 2016
Exhibit 20: Probability of M&A Success Based on Type of Deal

Success Success Threats (Ex-
Rate Category Type Description Example(s) Pricing, Phase)
Dying competitor signals exit, Obsolescence, incompatible
87-92 Opportunistic Bottom-trawlers Marconi, Palm
advantage to fast, cash bidders technologies
Fills void in acquirer's existing Hidden integration difficulties
80-85 Operational Bolt-ons P&G/Pantene
product/service offer, quickly cancel timing advantage
Next generation/different variant of Actual synergies limited to scale,
65-70 Operational Line extension equivalents Volkswagen/Skoda
existing product/service insufficient to cover APP
Same industry contraction: scale, Overestimation of market share
55-60 Transitional Consolidation -- mature Pharma, telecoms
overhead synergies gain importance
Logical complements to present Mistaken judgment of
Disney/ABC; P&G/Gillette;
40-45 Operational Multiple core-related complementary offer: products/channels/areas development potential (r-
Coty/Avon
Two or more related elements synergies)
Overstated premiums (APP)
Same industry contraction: Picking
37-42 Transitional Consolidation -- emerging ABC Capital Cities/Dumont based on target's prior
winners
performance
Exaggerated benefits attributed
Similar to complementary but one
30-35 Operational Single core-related complementary Daimler Chrysler to target in 'marriage made in
or less related elements
heaven'
Major change in emphasis in
Dependent on extraordinary
20-25 Transformational Lynchpin strategic acquiring company's business mix IBM/PwC Consulting
acquiring company
and forward strategy
Radical, high-risk experimentation
CEO's imagined vision
15-20 Transformational Speculative strategic with company's business mix and AOL/TW; Vivendi (Messier)
inconsistent with market realities
model
Based on Peter J. Clark and Roger W. Mills, Masterminding the Deal: Breakthroughs in M&A Strategy and Analysis (London: Kogan Page, 2013),
148-149.
For example, deals they call “opportunistic,” where a weak competitor sells out, succeed at a rate of around
90 percent. “Operational” deals, or cases where there are strong operational overlaps, also have an above-
average chance of success. The rate of success varies widely for “transitional” deals, which tend to build
market share, as the premiums buyers must pay to close those deals can be prohibitive. Finally, the success
rate of “transformational” deals, large leaps into different industries, tends to be very low.27
Another factor that can work in favor of acquirers is the source of deal financing. The research suggests the
market greets cash deals much more kindly than stock deals.28 There are a number of plausible explanations
for this. First, you can consider an acquisition funded with stock as two separate transactions: selling stock to
the public, and using the proceeds to buy the target. Management teams generally sell their stock when it’s
expensive, providing a negative signal to the market. Second, in a cash transaction all of the deal’s risk and
reward accrues to the buyer. In a stock-for-stock deal, the buyer shares the risk with the seller. This, too,
provides a weaker signal of conviction.29
Exhibit 21 shows the mix between all-cash deals and all-stock or blend deals. Cash deals are a much higher
percentage of the total than a decade or so ago. This reflects sizable cash balances, good access to the debt
markets, and the perception of many executives that the stocks of their companies remain undervalued.
October 19, 2016
Exhibit 21: All-Cash Deals and All Stock or Blend Deals, 1980-2015
All Cash Cash + Stock or All Stock
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
1980
1985
1990
1995
2000
2005
2010
2015
Source: Patrick A. Gaughan, Mergers, Acquisitions, and Corporate Restructurings – Fifth Edition (Hoboken, NJ: John Wiley & Sons, 2011), 577;
FactSet; Credit Suisse.
M&A was slow to rebound in the current cycle despite the stock market’s results and low interest rates. But
deal volume picked up sharply in the past couple of years and hit a record in 2015 in the U.S. and on a global
basis. Activity remains strong in 2016 but is down from the 2015 highs. Through the first three quarters of
2016, U.S. M&A is down by about 30 percent and global M&A is down about 20 percent year over year.
One noteworthy aspect of this M&A cycle is how well the market has received deals. Exhibit 18 shows that
the average deal value added in 2015 was nearly 60 percent higher than the average since 1997. What is
also unusual is how much of that value buyers are capturing.
Exhibit 22 shows McKinsey’s calculation of the percentage of deals that create value for acquirers. A buyer is
judged to create value if its stock goes up relative to the market. Note that an average of 38 percent of deals
created value for acquirers from 1997-2009, but the percentage rose to an average of 51 percent from
2010-2015.
October 19, 2016
Exhibit 22: Percentage of Deals That Create Value for Acquirers, 1997-2015
60%
55%
50%
Average
45%
40% Average
35%
30%
25%
20%
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
Source: Richard Dobbs, Marc Goedhart, and Hannu Suonio, “Are Companies Getting Better at M&A?” McKinsey on Finance, Winter 2007, 7-11;
David Cogman, “Global M&A: Fewer Deals, Better Quality,” McKinsey on Finance, Spring 2014, 23-25; David Cogman, McKinsey & Company.
Note: The percentage that create value is 1 minus the percentage of overpayers (POP). POP is McKinsey’s calculation of the percentage of
transactions in which the relative price movement of stocks was negative for the acquirer from two days prior to two days after the announcement.
Capital Expenditures. Capital expenditures are the second largest use of capital for companies. In 2015,
capital expenditures were about two-fifths of the amount companies spent on M&A. However, capital
expenditures tend to be steady and have a vastly lower variance than M&A over time.
Exhibit 23 shows the dollar amount of capital expenditures since 1980, as well as capital expenditures as a
percentage of sales. Spending declined from 10 percent of sales in 1981 to 5 percent of sales in 2004, but
rebounded to more than 6 percent of sales in 2015. A substantial part of the pickup in capital spending since
2004 is related to the resurgence in commodity prices, which led to sharp increases in spending in the energy
and materials sectors. For instance, the energy sector’s capital expenditures went from around 13 percent of
the total in the early 2000s to about 35 percent in recent years. But as the commodity cycle has cooled, so
too has capital spending, with the energy sector’s share of total expenditures dipping to 30% in 2015.
October 19, 2016
Exhibit 23: U.S. Capital Expenditures, 1980-2015

900,000 Dollar amount 11%
800,000 As a percentage of sales 10%

9%

700,000
8%
600,000
7%
$ Millions
500,000 6%
400,000 5%
4%
300,000
3%
200,000
2%
100,000 1%
0 0%
1980
1985
1990
1995
2000
2005
2010
2015
Note: Top 1,500 U.S. industrial firms. Dollar amounts are not inflated.
Executives and investors frequently distinguish between “maintenance” capital expenditures and total capital
expenditures. Maintenance spending is the minimum required to maintain or replace the long-term assets in
place. We can assume that capital expenditures beyond the maintenance level are in pursuit of growth.
Depreciation expense serves as a rough proxy for maintenance capital spending.30 Exhibit 24 shows capital
expenditures net of depreciation. Measured as a percentage of sales, growth capital expenditures are roughly
40 percent of overall capital expenditures. That maintenance is essential explains a good deal of the stability
of capital expenditures. Further, it suggests that in assessing the value creation prospects of capital
expenditures, you are best served to focus on the component that supports growth.
October 19, 2016
Exhibit 24: U.S. Capital Expenditures Net of Depreciation, 1980-2015

300,000 6%

250,000 5%
$ Millions
200,000 4%
150,000 3%
100,000 2%
50,000 1%
0 0%
1980
1985
1990
1995
2000
2005
2010
2015
What factors should you consider to judge whether capital expenditures create value? The industry is a good
starting point. Companies that invest in industries with a high return on invested capital and good growth
prospects are more likely to create value. You can refine this analysis by considering whether the company
has a specific competitive advantage as a low-cost producer or through differentiation.31
The cyclicality of the industry is another important consideration in assessing capital expenditures. Spending in
cyclical industries tends to follow the same pattern as what we have seen in M&A and buybacks: companies
spend when things look good and hunker down when they don’t. As a consequence, companies tend to add
too much capacity at the top of the cycle and suffer when the cycle recedes.
Finally, be mindful that relative comparisons of capital expenditures can be tricky. For example, analysts and
executives generally compare the level of a company’s spending to its peers. The retail industry is known for
this. The crucial question is not whether one company is spending more or less than another, but rather
whether a company is spending the proper amount.
The relative game applies on the country level as well. For example, in the early 1990s there was a palpable
fear that U.S. companies were investing too little relative to peer companies in countries such as Japan.32
What received less attention was the possibility that Japanese companies were investing too much and hence
failing to create value with many of their investments. We can make a similar distinction between public and
private companies. The goal is not to spend more or less than the competitor but rather to spend the correct
amount given the economic opportunity at hand.
Academic work on capital expenditures broadly supports the idea that the market rewards value creation and
refutes the idea that investors prefer short-term earnings gains at the expense of long-term value creation.33
The research shows that the stock market rewards companies that invest in high-quality projects, which is
October 19, 2016
generally signaled by a record of investments that have generated returns in excess of the cost of capital, and
penalizes companies that invest in low-quality projects. And for businesses with high economic returns, the
market responds positively to unexpected increases in capital expenditures and negatively to unexpected
decreases in capital expenditures.34
But there is also a limit to how rapidly a company can grow. Firms that increase their investments the most
tend to suffer from poor relative total shareholder returns in the years following the growth. This is consistent
with the thesis that empire building generally results in stock market underperformance and the evidence that
rapid asset growth predicts poor stock returns.35
Notwithstanding the steady economic recovery from the low of the financial crisis, capital expenditures are
expected to decline in 2016, having fallen by about 6 percent through the first half of the year. This in part
reflects a decline in oil prices, which has prompted a retrenchment of spending in energy.
Analysis of asset life and age supports a case for steady growth in capital expenditures over time. Exhibit 25
shows that the average asset life for the top 1,500 companies in the U.S. declined from roughly 16 years in
1980 to a low of 12 years in the early 2000s, with a rebound to 13 years today.
The average asset age rose from about 5 years in the early 1980s to 6.6 years currently. As a result, the
difference between asset life and asset age for the U.S. capital stock has shrunk from 10 years in the 1980s
to 6 years now. While numerous commentators have emphasized the aging capital stock over the past decade,
few have noted the simultaneous, albeit gentle, rise in asset lives.
Exhibit 25: U.S. Asset Life and Age, 1980-2015

Asset Life
16 Asset Age
15
14
13
12
Years
11
10
9
8
7
6
5
1980
1985
1990
1995
2000
2005
2010
2015

Note: Top 1,500 U.S. industrial firms; asset life is based on gross plant/depreciation expense; asset age = asset life * (1- net plant / gross plant).
October 19, 2016
Research and Development. Unlike M&A and capital expenditures, R&D is a capital allocation choice that
shows up on the income statement rather than the balance sheet. Accountants expense R&D in the period
the company incurs it, notwithstanding the potential long-term benefits, because they deem the outcomes too
uncertain and difficult to quantify. R&D is a set of activities that seeks to develop new products or the tools to
create new products.
In the U.S., businesses account for about 70-75 percent of total R&D spending, with the government and
academia splitting the other 25-30 percent. The industries that spend the most include information technology,
healthcare, materials, and aerospace and defense. Technology and healthcare combined represent more than
two-thirds of all R&D spending in the U.S., and technology R&D spending is roughly 1.6 times that of
healthcare.
Exhibit 26 shows the dollar amount of R&D since 1980 as well as R&D as a percentage of sales. R&D rose
from 1.3 percent of sales in 1980 to 2.7 percent of sales at the time of the dot-com bubble, only to decline to
2.2 percent in 2008 before returning to the prior peak of 2.7 percent of sales in 2015. The substantial rise in
R&D as a percentage of sales during the full period reflects the change in the composition of the market.
During this time, R&D-intensive sectors such as technology and healthcare have become a larger part of the
economy than sectors that are less R&D intensive.
Exhibit 26: U.S. Research and Development, 1980-2015

Dollar amount
350,000 3%
300,000

250,000
2%
$ Millions
200,000
150,000
1%
100,000
50,000
0 0%
1980
1985
1990
1995
2000
2005
2010
2015

R&D productivity is the relationship between the value a new product creates and the company’s investment in
that product. But assessing productivity is a challenge because there is a lag between investment and
outcome. A host of other factors, which are hard to capture, also weigh on the outcome. It is useful to
distinguish between the cost to launch, or “R&D efficiency,” and the value per launch, or “R&D effectiveness.”
One company may be good at bringing a product to market (R&D efficiency) while a different company may
be able to create more value for the product as the result of better design, marketing, or distribution
capabilities (R&D effectiveness).36
October 19, 2016
One approach to assess a company’s R&D productivity is to capitalize R&D, amortize it over an appropriate
period, and calculate the return on invested capital (ROIC) so as to be comparable to businesses that are not
R&D intensive.37 R&D capitalization has the effect of increasing profit (the R&D amortization amount is almost
always less than expensed R&D, hence adding to profit) and increasing invested capital (since R&D is
reclassified as a capital item rather than an expense). The challenge is to determine the appropriate
amortization period, or roughly the time to develop a product.
Some researchers who study the pharmaceutical industry assess R&D productivity by dividing a company’s
R&D budget over some period by the number of drugs the company has brought to market. Rather than
examining the cost of successful drugs only, this method captures the total costs a company incurs including
the cost of failure. Exhibit 27 shows the results of this analysis for the top 10 companies measured by R&D
dollars spent per drug. A great deal has been written about the decline in R&D productivity in the
pharmaceutical industry, and attitudes about the virtue of R&D are at the crux of alternative strategies for
value creation within the sector. 38
Exhibit 27: R&D Cost per New Drug for 10 Large Pharmaceutical Companies
10-year R&D Number of R&D per
Company spending new drugs drug
1 Abbott $13.2 billion 1 $13.2 billion
2 Sanofi $60.8 6 $10.1
3 AstraZeneca $38.2 4 $9.6
4 Hoffmann-La Roche $70.9 8 $8.9
5 Pfizer $77.8 10 $7.8
6 Wyeth $22.7 3 $7.6
7 Eli Lilly $26.7 4 $6.7
8 Bayer $33.1 5 $6.6
9 Schering-Plough $18.8 3 $6.3
10 Novartis $60.7 10 $6.1
Source: Matthew Herper, “How Much Does Pharmaceutical Innovation Cost? A Look at 100 Companies,” Forbes, August 8, 2013.
The academic research on the effectiveness of R&D spending is somewhat equivocal, in part because of the
measurement challenges and the decline in R&D productivity in the pharmaceutical industry. One of the best
ways to study the market’s reaction to any form of investment is to examine unexpected changes. In one such
study, finance professors studied more than 8,000 unexpected increases in R&D spending over a 50-year
period ended in 2001 and found that the stocks of those companies rose.39 Other researchers conclude that
the returns to R&D are positive and higher than other capital investments.40
A reasonable question is whether the stock market effectively reflects R&D spending. One large study found
that the market does it well. This means that companies that spend a large percentage of sales on R&D
realize similar stock market returns as companies that spend a small percentage of sales on R&D. The
researchers came to similar conclusions for advertising expenses, which are about one-half as large as R&D
expenses in the aggregate.41
Academics have also found that larger companies that significantly increase their R&D expenditures tend to
fare poorly in the stock market.42 That said, companies with strong execution capabilities can create value by
enhancing R&D effectiveness.43
Some recent research suggests that the technology companies that are in the bottom one-third of R&D
spending as a percentage of sales deliver higher returns to shareholders than those in the top third.44 This
October 19, 2016
finding underscores how tricky it is to assess R&D spending because a number of technology companies have
benefitted from R&D that was funded by the government.
Mariana Mazzucato, a professor of economics at the University of Sussex, addresses this issue in her
provocative book, The Entrepreneurial State.45 Her thesis is that the government funds a great deal of high-
risk R&D that companies go on to exploit commercially. She uses the vivid example of the iPhone from Apple
Inc., a company that has created a huge amount of shareholder value in the past decade. Four of the main
technologies inside the iPhone, including the Global Positioning System (GPS), the Internet, touch screen,
and voice recognition software, were developed by the U.S. government. As Mazzucato notes, Apple did a
brilliant job of integrating these technologies, designing an attractive and intuitive product, and marketing
effectively. But it did not develop some of the key technologies inside the phone, which means the company’s
shareholders did not have to shoulder those expenses.
Forecasters expect R&D spending to increase by about 3.5 percent in the U.S. and on a global basis in 2016.
The U.S., China, and Japan together represent more than half of global R&D spending, and ten countries
account for nearly 80 percent of the total. At current rates of funding and growth, China will surpass the U.S.
as the largest spender on R&D in the year 2026. In the U.S., growth in R&D spending is expected for all
industries engaged in significant R&D activity. The greatest increases are expected in the information and
communications technologies industry and the automotive and transportation systems industry, and the
smallest increase is seen in the life science industry.46
Net Working Capital. Net working capital is the capital a company requires to run its day-to-day operations.
It is defined as current assets minus non-interest-bearing current liabilities. Net working capital equals about
one-quarter of assets on average for companies in the U.S.47 The primary components of net working capital
include inventory, accounts receivable, and accounts payable. Interest-bearing current liabilities, which include
short-term debt and the current maturities of long-term debt, are a form of financing and are therefore not
part of net working capital.
Exhibit 28 shows the annual change in net working capital from 1980 through 2015. At the end of 2015, net
working capital stood at $1.9 trillion for the top 1,500 companies in the U.S., excluding the financial services
and regulated utility industries. We consider changes in net working capital as opposed to the absolute
amount, because changes are what you should consider to be an incremental investment. Net working capital
investments are substantially smaller than M&A, capital expenditures, or R&D.
October 19, 2016
Exhibit 28: U.S. Change in Net Working Capital, 1980-2015

200,000 4%

150,000 3%
100,000 2%
$ Millions
50,000 1%
0 0%
-50,000 -1%
-100,000 -2%
-150,000 -3%
1980
1985
1990
1995
2000
2005
2010
2015
We have defined net working capital to include cash. The picture changes dramatically if we exclude cash.
Two trends are noteworthy. First, the percentage of firms that are financed solely with equity has gone from 6
percent in 1980 to 20 percent today. Second, the cash held by the all-equity financed firms has gone from 9
percent of assets to 33 percent over the same period.48 As a result, increases in cash make up a substantial
fraction of the increase in net working capital. At the end of 2015, net working capital excluding cash was
about $200 billion for the top 1,500 U.S. industrial companies, roughly 10 percent of the total net working
capital sum. Exhibit 29 shows the change in net working capital excluding cash.
Exhibit 29: U.S. Change in Net Working Capital Excluding Cash, 1980-2015
200,000 4%
150,000 3%
100,000 2%
$ Millions
50,000 1%
0 0%
-50,000 -1%
-100,000 -2%
-150,000 -3%
1980
1985
1990
1995
2000
2005
2010
2015

October 19, 2016
Exhibit 30 shows both investments in net working capital and net capital expenditures together. These items
reflect capital investments in organic growth. The exhibit provides a useful view of the relative spending
between working and fixed capital. Net working capital declines in a handful of years, making it a source of
cash.
Exhibit 30: U.S. Change in Net Working Capital Plus Net Capital Expenditures, 1980-2015
550,000
500,000 Capital expenditures net of depreciation
450,000 Change in net working capital
400,000
350,000
300,000
250,000
$ Millions
200,000
150,000
100,000
50,000
0
-50,000
-100,000
-150,000
1980
1985
1990
1995
2000
2005
2010
2015
The cash conversion cycle (CCC), a calculation of how long it takes a company to collect on the sale of
inventory, is the standard way to analyze working capital efficiency. The CCC equals days in sales outstanding
(DSO) plus days in inventory outstanding (DIO) less days in payables outstanding (DPO).49 For example, Cisco
Systems, Inc.’s CCC in its latest fiscal year was 80 days (2016) while Apple’s was -33 days (2015).
Some firms, including Apple, have a negative CCC, which means that the company receives cash on the sale
of inventory before it pays its suppliers. This effectively makes the company’s suppliers a source of financing
and can be relevant in competitive interactions. For instance, Walmart Stores Inc.’s CCC in its latest fiscal
year was 11 days (2016) while Amazon.com’s was -24 days (2015). With a CCC for each company in hand,
you can compare the efficiency of working capital use from one company to the next. Exhibit 31 shows the
cash conversion for sectors within the S&P 500, excluding financials.
October 19, 2016
Exhibit 31: Cash Conversion Cycles for Sectors within the S&P 500, 2015
200
75th percentile
Median
25th percentile 156
150
109
100 97 96 100
88
Days
67 71 72
63
50 55 53
37 43 43
31 36 31 33
25 23 24
14 1
0
-7
-24 -14
-50
Consumer Consumer Energy Healthcare Industrials Information Materials Telecom Utilities
Discretionary Staples Technology Services
Source: FactSet and Credit Suisse. Format of exhibit from Ryan Davies and David Merin, “Uncovering Cash and Insights from Working Capital,”
McKinsey & Company, July 2014.
Note: S&P 500 companies, excluding financials, as of December 31, 2015.
Academic research shows a strong relationship between a lower CCC and a higher return on capital within,
and across, industries.50 In other words, good working capital management is associated with high returns on
invested capital. The impact on total shareholder returns, however, is less clear. Research suggests that a
dollar invested in working capital is worth less than a dollar either held in cash or invested in the firm. Further,
extending credit to customers through increasing receivables has a bigger effect on shareholder value than
increasing inventory.51
The main issue in the outlook for net working capital is what companies choose to do with their cash hoards.
Research shows that investors value cash on the balance sheet of companies with poor governance at $0.40-
$0.90 on the dollar in anticipation of value-destroying moves.52 M&A continues to be a likely use of cash and,
as we will see, companies continue to return cash to shareholders via buybacks and dividends at a steady clip.
Divestitures. Companies use divestitures to adjust their business portfolio. Actions include the sale of
divisions, spin-offs, and equity carve-outs. A company will divest an operation when it perceives the value to
another owner to be higher, or if the divestiture adds focus to the parent and hence improves results.
Exhibit 32 shows the magnitude of divestitures from 1980-2015. While divestitures generally draw less
attention than M&A, they represent a substantial component of capital allocation. In the last decade,
divestitures have averaged 3.8 percent of sales for the top 1,500 companies in the U.S., a level comparable
to gross buybacks and higher than dividends and R&D spending.
October 19, 2016
Exhibit 32: U.S. Divestitures, 1980-2015

Dollar amount
700,000 7%
600,000 6%

500,000 5%
$ Millions
400,000 4%
300,000 3%
200,000 2%
100,000 1%
0 0%
1995
1980
1985
1990
2000
2005
2010
2015
Note: U.S. announced divestitures; excludes debt tender offers, equity carve-outs, exchange offers, loan modifications, and open market repurchases.
Dollar amounts are not inflated.
Spin-offs are a prominent form of divestiture. In a spin-off, a company distributes shares of a wholly owned
subsidiary to its shareholders on a pro-rata and tax-free basis. For example, Danaher Corporation spun off
several of its segments into a new company, Fortive Corporation, in July 2016. Following the spin-off
Danaher shareholders owned shares in Danaher and Fortive. Exhibit 33 shows the value of announced spin-
offs and the number of completed spin-offs from 1980-2015.
Exhibit 33: U.S. Spin-Offs, 1980-2015

180,000 70
160,000 Deal Value

60
Number of Deals
140,000
Deal value ($ millions)
50
120,000
Number of deals
100,000 40
80,000 30
60,000
20
40,000
10
20,000
0 0
1980
1985
1990
1995
2000
2005
2010
2015
Source: Thomson Reuters; Spin-Off Research; Hemang Desai and Prem C. Jain, “Firm Performance and Focus: Long-Run Stock Market Performance
Following Spinoffs,” Journal of Financial Economics, Vol. 54, No. 1, October 1999, 81.
Note: Dollar amounts are not inflated.
October 19, 2016
There are a few considerations in assessing divestitures. First, research has established that most of the value
creation for a typical company comes from a relatively small percentage of its assets.53 This means that most
companies have businesses or assets that do not earn the cost of capital and that may be more valuable to
another owner.
Divestitures can lead to “addition by subtraction” when a company that divests an operation with a low return
on invested capital receives more than what the business is worth as an ongoing part of the firm. So there’s
an addition of value to the company even as there’s a subtraction in the size of the firm.
Second, we have already reviewed the evidence showing that M&A creates value in the aggregate but that
acquirers struggle to capture much, if any, of that value. This suggests it is better to be a seller than a buyer
on average. This point is particularly relevant when there are multiple bidders for an asset. Contested deals
frequently lead to what economists call the “winner’s curse.”54 When this occurs, the “winner” of the bidding
pays too much for the asset, hence the “curse.” The winner’s curse means there is a wealth transfer, above
and beyond the value of the asset, from the buyer to the seller.
Finally, most companies have a natural tendency to want to grow rather than shrink. As companies grow and
diversify, capital allocation and strategic control can become more challenging. When a CEO who understands
capital allocation takes the helm of a company with underperforming assets, there is a great opportunity to
create value through divestitures.55
Notwithstanding their significance in capital allocation, divestitures have received substantially less attention
than M&A in the academic literature. Research for the most part concludes that divestitures create value. A
meta-analysis of nearly 100 studies on divestitures concludes: “In the broadest possible terms, our results
suggest that on average, divestiture actions are associated with positive performance outcomes for the parent
firm.”56
Analysis also shows that spin-offs create value for the spin-offs themselves as well as the corporate parents.57
Researchers who did a meta-analysis of more than 25 papers in the spin-off literature summed up their
findings this way: “The main conclusion is consistent: spin-offs are associated with strongly significant
abnormal returns.” In 2016, the Bloomberg Spinoff Index is up more than twice as much as the S&P 500
Index. Researchers suggest the factors that explain these wealth effects include sharpened focus, better
information, and in some cases tax treatment.58
Divestitures remain active in 2016, reflecting the influence of activist investors and ongoing pressure for
companies to create value. The number of spin-offs in 2016 is on pace with the 40 completed deals in
2015.59 Similar to acquisitions, divestitures follow a wave with deals done at the peak of the cycle delivering
lower returns for shareholders than those done at the beginning.60
Dividends. A dividend is a cash payment to a shareholder that is generally paid from profits. Dividends and
share buybacks are the main ways companies return cash to shareholders. Companies can also return cash to
shareholders by selling the company for cash.
The most profound difference between buybacks and dividends may be the attitude of executives. Most
executives believe that once a dividend is established, paying it is on par with investment decisions such as
capital spending. In contrast, they tend to view buybacks as something to do with residual cash flow after the
company has made all investments that are appropriate.61
October 19, 2016
There are a couple of consequences of this difference in attitude. The first is that dividend payments are vastly
less volatile than buybacks. Indeed, of all the capital allocation options, dividends have among the lowest
standard deviation in growth, as exhibit 9 demonstrates. Exhibit 34 shows the annual amount of dividends on
common and preferred stock for the top 1,500 companies in the U.S., excluding the financial services and
regulated utility industries, from 1980 to 2015. Dividends are remarkably resilient and were especially stable
through the financial crisis from 2007-2009.62
Exhibit 34: U.S. Common and Preferred Dividends, 1980-2015

As a percentage of net income 90%
350,000
As a percentage of net income

80%
300,000
70%
250,000 60%
$ Millions
200,000 50%
150,000 40%
30%
100,000
20%
50,000 10%
0 0%
1980
1985
1990
1995
2000
2005
2010
Source: Credit Suisse HOLT. 2015

Exhibit 35 illustrates the quarterly dividends for the S&P 500, including financials, versus the price of the index.
Dividends dipped during the financial crisis as many companies in the financial services industry suspended, or
eliminated, their payouts. But overall, dividends fluctuated much less than the price of the S&P 500.
October 19, 2016
Exhibit 35: S&P 500 Dividends and Index Price, 1999-June 2016
Dividends
S&P 500
600 2,200
2,000
500
1,800
Dividends ($ billions)
S&P 500 Index

400
1,600
300 1,400
1,200
200
1,000
100
800
0 600
1999
2001
2000
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
Source: S&P Dow Jones and FactSet.
How should investors assess dividends? First, dividends are useful to consider in the context of cash flow. To
sustain a cash dividend, a company has to generate cash flow beyond the basic needs to maintain the
business and support its growth. So an investor should gauge a company’s cash flow prospects in order to
anticipate a company’s ability to pay dividends.63
Second, dividends can play an important role in the capital accumulation rate, also known as total shareholder
return (TSR). From time to time you hear that dividends provide the bulk of shareholder returns for equities in
the long run. That assertion is wrong if you assume the goal of an investor is to accumulate capital. In fact,
price appreciation is the only source of investment return that increases accumulated capital over time.64
The equity rate of return is a one-period measure and is simply the sum of stock price appreciation and the
dividend. The capital accumulation rate, or TSR, is a multi-period measure that assumes all dividends are
reinvested in the stock. Knowing price appreciation and dividend yield, the following equation allows you to
calculate TSR:
Total shareholder return (TSR) = Price appreciation + [(1 + price appreciation) * dividend yield]
The value of the compounding reinvested dividends means that the equity rate of return is always lower than
the TSR as long as price appreciation is positive. For example, assume price appreciation of 7 percent and a
dividend yield of 2 percent. The equity rate of return is 9 percent (.07 + .02) and the TSR is 9.14 percent (.07 +
[(1 + .07)*.02]).
The key is that for an investor to actually earn the TSR, all of the dividends they receive must be reinvested back
into the stock. That’s why price appreciation only determines the TSR.
October 19, 2016
It’s crucial to acknowledge that almost no one earns the full TSR because most individuals do not reinvest the
dividends they receive, and dividends are generally taxable. While there are no clear-cut data on the topic, it
appears that only one-tenth of all dividend proceeds are reinvested. Naturally, investors can use dividends to
consume. But if they do, they can’t earn the TSR.
Further, most investors must pay taxes on the dividends they receive. Exhibit 36 shows the top marginal tax
rate on dividends and capital gains from 1960 to the present. The TSR declines when you assume that only a
fraction is reinvested in the stock. Academic research supports the view that the tax rate on payouts affects
shareholder returns.65
Exhibit 36: U.S. Top Marginal Tax Rate, 1960-2016

100%
90%
80% Dividends
70%
60%
50%
Capital Gains
40%
30%
20%
10%
0%
2012
2016
1960
1964
1968
1972
1976
1980
1984
1988
1992
1996
2000
2004
2008
Source: Credit Suisse HOLT and the Tax Foundation.
Finally, investors in the U.S. should recognize that many of the mature, cash-rich companies that are excellent
candidates for paying a healthy dividend generate a high percentage of their profits outside the U.S. The
companies cannot repatriate this cash to the U.S. without incurring additional taxes. There are a number of
U.S. multinationals that do not have enough domestic cash to pay their dividends, even though their balance
sheets are flush. A number of these businesses simply borrow in the U.S. to fund their dividends.66
Academic research on dividends supports a few points. To begin, older companies are more likely to pay
dividends than younger companies. So any analysis of dividend yields must take into account the maturity of
the population of companies under consideration.67
Second, dividends provide a strong signal about management’s commitment to distribute cash to shareholders
and its confidence in the future earnings of the business. This is consistent with the managerial attitude that
dividends are sacrosanct once declared. For this reason, companies are very deliberate about the decision to
initiate a dividend.68
Dividends maintain steady, if modest growth. For example, dividends for the companies in the S&P 500
totaled roughly $390 billion over the 12 months ending June 30, 2016, up 5% over the preceding 12
months.69 But an assessment of payout policy is not complete without considering share buybacks.
October 19, 2016
Share Buybacks. A share buyback is the second main way that companies return cash to shareholders.
Whereas all shareholders are treated equally with a dividend, only shareholders who sell to the company
receive cash with a buyback. This means that shareholders realize very different outcomes based on whether
they choose to sell or hold the stock when they deem it to be overvalued, fairly valued, or undervalued.
Exhibit 37 shows that gross buybacks for the top 1,500 companies in the U.S. have grown considerably from
1980 to 2015. Buybacks are much more cyclical than dividends, consonant with the attitude that a company
should fund a buyback with cash that’s left over after all other uses, including dividends, have been exhausted.
Exhibit 37: U.S. Gross Share Buybacks, 1980-2015

As a percentage of net income 90%

500,000
80%
70%
400,000
60%
$ Millions
300,000 50%
40%
200,000
30%
20%
100,000
10%
0 0%
1980
1985
1990
1995
2000
2005
2010
2015

Exhibit 38 narrows the sample to companies in the S&P 500 Index from 1999 through the first half of 2016,
and compares their quarterly buyback volume to the level of the index. The exhibit makes clear that buybacks
hug the results for the market. This fits the notion that buybacks are a use for residual cash and also implies
that managements have a proclivity to buy high and not buy low.
October 19, 2016
Exhibit 38: S&P 500 Gross Buybacks and Index Price, 1999-June 2016
Buybacks
S&P 500
600 2,200
2,000
500
1,800
Buybacks ($ billions)
S&P 500 Index

400
1,600
300 1,400
1,200
200
1,000
100
800
0 600
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
Source: S&P Dow Jones and FactSet.
Despite the sharp rise in buybacks, many market analysts insist on using dividend yield as a measure of
payout policy and as a means to anticipate future market returns.70 In fact, you need to be very cautious in
comparing data before and after 1982. Buybacks were very scarce prior to that date because the Securities
and Exchange Act of 1934 prohibited the manipulation of securities prices. Since the rules weren’t clear about
what constituted manipulation, most companies avoided buybacks altogether.71
In 1982, Congress enacted Rule 10b-18, which grants companies a safe harbor provided they follow certain
rules. Those rules form a legal shield from the threat of being sued by specifying how a company can execute
a buyback in terms of manner, timing, price, and volume.72 The Securities and Exchange Commission has
subsequently updated the rules to reflect current market conditions. The year 1982 marks a new regime in
how companies return cash to shareholders.
When assessing a repurchase program, investors and executives should consider the golden rule of share
buybacks, which states: A company should repurchase its shares only when its stock is trading below its
expected value and when no better investment opportunities are available.73
The golden rule addresses both absolute and relative value. Companies should only invest where they
anticipate a payoff that has a positive net present value. This is a fancy way of saying “you will get more than
what you pay for.” This absolute benchmark applies to all of a company’s capital allocation decisions, including
M&A, capital expenditures, and R&D.
The rule also addresses relative value when it emphasizes that companies should prioritize higher return
internal investment opportunities over buybacks. Ideally, executives should rank their investment opportunities
by expected return and fund them from highest to lowest. A company should expect that all of the investments
it funds will earn above the cost of capital. While access to capital can be a constraint, most companies
generate sufficient cash flow to fund their internal investments.74
October 19, 2016
The second aspect of assessing a buyback is its impact on various shareholders under different conditions.
Only if a stock trades exactly at intrinsic value do buybacks and dividends treat all shareholders the same. If a
stock is overvalued or undervalued, the effect of a buyback is different for selling shareholders than it is for
those who continue to hold.
From the company’s standpoint, corporate value is conserved no matter how the company chooses to pay out
cash. What differs is who wins and who loses as the result of buying stock below or above intrinsic value.
Since management should focus on building value per share for continuing shareholders, it should always try
to buy back shares that are undervalued.
Exhibit 39 illustrates the principle. Say we have a company with a value of $100,000 and 1,000 shares
outstanding that decides to return $20,000 to its shareholders.
Exhibit 39: The Value Conservation Principle

Scenario A Scenario B Scenario C
Assume Assume Assume dividend
Assumptions Base buyback @ $200 buyback @ $50 Assumptions of $20
Buyback amount $20,000 $20,000 Dividend amount $20,000
Firm Value $ 100,000 $80,000 $80,000 Firm Value $80,000

Shares outstanding 1,000 1,000 1,000 Shares outstanding 1,000
Current price $100 $200 $50 Current price $10
Shares post buyback 900 600
Value/share $100 $88.89 $133.33 Value/share $80.00

Dividend/share $20.00
Selling shareholders 100 400
$200 $50
Value to sellers $20,000 $20,000
Ongoing shareholders 900 600 Ongoing shareholders $80,000

$88.89 $133.33 Dividends $20,000
$80,000 $80,000
Total value $100,000 $100,000 Total value $100,000
Per share +/- sellers $100.00 ($50.00)

Per share +/- holders ($11.11) $33.33
In Scenario A, we assume the stock price is $200, double the fair value of $100 ($100,000/1,000). The
company can buy 100 shares, leaving $80,000 of value and 900 shares outstanding. In this case, the selling
shareholders gain $100 per share ($200 proceeds - $100 value = $100) and the continuing shareholders
lose $11.11 per share ($88.89 continuing value - $100 initial value = -$11.11). Buying back overvalued
stock benefits sellers at the expense of buyers.
In Scenario B, we assume the stock trades at one-half of fair value, or $50 per share. The company can buy
400 shares, with $80,000 of remaining value and 600 shares outstanding. Now we see that the selling
shareholders lose $50 per share ($50 proceeds - $100 value = -$50) and continuing shareholders gain
$33.33 per share ($133.33 continuing value - $100 initial value = $33.33).
October 19, 2016
In Scenario C, the company pays a $20 dividend to all shareholders. Just as in the prior scenarios, the firm
value drops to $80,000, but each shareholder receives identical treatment, leaving aside tax considerations.
This analysis suggests a couple of points that investors commonly overlook. First, if you are the shareholder of
a company that is buying back stock, doing nothing is doing something. By choosing to hold the shares
instead of selling a pro-rated amount, you are effectively increasing your percentage ownership in the
company. One alternative is to sell shares in proportion to your stake, creating a homemade dividend and
maintaining a steady percentage ownership in the business.
Second, it is logical that you would prefer that the companies you hold in your portfolio buy back stock rather
than pay a dividend. If you own shares of companies that you think are undervalued, buybacks will increase
value per share by definition. The only instance where this may not be true is if you believe that a dividend
would provide a more powerful signal to the market, hence creating more value than a buyback.
Tying together these thoughts, there are basically three schools of thought regarding buybacks: fair value,
intrinsic value, and accounting-motivated. The intrinsic value school is where you want to be if possible.
The fair value school takes a steady and consistent approach to buybacks. Management believes that over
time it will buy back shares when they are both overvalued and undervalued, but for the most part when they
are about fairly priced. This approach offers shareholders substantial flexibility as it allows them to hold shares
and defer tax liabilities or create homemade dividends by selling a pro-rated number of shares.
The fair value school is consistent with the free cash flow hypothesis, which says that managers who have
excess cash will invest it in projects with a negative net present value. By disbursing cash, a company buying
back its shares reduces the risk of doing something foolish with the funds.75 Research suggests that most
companies would have been better off buying back stock consistently versus their actual behavior of buying
heavily in some periods and lightly, or not at all, in others.76
The intrinsic value school believes a company should only buy back shares when it deems them to be
undervalued. A company must have asymmetric information or beliefs, as well as analytical prowess, to
profitably pursue this approach. Asymmetric information means that company management has information
that the stock price fails to reflect. Differing beliefs occur when management has the same information as the
market but comes to different conclusions about what that information means.
Analytical prowess means that the executives at the company know how to translate their differential view into
an estimate of the relationship between the stock price and intrinsic value. Investors should not assume that
management has this ability. Indeed, surveys consistently show that executives believe their stock to be cheap.
For example, in a survey from mid-2013, 60 percent of chief financial officers (CFOs) thought that U.S.
equities were overvalued, but only 11 percent thought their own stock was overvalued.77
Management can act on its conviction by being bold with its buyback program, buying back a substantial
percentage of the shares or even buying them at a premium to the prevailing price through a tender offer.78
This school fits the signaling hypothesis, which suggests that companies buy back shares when they deem
them to trade below intrinsic value. Further, it is important to focus on actual share buybacks versus buyback
announcements. The evidence supporting the signaling hypothesis is mixed, but 85 percent of CFOs believe
that their buyback decision conveys information.79
Boosting short-term accounting results, especially earnings per share (EPS), is what motivates the final
school.80 When surveyed, three-fourths of CFOs cite increasing EPS as an important or very important factor
October 19, 2016
in the decision to buy back shares. Two-thirds of CFOs say that offsetting the dilution from option or other
stock-based programs is important. This underscores another essential point: you should consider buybacks
net of equity issuance.
The problem with the accounting-motivated school is that its actions are not necessarily aligned with the
principle of value creation.81 For example, there may be a case where buying back overvalued stock boosts
EPS and helps management reach a financial objective that prompts a bonus. In this case the motivation is
impure because management’s proper goal is to allocate capital in an economically sound fashion for
shareholders.
Investors assessing companies buying back stock should make an effort to determine which school the
management team is in. It can be the case that management buys back stock for the right reason and realizes
accounting benefits as a result. That’s fine. But investors should be on the lookout for companies that make
decisions based on the accounting results without sufficient regard for the economic merits.
A couple of findings from the academic research are worth highlighting. The first is that it appears companies
are increasingly using buybacks as a substitute for dividends.82 As a result, total shareholder yield (sum of
dividends and buybacks divided by equity market capitalization) may be a better indicator of a company’s
proclivity to pay out than a simple dividend yield. Exhibit 40 shows the total shareholder yield, with and without
equity issuance, and the cost of equity for the top 1,500 companies in the U.S. from 1980-2015. The
shareholder yield has been remarkably stable, belying the decline in dividend yield. Equity issuance lowers the
total shareholder yield by 140 basis points on average, with a range of 70 to 310 basis points.83
Exhibit 40: U.S. Total Shareholder Yield versus Cost of Equity, 1980-2015
20%
Cost of Equity
18% Total Shareholder Yield (Gross)
16% Total Shareholder Yield (Net)
14%
12%
10%
8%
6%
4%
2%
0%
2010
1980
1985
1990
1995
2000
2005
2015
Source: Credit Suisse HOLT and Aswath Damodaran.

Note: Top 1,500 U.S. industrial firms.
October 19, 2016
Research suggests that buybacks were well received by the stock market in the early days. This is likely the
result of a couple of drivers, including the novelty of buybacks and hence the stronger signal they sent, as well
as the fact that more buybacks were in the form of Dutch auctions and tender offers versus open market
purchases, which are more prevalent today. Analysis of recent buybacks suggests mixed effects.84
Buybacks continue at a healthy clip. For example, buybacks for the companies in the S&P 500 totaled $585
billion over the 12 months ending June 30, 2016.85 This fits the idea that managements buy when they feel
confident. Buybacks and dividends combined totaled $975 billion for companies in the S&P 500 for the 12
months ending June 30, 2016, in line with the all-time 12-month record set in March 2016.
Assessing Management’s Capital Allocation Skills
“All roads in managerial evaluation lead to capital allocation.”86
The final part of this report provides a framework for assessing a management team’s capital allocation skills.
This framework has four components. First, you want to study how a company has allocated capital in the
past. Next, you need to examine the company’s return on invested capital and, more importantly, return on
incremental invested capital. Third is a careful consideration of incentives and corporate governance. And
finally, you can compare management’s actions to the five principles of capital allocation.
Regulation may constrain the choices a management team has in the allocation of capital. In industries
including insurance and banks, regulators seek to establish capital adequacy to offset possible adverse
outcomes. In utilities, regulations limit the returns on invested capital in order to best serve the public good.
Understanding regulations and how they might change is essential for these industries.
Past Spending Patterns. The first step in assessing a company’s capital allocation skills is to see how
management has allocated capital in the past. You should break the analysis into two parts, one dealing with
investments in the operations (M&A, capital expenditures, R&D, and working capital) and the other with
returning cash to claimholders (dividends, buybacks, and debt repayment).
The value of a business is the present value of future free cash flow (FCF). Free cash flow is defined as net
operating profit after tax (NOPAT), a measure of the cash earnings of the business that assumes no financial
leverage, minus investment (I) in future growth:
FCF = NOPAT – I
NOPAT is determined by sales and sales growth, operating profit margins, and the cash tax rate. Investment
is determined by changes in working capital, capital expenditures net of depreciation, and acquisitions net of
divestitures. You can calculate these sums using what Alfred Rappaport, a professor emeritus at the J. L.
Kellogg Graduate School of Management at Northwestern University, calls “value drivers.”87 Capital allocation
is primarily about the value drivers that determine investment.
To make the comparison clean, Rappaport defines value drivers as the number of cents the company invests
in each use for every $1.00 change in sales. For example, if a company’s working capital grows by $10 in a
given year and its sales grow by $100, the incremental working capital rate is 10 percent ($10/$100). If in
the same year capital expenditures are $130 and depreciation is $70, the fixed capital rate is 60 percent
($60/$100). You can calculate the value driver for acquisitions less divestitures in the same way.
October 19, 2016
A useful first step in assessing capital allocation is to see how much was invested in each area for an
incremental dollar of sales over time. We like to calculate results for a minimum of three years, if available, and
prefer to go back five to ten years when possible. Here are the numbers for Walmart for the five years ending
in fiscal 2016:88
Incremental working capital investment rate = 3.6 percent

Incremental fixed capital rate = 31.6 percent
Incremental M&A rate = 0.2 percent
Instantly, you will see whether the company is investing in working capital, capital expenditures, or M&A. That
allows you to focus your attention. In this case, it is clear that capital expenditures are the main use of capital.
Here are the numbers for Cisco Systems over the past five years (fiscal 2011-2016):
Incremental working capital investment rate = 17.0 percent

Incremental fixed capital rate = 41.2 percent
Incremental M&A rate = 226.7 percent
Now you can see that M&A has been more important than capital expenditures. In this case, you would roll up
your sleeves and figure out how management approaches its M&A decisions. You might also review past
deals to see how the market reacted.
This analysis is also useful to assess the change in practices from one CEO to the next. Some CEOs may
seek to grow primarily organically, which will raise one set of analytical issues. A successor may be more
acquisitive, raising a separate set of issues. Assuming past behaviors provide some basis for anticipating
future behavior, this analysis is very useful.
Look for inflection points as well. Are capital expenditures ramping up versus prior levels of spending? Is the
company improving its cash conversion cycle? You want to note changes in spending patterns so as to align
your analysis with the developments at the company.
The second component of this analysis is to understand how and why management has returned cash to
claimholders. This also requires considering a company’s capital structure and whether it can or should
change. The key is to understand the rationale and motivation for the decisions management makes to
evaluate whether they are consistent with the principles of building long-term value per share.
In assessing a company’s past capital allocation, it’s interesting to determine who exactly is making the
decision. Researchers surveyed executives and found that CEOs are least likely to delegate decisions about
M&A but much more likely to defer to colleagues on issues such as capital structure and payout ratio. CEOs
delegate less if they have a master’s degree in business administration, have been around for a long time, or
are particularly knowledgeable about a project. CEOs delegate more when the firm is large or complex. Most
companies say they use the net present value rule to make investments, but the reputation of the division
manager requesting resources is important as is senior management’s “gut feel.”89
It’s also useful to understand how the process works. As a practical matter, many companies approach capital
allocation through a budgeting process. In a simple version, each division has a capital budget and can either
accept that amount or ask for more. Such a request may be subject to a value audit. Research shows that
such a budgeting process can lead to overinvestment in low return projects if the budget exceeds the
opportunities and underinvestment if the opportunities exceed the budget.90
October 19, 2016
Calculating Return on Invested Capital and Return on Incremental Invested Capital. The second
component to assessing capital allocation is determining the output of management’s decisions through an
analysis of return on invested capital (ROIC) and return on incremental invested capital (ROIIC). ROIC provides
a picture of the company’s overall performance while ROIIC dwells on the efficiency of incremental spending.
Our report, “Calculating Return on Invested Capital: How to Determine ROIC and Address Common Issues,”
provides details on how to calculate ROIC and ROIIC and includes case studies.91 Here’s a quick summary.
NOPAT is the numerator of ROIC. Because NOPAT assumes no financial leverage, the sum is the same
whether a company is highly levered or free of debt. This is essential for comparability within and across
industries.
Invested capital is the denominator of ROIC. You can think of invested capital in two ways that are equivalent.
First, it’s the amount of net assets a company needs to run its business. Alternatively, it’s the amount of
financing a company’s creditors and shareholders need to supply to fund those net assets. These approaches
are the same since dual-entry accounting requires that both sides of the balance sheet equal one another.
You should calculate ROIC using the assets side of the balance sheet if given a choice, as that allows you to
see how efficiently the company is using capital. In contrast, the right-hand side shows only how much capital
the firm has and how it has chosen to finance the business. Ideally, you should calculate ROIC from both the
left- and right-hand sides of the balance sheet.
In fiscal 2016, Walmart’s NOPAT was $15.5 billion and its average invested capital was $143.0 billion, for an
ROIC of 10.8 percent. This is well in excess of the company’s cost of capital. Since strategies, a bundle of
investments, must earn a return in excess of the cost of capital in order to pass the NPV test, ROIC can be a
rough proxy for value creation.
Academic research shows that the market rewards investment in organic growth in high return businesses.
Typically, companies that earn high ROICs are said to have some sort of competitive advantage. A quick
analysis of ROIC indicates whether a company has a competitive advantage and, if so, what lies at the
foundation of that advantage.
Bruce Greenwald, a professor at Columbia Business School, argues that there are two sources of competitive
advantage: consumer advantage and production advantage. The key to each advantage is the creation of
barriers to entry that fend off competition. Barriers to entry are particularly strong when a company enjoys
economies of scale, which mean that the cost per unit for the incumbent is lower than that for a challenger.92
A consumer advantage is the result of the habitual use of a product, high costs of switching to a new product,
or high costs of searching for a superior product. A production advantage allows a company to deliver its
goods or services more cheaply than its competitors and is the result of either privileged access to inputs or to
proprietary technology that is difficult or costly to imitate. A competitive strategy analysis focuses on identifying
these sources of advantage and assessing their durability.
ROIC can provide a quick and useful way to investigate competitive advantage. You can decompose ROIC into
two parts, a modified version of what is known as a DuPont Analysis:
Return on invested capital (ROIC) = NOPAT x ____Sales____

Sales Invested Capital
October 19, 2016
The ratio of NOPAT/Sales, or NOPAT margin, is a measure of profit per unit. Sales/Invested Capital, or
invested capital turnover, is a measure of capital efficiency. Sales cancel out when you multiply the terms and
you are left with NOPAT/Invested Capital, or ROIC.
It is easy to imagine two companies arriving at the same ROIC by different paths. Walmart got to its 10.8
percent ROIC with a 3.2 percent NOPAT/Sales ratio and a 3.4 times Sales/Invested Capital ratio. This is a
classic low-margin, high-invested capital turnover business. A luxury goods seller, on the other hand, may
reach the same ROIC with an 18.0 percent NOPAT/Sales ratio and 0.6 times invested capital turnover.
Exhibit 41 summarizes the analysis. If a company gets to a high ROIC through a high NOPAT margin, you
should focus your analysis on a consumer advantage. If the company’s high return comes from a high turnover
ratio, emphasize analysis of a production advantage. For companies that are high in both, consider how the
advantages are reinforced by economies of scale.
Exhibit 41: ROIC and Competitive Advantage
Consumer and
Production
Production
Advantage
Advantage
Invested Capital Turnover
Consumer
No Advantage
Advantage
NOPAT Margin
Having defined and discussed ROIC we must now emphasize that it’s not the absolute ROIC that matters but
rather the change in ROIC. Or, even more accurately, what’s crucial is the expectation for changes in ROIC.
Needless to say, the market is not always perfect at anticipating change in ROIC, so having a sense of where
ROIC is going can be of great value.93
One potentially useful measure is return on incremental invested capital, or ROIIC. ROIIC properly recognizes
that sunk costs are irrelevant and that what matters is the relationship between incremental earnings and
incremental investments.
The definition of ROIIC is as follows:
ROIIC = Year2 NOPAT – Year1 NOPAT

Year1 invested capital – Year0 invested capital
October 19, 2016
In words, ROIIC compares the change in NOPAT in a given year to the investments made in the prior year.
Let’s say a company’s Year0 invested capital is $2,000 and it invests $200 during the year (making Year1
invested capital $2,200). Further, NOPAT from Year1 to Year2 climbs from $300 to $350. Given these
assumptions, ROIIC is 25 percent [($350-300)/($2,200-2,000)].
It is preferable to calculate ROIIC on a rolling three- or five-year basis for businesses with investments or
NOPAT that are lumpy. At the other extreme, you can take quarterly changes and annualize them if you want
to see if there are any recent trends or improvements. Obviously these results will be the most volatile, but
they can give you some insights into how the business is doing. As an example of the calculation, Walmart’s
ROIIC is 105 percent for fiscal 2016, -44 percent for a rolling three-year period ended 2016, and -11 percent
for the rolling five-year period ended 2016.
High ROIICs generally indicate that a business is either capital efficient or has substantial operating leverage
(which often proves transitory). Calculating a company’s historical ROIIC can be very helpful in understanding
potential earnings moves.
A final note of warning: ROIIC—for a host of technical reasons—is not really an economic measure of value.
Further, ROIIC makes the strong underlying assumption that the ROIC on the base business remains stable.
This is clearly not always true. So use the measure to determine the likelihood of change and to understand
past patterns, but don’t compare it with the cost of capital or consider it a true return measure.94
Incentives and Corporate Governance. One of the essential lessons of economics is that incentives matter.
But it is also the case that incentives designed to achieve one objective can lead to unintended
consequences.95 The goal of this section is to consider whether the incentives a company has in place
encourage judicious capital allocation. Most of these incentives address compensation.
Agency theory is the classic way to explain why the managers of a company may not act in the interests of the
shareholders.96 The idea is that conflicts can arise when there is a separation between ownership and control
of a firm. There are three areas where these conflicts tend to arise.97
The first is that while it is clear that shareholders want management to maximize the value of their holdings,
management may derive benefits from controlling resources that don’t enrich shareholders. For example, if
remuneration is roughly correlated with the size of the firm, management may seek to do value-destroying
M&A deals to grow.
The second area of conflict is with tolerance for risk. Since shareholders tend to hold stocks as part of a
diversified portfolio and managers are disproportionately exposed to their own company, managers may seek
less risk than shareholders would deem appropriate.
The final conflict is with time horizon. To the degree that compensation plans have a shorter time horizon than
the period shareholders use to assess the merit of an investment, there can be a mismatch. So managers may
dwell on short-term boosts in earnings. Indeed, research shows that a large majority of managers are willing to
forego value-creating investments to deliver near-term earnings.98
So what kind of executive compensation scheme provides the proper incentives for management to build
value? You can start with what you don’t want, which is incentive compensation that is completely
independent of value creation. In this case, an executive would have limited incentive to build value because
he or she would not benefit directly from that increase. At the other extreme would be the case where the
CEO owns 100 percent of the company, blunting any concerns about agency theory.
October 19, 2016
As a broad characterization, compensation for CEOs in the past 30 years has moved from one based heavily
on salary and bonus to one much more sensitive to stock price performance.99 But the shift to stock-based
compensation, seemingly a step in reducing agency costs, has brought with it a host of other challenges.
Most pronounced is that many executives are now focused on boosting the stock price by whatever means
they can rather than focusing on creating value, which ultimately gets reflected in the market price.
There is a spirited debate about whether equity-based compensation is doing a proper job of encouraging
management to focus on long-term performance.100 In practice, there are two challenges to equity-based
compensation that make it less effective than it might be. Properly structured compensation programs can
address both challenges, but rarely do. The first is a company’s stock price is only a rough measure of
corporate performance. Factors outside of management’s control, including general economic conditions,
interest rates, inflation expectations, and the equity risk premium, can play a larger role in stock price changes
than corporate results do.101
The second challenge is that while the stock market does provide managers with information about investment
opportunities and the past decisions of managers, that information can be noisy in the short run.102 That few
managers understand market expectations effectively compounds this challenge.103
Before discussing how to address these challenges, let’s take a look at the metrics that companies most
commonly use in their incentive compensation. Frederic W. Cook & Co., a consulting firm dedicated to
executive compensation, does an annual survey of the largest 250 companies in the S&P 500. Exhibit 42
shows the results. In recent years, TSR has emerged as the most common incentive metric, followed by
measures of profit and capital efficiency.104
Exhibit 42: Most Commonly Used Long-Term Incentive Metrics

2015 2014 2013
Total shareholder return 54% 58% 54%
Profit (EPS, etc.) 51 50 49
Capital efficiency 41 41 40
Revenue 20 21 20
Cash flow 11 13 12
Other 14 15 17
Source: Frederic W. Cook & Co., “The 2015 Top 250 Report: Long-Term Incentive Grant Practices for Executives,” December 2015.
On the surface it may appear encouraging that TSR is on top of the list. But there are a couple of reasons for
caution. Using TSR as an incentive metric doesn’t really matter if a company doesn’t know how to create
value. Having the right goal isn’t helpful if you don’t know how to achieve that goal. And since TSR is absolute
versus relative to some benchmark, external factors may play a bigger role in compensation than company-
specific factors. So unless TSR is relative to an appropriate benchmark, it fails to reflect the efforts of the firm.
The Credit Suisse HOLT team built a scorecard to assess the quality of management incentives. Unlike the
Frederic W. Cook & Co. survey, the HOLT approach is to award points for positive incentive measures such
as operational drivers, return on capital, relative TSR, and long-term plans, and to deduct points for negative
measures including no disclosure, absence of financial targets, substantial option expense, and no long-term
plan. The sample includes most of the top 1,000 companies in the U.S.105
October 19, 2016
Exhibit 43 shows the average management incentive score by sector using the proxy statements filed in 2015.
The sectors with the most positive scores include materials and consumer staples, while telecommunication
services and information technology fare relatively poorly.
Exhibit 43: Average Management Incentive Scores by Sector, 2015
Materials
Consumer Staples
Industrials
Healthcare
Financials
Energy
Utilities
1.0 1.5 2.0 2.5 3.0

So what elements should you look for in an effective incentive program? The key is to look for a company that
seeks to build long-term value per share with the belief that the stock market will ultimately follow that value. If
the market fails to reflect that value, management can take action by sharpening communication or buying
back stock.
There are three elements to an incentive compensation program that supports judicious capital allocation.106
The first is to compensate senior executives with stock options or restricted stock units that are indexed to
either the market overall or an appropriate peer group. Presuming that exogenous factors affect peers in a
similar fashion as the target firm, indexing takes a large step toward isolating management skill and reducing
the role of luck. Only individuals who can influence the stock price should be paid in equity, which limits the
number of eligible executives.
Second, executives who run operating units, as well as front line employees, should be paid for exceeding
long-term goals for the operating value drivers. These include sales growth, operating profit margins, and
some measure of return on invested capital. Broader value drivers can be further broken down into leading
indicators of value, performance measures that roll up to the value drivers.
For example, if a retailer has a goal of opening five new stores in a year, a leading indicator of value might
include finding a store location and signing a lease. Here again, the incentives are awarded based on what the
individual employees can control. Warren Buffett explains that a good plan “should be (1) tailored to the
economics of the specific operating business; (2) simple in character so that the degree to which they are
being realized can be easily measured; and (3) directly related to the daily activities of the plan participants.”107
October 19, 2016
Finally, recognize that the debate about the short term versus the long term is an empty one. Instead,
acknowledge that the goal is to maximize long-term value per share. This applies to activities that
management expects to pay off quickly or in the distant future.108 Amazon.com is a company that appears
comfortable taking a long-term view. The company’s CEO, Jeff Bezos, argues that there is less competition
for long-term initiatives. He says, “If everything you do needs to work on a three-year time horizon, then you’re
competing against a lot of people. But if you’re willing to invest on a seven-year time horizon, you’re now
competing against a fraction of those people, because very few companies are willing to do that. Just by
lengthening the time horizon, you can engage in endeavors that you could never otherwise pursue. At Amazon
we like things to work in five to seven years.”109
Incentives are an important determinant of behavior. Examine whether a management team is committed to
building long-term value by examining their words, incentives, and actions. Agency costs are alive and well,
and in many cases companies try to boost their stock price using artificial or superficial methods versus
boosting underlying long-term value through the proper conception and execution of a strategic plan.
Five Principles of Capital Allocation. In their book, The Value Imperative, James McTaggart, Peter Kontes,
and Michael Mankins describe four principles of resource allocation that apply readily to our discussion about
capital allocation.110 We added one to expand the list to five and believe that these principles are a sound
benchmark that you can use to measure management’s mindset regarding their capital allocation practices. 111
1. Zero-based capital allocation. Companies generally think about capital allocation on an incremental
basis. For example, a study of more than 1,600 U.S. companies by McKinsey found that there was a
0.92 correlation between how much capital a business unit received in one year and the next. For one-
third of the companies, that correlation was 0.99.112 In other words, inertia appears to play a large role in
capital allocation.
The proper approach is zero-based, which simply asks, “What is the right amount of capital (and the right
number of people) to have in this business in order to support the strategy that will create the most
wealth?”113 There is no reference to how much the company has already invested in the business, only
how much should be invested.
Research by McKinsey suggests that those companies that showed a zero-based allocation mindset, and
hence were the most proactive in reallocating resources, delivered higher TSRs than the companies that
took more of an incremental approach.114 Further, academic research shows that those companies that
are good at internal capital allocation tend to be good at external allocation as well.115
2. Fund strategies, not projects. The idea here is that capital allocation is not about assessing and
approving projects, but rather assessing and approving strategies and determining the projects that
support the strategies. Practitioners and academics sometimes fail to make this vital distinction.116 There
can be value-creating projects within a failed strategy, and value-destroying projects within a solid strategy.
Another reason to be cautious about a project approach is that it is easy to game the system. It is
common for companies to have thresholds for project approval. For instance, a plant manager can
approve small projects, business unit heads larger ones, the CEO bigger ones still, and the board of
directors the largest investments. But at each level, analysts can manipulate the numbers to look good.
One of the aspects of the institutional imperative, as Buffett describes it, is, “Any business craving of the
leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared
by his troops.”117
October 19, 2016
The key to this principle is recognizing that a business strategy is a bundle of projects and that the value of
the bundle is what matters. The CEO and board must evaluate alternative strategies and consider the
financial prospects of each.
3. No capital rationing. The attitude at many companies, which the results of surveys support, is that
capital is “scarce but free.” The sense is that the business generates a limited amount of capital which
makes it “scarce,” but since it comes from within it is “free.”
The primary source of capital for companies in the U.S. is the cash they generate. The patterns of
spending on the various uses of capital indicate the attitude of managements. Capital expenditures, R&D,
and dividends receive priority, and M&A and share buybacks are considered when economic results are
good. Internal capital allocation tends to be very stable from year to year, and inertia plays a large role.
Business units may jockey for more capital but, as we have seen, the changes in year-to-year allocation
tend to be modest. These observations are consistent with the “scarce but free” mindset.
A better mindset is that capital is plentiful but expensive. There are two sources of capital that companies
can tap beyond the cash generated internally. The first is redeploying capital from businesses that do not
earn sufficient returns. Management can execute this inside the company or sell the underperforming
businesses and redeploy the proceeds. The second is the capital markets. When executives have value-
creating strategies that need capital, the markets are there to fund them in all but the most challenging
environments.
The notion that internally generated capital is free is also problematic. Thoughtful capital allocators
recognize that all capital has an opportunity cost, whether the source is internal or external. As a
consequence, managers should explicitly account for the cost of capital in all capital allocation decisions.
Too frequently, companies select actions that add to earnings or earnings per share without properly
reckoning for value.
The limiting resource for many companies is not access to capital but rather access to talent. Finding
executives with the proper skills for success, including an aptitude for allocating capital, is not easy. This is
a valid challenge but relates to recruiting and development, not access to capital.
4. Zero tolerance for bad growth. Companies that wish to grow will inevitably make investments that do
not pay off. The failure rate of new businesses and new products is high. Seeing an investment flop is no
sin; indeed it is essential to the process of creating value. What is a sin is remaining committed to a
strategy that has no prospects to create value, hence draining human and financial resources.
Executives who follow this principle invest in innovation but are ruthless in cutting losses when they see
that a strategy is unlikely to pay off. Many companies have the opportunity to create substantial value by
exiting businesses where they have no advantage. This reduces cross-subsidization within the organization
and allows for the best managers to work for the businesses that create the most value.
5. Know the value of assets, and be ready to take action to create value. Intelligent capital allocation
is similar to managing a portfolio of stocks in that it is very useful to have a sense of the difference, if any,
between the value and price of each asset. This includes the value of the company and its stock price.
Naturally, such analysis must include considerations such as taxes.
With a ready sense of value and price, management should be prepared to take action to create value.
Sometimes that means acquiring, other times that means divesting, and frequently there are no clear gaps
October 19, 2016
between value and price. As we have seen, managers tend to prefer to buy than to sell, even though the
empirical record shows quite clearly that sellers fare better than buyers, on average.
As we mentioned in the introduction, the answer to most capital allocation questions is, “It depends.”
Managers who adhere to this final principle understand when it makes sense to act on behalf of long-term
shareholders.
Conclusion
Capital allocation is one of management’s prime responsibilities. Yet few senior executives are versed or
trained in methods to allocate capital most effectively. Further, incentive programs frequently encourage
behaviors that are not in the best interests of long-term shareholders. We believe that the goal of capital
allocation is to build long-term value per share.
In this report, we examined the sources and uses of capital. We found that U.S. corporations fund most of
their investments internally and that M&A and capital expenditures are the largest uses of capital for
operations. We then examined seven capital allocation alternatives, noting what the actual spending has been,
how to think about that alternative analytically, what the academic research says, and the near-term outlook.
Finally, we set out a framework to assess the capital allocation practices of a management team. This
framework includes examining past behavior, calculating return on invested capital, weighing incentives, and
considering the five principles of thoughtful capital allocation.
October 19, 2016
Acknowledgment
We thank the Credit Suisse HOLT team for their essential contributions to this research. In particular, we
appreciate the assistance of Ron Graziano, Tom Hillman, David Matsumura, Bryant Matthews, and Chris
Morck. We could not have done this analysis without their aid.
October 19, 2016
Checklist for Assessing Capital Allocation Skills
Past Spending Patterns

Have you analyzed how companies have spent money in the past, separating operating uses from return
of capital to claimholders?
Do you know if management thinks about that use of capital properly?

Have there been shifts in the pattern of spending?
If there is new management, has spending changed?
ho makes which capital allocation decision?
How does the company conduct its budgeting process?
Calculate ROIC and ROIIC
Have you calculated ROIC over time and observed a trend?
—does this suggest a consumer or production
advantage?
Have you compared the company’s results to those of its peers?
Have you calculated ROIIC for one-, three-, and five-year rolling periods?
Incentives and Governance
Have you examined the company’s incentive score?
Five Principles of Capital Allocation

-based capital allocation or is it dominated by spending inertia?
strategies or projects?
ce but free” attitude about capital, or “abundant but costly?”
Does the company prune businesses with poor prospects for creating value?
ts assets and does it act accordingly?
October 19, 2016
Endnotes
1
Michael E. Porter, “What is Strategy?” Harvard Business Review, November-December, 1996, 61-78. For a
more in-depth discussion, see Joan Magretta, Understanding Michael Porter: The Essential Guide to
Competition and Strategy (Boston, MA: Harvard Business Review Press, 2012).
2
www.berkshirehathaway.com/letters/1987.html.
3
4
5
for Success (Boston, MA: Harvard Business Review Press, 2012). For another text that describes capital
allocation, see Justin Pettit, Strategic Corporate Finance: Applications in Valuation and Capital Structure
6
Michael J. Mauboussin and Dan Callahan, “What Does a Price-Earnings Multiple Mean? An Analytical Bridge
between P/Es and Solid Economics,” Credit Suisse Global Financial Strategies, January 29, 2014.
7
Stewart C. Myers and Nicholas S. Majluf, “Corporate Financing and Investment Decisions When Firms Have
Information that Investors Do Not Have,” Journal of Financial Economics, Vol. 13, No. 2, June 1984, 187-
221.
8
Michael J. Mauboussin and Dan Callahan, “Disbursing Cash to Shareholders: Frequently Asked Questions
about Buybacks and Dividends,” Credit Suisse Global Financial Strategies, May 6, 2014.
9
Stephen A. Ross, Randolph W. Westerfield, Jeffrey F. Jaffe, Corporate Finance – Sixth Edition (Boston, MA:
McGraw-Hill/Irwin, 2002), 385.
10
Jason Zweig, “Peter’s Uncertainty Principle,” Money Magazine, November 1994, 143-149.
See http://money.cnn.com/2004/10/11/markets/benstein_bonus_0411/index.htm.
Here is Zweig’s question and Bernstein’s answer:
Q: Hugh Liedtke, the former CEO of Pennzoil, used to joke that he believed in the “bladder theory”:
Companies pay dividends so that management can’t p--s all the money away.
A: It’s hard to improve on that. In the 1960s, in “A Modest Proposal,” I suggested that companies should be
required to pay out 100% of their net income as cash dividends. If companies needed money to reinvest in
their operations, then they would have to get investors to buy new offerings of stock. Investors would do that
only if they were happy both with the dividends they’d received and the future prospects of the company.
Markets as a whole know more than any individual or group of individuals. So the best way to allocate capital
is to let the market do it, rather than the management of each company. The reinvestment of profits has to be
submitted to the test of the marketplace if you want it to be done right.
For academic research supporting this point, see Jeffrey Wurgler, “Financial Markets and the Allocation of
Capital,” Journal of Financial Economics, Vol. 58, Nos. 1-2, 2000, 187-214.
11
Juliane Begenau and Berardino Palazzo, “Firm Selection and Corporate Cash Holdings,” Harvard Business
School Working Paper, No. 16-130, May 2016. Also, Thomas W. Bates, Kathleen M. Kahle, and René M.
Stulz, “Why Do U.S. Firms Hold So Much More Cash than They Used To?” Journal of Finance, Vol. 64, No. 5,
October 2009, 1985-2021.
12
John Asker, Joan Farre-Mensa, and Alexander Ljungqvist, “Corporate Investment and Stock Market Listing:
A Puzzle?” European Corporate Governance Institute (ECGI) - Finance Research Paper Series, January 27,
2014.
13
For the mix shift, see Douglas J. Skinner, “The Evolving Relation Between Earnings, Dividends, and Stock
Repurchases,” Journal of Financial Economics, Vol. 87, No. 3, March 2008, 582-609. Also, Gustavo Grullon,
Bradley Paye, Shane Underwood, and James P. Weston, “Has the Propensity to Pay Out Declined?” Journal
of Financial and Quantitative Analysis, Vol. 46, No. 1, February 2011, 1-24. Also, Jacob Boudoukh, Roni
October 19, 2016
Michaely, Matthew Richardson, and Michael R. Roberts, “On the Importance of Measuring Payout Yield:
Implications for Empirical Asset Pricing,” Journal of Finance, Vol. 63, No. 2, April 2007, 877-915.
14
See http://www.blackrock.com/corporate/en-no/literature/press-release/ldf-corp-gov-2016.pdf.
15
Erin Medlyn and Alex Granados, “Survey: CFOs Weigh In on Affordable Care Act, Interest Rates, Stock
Market Overhang,” Fuqua School of Business, Duke University Press Release, September 11, 2013. See
www.fuqua.duke.edu/news_events/news-releases/cfo-survey-results-2013-q3/#.U63JUuTD-KQ. Also,
Ryan Banerjee, Jonathan Kearns, and Marco Lombardi, “(Why) Is Investment Weak?” BIS Quarterly Review,
March 2015, 67-82.
16
Returns,” Journal of Finance, Vol. 63, No. 4, August 2008, 1609-1651. Also, Eugene F. Fama and Kenneth
R. French, “A Five-Factor Asset Pricing Model,” Journal of Financial Economics, Vol. 116, No. 1, April 2015,
1-22. Also, Adriana S. Cordis and Chris Kirby, “Capital Expenditures and Firm Performance: Evidence from a
Cross-Sectional Analysis of Stock Returns,” Accounting & Finance, Forthcoming, 2016. For non-U.S. results,
see Akiko Watanabe, Yan Xu, Tong Yao, and Tong Yu, “The Asset Growth Effect: Insights for International
Equity Markets,” Journal of Financial Economics, Vol. 108, No. 2, May 2013, 259-263. Also, Sheridan
Titman, K. C. John Wei, and Feixue Xie, “Market Development and the Asset Growth Effect: International
Evidence,” Journal of Financial and Quantitative Analysis, Vol. 48, No. 5, October 2013, 1405-1432. The
quotation in the body of the text comes from Cooper, Gulen, and Schill.
17
Peter J. Clark and Roger W. Mills, Masterminding the Deal: Breakthroughs in M&A Strategy and Analysis
(London: Kogan Page, 2013). Also, Matthew Rhodes-Kropf and S. Viswanathan, “Market Valuation and
Merger Waves,” Journal of Finance, Vol. 59, No. 6, December 2004, 2685-2718.
18
Gerry McNamara, Jerayr Haleblian, and Bernadine Johnson Dykes, “The Performance Implications of
Participating in an Acquisition Wave,” Academy of Management Journal, Vol. 51, No. 1, February 2008, 113-
130.
19
Mark L. Sirower, The Synergy Trap: How Companies Lose the Acquisition Game (New York: Free Press,
1997). For a tutorial and spreadsheet that guides this analysis, see
www.expectationsinvesting.com/tutorial10.shtml.
20
Companies – Sixth Edition (Hoboken, NJ: John Wiley & Sons, 2015), 587. Also, Connor Lynagh, “Does the
Market Reward Accretive Deals? An Investigation of Acquirer Performance and Earnings per Share Accretion,”
Glucksman Institute for Research in Securities Markets Working Paper, April 1, 2014.
21
Erik Devos, Palani-Rajan Kadapakkam, and Srinivasan Krishnamurthy, “How Do Mergers Create Value? A
Comparison of Taxes, Market Power, and Efficiency Improvements as Explanations for Synergies,” Review of
Financial Studies, Vol. 22, No. 3, March 2009, 1179-1211. One exception is the surge in “inversions,” cases
where U.S. companies change domiciles after acquiring foreign targets to reduce their taxes. Congress
passed a law in 2004 that was meant to stop inversions, but companies figured out how to circumvent the
rules a few years ago. This led to a mini-boom in inversions, including more than 20 since 2012. See Zachary
Mider and Jesse Drucker, “Tax Inversion: How U.S. Companies Buy Tax Breaks,” Bloomberg.com, April 6,
2016. In April 2016, the U.S. Treasury Department proposed stringent new regulations to make inversions
more difficult, and in October 2016 the department finalized the rules. Despite allowing for a variety of
exceptions, the government expects to collect $461-$600 million per year through the new regulations. See
Richard Rubin, “Treasury Announces Final Regulations on Earnings Stripping,” Wall Street Journal, October
13, 2016.
22
“How Synergies Drive Successful Acquisitions: Identifying, Realizing, and Tracking Synergies in the M&A
Process,” Transaction Services Roundtable-PricewaterhouseCoopers, 2010.
23
Alfred Rappaport and Mark L. Sirower, “Stock or Cash? The Trade-Offs for Buyers and Sellers in Mergers
and Acquisitions,” Harvard Business Review, November-December 1999, 147-158. Further, academic
research suggests that serial acquirers fail to create value. See Tomi Laamanen and Thomas Keil,
October 19, 2016
“Performance of Serial Acquirers: Toward an Acquisition Program Perspective,” Strategic Management

Journal, Vol. 29, No. 6, June 2008, 663-672.
24
Jerayr Haleblian, Cynthia E. Devers, Gerry McNamara, Mason A. Carpenter, and Robert B. Davison,
“Taking Stock of What We Know About Mergers and Acquisitions: A Review and Research Agenda,” Journal
of Management, Vol. 35, No. 3, June 2009, 469-502.
25
Koller, Goedhart, and Wessels, 570.
26
Mark L. Sirower and Sumit Sahni, “Avoiding the ‘Synergy Trap’: Practical Guidance on M&A Decisions for
CEOs and Boards,” Journal of Applied Corporate Finance, Vol. 18, No. 3, Summer 2006, 83-95.
27
For a similar analysis, see Joseph L. Bower, “Not All M&A’s Are Alike—and That Matters,” Harvard
Business Review, March 2001, 92-101.
28
Tim Loughran and Anand M. Vijh, “Do Long-Term Shareholders Benefit From Corporate Acquisitions?”
Journal of Finance, Vol. 52, No. 5, December 1997, 1765-1790. Also, Anushree Awasthee and David
Cogman, “Creating Value from M&A—Advantage Asia?” McKinsey on Finance, Number 58, Spring 2016,
12-14.
29
Here’s an example. Assume a buyer has a market capitalization of $2,000 and a seller has a pre-deal
market capitalization of $800. Say that the buyer bids $1,000 (a $200 premium, or 25 percent) in cash but
that the true synergy is $400. The value of the buyer would rise to $2,200 as the synergy exceeds the
premium by $200. Now assume the same starting point but that the buyer is using stock for the deal. The
buyer will end up with two-thirds percent of the combined entity, and two-thirds of the $200 in additional value
will flow to the buyer and one-third will go to the seller.
30
For a more detailed, and likely more accurate, approach see Bruce C. N. Greenwald, Judd Kahn, Paul D.
Sonkin, and Michael van Biema, Value Investing: From Graham to Buffett and Beyond (Hoboken, NJ: John
Wiley & Sons, 2001), 96. Specifically, they recommend three steps: 1. Calculate the ratio of gross property,
plant, and equipment (PPE) to sales for each of the past five years and find the average; 2. Use this to
indicate the dollars of PPE it takes to support each dollar of sales; 3. Multiply this ratio by the growth (or
decrease) in sales dollars the company achieved in the current year. The result of that calculation is capital
expenditures dedicated to growth.
31
For a general framework for competitive strategy analysis, see Michael J. Mauboussin and Dan Callahan,
“Measuring the Moat: Assessing the Magnitude and Sustainability of Value Creation,” Credit Suisse Global
Financial Strategies, July 22, 2013. For more specific issues surrounding capital expenditures, see Alan C.
Shapiro, “Corporate Strategy and the Capital Budgeting Decision,” Midland Corporate Finance Journal, Spring
1985, 22-36.
32
Michael E. Porter, “Capital Choices: Changing the Way America Invests in Industry,” Journal of Applied
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33
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John J. McConnell and Chris J. Muscarella, “Corporate Capital Expenditure Decisions and the Market Value
of the Firm,” Journal of Financial Economics, Vol. 14, No. 3, September 1985, 399-422. Also, Kee H.
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Expenditure Decisions,” Journal of Banking & Finance, Vol. 22, No. 1, January 1998, 41-60.
35
Sheridan Titman, K. C. John Wei, and Feixue Xie, “Capital Investments and Stock Returns,” Journal of
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36
Steven M. Paul, Daniel S. Mytelka, Christopher T. Dunwiddie, Charles C. Persinger, Bernard H. Munos,
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Grand Challenge,” Nature Reviews Drug Discovery, Vol. 9, March 2010, 203-214.
37
Aswath Damodaran, “Research and Development Expenses: Implications for Profitability Measurement and
Valuation,” NYU Working Paper No. FIN-99-024, 1999.
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Jack W. Scannell, Alex Blanckley, Helen Boldon, and Brian Warrington, “Diagnosing the Decline in
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October 19, 2016
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39
Allan C. Eberhart, William F. Maxwell, and Akhtar R. Siddique, “An Examination of Long-Term Abnormal
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40
Bronwyn H. Hall, Jacques Mairesse, and Pierre Mohnen, “Measuring the Returns to R&D,” in Bronwyn H.
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41
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42
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Tom Hillman and Chris Morck, “Using the HOLT Framework to Assess Acquisition Skill,” Credit Suisse
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44
Patrick Seitz, “Top Tech Stocks Not Big R&D Spenders, Surprising Study Shows,” Investors.com, July 7,
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45
Mariana Mazzucato, The Entrepreneurial State: Debunking Public vs. Private Sector Myths (London:
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46
“2016 Global R&D Funding Forecast,” R&D Magazine, Winter 2016.
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Robert Kieschnick, Mark Laplante, and Rabih Moussawi, “Working Capital Management and Shareholders’
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48
Michael Kisser, “The Real Option Value of Cash,” Review of Finance, Vol. 17, No. 5, September 2013,
1649-1697.
49
DSO = [(Beginning accounts receivable + ending accounts receivable)/2]/(Revenue/365). DIO =
[(Beginning inventory + ending inventory)/2]/(Cost of goods sold/365). DPO = [(Beginning accounts payable
+ ending accounts payable)/2]/(Cost of goods sold/365).
50
Manuel L. Jose, Carol Lancaster, and Jerry L. Stevens, “Corporate Returns and Cash Conversion Cycles,”
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51
Kieschnick, Laplante, and Moussawi.
52
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53
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October 19, 2016
57
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58
For the recent performance of spin-offs, see Dani Burger, “Cold Spell Ends for Spinoffs as Rising Market
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61
62
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David Zion, Ron Graziano, Ravi Gomatam, and Jason Williams, “Parking Lots of Cash & Earnings Overseas:
At Least $750 Billion in Cash & Nearly $2.3 Trillion in Earnings,” Credit Suisse Equity Research, March 11,
2016. Also, C. Fritz Foley, Jay C. Hartzell, Sheridan Titman, and Garry Twite, “Why Do Firms Hold So Much
Cash? A Tax-Based Explanation,” Journal of Financial Economics, Vol. 86, No. 3, December 2007, 579-607.
67
Ali Fatemi and Recep Bildik, “Yes, Dividends are Disappearing: Worldwide Evidence,” Journal of Banking &
Finance, Vol. 36, No. 3, March 2012, 662-677.
68
Jayant R. Kale, Omesh Kini, and Janet D. Payne, “The Dividend Initiation Decisions of Newly Public Firms:
Some Evidence on Signaling with Dividends,” Journal of Financial and Quantitative Analysis, Vol. 47, No. 2,
April 2012, 365-396. Also, Doron Nissim and Amir Ziv, “Dividend Changes and Future Profitability,” Journal
of Finance, Vol. 56, No. 6, December 2001, 2111-2133.
69
Shirley A. Lazo, “Another Banner Year for Dividends,” Barron’s, June 7, 2014.
70
Robert D. Arnott and Clifford S. Asness, “Surprise! Higher Dividends = Higher Earnings Growth,” Financial
Analysts Journal, Vol. 59, No. 1, January/February 2003, 70-87.
71
Jordan Voss, “Why do Firms Repurchase Stock?” Major Themes in Economics, Spring 2012.
72
See www.sec.gov/divisions/marketreg/r10b18faq0504.htm.
73
Returns (Boston, MA: Harvard Business School Press, 2001), 174.
74
For details on calculating the rate of returns for buybacks, see Mauboussin and Callahan, “Disbursing Cash
to Shareholders.”
75
Michael C. Jensen, “Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers,” American
Economic Review, Vol. 76, No. 2, May 1986, 323-329.
76
Alice A. Bonaimé, Kristine W. Hankins, and Bradford D. Jordan, “The Cost of Financial Flexibility: Evidence
from Share Repurchases,” Journal of Corporate Finance, Vol. 38, June 2016, 345-362. Also, Chao Zhuang,
“Share Repurchases, Market Timing, and the Distribution of Free Cash Flow,” Working Paper, March 10,
2015.
October 19, 2016
77
“CFO Signals™: What North America’s Top Finance Executives Are Thinking—and Doing,” Deloitte
Research, Second Quarter 2013.
78
Jin Wang and Lewis D. Johnson, “Information Asymmetry, Signaling, and Share Repurchase,” Working
Paper, February 2008.
79
Gustavo Grullon and David L. Ikenberry, “What Do We Know about Share Repurchases?” Journal of
Applied Corporate Finance, Vol. 13, No. 1, Spring 2000, 31-51. For the survey result, see Brav, Graham,
Harvey, and Michaely, 2005.
80
While buybacks do boost the EPS of individual companies, they don’t enhance value. See Jacob Oded and
Allen Michel, “Stock Repurchases and the EPS Enhancement Fallacy,” Financial Analysts Journal, Vol. 64, No.
4, July/August 2008, 62-75. Further, buybacks have a negligible impact on the S&P 500 Index. Howard
Silverblatt, a senior index analyst at S&P, writes, “The S&P index weighting methodology adjusts for shares,
so buybacks are reflected in the calculations. Specifically, the index reweights for major share changes on an
event-driven basis, and each quarter, regardless of the change amount, it reweights the entire index
membership. The actual index EPS calculation determines the index earnings for each issue in USD, based on
the specific issues’ index shares, index float, and EPS. The calculation negates most of the share count
change, and reduces the impact on EPS.” See Howard Silverblatt, “Buybacks and the S&P 500® EPS,”
Indexology Blog, March 7, 2014.
81
Heitor Almeida, Vyacheslav Fos, and Mathias Kronlund, “The Real Effects of Share Repurchases,” Journal
of Financial Economics, Vol. 119, No. 1, January 2016, 168-185. Also, Konan Chan, David L. Ikenberry,
Inmoo Lee, and Yanzhi Wang, “Share Repurchase as a Potential Tool to Mislead Investors,” Journal of
Corporate Finance, Vol. 16, No. 2, April 2010, 137-158.
82
Gustavo Grullon and Roni Michaely, “Dividends, Share Repurchases, and the Substitution Hypothesis,”
Journal of Finance, Vol. 57, No. 4, August 2002, 1649-1684.
83
Antti Ilmanen, Expected Returns: An Investor’s Guide to Harvesting Market Rewards (Chichester, UK: John
Wiley & Sons, 2011), 129.
84
For older announcements see David Ikenberry, Josef Lakonishok, Theo Vermaelen, “Market Underreaction
to Open Market Share Repurchases,” Journal of Financial Economics, Vol. 39, Nos. 2 and 3, October-
November 1995, 181-208. For more recent announcements, see Fangjian Fu and Sheng Huang, “The
Persistence of Long-Run Abnormal Returns Following Stock Repurchases and Offerings,” Management
Science, Vol. 62, No. 4, April 2016, 964-984. Also, Theodoros Evgeniou, Enric Junqué de Fortuny, Nick
Nassuphis, and Theo Vermaelen, “Share Buyback and Equity Issue Anomalies Revisited,” INSEAD Working
Paper 2016/21/DSC/FIN, April 7, 2016. In addition, Eugene F. Fama and Kenneth R. French, “Dissecting
Anomalies with a Five-Factor Model,” Review of Financial Studies, Vol. 29, No. 1, January 2016, 69-103.
85
“S&P 500 Buybacks Fall 21% in Q2 2016,” S&P Dow Jones Indices, September 28, 2016.
86
Michael J. Mauboussin, More Than You Know: Finding Financial Wisdom in Unconventional Places –
Updated and Expanded (New York: Columbia Business School Publishing, 2008), 64.
87
Free Press, 1986), 51-55.
88
This analysis does not reflect capitalized leases.
89
John R. Graham, Campbell R. Harvey, and Manju Puri, “Capital Allocation and Delegation of Decision-
Making Authority within Firms,” Journal of Financial Economics, Vol. 115, No. 3, March 2015, 449-470.
90
Milton Harris and Artur Raviv, “The Capital Budgeting Process: Incentives and Information,” Journal of
Finance, Vol. 51, No. 4, September 1996, 1139-1174.
91
Michael J. Mauboussin and Dan Callahan, “Calculating Return on Invested Capital: How to Determine ROIC
and Address Common Issues,” Credit Suisse Global Financial Strategies, June 4, 2014.
92
Strategy (New York: Portfolio, 2005).
93
Michael J. Mauboussin and Dan Callahan, “Economic Returns, Reversion to the Mean, and Total
Shareholder Returns,” Credit Suisse Global Financial Strategies, December 6, 2013.
October 19, 2016
94
Michael J. Mauboussin and Alexander Schay, “Where’s the Bar? Introducing Market-Expected Return on
Investment (MEROI),” Credit Suisse First Boston Equity Research, June 12, 2001.
95
Canice Prendergast, “The Provision of Incentives in Firms,” Journal of Economic Literature, Vol. 37, No. 1,
March 1999, 7-63.
96
Michael C. Jensen and William H. Meckling, “Theory of the Firm: Managerial Behavior, Agency Costs, and
Ownership Structure,” Journal of Financial Economics, Vol. 3, No. 4, October 1976, 305-360. For the
empirical validity of agency theory, see Kathleen M. Eisenhardt, “Agency Theory: An Assessment and Review,”
Academy of Management Review, Vol. 14, No. 1, January 1989, 57-74.
97
Richard A. Lambert and David F. Larcker, “Executive Compensation, Corporate Decision Making, and
Shareholder Wealth: A Review of the Evidence,” in Fred K. Foulkes, ed., Executive Compensation: A
Strategic Guide for the 1990s (Boston, MA: Harvard Business School Press, 1991), 98-125.
98
John R. Graham, Campbell R. Harvey, and Shiva Rajgopal, “Value Destruction and Financial Reporting
Decisions,” Financial Analysts Journal, Vol. 62, No. 6, November/December 2006, 27-39.
99
Brian J. Hall and Jeffrey B. Liebman, “Are CEOs Really Paid Like Bureaucrats?” Quarterly Journal of
Economics, Vol. 113, No. 3, August 1998, 653-691.
100
For the negative case see Lucian A. Bebchuk and Jesse M. Fried, “Paying for Long-Term Performance,”
University of Pennsylvania Law Review, Vol. 158, No. 7, June 2010, 1915-1960. For the affirmative case
see Steven N. Kaplan, “Weak Solutions to an Illusory Problem,” University of Pennsylvania Law Review, Vol.
159, 2010, 43-56 and Steven N. Kaplan and Joshua Rauh, “Wall Street and Main Street: What Contributes
to the Rise in the Highest Incomes?” Review of Financial Studies, Vol. 23, No. 3, March 2010, 1004-1050.
101
Florian Hoffmann and Sebastian Pfeil, “Reward for Luck in a Dynamic Agency Model,” Review of Financial
Studies, Vol. 23, No. 9, September 2010, 3329-3345.
102
James Dow and Gary Gorton, “Stock Market Efficiency and Economic Efficiency: Is There a Connection?”
Journal of Finance, Vol. 52, No. 3, July 1997, 1087-1129.
103
Rappaport, Creating Shareholder Value, 148-168.
104
Frederic W. Cook & Co., “The 2015 Top 250 Report: Long-Term Incentive Grant Practices for Executives,”
December 2015, see: www.fwcook.com/content/Documents/Publications/FWC_2015_Top_250.pdf.
105
Tom Hillman and David Matsumura, “The Board Score: Linking Corporate Performance and Valuation to
Management Incentives,” Credit Suisse HOLT, July 2014.
106
This discussion borrows heavily from Alfred Rappaport, “Ten Ways to Create Shareholder Value,” Harvard
Business Review, September 2006, 66-77.
107
http://www.berkshirehathaway.com/letters/1996.html.
108
Alfred Rappaport, Saving Capitalism from Short-Termism: How to Build Long-Term Value and Take Back
Our Financial Future (New York: McGraw Hill, 2011), 140-142.
109
Steven Levy, “Jeff Bezos Owns the Web in More Ways Than You Think,” Wired Magazine, November 13,
2011.
110
McTaggart, Kontes, and Mankins, 239-255.
111
We believe that these principles, when coupled with the discussion in part two, are consistent with what
Thorndike calls “The Outsider’s Checklist.” See Thorndike, 218-220.
112
Stephen Hall, Dan Lovallo, and Reiner Musters, “How to Put Your Money Where Your Strategy Is,”
McKinsey Quarterly, March 2012.
113
McTaggart, Kontes, and Mankins, 243.
114
Research shows that public companies do a better job of allocating capital to growth opportunities than
private companies do. See Sandra Mortal and Natalia Reisel, “Capital Allocation by Public and Private Firms,”
Journal of Financial and Quantitative Analysis, Vol. 48, No. 1, February 2013, 77-103. For an academic
discussion of the functioning of internal capital markets, see Jeremy C. Stein, “Internal Capital Markets and
the Competition for Corporate Resources,” Journal of Finance, Vol. 52, No. 1, March 1997, 111-133.
October 19, 2016
115
Meng Ye, “Efficiency of Internal Capital Allocation and the Success of Acquisitions,” University of New
Orleans Theses and Dissertations, Paper 1106, December 20, 2009.
116
Clayton M. Christensen, Stephen P. Kaufman, and Willy C. Shih, “Innovation Killers: How Financial Tools
Destroy Your Capacity to Do New Things,” Harvard Business Review, January 2008, 98-105.
117
Buffett, 1989.
October 19, 2016
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®
HOLT
With respect to the analysis in this report based on the Credit Suisse HOLT methodology, Credit Suisse certifies that (1) the views expressed in this
report accurately reflect the Credit Suisse HOLT methodology and (2) no part of the Firm's compensation was, is, or will be directly related to the
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Measuring the Moat

Assessing the Magnitude and Sustainability of Value Creation
November 1, 2016
Authors
Dan Callahan, CFA

Darius Majd
“The most important thing to me is figuring out how big a moat there is around
the business. What I love, of course, is a big castle and a big moat with piranhas
and crocodiles.”
Warren E. Buffett
Linda Grant, “Striking Out at Wall Street,” U.S. News & World Report, June 12, 1994
Sustainable value creation is of prime interest to investors who seek to

anticipate expectations revisions.
This report develops a systematic framework to determine the size of a
company’s moat.
We cover industry analysis, firm-specific analysis, and firm interaction.
November 1, 2016
Table of Contents
Executive Summary ................................................................................................................................ 3
Introduction ............................................................................................................................................ 4
Competitive Life Cycle ................................................................................................................. 4
Economic Moats ......................................................................................................................... 7
What Dictates a Company’s Destiny? ........................................................................................... 8
Industry Analysis ................................................................................................................................... 10

The Lay of the Land .................................................................................................................. 11
Industry Map ................................................................................................................. 11
Profit Pool .................................................................................................................... 13
Industry Stability ............................................................................................................ 15
Industry Classification .................................................................................................... 17
Industry Structure – Five Forces Analysis .................................................................................... 18
Entry and Exit ............................................................................................................... 19
Competitive Rivalry ........................................................................................................ 25
Disruption and Disintegration ..................................................................................................... 27
Firm-Specific Analysis ........................................................................................................................... 32

A Framework for Added-Value Analysis ...................................................................................... 32
Value Chain .............................................................................................................................. 33
Sources of Added Value ............................................................................................................ 34
Production Advantages .................................................................................................. 34
Consumer Advantages ................................................................................................... 38
Government .................................................................................................................. 41
Firm Interaction – Competition and Cooperation ...................................................................................... 42
Brands ................................................................................................................................................. 46
Management Skill and Luck................................................................................................................... 48
Regression Toward the Mean ................................................................................................................ 50
Bringing It All Back Together ................................................................................................................. 51
Warren Buffett on Economic Moats ........................................................................................................ 52
Appendix A: Checklist for Assessing Value Creation ................................................................................ 53
Appendix B: Profit Pool Analysis for Health Care ..................................................................................... 55
Endnotes ............................................................................................................................................. 59
References .......................................................................................................................................... 65
Books ...................................................................................................................................... 65
Articles and Papers ................................................................................................................... 69
Measuring the Moat 2

November 1, 2016
Executive Summary
Sustainable value creation has two dimensions: the magnitude of the spread between a company’s return
on invested capital and the cost of capital and how long it can maintain a positive spread. Both
dimensions are of prime interest to investors and corporate executives.
Sustainable value creation as the result solely of managerial skill is rare. Competitive forces and
endogenous variance drive returns toward the cost of capital. Investors should be careful about how
much they pay for future value creation.
Warren Buffett consistently emphasizes that he wants to buy businesses with prospects for sustainable
value creation. He suggests that buying a business is like buying a castle surrounded by a moat and that
he wants the moat to be deep and wide to fend off all competition. Economic moats are almost never
stable. Because of competition, they are getting a little bit wider or narrower every day. This report
develops a systematic framework to determine the size of a company’s moat.
Companies and investors use competitive strategy analysis for two very different purposes. Companies
try to generate returns in excess of the cost of capital, while investors try to anticipate revisions in
expectations for financial performance. If a company’s share price already captures its prospects for
sustainable value creation, investors should expect to earn a market rate of return, adjusted for risk.
Industry effects are the most important in the sustainability of high performance and a close second in
the emergence of high performance. However, industry effects are much smaller than firm-specific
factors for low performers. For companies that are below average, strategies and resources explain
90 percent or more of their returns.
The industry is the correct place to start an analysis of sustainable value creation. We recommend
understanding the lay of the land, which includes getting a grasp of the participants and how they interact,
an analysis of profit pools, and an assessment of industry stability. We follow this with an analysis of the
five forces and a discussion of the disruptive innovation framework.
A clear understanding of how a company creates shareholder value is core to understanding sustainable
value creation. We define three broad sources of added value: production advantages, consumer
advantages, and external advantages.
How firms interact plays a vital role in shaping sustainable value creation. We consider interaction through
game theory, co-opetition, and co-evolution.
Brands do not confer competitive advantage in and of themselves. Customers hire them to do a specific
job. Brands that do those jobs reliably and cost effectively thrive. Brands only add value if they increase
customer willingness to pay or if they reduce the cost to provide the good or service.
Regression toward the mean is a powerful force. Empirical results show which industries regress at the
fastest rate, providing a useful quantitative complement to the qualitative assessment here.
Appendix A provides a complete checklist of questions to guide the strategic analysis.

November 1, 2016
Introduction
Corporate managers seek to allocate resources so as to generate attractive long-term returns on investment.
Investors search for stocks of companies that are mispriced relative to expectations for financial results
embedded in the shares. In both cases, sustainable value creation is of prime interest.
What exactly is sustainable value creation? We can think of it in two dimensions. First is the magnitude of
returns in excess of the cost of capital that a company does, or will, generate. Magnitude considers not only
the return on investment but also how much a company can invest at a rate above the cost of capital. Growth
only creates value when a company generates returns on investment that exceed the cost of capital.
The second dimension of sustainable value creation is how long a company can earn returns in excess of the
cost of capital. This concept is also known as fade rate, competitive advantage period (CAP), value growth
duration, and T.1 Despite the unquestionable significance of the longevity dimension, researchers and
investors give it insufficient attention.
How is sustainable value creation distinct from the more popular notion of sustainable competitive advantage?
A company must have two characteristics to claim that it has a competitive advantage. The first is that it must
generate, or have an ability to generate, returns in excess of the cost of capital. Second, the company must
earn an economic return that is higher than the average of its competitors.2
As our focus is on sustainable value creation, we want to understand a company’s economic performance
relative to the cost of capital, not relative to its competitors. Naturally, these concepts are closely linked.
Sustainable value creation is rare, and sustainable competitive advantage is even rarer.
Competitive Life Cycle
We can visualize sustainable value creation by looking at a company’s competitive life cycle. (See Exhibit 1.)
Companies are generally in one of four phases:
Innovation. Young companies typically realize a rapid rise in return on investment and significant
investment opportunities. Substantial entry into and exit out of the industry are common at this point in
the life cycle.
Fading returns. High returns attract competition, generally causing economic returns to move toward
the cost of capital. In this phase, companies still earn excess returns, but the return trajectory is down.
Investment needs also moderate, and the rate of entry and exit slows.
Mature. In this phase, the market in which the companies compete approaches competitive equilibrium.
As a result, companies earn a return on investment similar to the industry average, and competition within
the industry ensures that aggregate returns are no higher. Investment needs continue to moderate.
Subpar. Competitive forces and technological change can drive returns below the cost of capital,
requiring companies to restructure. These companies can improve returns by shedding assets, shifting
their business model, reducing investment levels, or putting themselves up for sale. Alternatively, these
firms can file for bankruptcy to reorganize the business or liquidate the firm’s assets.

November 1, 2016
Exhibit 1: A Firm’s Competitive Life Cycle

Above-Average Average Below-Average
but Fading Returns Returns Returns
High Innovation Fading Returns Mature Needs Restructuring
Discount Rate
Economic (Required
Return Rate of Return)
Reinvestment
Rates
Regression toward the mean says that an outcome that is far from average will be followed by an outcome
that has an expected value closer to the average. There are two explanations for regression toward the mean
in corporate performance. The first is purely statistical. If the correlation between cash flow return on
investment (CFROI®) in two consecutive years is not perfect, there is regression toward the mean.
Think of it this way: there are aspects of running the business within management’s control, including
selecting the product markets it chooses to compete in, pricing, investment spending, and overall execution.
Call that skill. There are also aspects of the business that are beyond management’s control, such as
macroeconomic developments, customer reactions, and technological change. Call that luck. Whenever luck
contributes to outcomes, there is regression toward the mean. If year-to-year CFROIs are highly correlated,
regression toward the mean happens slowly. If CFROIs are volatile, causing the correlation to be low,
regression toward the mean is rapid.
The second explanation for regression toward the mean is that competition drives a company’s return on
investment toward the opportunity cost of capital. This is based on microeconomic theory and is intuitive. The
idea is that companies that generate a high economic return will attract competitors willing to take a lesser,
albeit still attractive, return. Ultimately, this process drives industry returns toward the opportunity cost of
capital. Researchers have documented the accuracy of this prediction.3 Companies must find a way to defy
these powerful competitive forces in order to achieve sustainable value creation.
Recent research on the rate of regression reveals some important observations. First, the time that an average
company can sustain excess returns is shrinking. This phenomenon is not relegated to high technology but is
evident across a wide range of industries.4 This reduction in the period of sustained value creation reflects the
greater pace of innovation brought about in part by increased access to, and utilization of, information
technology.
®

CFROI is a registered trademark in the United States and other countries (excluding the United Kingdom) of Credit Suisse
Group AG or its affiliates.

November 1, 2016
Second, the absolute level of returns and the level of investment are positively related to the rate of fade.5 A
company that generates a high return on investment while investing heavily signals an attractive opportunity to
both existing and potential competitors. Success sows the seeds of competition.
Why is sustainable value creation so important for investors? To start, investors pay for value creation. Exhibit
2 looks at the S&P 500 since 1961 and provides a proxy for how much value creation investors have been
willing to pay for. We establish a steady-state value by capitalizing the last four quarters of operating net
income for the S&P 500 by an estimate of the cost of equity capital.6 We then attribute any value above the
steady-state to expected value creation.
The exhibit shows that 40 percent of the value of the S&P 500 today reflects anticipated value creation,
above the average of the last 55 years. Following a sharp drop in 2011 to a level near a 50-year low, the
expectations for value creation have risen to a level modestly above the long-term average.
Exhibit 2: Rolling Four Quarter Anticipated Value Creation, 1961-2017E

70
2 standard deviations
60
Anticipated Value Creation (%)
50
Current
Average
40
30
20
10 2 standard deviations
-10
-20
1967
1961
1963
1965
1969
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011
2013
2015
2017
Source: Standard & Poor’s, Aswath Damodaran, Credit Suisse.

Note: As of November 1, 2016.
More significant, sustained value creation is an important source of expectations revisions. There is a crucial
distinction between product markets and capital markets. Companies try to understand the industry and
competitive landscape in their product markets so as to allocate resources in a way that maximizes long-term
economic profit. Investors seek to understand whether today’s price properly reflects the future and whether
expectations are likely to be revised up or down.
Companies and investors use competitive strategy analysis for two very different purposes. Companies try to
generate returns above the cost of capital, while investors try to anticipate revisions in expectations. Investors

November 1, 2016
should anticipate earning a market return, adjusted for risk, if a company’s share price already captures its
prospects for sustainable value creation. But companies that can create value longer than the market expects
generate excess returns with volatility that is lower than expected.7
We will spend most of our time trying to understand how and why companies attain sustainable value creation
in product markets. But we should never lose sight of the fact that our goal as investors is to anticipate
revisions in expectations. Exhibit 3 shows the process and emphasizes the goal of finding and exploiting
expectations mismatches.
Exhibit 3: The Link between Market Expectations and Competitive Strategy

Market-Implied
Expectations
for Value Creation
Potential for Industry

Expectations Revisions Analysis
Firm-Specific
Analysis
Economic Moats
Warren Buffett, the chairman of Berkshire Hathaway, has emphasized over the years that he looks for
businesses with sustainable competitive advantages. He suggests that buying a business is akin to buying a
castle surrounded by a moat. Buffett wants the economic moat to be deep and wide to fend off all
competition. He goes a step further by noting that economic moats are almost never stable. Moats either get
a little bit wider or a little bit narrower every day.8 This report develops a systematic framework to determine
the size of a company’s moat.

November 1, 2016
What Dictates a Company’s Destiny?
Peter Lynch, who skillfully ran Fidelity’s Magellan mutual fund for more than a decade, quipped that investors
are well advised to buy a business that’s so good that an idiot can run it, because sooner or later an idiot will
run it.9 Lynch’s comment introduces an important question: What dictates a firm’s economic returns? We are
not asking what determines a company’s share price performance, which is a function of expectations
revisions, but rather its economic profitability.10
Before we answer the question, we can make some empirical observations. The top panel of Exhibit 4 shows
the spread between CFROI and the cost of capital for 68 global industries, as defined by MSCI’s Global
Industry Classification Standard (GICS), using median returns over the past five fiscal years. The sample
includes more than 10,000 public companies. We see that some industries have positive economic return
spreads, some are neutral, and some don’t earn the cost of capital.
Exhibit 4: Industry Returns Vary from Value-Creating to Value-Destroying

40
CFROI minus Discount Rate (%)
30
20
10
-10
-20
Beverages Containers & Packaging Marine
40 40 40
30 30 30
20 20 20
10 10 10
0 0 0
-10 -10 -10
-20 -20 -20

Note: Data through latest fiscal year as of 10/25/16.
The bottom panel of Exhibit 4 shows the spread between CFROI and the cost of capital for the companies in
three industries: one that creates value, one that is value neutral, and one that destroys value. The central
observation is that even the best industries include companies that destroy value and the worst industries have
companies that create value. That some companies buck the economics of their industry provides insight into
the potential sources of economic performance. Industry is not destiny.
Finding a company in an industry with high returns or avoiding a company in an industry with low returns is not
enough. Finding a good business capable of sustaining high performance requires a thorough understanding
of the conditions for the industry and the firm.

November 1, 2016
A final word before we proceed. Our unit of analysis will be the firm. In most cases, the proper unit of analysis
is the strategic business unit. This is especially true for multidivisional companies that compete in disparate
industries. The following framework is applicable on a divisional level. So we recommend conducting the
analysis for each strategic business unit of a multidivisional company and aggregating the results.

November 1, 2016
Industry Analysis
We have established that industry effects and firm effects are relevant in understanding corporate
performance. The question is in what proportion.11
Anita McGahan and Michael Porter, two prominent scholars of business strategy, analyzed roughly 58,000
firm-year observations for U.S. businesses from 1981-1994.12 They assessed the impact of four factors on
the sustainability and emergence of abnormal profitability:
Year. The year effect captures the economic cycle. You can think of it as the macroeconomic factors that
influence all businesses in the economy.
Industry. Industry effects refer to how being part of a particular industry affects firm performance. A firm
may benefit from industry effects if the industry has an attractive structure, including high barriers to entry.
Corporate-parent. A corporate-parent effect arises when a business within a diversified firm on average
underperforms or outperforms its industry. For example, the corporate-parent effect was positive for Taco
Bell, which saw its profitability improve in the 1980s following its acquisition by PepsiCo.
Segment-specific. This effect captures the characteristics unique to a firm that drive its performance
relative to rivals within the same industry. Such characteristics may include a firm’s resources, positioning,
or how effectively its managers execute strategy.
Exhibit 5 summarizes McGahan and Porter’s results. They define sustainability of profits as “the tendency of
abnormally high or low profits to continue in subsequent periods.” Emergence looks backward from the current
year and measures the contributions to abnormal profits through time. High performers are those companies
that generate profits in excess of the median of their industry, and low performers are those below the median.
Exhibit 5: Importance of Various Factors on Abnormal Profitability

Sustainability Emergence
High Performers Low Performers High Performers Low Performers
Year 3% -7% 2% -5%
Industry 44% 12% 37% 13%
Corporate-Parent 19% -4% 18% 2%
Segment-Specific 34% 99% 43% 90%
Source: Anita M. McGahan and Michael E. Porter, “The emergence and sustainability of abnormal profits,” Strategic Organization, Vol. 1, No. 1,
February 2003, 79-108.
McGahan and Porter found that industry effects are most important in the sustainability of high performance
and a close second in the emergence of high performance behind segment-specific effects. However,
industry effects are much smaller than segment-specific effects for low performers. The strategies and
resources of below-average companies explain 90 percent or more of their returns in the case of either
sustainability or emergence. Business managers and analysts searching for emerging or sustained competitive
advantages might also note that the economic cycle is not important to the sustainability or emergence of
performance.

November 1, 2016
We break the industry analysis into three parts:
1. Get the lay of the land. This includes creating an industry map to understand the competitive landscape,
constructing profit pools to see how the distribution of economic profits has changed over time,
measuring industry stability, and classifying the industry so as to improve alertness to the main issues and
opportunities.
2. Assess industry attractiveness through an analysis of the five forces. Of the five forces, we spend
the bulk of our time assessing barriers to entry and rivalry.
3. Consider the likelihood of being disrupted by innovation. We consider the role of disruptive
innovation and why industries transition from vertical to horizontal integration.
The Lay of the Land
Industry Map
Creating an industry map is a useful way to start competitive analysis.13 A map should include all the
companies and constituents that might have an impact on a company’s profitability. The goal of an industry
map is to understand the current and potential interactions that ultimately shape the sustainable value creation
prospects for the whole industry as well as for the individual companies within the industry.
From an industry point of view, you can think of three types of interactions: supplier (how much it will cost to
get inputs), customer (how much someone is willing to pay for a good or service), and external (other factors
that come into play, such as government action). Exhibit 6 shows an illustration for the U.S. airline industry.
Clients can create industry maps for specific companies using Credit Suisse’s PEERs tool, which analyzes a
company’s supply chain. Peers can be accessed within RAVE, Credit Suisse’s research database, which also
provides access to the forecasts of Credit Suisse analysts and a variety of other tools.
Here are some points to bear in mind as you develop an industry map:
List firms in order of dominance, typically defined as size or market share;
Consider potential new entrants as well as existing players;
Understand the nature of the economic interaction between the firms (e.g., incentives, payment terms);
Evaluate any other factors that might influence profitability (e.g., labor, regulations).
A study by Lauren Cohen and Andrea Frazzini, professors of finance, suggests that investors may benefit from
paying close attention to industry maps. The researchers examined how shocks to one firm rippled through to
other firms via supply or demand links. They tested whether the market adequately incorporated the
information that one firm released into the stock prices of its partner firms. They found that investors fail to
adequately incorporate such information, creating a profitable trading strategy.
Cohen and Frazzini state that “the monthly strategy of buying firms whose customers had the most positive
returns in the previous month, and selling short firms whose customers had the most negative returns, yields
abnormal returns of 1.55% per month, or an annualized return of 18.6% per year.” There is also evidence that
analysts who cover both suppliers and customers provide more accurate earnings forecasts.14

November 1, 2016
Exhibit 6: U.S. Airline Industry Map

Financing Global distribution systems
Leasing, banks, investors Sabre
Amadeus
Airports Government Travelport
Gates, takeoff/landing slots Regulation
Mandated services (e.g.,
Jet fuel security, air traffic control) Travel intermediaries
Travel agents
Corporate travel departments
Unions Website aggregators
Priceline.com
Labor Airlines Expedia
Cabin crew, pilots American (hub) Orbitz
Ground staff, other services United Continental (hub) TripAdvisor
Delta (hub)
Southwest (LCC)
External providers JetBlue (LCC) Fliers
Atlas Air Alaska Air (hub) Commercial
Air Transport Services Group SkyWest (regional) Business
Spirit (LCC)
Hawaiian Holdings (regional)
Parts suppliers Virgin America (LCC) Air freight and logistics
Engines Allegiant Travel (LCC) UPS
General Electric Republic Airways (mix) FedEx
Pratt & Whitney (UTX) Frontier (LCC) C.H. Robinson
Rolls-Royce UTi Worldwide
Other Expeditors
UTC Aerospace (UTX) Echo Global Logistics
Honeywell Forward Air
General Dynamics Aircraft
Textron Boeing
Precision Castparts Airbus
Spirit AeroSystems Bombardier
Rockwell Collins AVIC
Parker-Hannifin Embraer
L-3 Communications
Triumph Group
B/E Aerospace
Moog
CAE
TransDigm
Hexcel
Heico

Note: LCC = low-cost carrier.

November 1, 2016
Profit Pool
The next step is to construct a profit pool.15 A profit pool shows the distribution of an industry’s value creation
at a point in time. The horizontal axis measures size, typically invested capital or sales as a percentage of the
industry, and the vertical axis measures economic profitability (e.g., CFROI minus the discount rate). As a
result, the area of each rectangle—the product of invested capital and economic return—is the total value
added for that sector or company. For example, a company that has $200 million of invested capital and a
spread of 5 percentage points between its CFROI and discount rate generates $10 million in economic profit
($10 million = $200 million x .05). The total profit pool of the industry is the sum of the added value for all of
the companies.
To understand the overall profitability of an industry, it is useful to analyze the average profitability over a full
business cycle, which is generally three to five years.16 But average profitability doesn’t reveal how value has
migrated over time. Profit pools are particularly effective because they allow you to trace the increases or
decreases in the components of the value-added pie. One effective approach is to construct a profit pool for
today, five years ago, and ten years ago and then compare the results over time.
Exhibit 7 is a profit pool for the airlines industry. (See Appendix B for the health care sector.) It shows the
main components in the industry’s value chain including airlines, airports, and a variety of services. You can
see from the horizontal axis that airlines and airports use the majority of the capital invested in the industry.
These are also the businesses with among the lowest economic returns, which the vertical axis reflects.
Some businesses generate strong returns, including computer reservations systems (CRS), travel agents,
freight forwarders, and various service jobs. But with so little capital invested, they are too small to offset the
value destruction from airlines and airports. As a consequence, the industry as a whole destroyed an average
of $17 billion of shareholder capital per year through the 2004-11 business cycle, according to the
International Air Transport Association.17
Exhibit 7: Airline Industry Profit Pool by Activity, 2004-2011
40
Travel agents
35
30
ROIC - WACC (Percent)
25 CRS
20 Maintenance
Ground
15 services
Freight
Catering
10
forwarders
5
ANSPs
Airlines Airports Lessors
0
-5 Manufacturers 100%
-10
Share of Industry Gross Investment
Source: Based on IATA, "Profitability and the air transport value chain," IATA Economics Briefing No. 10, June 2013, 19-20.
CRS = computer reservations systems; ANSP = air navigation service provider.

November 1, 2016
We can also construct a profit pool of the leading companies within an industry. Exhibit 8 shows profit pools
for the U.S. airline companies for 2005, 2010, and 2015. The horizontal axis represents 100 percent of the
capital invested in the industry by public companies. These charts provide a bottom-up view of the industry’s
migration from value destruction to value creation.
Exhibit 8: Airline Industry Profit Pools by Company, 2005-2015

2005
6
CFROI minus Discount Rate (Percent)
2 South-
100%
west
United
0
Other
-2
Continental JetBlue
Alaska
-4
-6
American US Air
2010
6
2
South- 100%
Alaska
United Continental west
0
Delta Other
US Air
-2 JetBlue
-4
American
-6
2015
6 Alaska
JetBlue
2 United Continental
100%
0
American Delta South-
west Other
-2
-4
-6


November 1, 2016
Most airlines destroyed value over the first half of the decade, consistent with the industry’s history of weak
returns on capital as the result of low barriers to entry and high fixed costs. Even the low-cost, point-to-point
carriers struggled despite a history of outperforming the legacy carriers. But the performance of all the major
airlines improved considerably in recent years, with the six largest companies earning above their cost of
capital by 2015. Factors that drove the improvement include a sharp decline in the price of oil, better capacity
utilization, and extensive consolidation following a slew of bankruptcies.18 The x-axis shows that the top four
carriers increased their market share from roughly 70 percent in 2005 to 80 percent in 2015.
Industry Stability
Industry stability is another important metric. Generally speaking, stable industries are more conducive to
sustainable value creation. Unstable industries present substantial competitive challenges and opportunities.
The value migration in unstable industries is greater than that of stable industries, making sustainable value
creation that much more elusive.
We can measure industry stability a couple of ways. One simple but useful proxy is the steadiness of market
share. This analysis looks at the absolute change in market share for the companies within an industry over
some period. (We typically use five years.) We then add up the absolute changes and divide the sum by the
number of competitors. The lower the average absolute change in market share, the more stable the industry.
Exhibit 9 shows the market share stability for four industries. There is relative stability in automobile
manufacturing, while personal computers and mobile phones show moderate change, and there is substantial
change in the smartphone market. Our rule of thumb is that absolute average changes of 2.0 or less over five
years constitute a stable industry.

November 1, 2016
Exhibit 9: Market Share Stability, 2010-2015

Auto Manufacturers (U.S. Market) 2010 2015 5-Year Change
General Motors 19% 18% 2%
Ford Motor Company 17% 15% 2%
Toyota Motor Corporation 15% 14% 1%
Honda Motor Company 11% 9% 2%
Chrysler Group/FCA 9% 13% 3%
Nissan Motor Company 8% 9% 1%
Hyundai-Kia 8% 8% 0%
Volkswagen Group 3% 3% 0%
BMW-Mini 2% 2% 0%
Subaru 2% 3% 1%
Mazda 2% 2% 0%
Daimler 2% 2% 0%
Other 2% 2% 1%
Total 100% 100%
Average Absolute Change 1%
Personal Computers (Global by Units) 2010 2015 5-Year Change
Others 48% 52% 4%
Hewlett-Packard 16% 13% 3%
Acer Group 12% 5% 7%
Dell Inc 11% 10% 1%
Lenovo Group 9% 14% 6%
Asus 5% 5% 1%
Total 100% 100%
Mobile Phones (Global) 2010 2015 5-Year Change
Other 40% 49% 9%
Nokia/Microsoft 29% 7% 22%
Samsung 18% 21% 3%
LG Electronics 7% 4% 3%
Apple 3% 11% 8%
ZTE 2% 3% 1%
Huawei 2% 5% 4%
Total 100% 100%
Smartphones (Global) 2010 2015 5-Year Change
Nokia 34% 0% 34%
Other 27% 48% 21%
Research in Motion 17% 0% 16%
Apple 15% 16% 1%
Samsung 7% 23% 16%
Huawei 0% 7% 7%
Xiaomi 0% 5% 5%
Total 100% 100%
Source: Company data, Gartner, Nielsen, Credit Suisse.
Another way to measure industry stability is the trend in pricing. Price changes reflect a host of factors,
including cost structure (fixed versus variable), entry and exit dynamics, macroeconomic variables,
technological change (e.g., Moore’s Law and Wright’s Law), and rivalry. All else being equal, more stable
pricing reflects more stable industries. Warren Buffett places special emphasis on pricing power. He said,
“The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise
prices without losing business to a competitor, you’ve got a very good business. And if you have to have a
prayer session before raising the price 10 percent, then you’ve got a terrible business.”19 Exhibit 10 shows the
pricing trends for a variety of industries, classified as slow-, medium-, and fast-cycle businesses. Sustaining
value creation in a fast-cycle industry is a challenge.

November 1, 2016
Exhibit 10: Pricing Stability, 2009-2014

Average Annual
Industry Price Change
Slow-cycle markets
Dental Laboratories 7.7%
Rail and Transportation 4.4%
Breweries 3.4%
Standard-cycle markets
Highways and Streets 3.0%
Motor and Generator Manufacturing 2.8%
Bread and Bakery Product Manufacturing 2.5%
Fast-cycle markets
Warehousing and Storage -1.3%
Wireless Telecommunications Carriers (Except Satellite) -2.3%
Electronics and Appliance Stores -2.5%
Source: U.S. Department of Commerce Bureau of Economic Analysis; Based on Jeffrey R. Williams, Renewable Advantage (New York: The Free
Press, 2000), 11.
Industry Classification
Before turning to an industry analysis using the five forces framework, it’s useful to classify the industry you’re
analyzing. The analytical process remains the same no matter which category the industry falls into. But the
classification does provide guidance as to what issues you need to emphasize as you step through the
analysis. For example, the challenges in a mature industry are likely to be quite distinct from those in an
emerging industry. Exhibit 11 provides some broad classifications and the types of opportunities you should
associate with each.
Exhibit 11: Industry Structure and Strategic Opportunities

Industry Structure Opportunities
Fragmented industry Consolidation:

- Discover new economies of scale
- Alter ownership structure
Emerging industry First-mover advantages:
- Technological leadership
- Preemption of strategically valuable assets
- Creation of customer switching costs
Mature industry Product refinement
Investment in service quality
Process innovation
Declining industry Leadership strategy
Niche strategy
Harvest strategy
Divestment strategy
International industry Multinational opportunities
Global opportunities
Transnational opportunities
Network industry First-mover advantages
“Winner-takes-all” strategies
Hypercompetitive industry Flexibility
Proactive disruption
Source: Jay B. Barney, Gaining and Sustaining Competitive Advantage (Upper Saddle River, NJ: Prentice-Hall, Inc., 2002), 110.

November 1, 2016
Industry Structure—Five Forces Analysis
Michael Porter is well known for his five-forces framework (see Exhibit 12), which remains one of the best
ways to assess an industry’s underlying structure.20 While some analysts employ the framework to declare an
industry attractive or unattractive, Porter recommends using industry analysis to understand “the underpinnings
of competition and the root causes of profitability.” Porter argues that the collective strength of the five forces
determines an industry’s potential for value creation. But the industry does not seal the fate of its members.
An individual company can achieve superior profitability compared to the industry average by defending against
the competitive forces and shaping them to its advantage.21
Exhibit 12: Michael Porter's Five Forces That Shape Industry Structure
Threat of
new entrants
Rivalry among
existing firms
Bargaining power Bargaining power
of suppliers of buyers
Threat of
substitutes
Source: Michael E. Porter, Competitive Strategy (New York: The Free Press, 1980), 4.
While analysts commonly treat Porter’s five forces with equal emphasis, we believe that the threat of entry and
rivalry are so important that they warrant deeper consideration than the others. Further, our section on firm-
specific analysis will put a finer point on some of the other forces. For now, here is a quick look at supplier
power, buyer power, and substitution threat:22
Supplier power is the degree of leverage a supplier has with its customers in areas such as price, quality,
and service. An industry that cannot pass on price increases from its powerful suppliers is destined to be
unattractive. Suppliers are well positioned if they are more concentrated than the industry they sell to, if
substitute products do not burden them, or if their products have significant switching costs. They are also
in a good position if the industry they serve represents a relatively small percentage of their sales volume
or if the product is critical to the buyer. Sellers of commodity goods to a concentrated number of buyers
are in a much more difficult position than sellers of differentiated products to a diverse buyer base.
Buyer power is the bargaining strength of the buyers of a product or service. It is a function of buyer
concentration, switching costs, levels of information, substitute products, and the offering’s importance to
the buyer. Informed, large buyers have much more leverage over their suppliers than do uninformed,
diffused buyers.

November 1, 2016
Substitution threat addresses the existence of substitute products or services, as well as the likelihood
that a potential buyer will switch to a substitute product. A business faces a substitution threat if its prices
are not competitive and if comparable products are available from competitors. Substitute products limit
the prices that companies can charge, placing a ceiling on potential returns.
The threat of new entrants, or barriers to entry, is arguably the most important of Porter’s five forces. Before
we delve into the factors that determine impediments to entry, it is worthwhile to review the empirical research
on entry and exit.
Entry and Exit
Exhibit 13 shows the rate of entry and exit for U.S. establishments across all industries since 1977, using the
U.S. Census’s Business Dynamics Statistics (BDS). Most studies on corporate demography use
establishments as the unit of analysis because that is the way that the Census Bureau collects and reports the
data. Establishments are the physical sites where corporations operate whereas firms are the aggregations of
all the establishments a parent company owns. Most firms, and especially young ones, have only one
establishment. Note that not all exits are failures. For example, some exits are planned or are the result of the
sale of a viable business.23
A useful way to think about entry and exit is to imagine an industry with 100 firms today. Based on the annual
rates since 2000, an average of 11 new firms will enter the industry in each year and 10 will leave. This brings
the total number of firms to 101. Because the rate of entry typically exceeds that of exit, the number of
establishments in the U.S. has increased over time.
Exhibit 13: Rate of Entry and Exit for Establishments in the U.S., 1977-2014
18%
Entry Rate
Exit Rate
16%
14%
12%
10%
8%
6%
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
Source: U.S. Census Bureau, Center for Economic Studies, Business Dynamics Statistics; Credit Suisse.

November 1, 2016
It is also important to understand the history of entry and exit for the specific industry you are analyzing. These
rates vary widely based on where the industry is in its life cycle and on the industry’s barriers to entry and exit.
Research shows that the number of firms in new industries follows a consistent path.
The market is uncertain about the products it favors in the early stage of industry development, which
encourages small and flexible firms to enter the industry and innovate. As the industry matures, the market
selects the products it wants and demand stabilizes. The older firms benefit from economies of scale and
entrenched advantages, causing a high rate of exit and a move toward a stable oligopoly.24 Exhibit 14 shows
the entry and exit rates for a variety of sectors, grouped according to Standard Industrial Classification (SIC)
codes.
Exhibit 14: Annual Average Rate of Entry and Exit by Sector in the U.S., 1977-2014
16% Agricultural
Services,
Forestry,
Fishing
Transportion, Construction
14%
Public Utilities
Entry Rate
Services
Mining
12% Finance, Retail trade
Insurance, Real
Estate
10% Wholesale trade
Manufacturing
8%
8% 10% 12% 14% 16%
Exit Rate
There is a strong correlation between the rate of entry and exit for each sector. For instance, manufacturing
has low rates of entry and exit, while construction has very high rates, suggesting that the manufacturing
sector possesses stronger barriers to entry and exit.
Perhaps the most widely cited study of entry and exit rates is that of Timothy Dunne, Mark Roberts, and Larry
Samuelson (DRS). They examined more than 250,000 U.S. manufacturing firms over a 20-year span ended
in the early 1980s.25
A useful way to summarize the findings of DRS is to imagine a hypothetical industry in the year 2016 that has
100 firms with sales of $1 million each. Should the patterns of entry and exit in U.S. industries during the
period of their study apply to the future, the following will occur:26
Entry and exit will be pervasive. After five years, between 30 and 45 new firms will have entered the
industry and will have combined annual sales of $15-20 million. Half of these entrants will be diversified
firms competing in other markets, and half will be new firms. During the same time, 30 to 40 firms with

November 1, 2016
aggregate sales of $15-20 million will leave the industry. So the industry will experience a 30-45 percent
turnover in firms, with the entering and exiting firms representing 15-20 percent of the industry’s volume.
Companies entering and exiting tend to be smaller than the established firms. A typical entrant
is only about one-third the size of an incumbent, with the exception of diversifying firms that build new
plants. These diversifying firms, which represent less than 10 percent of total new entrants, tend to be
roughly the same size as the incumbents.
Entry and exit rates vary substantially by industry. Consistent with Exhibit 14, research by DRS
shows that low barriers to entry and low barriers to exit tend to go together.
Most entrants do not survive ten years, but those that do thrive. Of the 30 to 45 firms that enter
between 2016 and 2021, roughly 80 percent will exit by 2026. But the survivors will more than double
their relative size by 2026.
Other studies have found similarly low chances of survival for new firms.27 Research by Credit Suisse HOLT®
shows that less than 50 percent of public firms survive beyond ten years. Our analysis of the BDS data also
reveals low survival rates. Exhibit 15 shows one-year and five-year survival rates based on the birth year of the
establishment. The rate today is similar to that of 1977. The latest figures show one-year survival rates of
about 80 percent and five-year survival rates of roughly 50 percent.
Exhibit 15: Survival Rates for Establishments in the U.S. by Birth Year, 1977-2014
100%
One-year rate
Five-year rate
90%
80%
70%
60%
50%
40%
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
What influences the decision of a challenger to enter in the first place? On a broad level, potential entrants
weigh the expected reactions of the incumbents, the anticipated payoffs, and the magnitude of exit costs.28
Researchers also find that challengers neglect the high base rates of business failure, leading to
overconfidence and a rate of entry that appears higher than what is objectively warranted. We’ll explore each
of these factors.

November 1, 2016
Let’s first look at the expectations of incumbent reaction to a potential new entry. Four specific factors predict
the likely ferocity of incumbent reaction: asset specificity, the level of the minimum efficient production scale,
excess capacity, and incumbent reputation.
For a long time, economists thought that a firm’s commitment to a market was related to how much money
the company had invested in assets. More careful analysis revealed that it’s not the quantity of assets that
matters but how specific those assets are to the market. A firm that has assets that are valuable only in a
specific market will fight vigorously in order to maintain its position.
A clear illustration is a railroad versus an airline route. Say a company builds a railroad track from New York to
Chicago. It can use that asset for only one thing: to move a train back and forth between those two cities. As
a result, that company will go to great lengths to protect its position.29 Now consider an airline that flies from
New York to Chicago. If that route proves uneconomic, the airline can reroute the plane to a more attractive
destination.
Asset specificity takes a number of forms, including site specificity, where a company locates assets next to a
customer for efficiency; physical specificity, where a company tailors assets to a specific transaction;
dedicated assets, where a company acquires assets to satisfy the needs of a particular buyer; and human
specificity, where a company develops the skills, knowledge, or know-how of its employees.30
The next factor is production scale. For many industries, unit costs decline as output rises. But this only
occurs up to a point. This is especially relevant for industries with high fixed costs. A firm enjoys economies of
scale when its unit costs decline with volume gains. At some point, however, unit costs stop declining with
incremental output and companies get to constant returns to scale. The minimum efficient scale of production
is the smallest amount of volume a company must produce in order to minimize its unit costs. (See Exhibit
16.)
The minimum efficient scale of production tells a potential entrant how much market share it must gain in
order to price its goods competitively and make a profit. It also indicates the size of an entrant’s upfront capital
commitment. When the minimum efficient scale of production is high relative to the size of the total market, a
potential entrant is looking at the daunting prospect of pricing its product below average cost for some time to
get to scale. The steeper the decline in the cost curve, the less likely the entry. The main way an entrant can
try to offset its production cost disadvantage is to differentiate its product, allowing it to charge a price
premium versus the rest of the industry.
Minimum efficient scale is generally associated with manufacturing businesses, including automobile and
semiconductor fabrication plants. For example, the cost for Intel to produce its first Xeon microprocessor was
more than $10 billion, including the fabrication plant and associated research and development. But once the
chip was designed and the fab was up and running, the cost to produce incremental units dropped sharply.
The concept of minimum efficient scale also applies to knowledge businesses where a company creates
content once at a very high cost and then replicates it for the market. The same cost curve exists for software
as for hardware and it is even steeper in most cases.

November 1, 2016
Exhibit 16: Minimum Efficient Scale as a Barrier to Entry
Cost per unit
Minimum
Efficient
Scale Average
Cost
Q
Output
Source: Sharon M. Oster, Modern Competitive Analysis (Oxford: Oxford University Press, 1999), 62.
A third factor in assessing incumbent reaction is excess capacity. The logic here is quite straightforward.
Assuming that demand remains stable, an entrant that comes into an industry that has too much capacity
increases the excess capacity of the incumbents. If the industry has economies of scale in production, the
cost of idle capacity rises for the existing companies. As a result, the incumbents are motivated to maintain
their market share. So the prospect of a new entrant will trigger a price drop. This prospect deters entry.
The final factor is incumbent reputation. Firms usually compete in various markets over time. As a
consequence, they gain reputations as being ready to fight at the least provocation or as being
accommodating. A firm’s reputation, backed by actions as well as words, can color an entrant’s decision.
Another important shaper of barriers to entry is the magnitude of the entrant’s anticipated payoff. An entrant
cannot be sure that it will earn an attractive economic profit if the incumbent has an insurmountable
advantage. Incumbent advantages come in the form of precommitment contracts, licenses and patents,
learning curve benefits, and network effects.
The first incumbent advantage is precommitment contracts. Often, companies secure future business through
long-term contracts. These contracts can be efficient in reducing search costs for both the supplier and the
customer. A strong incumbent with a contract in place discourages entry.
Precommitment contracts take a number of forms. One is if an incumbent has favorable access to an
essential raw material. An example of this occurred shortly following World War II. Alcoa, an aluminum
producer, signed exclusive contracts with all of the producers of an essential material in aluminum production
called high-grade bauxite. The inability to access bauxite on such favorable terms deterred potential entrants.
Another form of precommitment contract is a long-term deal with customers. In the mid-1980s, Monsanto
(NutraSweet) and Holland Sweetener Company were two producers of the sweetener aspartame. After the
patent on aspartame expired in Europe in 1987, Holland entered the market to compete against Monsanto.
The competition drove down the price of aspartame 60 percent, and Holland lost money.

November 1, 2016
But Holland had its eye on the real prize, the U.S. market, where the patent was to expire in 1992. In a classic
precommitment move, Monsanto signed long-term contracts to supply the largest buyers of aspartame,
Coca-Cola and PepsiCo, and effectively shut Holland out of the United States. This suggests a crucial lesson
for companies and investors: all buyers want to have multiple suppliers, but it doesn’t mean that they will use
multiple suppliers. Holland created a great deal of value for Coke and Pepsi but none for itself.31
Precommitment also includes quasi-contracts, such as a pledge to always provide a good or service at the
lowest cost. Such pledges, if credible, deter entry because new entrants rarely have the scale to compete with
incumbents.
Licenses and patents also shape a potential entrant’s payoff for reasons that make common sense. A number
of industries require a license or certification from the government to do business. Acquiring licenses or
certifications is costly, hence creating a barrier for an entrant.
Patents are also an important entry barrier. But the spirit of a patent is different from that of a license. The
intent of a patent is to allow an innovator to earn an appropriate return on investment. Most innovations require
substantial upfront costs. So a free market system needs a means to compensate innovators to encourage
their activities. Patents do not discourage innovation, but they do deter entry for a limited time into activities
that are protected.
Learning curves can also serve as a barrier to entry. The learning curve refers to an ability to reduce unit costs
as a function of cumulative experience. Researchers have studied the learning curve for hundreds of products.
The data show that, for the median firm, a doubling of cumulative output reduces unit costs by about
20 percent.32 A company can enjoy the benefits of the learning curve without capturing economies of scale,
and vice versa. But generally the two go hand in hand.
Network effects are another important incumbent advantage that can weigh on an entrant’s payoff. Network
effects exist when the value of a good or service increases as more members use that good or service. As an
example, Uber is attractive to passengers precisely because so many riders and drivers congregate on the
platform. In a particular business, positive feedback often ensures that one network becomes dominant. For
example, in the U.S. Uber has not only weathered competitive onslaught, it has also strengthened its position.
Size, network structure, and connectivity contribute to network strength.33
Good examples today are the online social networks, including Facebook and Instagram, which become more
valuable to a user as more people join. We also see network effects in the smartphone market between the
dominant operating systems and application developers. Because the vast majority of users own devices
operating on Android or iOS, application developers are far more likely to build applications for them than for
other operating systems. This creates a powerful ecosystem that is daunting for aspiring entrants.34
The last point, consistent with DRS’s analysis of entry and exit, is the link between barriers to entry and
barriers to exit. High exit costs discourage entry. The magnitude of investment an entrant requires and the
specificity of the assets determine the size of exit barriers. Low investment needs and non-specific assets are
consistent with low barriers to entry.
Robert Smiley, a retired economist who specialized in competitive strategy, surveyed product managers about
their strategies to deter entry.35 While his analysis was limited to consumer products companies, the results
are instructive nonetheless. (See Exhibit 17.) The first three strategies—learning curve, advertising, and
R&D/patents—create high entry costs. The last three—reputation, limit pricing, and excess capacity—

November 1, 2016
influence judgments of post-entry payoffs. Virtually all managers reported using one or more of these
strategies to deter entry.
Exhibit 17: Reported Use of Entry-Deterring Strategy

Learning R&D/ Limit Excess
Curve Advertising Patents Reputation Pricing Capacity
New Products
Frequently 26% 62% 56% 27% 8% 22%
Occasionally 29 16 15 27 19 20
Seldom 45 22 29 47 73 58
Existing Products
Frequently 52% 31% 27% 21% 21%
Occasionally 26 16 22 21 17
Seldom 21 54 52 58 62
Source: Robert Smiley, "Empirical Evidence on Strategic Entry Deterrence”, International Journal of Industrial Organization, Vol. 6, June 1988, 172.
Behavioral factors also play a role in the decision to enter a business. A pair of economists, Colin Camerer and
Dan Lovallo, designed an experiment to understand why subjects enter a game.36 When the scientists
informed the subjects that the payoffs were based on skill, the individuals overestimated their probability of
success. As a result, they entered the game at a higher rate than those who were told that the payoffs were
random. Most subjects who entered the game believed they would have positive profits despite the negative
total profit among all entrants.
The researchers attributed the overconfidence of the entrants to “reference group neglect.” The idea is that
the entrants focused on what they perceived to be their unique skills while ignoring the abilities of their
competitors and the high failure rate of new entries as reflected in the reference group. The failure to consider
a proper reference class pervades many of the forecasts we make.37 In the business world, reference class
neglect shows up as unwarranted optimism for the length of time it takes to develop a new product, the
chance that a merger succeeds, and the likelihood of an investment portfolio outperforming the market.38
Competitive Rivalry
Rivalry among firms addresses how fiercely companies compete with one another along dimensions such as
price, service, new product introductions, promotion, and advertising. In almost all industries, coordination in
these areas improves the collective economic profit of the firms. For example, competitors increase their
profits by coordinating their pricing. Of course, coordination must be tacit, not explicit.
There is a tension between coordinating and cheating in most industries. A firm that “cheats” by lowering the
price on its product stands to earn disproportionate profits if the other firms do not react. We can think of
rivalry as understanding, for each firm, the trade-offs between coordination and cheating. Lots of coordination
suggests low rivalry and attractive economic returns. Intense rivalry makes it difficult for firms to generate high
returns.
Coordination is difficult if there are lots of competitors. In this case, each firm perceives itself to be a minor
player and is more likely to think individualistically. Naturally, the flip side suggests that the existence of fewer
firms leads to more opportunity for coordination. Research shows that most cases of price fixing that the
government prosecutes involve industries with fewer firms than average.39

November 1, 2016
A concentration ratio is a common way to measure the number and relative power of firms in an industry. The
Herfindahl-Hirschman Index (HHI) is a popular method to estimate industry concentration. The HHI considers
not only the number of firms but also the distribution of the sizes of firms. A dominant firm in an otherwise
fragmented industry may be able to impose discipline on others. In industries with several firms of similar size,
rivalry tends to be intense.
Exhibit 18 shows the HHI for 20 industries. Many economists characterize readings in excess of 1,800 as
industries with reduced rivalry. The index is equal to 10,000 times the sum of the squares of the market
shares of the 50 largest firms in an industry. If there are fewer than 50 firms, the amount is summed for all
firms in the industry. For instance, for an industry with four companies and market shares of 40 percent,
30 percent, 20 percent, and 10 percent, the index would be 3,000. (Take 10,000 x [(.4)2 + (.3) 2 + (.2) 2 +
(.1)2].)
Exhibit 18: Herfindahl-Hirschman Index for Selected Industries

Industry (Manufacturing) Herfindahl-Hirschman Index
Breakfast cereal 2,333
Household appliances 1,576
Tires 1,377
Automobiles 1,178
Plastic bottles 934
Flour milling 772
Explosives 771
Book printing 623
Poultry processing 600
Stationery products 497
Iron founderies 454
Sporting and athletic goods 373
Animal food 369
Basic chemicals 362
Fabric mills 275
Motor vehicle bodies 207
Adhesives 182
Machinery 91
Computer and electronic products 72
Retail bakeries 12
Source: U.S. Census Bureau, Concentration Ratios - 2012 Economic Census.
If industry concentration is a reliable indicator of the degree of rivalry, you’d expect to see some link between
concentration and profitability. Researchers have shown this to be the case. Two professors of finance, Kewei
Hou and David Robinson, examined industries for the years 1963-2001 and found that concentrated
industries earned above average profits and less concentrated industries earned below average profits.40
Another influence of rivalry is firm homogeneity. Rivalry tends to be less intense in industries with companies
that have similar goals, incentive programs, ownership structures, and corporate philosophies. But in many
instances, competitors have very different objectives. For example, an industry may have companies that are
public, privately held, or owned by private equity firms. These competitors may have disparate financial
objectives, incentive structures, and time horizons. The strategies that companies within an industry pursue will
reflect the heterogeneity of objectives.41

November 1, 2016
Asset specificity plays a role in rivalry. Specific assets encourage a company to stay in an industry even when
conditions become trying because there is no alternative use for the assets. Assets include physical assets,
such as railroad tracks, as well as intangible assets such as brands.
Demand variability shapes coordination costs and hence has an influence on rivalry. When demand variability is
high, companies have a difficult time coordinating internally and have little opportunity to effectively coordinate
with competitors. Variable demand is a particularly important consideration in industries with high fixed costs.
In these industries, companies often add too much capacity at points of peak demand. While companies use
this capacity at the peak, the capacity is excessive at the trough and spurs even more intense competition at
the bottom of the cycle. The conditions of variable demand and high fixed costs describe many commodity
industries, which is why their rivalry is so bitter and consistent positive economic returns are so elusive.
Industry growth is a final consideration. When the pie of potential excess economic profits grows, companies
can create shareholder value without undermining their competitors. The game is not zero-sum. In contrast,
stagnant industries are zero-sum games and the only way to increase value is to take it from others. So a rise
in rivalry often accompanies a decelerating industry growth rate.
Disruption and Disintegration
Most strategy frameworks focus primarily on figuring out which industries are attractive and which companies
are well positioned. Clayton Christensen, a professor of management, developed a theory to explain why great
companies fail and how companies succeed through innovation. Christensen wondered why it was common
for companies with substantial resources and smart management teams to lose to companies with simpler,
cheaper, and inferior products. His theory of disruptive innovation explains that process. 42
Christensen starts by distinguishing between sustaining and disruptive innovations. Sustaining innovations
foster product improvement. They can be incremental, discontinuous, or even radical. But the main point is
that a sustaining innovation operates within a defined value network—the “context within which a firm
identifies and responds to customers’ needs, solves problems, procures input, reacts to competitors, and
strives for profit.”43
A disruptive innovation, by contrast, approaches the same market with a different value network. Consider
book selling as an example. The evolution from mom-and-pop bookstores to superstores was a clear
innovation, but the value network was the same. Amazon.com introduced a new value network when it started
selling books online. It is common for disruptors to trade lower operating profit margins for high capital
turnover in their bid to earn returns on invested capital in excess of the cost of capital.
Christensen distinguishes between the two types of disruptive innovation: low-end disruption and new-market
disruption. A low-end disruptor offers a product that already exists. For instance, when Southwest Airlines
entered the airline industry, it provided limited flights with no frills at a very low cost. Southwest couldn’t, and
didn’t, compete with the large legacy carriers.
A new-market disruption, on the other hand, competes initially against “non-consumption.”44 It appeals to
customers who previously did not buy or use a product because of a shortage of funds or skills. A new-market
disruptive product is cheap or simple enough to enable a new group to own and use it.
The transistor radio, introduced in the 1950s, is an example of a new-market disruption. Manufacturers such
as Sony targeted teenagers, a group who wanted to listen to music on their own but who couldn’t afford

November 1, 2016
tabletop radios. Teenagers were so thrilled that they could listen to these pocket-sized radios away from their
parents that they ignored the static and poor sound quality.45
Disruptive innovations initially appeal to relatively few customers who value features such as low price, smaller
size, or greater convenience. Christensen finds that these innovations generally underperform established
products in the near term but are good enough for a segment of the market.
Exhibit 19 presents Christensen’s model visually. The horizontal axis is time, and the vertical axis is product
performance. The shaded area represents customer needs and takes the shape of a distribution that includes
low-end, average, and high-end customers.
The upward-sloping line at the top is the performance trajectory of sustaining innovations. The parallel,
upward-sloping line below it is the performance trajectory for a disruptive innovation.
Exhibit 19: Christensen's Model of Disruptive Innovation

Sustaining
Performance Innovation
Overshoot customer
performance needs
Mainstream
Customer
Needs
Meet customer
needs at lower price
Disruptive
Innovation
Time
Source: Clayton M. Christensen, The Innovator's Dilemma (Boston, MA: Harvard Business School Press, 1997), xvi.
One of the key insights of the model is that innovations often improve at a rate faster than the consumer
demands. Established companies, through sustaining technologies, commonly provide customers with more
than they need or more than they are ultimately willing to pay for. When innovation drives performance for a
sustaining technology past the needs of mainstream customers, the product is “overshot.” Indications that a
market is overshot include customers who are unwilling to pay for a product’s new features and who don’t use
many of the available features.
When the performance of a sustaining innovation exceeds the high end of the consumer’s threshold, the basis
of competition shifts from performance to speed-to-market and delivery flexibility. For instance, as the
personal computer market became overshot in the 1990s, manufacturers focused on performance, such as
Compaq, lost to manufacturers with more efficient delivery models, such as Dell.

November 1, 2016
The trajectory of product improvement allows disruptive innovations to emerge because even if they fail to
meet the demands of mainstream users today they become competitive tomorrow. Further, disruptive
innovations end up squeezing the established producers because the disruptors have lower cost structures.
Christensen likes to use the example of the mini-mills versus integrated mills in the steel industry. Mini-mills
melt scrap steel, so they are a fraction of the size of the integrated mills that make steel in blast furnaces.
Because the integrated mills controlled the whole process, they started with the substantial advantage of
producing steel of high quality.
The mini-mills launched their simpler and cheaper model in the 1970s. Their inferior quality initially limited
them to making rebar, the bars that reinforce concrete. This is the least expensive and least valuable market
for steel. Indeed, the operating profit margins for integrated mills improved after they left the market for rebar
to the mini-mills. As Christensen says, “It felt good to get in and good to get out.”
But the good feeling didn’t last long. Just as the theory predicts, the mini-mills rapidly improved their ability to
make better steel and started to compete in markets that had more value. That process continued over time
until the mini-mills shouldered into the high end of the market and destroyed the profitability of the integrated
mills.
A crucial point of Christensen’s work is that passing over disruptive innovations may appear completely rational
for established companies. The reason is that disruptive products generally offer lower margins than
established ones, operate in insignificant or emerging markets, and are not in demand by the company’s most
profitable customers. As a result, companies that listen to their customers and practice conventional financial
discipline are apt to disregard disruptive innovations.
Exhibit 20 summarizes Christensen’s three categories of innovation, sustaining, low-end, and new-market,
and considers the customers they serve, the technology they utilize to attract customers, the business models
they employ, and the expected incumbent response to each. The incumbent response warrants specific
attention. If a new competitor comes along with a sustaining innovation, incumbents are highly motivated to
defend their turf. Christensen suggests it is very rare to see an incumbent lose this battle to a challenger.
For low-end disruptions, the motivation of incumbents is generally to flee. This is what the integrated mills did.
In the short run, fleeing helps profit margins by encouraging the incumbent to focus on the most lucrative
segment of the market. In the long run, it provides resources for the disruptor to build capabilities that allow it
to penetrate the mainstream market on a cost-effective basis.
Incumbents are typically content to ignore new-market disruptions. The example of the transistor radio shows
why. Because the portable radios did not encroach on the base of the established tabletop radio customers,
the incumbent firms were motivated to disregard the new product.

November 1, 2016
Exhibit 20: Innovation Categories and Characteristics
Sustaining Low -End New- Market

Innovation Disruption Disruption
Undershot Overshot customer Non-consumer or

Customers customer
at low end of
existing market non-producer
Technology Improvement along Good enough Simpler, customizable;

(product/service primary basis of performance at lets people "do it
/process) competition lower prices themselves"
Extension of Completely new

Attractive returns at
Business Model winning model, different from
business model lower prices
core business
Competitor Motivated
Motivated to flee Motivated to ignore
Response to respond
Source: Based on Clayton M. Christensen and Michael E. Raynor, The Innovator’s Solution (Boston, MA: Harvard Business School Press, 2003), 51.
Christensen has also done insightful work on understanding and anticipating the circumstances under which
an industry is likely to shift from vertical to horizontal integration.46 This framework is relevant for assessing the
virtue of outsourcing. While outsourcing has provided some companies with great benefits, including lower
capital costs and faster time to market, it has also created difficulty for companies that tried to outsource
under the wrong circumstances.
Firms that are vertically integrated dominate when industries are developing because the costs of coordination
are so high. Consider the computer industry in 1980. (See Exhibit 21.) Most computer companies were
vertically integrated to ensure that their products would actually work.
But as an industry develops, various components become modules. The process of modularization allows an
industry to flip from vertical to horizontal. This happened in the computer industry by the mid-1990s.
Modularization, which is not simple from an engineering standpoint, allows for standardization and the
assembly of products off the shelf.

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Exhibit 21: Disintegration of the Computer Industry

The Vertical Computer Industry – Circa 1980 The Horizontal Computer Industry – Circa 1995
Sales and Sales and Retail

Superstores Dealers Mail Order
distribution distribution Stores
Application Application
Word Word Perfect Etc.
software software
Operating Operating
DOS and Windows OS/2 Mac UNIX
system system
Computer Computer Compaq Dell Packard Bell Hewlett – IBM Etc.

Packard
Chips Chips Intel Architecture Motorola RISCs
Sperry
IBM DEC Wang
Univac
Source: Andrew S. Grove, Only the Paranoid Survive (New York: Doubleday, 1999), 44.
Boeing’s ordeal with the 787 Dreamliner is a cautionary tale about the perils of outsourcing too early.47
Historically, Boeing used a process called “build-to-print,” where the company did all of the design for an
aircraft in-house and sent suppliers very specific instructions. For the 787, Boeing decided to outsource the
design and construction of various sections of the plane, with the goal of lowering costs and quickening
assembly times.
The program was a mess. The first plane was supposed to arrive in 1,200 parts but showed up in 30,000
pieces. Boeing had to bring substantial parts of the design back in-house at a large cost of money and time.
The company failed to realize that outsourcing doesn’t make sense for products that require complex
integration of disparate subcomponents. The coordination costs are simply too high.
Industry analysis provides important background for understanding a company’s current or potential
performance. Now we turn to analyzing the firm.

November 1, 2016
Firm-Specific Analysis
Core to understanding sustainable value creation is a clear understanding of how a company creates
shareholder value. A company’s ability to create value is a function of the strategies it pursues, its interaction
with competitors, and how it deals with non-competitors.48
Much of what companies discuss as strategy is not strategy at all. As Michael Porter emphasizes, strategy is
different than aspirations, more than a particular action, and distinct from vision or values. Further, Porter
differentiates between operational effectiveness and strategic positioning. Operational effectiveness describes
how well a company does the same activity as others. Strategic positioning focuses on how a company’s
activities differ from those of its competitors. And where there are differences, there are trade-offs.49
We first provide a fundamental framework for value creation. We then consider the various ways a company
can add value. Finally, we delve into firm interaction using game theory and principles of co-evolution.
A Framework for Added-Value Analysis
Adam Brandenburger and Harborne Stuart, professors of strategy, offer a very concrete and sound definition
of how a firm adds value.50 Their equation is simple:
Value created = willingness-to-pay – opportunity cost
The equation basically says that the value a company creates is the difference between what it gets for its
product or service and what it costs to produce that product (including the opportunity cost of capital).
Understanding what each of the terms means is fundamental to appreciating the equation.
Let’s start with willingness to pay. Imagine someone hands you a brand new tennis racket. Clearly, that is
good. Now imagine that the same person starts withdrawing money from your bank account in small
increments. The amount of money at which you are indifferent to having the racket or the cash is the definition
of willingness to pay. If you can buy a product or service for less than your willingness to pay, you enjoy a
consumer surplus.
The flip side describes opportunity cost. A firm takes some resource from its supplier. Opportunity cost is the
cash amount that makes the supplier perceive the new situation (cash) as equivalent to the old situation
(resource).
Brandenburger and Stuart then go on to define four strategies to create more value: increase the willingness
to pay of your customers; reduce the willingness to pay of the customers of your competitors; reduce the
opportunity cost of your suppliers; and increase the opportunity cost of suppliers to your competitors. This
framework also fits well with Porter’s generic strategies to achieve competitive advantage—cost leadership
(production advantage) and differentiation (consumer advantage).
Brandenburger teamed up with his colleague Barry Nalebuff to create what they call a “value net.”51 We
present the value net slightly differently than the authors do, but the components and configuration are
identical. (See Exhibit 22.) On the left are the firm’s suppliers. On the right are the firm’s customers. Between
the suppliers and customers are the company, its competitors, and its complementors—a term we will define
in more detail. For now, the point is that companies beyond a firm’s suppliers, customers, and competitors
can affect the amount of added value that it can capture.

November 1, 2016
Exhibit 22: Added-Value Analysis – The Value Net

Competitors
Suppliers Company Customers
Complementors
Source: Adapted from Adam M. Brandenburger and Barry J. Nalebuff, Co-opetition (New York: Doubleday, 1996), 17.
The value net fits comfortably into Michael Porter’s traditional analyses but adds an important element:
strategy is not only about risk and downside but also about opportunity and upside. Research in industrial
organization emphasizes non-cooperative game theory, a reasonable approach for well-established industries
near product price equilibrium. But cooperative game theory recognizes that many industries are dynamic and
offer opportunities to cooperate as well as to compete.
The Value Chain
Michael Porter also developed value chain analysis, a powerful tool for identifying a company’s sources of
competitive advantage. The value chain is “the sequence of activities your company performs to design,
produce, sell, deliver, and support its products.”52 (Exhibit 23 depicts a generic value chain.) Porter
recommends focusing on discrete activities rather than broad functions such as marketing or logistics, which
he considers too abstract. The objective is to assess each activity’s specific contribution to the company’s
ability to capture and sustain competitive advantage, be it through higher prices or lower costs.
Exhibit 23: The Value Chain
Supply chain Marketing & Post-sales

R&D Operations
management sales service
Source: Joan Magretta, Understanding Michael Porter: The Essential Guide to Competition and Strategy (Boston, MA: Harvard Business Review Press,
2012).
Creating an effective value chain analysis involves the following steps:
Create a map of the industry’s value chain. Show the sequence of activities that most of the
companies in the industry perform, paying careful attention to the activities specific to the industry that
create value.
Compare your company to the industry. Examine your company’s configuration of activities and see
how it compares to others in the industry. Look for points of difference that may reflect a competitive
advantage or disadvantage. If a company’s value chain closely resembles that of its peers, then the
companies are likely engaged in what Porter calls a “competition to be the best.” This is when rivals

November 1, 2016
pursue similar strategies across the same activities, and it often leads to price wars and destructive,
zero-sum competition.53
Identify the drivers of price or sources of differentiation. To create superior value, a company
should look for existing or potential ways to perform activities differently or to perform different activities.
This can come anywhere along the value chain, starting with product design and ending with post-sales
service.
Identify the drivers of cost. Estimate as closely as possible the full costs associated with each activity.
Look for existing or potential differences between the cost structure of the company and that of
competitors. Pinpointing the specific drivers of a cost advantage or disadvantage can yield crucial insights.
This allows a manager to rethink how, or why, a company performs a particular activity.
Sources of Added Value
There are three broad sources of added value: production advantages, consumer advantages, and external
(e.g., government) factors. Note that there is substantial overlap between this analysis and the industry
analysis, but here we focus on the firm.
Production Advantages
Firms with production advantages create value by delivering products that have a larger spread between
perceived consumer benefit and cost than their competitors, primarily by outperforming them on the cost side.
We distill production advantages into two parts: process and scale economies.
Here are some issues to consider when determining whether a firm has a process advantage:
Indivisibility. Economies of scale are particularly relevant for businesses with high fixed costs. One
important determinant of fixed costs is indivisibility in the production process. Indivisibility means that a
company cannot scale its production costs below a minimum level even if output is low. The baking
business is an example. If a bakery wants to service a region, it must have a bakery, trucks, and drivers.
These parts are indivisible, and a firm must bear their cost no matter what bread demand looks like. At the
same time, if the trucks go from half empty to completely full, fixed costs don’t change much.
Complexity. Simple processes are easy to imitate and are unlikely to be a source of advantage. More
complex processes, in contrast, require more know-how or coordination capabilities and can be a source
of advantage. For instance, Procter & Gamble (P&G) reportedly spent eight years and hundreds of
millions of dollars to develop Tide Pods, a unit-dose capsule form of laundry detergent. Much of the
spending went toward a dedicated staff of technical professionals, testing on thousands of consumers,
and hundreds of packaging and product sketches. The government granted P&G numerous patents on
detergent chemistry, the pod’s casing, and the manufacturing process. Bob McDonald, P&G’s CEO at
the time, demonstrated his confidence in the intellectual property when he said, “I don't imagine that this
is going to be able to be copied in any way that it will become a threat.” 54
Rate of change in process cost. For some industries, production costs decline over time as a result of
technological advances. For example, the process-related cost of building an e-commerce company today
is less than in the past because you can purchase most of the necessary components off the shelf. But
the cost in the future is likely to be lower than the cost today for the same reason. For industries with
declining process costs, the incumbent has learning curve advantages, while the challenger has the
November 1, 2016
advantage of potentially lower future costs. So the analysis must focus on the trade-off between learning
advantages and future cost advantages.
Protection. Look for patents, copyrights, trademarks, and operating rights that protect a firm’s process.
Research suggests that products with patent protection generate higher economic returns as a group than
any single industry.55
Resource uniqueness. Alcoa’s bauxite contract is a good illustration of access to a unique resource.
Economies of scale are the second category of potential production advantage. Exhibit 24 illustrates the
distinction between supply- and demand-side scale economies. A firm creates value if it has a positive spread
between its sales and costs, including opportunity costs.56 A firm can create more value by either reducing its
costs or increasing the price it receives. Evidence suggests that differences in customer willingness to pay
account for more of the profit variability among competitors than disparities in cost levels.57
The well-known cost curve depicted in Exhibit 24 shows that, as a manufacturing company increases its
output, its marginal and average unit costs decline up to a point. This is classic increasing returns to scale, as
the company benefits from positive feedback on the supply side. It is all about lowering costs. However,
positive feedback tends to dissipate for manufacturing companies because of bureaucracy, complexity, or
input scarcity. This generally happens at a level well before dominance: market shares in the industrial world
rarely top 50 percent. Positive feedback on the demand side comes primarily from network effects, a point we
will develop further in our discussion of consumer advantages.
Exhibit 24: Supply- versus Demand-Side Driven Scale Economies

Supply-Side Demand-Side
Average Cost per Unit
Willingness to Pay
Output Users
Opportunity cost Cost Price Willingness to pay
Supplier’s share Firm’s share Buyer’s share
Total Value Created


November 1, 2016
Some areas to consider when determining whether or not a company has supply-side scale advantages
include:
Distribution. Start by determining whether the firm has local, regional, or national distribution scale. We
would note that very few firms have national distribution scale. One good example is retailing. Wal-Mart
built its business in the 1970s and 1980s through regional distribution advantages. Most retailers have
only regional advantages and often fail to generate meaningful economic profits outside their core
markets.
One useful way to assess distribution strength is to look at the firm’s operations and revenues on a map.
Firms likely have some advantages where assets and revenue are clustered.58
Purchasing. Some firms can purchase raw materials at lower prices as the result of scale. For instance,
Home Depot was able to add over 200 basis points to its gross margin in the late 1990s by lowering its
cost of merchandising through product line reviews and increased procurement of imported products.
Home Depot used its size to get the best possible price from its suppliers. Increasingly, large firms are
lowering their supplier’s opportunity cost by providing the supplier with better information about demand.
Research and development. Economies of scope, related to economies of scale, exist when a
company lowers its unit costs as it pursues a variety of activities. A significant example is research and
development spillovers, where the ideas from one research project transfer to other projects. For example,
Pfizer sought a drug to treat hypertension, then thought it might treat angina, and then found an unusual
side effect which led to the blockbuster drug, Viagra.59 Companies with diverse research portfolios can
often find applications for their ideas more effectively than companies with smaller research portfolios.
Advertising. The advertising cost per consumer for a product is a function of the cost per consumer of
sending the message and the reach. If the fixed costs in advertising, including advertisement preparation
and negotiating with the broadcaster, are roughly the same for small and large companies, then large
companies have an advantage in cost per potential consumer because they can spread their costs over a
much larger base.
For example, say both McDonald’s and Wendy’s have equally effective national advertising campaigns in
the United States. That McDonald’s has almost three times as many stores as Wendy’s does means that
McDonald’s advertising cost per store is lower.
Companies that enjoy economies of scale in their local geographic or product markets should also be aware of
the impact of globalization on their industries. Analysis by McKinsey, a consulting firm, suggests that about
one-third of all industries are global, one-third national, and one-third regional. (See Exhibit 25.) Their
research also shows that industries are becoming increasingly global over time.

November 1, 2016
Exhibit 25: Various Industries and Their Stages of Globalization

GLOBAL
Industry Examples
Physical commodities 1 Petroleum, mineral ores, timber
Scale-driven business 2 Aircraft engines, construction equipment, semiconductors,

~33% goods and services airframes, shipping, refineries, machine tools, telecom equipment
Globally
defined Manufactured 3 Refined petroleum products, aluminum, specialty steel, bulk
commodities pharmaceuticals, pulp, specialty chemicals
Labor skill/productivity-driven 4 Consumer electronics, personal computers, cameras, automobiles,

consumer goods televisions
Brandable, largely regulated 5 Beer, shoes, luxury goods, pharmaceuticals, movie production
consumer goods
~33%
Nationally Professional business services 6 Investment banking, legal services, accounting services, consulting
defined services
Historically highly regulated

(nationally) industries
7 Personal financial services, telecommunications service providers,
electric power service providers
High interaction cost consumer Food, television production, retail distribution, funeral homes,
goods and services
8 small business services
~33%
Locally Locally regulated or high trans- Construction materials, real property, education, household
defined portation cost goods and services 9 services, medical care
Government services Civil servants, national defense

10
LOCAL
Source: Lowell Bryan, Jane Fraser, Jeremy Oppenheim, and Wilhelm Rall, Race for the World (Boston, MA: Harvard Business School Press, 1999),
45.
Globalization ties to economies of scale in two important ways. First, companies enjoying economies of scale
in their local markets often find it extremely challenging to replicate those advantages in new product or
geographic markets. Even Wal-Mart has struggled overseas, where competitors dominant in those regions
enjoy cost advantages in areas such as advertising and distribution. Any institutional advantages Wal-Mart has
in terms of efficiency or use of technology are offset by the local economies of scale its competitors have
earned.
Second, increasing globalization may undercut the advantages of economies of scale in some industries. This
is tied to the idea that an industry leader can more easily maintain dominance in a market of restricted size. In
a restricted market, an upstart needs to capture a significant amount of market share to reach economies of
scale, a challenge given it must wrestle share from the leader itself. But as an industry undergoes
globalization, economies of scale are actually easier to obtain for new competitors, as they no longer need to
capture a significant share of a local market.60
If you believe a firm has a production advantage, think carefully about why its costs are lower than those of its
competitors. Firms with production advantages often have lower gross margins than companies with consumer
advantages.

November 1, 2016
Consumer Advantages
Consumer advantage is the second broad source of added value. Firms with consumer advantages create
value by delivering products with a spread between perceived consumer benefit and cost that is larger than
that of its competitors. They do so primarily by outperforming competitors on the benefit side.
Here are some common features of companies with consumer advantages:
Habit and high horizontal differentiation. A product is “horizontally differentiated” when some
consumers prefer it to competing products. This source of advantage is particularly significant if
consumers use the product habitually. A product need not be unambiguously better than competing
products; it just has to have features that some consumers find attractive. Soft drinks are an example.
Competing with Coca-Cola is hard because many consumers habitually drink Coke and are fiercely
attached to the product.61
Experience goods. An experience good is a product that consumers can assess only when they’ve tried
it. Search goods, in contrast, are products that a consumer can easily assess at the time of purchase
(e.g., hockey pucks or office furniture). With experience goods, a company can enjoy differentiation
based on image, reputation, or credibility. Experience goods are often technologically complex.
Switching costs and customer lock-in. Customers must bear costs when they switch from one
product to another. The magnitude of switching costs determines the degree to which a customer is
locked in. Sometimes switching costs are large and obvious (e.g., $100 million for a company to replace
its network), and sometimes they’re small but significant (e.g., $100 per customer for 1 million
customers to switch insurance providers).
An example of a product with high switching costs is an enterprise resource planning (ERP) system. In
addition to the high initial cost for the license, a company implementing a new ERP system must also
expend a significant amount of internal resources for things such as user training and IT support.
Moreover, because a company must customize an ERP system to its business processes, it makes it
even more costly to switch providers. Exhibit 26 provides a breakdown of various forms of lock-in and
their associated switching costs.

November 1, 2016
Exhibit 26: Types of Lock-In and Associated Switching Costs

Type of Lock-In Switching Costs
Contractual commitments Compensatory or liquidated damages
Durable purchases Replacement of equipment; tends to decline

as the durable ages
Brand- specific training Learning a new system, both direct costs and
lost productivity; tends to rise over time
Information and databases Converting data to new format; tends to rise

over time as collection grows
Specialized suppliers Funding of new supplier; may rise over time

if capabilities are hard to find/maintain
Search costs Combined buyer and seller search costs;

includes learning about quality of alternatives
Loyalty programs Any lost benefits from incumbent supplier,

plus possible need to rebuild cumulative use
Source: Carl Shapiro and Hal R. Varian, Information Rules (Boston, MA: Harvard Business School Press, 1999), 117.
Network effects. Network effects can be an important source of consumer advantage, especially in
businesses based on information. You can think of two types of networks. (See Exhibit 27.) The first is a
hub-and-spoke network, where a hub feeds the nodes. Examples include most airlines and retailers. In
these networks, network effects exist but are modest.
Exhibit 27: Network Effects Are Stronger for Interactive Networks than for Radial Networks
Radial Interactive
The second type is an interactive network, where the nodes are either physically (telephone wires) or virtually
(the same software) connected to one another. Network effects tend to be significant for interactive networks
because the good or service becomes more valuable as more people use it. For example, Visa and
MasterCard have formidable advantages in the market for payment systems as a result of their strong network
effects.
Positive feedback is critical in interactive networks. If more than one interactive network is competing for
customers, the network that pulls ahead will benefit from positive feedback, leading to a winner-take-most

November 1, 2016
outcome. The dominant network benefits from having the most users and scale, and the switching costs for
its customers rise as the network grows. The classic example of this de facto standard setting is Microsoft’s
personal computer operating system business.
The pattern of cumulative users of an interactive network follows an S-curve, similar to the diffusion of other
innovations. However, the S-curve tends to be steeper for interactive networks.62 Everett Rogers, a prominent
sociologist, found that the plot of new adopters to a technology or network follows a normal distribution.
Judging the source and longevity of a company’s added value is central to understanding the likelihood of
sustainable value creation. A number of companies, including AOL, MySpace, and Friendster, appeared to
have built valuable networks only to see their value fizzle.
If you believe a firm has a consumer advantage, consider why the consumer’s willingness to pay is high and
likely to stay high. Consumer advantages generally appear in the form of high gross margins.
Exhibit 28 allows us to see which companies have production or consumer advantages by disaggregating the
sources of economic return on investment. (CFROI = CFROI Margin x Asset Turnover.) The vertical axis is
asset turnover. Companies with a production advantage generally have high asset turnover. The horizontal axis
is profit margin. High margins are consistent with a consumer advantage. The isocurve shows all the points
that equal a six percent CFROI. Using data from Credit Suisse HOLT, the exhibit plots the profit margins and
asset turnover for the largest 100 non-financial companies in the world, by market capitalization, for the latest
fiscal year. All companies that fall above or to the right of the isocurve earn CFROIs in excess of six percent.
The panel at the bottom of Exhibit 28 shows how companies can take different paths to the same economic
return. For instance, Nike and Alphabet have CFROIs of 17 percent. But Nike has a relatively low margin and
high asset turnover, whereas Alphabet has a high margin and low turnover.

November 1, 2016
Exhibit 28: Sources of Economic Return for the Largest 100 Firms in the World
5
Production
Advantage
Asset Turnover (x)
3
Consumer
Advantage
2 Wal-Mart
Home Depot
1 Nike
Qualcomm
GE McDonald's Alphabet
Amgen
0
-5 0 5 10 15 20 25 30 35 40 45 50 55 60 65 70
CFROI Margin (Percent)
Production Advantage Consumer Advantage

CFROI (%) Company Margin (%) Turns (x) Company Margin (%) Turns (x)
17 Nike 14 1.2 Alphabet 43 0.4
16 Home Depot 12 1.4 Qualcomm 36 0.4
13 General Electric 15 0.8 Amgen 56 0.2
11 Walgreen Boots Alliance 8 1.5 Roche Holding 38 0.3
10 Wal-Mart 5 1.9 McDonald's 31 0.3
9 Daimler 9 1.0 Pfizer 36 0.3
7 Samsung 14 0.5 Union Pacific 35 0.2
Note: Data for latest fiscal year as of 10/25/16.
Government
The final source of added value is external, or government related. Issues here include subsidies, tariffs,
quotas, and both competitive and environmental regulation. Changes in government policies can have a
meaningful impact on added value. Consider the impact of deregulation on the airline and trucking industries,
Basel III on financial services, the Affordable Care Act on health care, and tariffs on the solar energy
industry.63

November 1, 2016
Firm Interaction—Competition and Cooperation
How firms interact with one another plays an important role in shaping sustainable value creation.64 Here we
not only consider how companies interact with their competitors but also how companies co-evolve.
Game theory is one of the best tools to understand interaction. Game theory forces managers to put
themselves in the shoes of other companies rather than viewing competition solely from their own point of
view.
The prisoner’s dilemma is the classic example of two-person interaction in game theory.65 We can consider
the prisoner’s dilemma in a business context by looking at a simple case of capacity addition. Say two
competitors, A and B, are deciding whether to add capacity. If competitor A adds capacity and B doesn’t, A
gets an outsized payoff. (See the bottom left corner of Exhibit 29.) Likewise, if B adds capacity and A
doesn’t, B gets the large payoff (top right corner). If neither expands, the total payoff for A and B is the
highest (top left corner). But if both add capacity, the total payoff is the lowest (bottom right corner).
If a company plays this game once, the optimal strategy is to add capacity. Consider the problem from the
point of view of company A. The expected payoff from adding capacity is higher than the expected value of
not expanding. The same logic applies from B’s standpoint. So adding capacity gets the competitors to the
Nash equilibrium, the point where no competitor can gain by changing its strategy unilaterally.
Exhibit 29: Capacity Addition and the Prisoner's Dilemma

Competitor B
Don’t Expand Add Capacity
B B
A A
Don’t Expand
35 40
Competitor A
35 25
B B
A A
Add Capacity
25 30
40 30
You might assume that companies always evaluate the potential reactions of their competitors. But that is
frequently not the case. During a roundtable discussion in the mid-1990s, for instance, the chief financial
officer of International Paper revealed that his company considered basic economic conditions when weighing
the decision to build a new paper facility. But he conceded the absence of a game theoretic approach: “What
we never seem to factor in, however, is the response of our competitors. Who else is going to build a plant or
machine at the same time?”66
Pankaj Ghemawat, a professor of strategy, provides a more sophisticated example based on the actual pricing
study of a major pharmaceutical company.67 The situation is that a challenger is readying to launch a

November 1, 2016
substitute for one of the incumbent’s most profitable products. The incumbent’s task is to determine the
pricing strategy that maximizes the value of its established product.
Exhibit 30 shows the payoffs for the incumbent (I) and challenger (C) given various assumptions. For example,
with no price change for the incumbent and very low pricing by the challenger, the model suggests a payoff of
350 for the incumbent and 190 for the challenger (upper left corner). This analysis allowed the incumbent’s
management to view the situation from the challenger’s point of view versus considering only what it hoped
the challenger would do.
Exhibit 30: The Payoff Matrix in the Face of a Challenger Product Launch
Incumbent (I) Challenger (C) Price

Price Very Low Low Moderate High
I C I C I C I C
190 168 129 116
No price change 350 507 585 624
I C I C
C has large price 163 168
advantage 418 507
I C I C I C
C has small price 155 138 126
advantage 454 511 636
I C I C I C I C
I neutralizes C’s 50 124 129 128
advantage 428 504 585 669
Source: Adapted from Pankaj Ghemawat, Strategy and the Business Landscape-3rd Ed. (Upper Saddle River, NJ: Prentice-Hall, Inc., 2009), 71.
In our simple cases of capacity additions and product launches, we treated competitor interaction as if it were
a one-time event. In reality, companies interact with one another all the time. So the next level of analysis
considers repeated games.
Robert Axelrod, a political scientist, ran a tournament to see which strategy was most successful in an iterated
prisoner’s dilemma. Instead of playing just once, the competitors played 200 rounds of the game with payoffs
similar to that in Exhibit 29.68 The winning strategy was tit for tat. Tit for tat starts by cooperating but then
mimics its competitor’s last move. So if a competitor cuts price, a company employing tit for tat would cut
price as well. If the competitor then raises prices, tit for tat immediately follows. In practice, tit for tat is
effective only if companies can judge clearly the intentions of their competitors.
Game theory is particularly useful in considering pricing strategies and capacity additions.69 A thorough review
of a firm’s pricing actions and capacity additions and reductions can provide important insight into rivalry and
rationality. You can do similar analysis at the industry level. Institutional memory, especially for cyclical
businesses, appears too short to distinguish between a one-time and an iterated prisoner’s dilemma game.
Companies and analysts can go beyond a payoff matrix that considers only one-time interaction and build a
tree based on sequential actions. The approach here is similar to strategy in chess: look forward and reason
backward.70
Exhibit 31 is an example of a game tree that Pankaj Ghemawat developed to reflect the payoffs from various
decisions in the early days of the satellite radio industry when two companies, Sirius Satellite Radio and XM

November 1, 2016
Satellite Radio, went head-to-head.71 Sirius’s choice was between escalating its investment by acquiring its
own content and following the traditional radio model of licensing content. In either case, XM could have
responded by choosing to escalate its own content investment. The payoffs at the end of the tree show the
economic consequences of the various scenarios. In reality, such analysis is difficult because the range of
alternatives is large. But game trees provide insight into competitive interaction and hence the prospects for
sustainable value creation.
Exhibit 31: Mapping Sequential Moves in Content Acquisition for Satellite Radio Companies
Not escalate Sirius: $1.4B
content XM: $2.1B
XM
Not escalate
content Sirius: $1.4B
Escalate
content XM: $1.7B
Sirius
Not escalate Sirius: $1.7B
content XM: $1.4B
Escalate
content
XM
Escalate Sirius: $1.4B

content XM: $0.8B
Source: Pankaj Ghemawat, Strategy and the Business Landscape-3rd Ed. (Upper Saddle River, NJ: Prentice-Hall, Inc., 2009), 74-77.
Another good example of game theory is the month-long turmoil in the interbank loan market during the fall of
2008. John Stinespring and Brian Kench, professors of economics, describe the decisions that banks faced
when the bankruptcy of Lehman Brothers sent a jolt of fear through the financial system. One result was that
banks became reluctant to lend overnight to one another. This institutional lending and borrowing is essential
to the liquidity of the financial system.72
Stinespring and Kench frame the decision in the throes of the crisis as a game of Loan or No Loan for two
banks, A and B. (See Exhibit 32.) The payoffs in the table are the expected profits for each bank. (A’s profits
are shown on the left, and B’s are on the right.) If both banks choose “Loan,” liquidity is preserved in the
system, and both banks secure an expected profit of $10. If both banks choose “No Loan,” interbank lending
decreases, liquidity dries up, and both banks incur an expected loss of $10.
Exhibit 32: Prisoner’s Dilemma in Interbank Loan Market

Bank B
No Loan Loan
Bank A
No Loan -10, -10 15, -15
Loan -15, 15 10, 10
Source: John Robert Stinespring and Brian T. Kench, “Explaining the Interbank Loan Crisis of 2008: A Teaching Note,” February 1, 2009. See:
http://ssrn.com/abstract=1305392.

November 1, 2016
The best result for the system is for both banks to Loan. Nevertheless, when we follow the logic of the payoff
matrix, we see that A is unlikely to choose Loan when it considers what B might do. (The same logic applies
for B.) If A thinks B will choose No Loan, A will select No Loan (-10 versus -15). If A thinks that B will
choose Loan, A’s best response is still No Loan (+15 versus +10). It’s a classic prisoner’s dilemma, where
the optimal strategy in a single interaction is the least attractive in repeated interactions.
Our discussion so far has focused on competition. But thoughtful strategic analysis also recognizes the role of
co-evolution, or cooperation, in business. Not all business relationships are based on conflict. Sometimes
companies outside the purview of a firm’s competitive set can heavily influence its value creation prospects.
Consider the example electric car manufacturers and the makers of charging stations. A consumer is more
likely to purchase an electric vehicle when the number and quality of options for charging increases. And
charging stations are more valuable if there are more electric vehicles on the road. Complementors make the
added value pie bigger. Competitors fight over a fixed pie.

November 1, 2016
Brands
When queried about sustainable competitive advantage, many executives and investors cite the importance of
brands. The question is whether brands, in and of themselves, are a source of advantage.
Interbrand, a brand consultant, publishes annually its list of the most valuable brands in the world.73 If brands
are clearly linked to value creation, you should see a one-to-one relationship between brand strength and
economic returns. This is not the case empirically. Of the companies that own the top ten most valuable
brands, two barely earned their cost of capital in the latest fiscal year, and there is a weak correlation between
brand ranking and economic return. (See Exhibit 33.) So a brand is clearly not sufficient to ensure that a
company earns economic profits, much less sustainable economic profits.
Exhibit 33: Brand Popularity Does Not Translate into Value Creation
Best Global Brands, 2016
26
24
22
20
18
16
14
12
10
8
6
4
2
0
-2
Disney
Amazon.com
BMW
McDonald's
Honda
Gillette (Procter & Gamble)

Nike
IBM
General Electric
Coca-Cola
Microsoft
Toyota
Louis Vuitton (LVMH)
SAP
Apple
Facebook
Cisco
American Express
Google (Alphabet)
Samsung
Intel
Oracle
Hennes & Mauritz
Pepsi
Mercedes-Benz (Daimler)
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
Rank
Source: Interbrand, Credit Suisse HOLT; Note: Returns data for financial companies represented by cash flow return on equity minus cost of equity.
Note: Data for latest fiscal year as of 10/25/16.
One way to think about brands is to consider what job a consumer is “hiring” a product or service to do.74
Companies tend to structure their target markets by product category or by customer characteristics. But
consumers do not buy something just because the average consumer in their demographic is supposed to like
it. Instead, they find they need something to get done and they hire a product to do the job. A company can
differentiate itself and build a more enduring brand if it truly understands the job customers want done and
develops its products or services accordingly. A brand, then, represents a product or service that is effective at
getting a job done.

November 1, 2016
From an economic standpoint, the best way to approach brands is to consider the amount of value added. A
brand that represents a business benefiting from network effects or that confers horizontal differentiation may
increase a customer’s willingness to pay. Google, for instance, benefits from the company’s network effects
and adds value to the constituents in its ecosystem. The willingness to pay for a brand is high if you are in the
habit of using it, have an emotional connection to it, trust it, or believe that it confers social status.
It is less common for brands to add value by reducing supplier opportunity cost. A fledgling supplier may try to
land a prestigious company, even at a discounted price, as part of its effort to establish credibility. To the
degree that a brand plays a role in the perception of prestige or credibility, it can reduce supplier opportunity
cost and hence increase added value for the branded company.

November 1, 2016
Management Skill and Luck
Managerial skill entails creating a strategy and executing it effectively. But while better strategies will lead to
more successes over time, a good process provides no guarantee of a good outcome. In the highly complex
environment in which companies compete, randomness, or luck, also greatly influences outcomes.75
Customers, competitors, and technological change all contribute to uncertainty in decisions. This suggests
that outsiders should evaluate management teams and the strategies they devise based on the processes they
employ rather than the outcomes they achieve.76
There are numerous books that purport to guide management toward success. Most of the research in these
books follows a common method: find successful businesses, identify the common practices of those
businesses, and recommend that the manager imitate them.
Perhaps the best known book of this genre is Good to Great by Jim Collins. He analyzed thousands of
companies and selected 11 that experienced an improvement from good to great results. He then identified
the common attributes he believed caused those companies to improve and recommended that other
companies embrace those attributes.77 Among the traits were leadership, people, focus, and discipline. While
Collins certainly has good intentions, the trouble is that causality is not clear in these examples. Because
performance always depends on both skill and luck, a given strategy will succeed only part of the time.
Jerker Denrell, a professor of behavioral science, discusses two crucial ideas for anyone who is serious about
assessing strategy. The first is the undersampling of failure. By sampling only past winners, studies of
business success fail to answer a critical question: How many of the companies that adopted a particular
strategy actually succeeded?78
Let’s say two companies, A and B, pursue the same strategy and that A succeeds while B fails. A’s financial
performance will look great, while B will die, dropping out of the sample. If we only draw our observations from
the outcome rather than the strategy, we will only see company A. And because we generally associate
success with skill, we will assume that company A’s favorable outcome was the result of skillful strategy.
Naturally, by considering company B’s results as well, we have a better sense of the virtue of the strategy. To
counter this effect, Denrell recommends evaluating all of the companies that pursue a particular strategy so as
to see both successes and failures.
Denrell’s second idea is that it may be difficult to learn from superior performance.79 The notion is that
superior corporate performance is frequently the result of a cumulative process that benefitted from luck. Said
differently, if you were to rewind the tape of time and play it again, the same companies would not succeed
every time. Since some high-performing companies succeed by dint of luck, there is very little to learn from
them. Indeed, companies with good financial performance that compete in industries where cumulative
processes are less pronounced may provide better lessons into the sources of success.
Frustrated by a dearth of rigorous studies on business success, Michael Raynor and Mumtaz Ahmed,
consultants at Deloitte, teamed up with Andrew Henderson, a professor of management, to do a statistical
study to determine which companies achieved levels of superior performance for a sufficient time to
confidently rule out luck. The researchers studied more than 25,000 U.S. publicly traded companies from
1966 to 2010 and used quantile regression to rank them according to their relative performance on return on
assets (ROA). (Bryant Matthews, who manages HOLT Model Development, replicated their process and
found very similar results.)

November 1, 2016
This analysis, which controlled for extraneous factors such as survivor bias, company size, and financial
leverage, allowed them to understand the empirical parameters of past corporate performance. They then
weeded out the instances of high performance that were due to randomness in order to find truly great
companies. The bad news is that a large percentage of above average corporate performance is attributable to
luck. The good news is that some companies truly are exceptional performers. Their analysis yielded a sample
of 344 such companies.80
Raynor and Ahmed used their model to see whether the firms hailed as exemplary performers in popular
books on business success were likely simply the beneficiaries of luck. The authors examined 699 companies
featured in 19 popular books on high performance and tested them to see how many were truly great. Of the
companies that they were able to categorize, just 12 percent met their criteria.81
In an earlier paper they wrote, “Our results show that it is easy to be fooled by randomness, and we suspect
that a number of the firms that are identified as sustained superior performers based on 5-year or 10-year
windows may be random walkers rather than the possessors of exceptional resources.”82
Once the researchers identified their sample of truly skillful companies, they did what other authors of the
“success study” genre do: they studied the strategies of those superior companies for common patterns that
might prove useful to business executives trying to replicate such sustained success.
They divided the skillful companies into two groups according to the performance threshold they crossed often
enough to rule out luck: Miracle Workers (top 10 percent of ROA), which consisted of 174 companies, and
Long Runners (top 20-40 percent of ROA), which consisted of 170 companies. They labeled the final group
Average Joes.
By identifying a sample of truly superior companies, the authors were able to study the behaviors that
appeared to be behind their performance advantages. They couldn’t find any commonalities when they looked
at specific actions but made a breakthrough when they examined the general manner in which these
companies thought. The manner was highly consistent and fit with a generic differentiation strategy. Raynor
and Ahmed argue that, when considering business decisions, the skillful companies acted as if they followed
two essential rules:
1. Better before cheaper: compete on differentiators other than price.
2. Revenue before cost: prioritize increasing revenue over reducing costs.
Based on this analysis, they suggest two steps for managers. The first is to gain a clear sense of a company’s
competitive position and profit formula. Following this step, a company should understand clearly the
composition of its returns (return on assets = return on sales x total asset turnover) and its relative competitive
position. Companies often compare their current financial performance to the past rather than to that of
competitors. Business is a game of relative, not absolute, performance.
The second step is to make resource allocation decisions consistent with the rules. So when faced with a
choice between offering a product or service with a low price and minimal standards versus a higher price and
superior benefits, such as a strong brand or greater convenience, executives should opt for the latter. Or a
company should prefer a merger that realizes the opportunity to expand versus one that simply achieves
economies of scale.

November 1, 2016
Regression Toward the Mean
There is regression toward the mean any time the correlation between two assessments of the same measure
over time is less than 1.0. The rate of regression is a function of the correlation coefficient. A correlation
coefficient of 1.0 indicates that the next result is exactly predictable from the last, and a correlation of zero
shows that the outcome is random. Activities with high correlations are based more on skill, and those with
low correlations are based more on luck.
The second column of Exhibit 34 shows the year-to-year correlations for CFROI for 25 industries. The data
are intuitive. Industries selling consumer packaged goods are less subject to rapid regression than industries
with exposure to commodities, financials, or technology. What’s valuable is that the exhibit provides a
quantitative means to think about the rate of regression.
The third column of the exhibit shows the average CFROI for each industry. This is essentially the CFROI to
which an individual company’s results regress.
The combination of a qualitative framework in the report and the quantitative results below provides an investor
or executive with a robust framework to assess sustainable value creation.
Exhibit 34: Rate of Regression and Toward What Mean CFROIs Regress for 25 Industries
How Much Regression? Toward What Mean?
One-Year Correlation Long-Term Average
Sector Coefficient CFROI (%)
Food, Beverage, & Tobacco 0.95 8.6
Household & Personal Products 0.95 12.3
Food & Staples Retailing 0.93 8.2
Consumer Services 0.92 8.0
Commercial & Professional Services 0.91 11.1
Capital Goods 0.89 6.7
Health Care Equipment & Services 0.89 11.7
Pharmaceuticals, Biotechnology, & Life Sciences 0.89 8.1
Media 0.88 9.9
Transportation 0.87 5.2
Consumer Durables & Apparel 0.87 8.5
Retailing 0.87 8.7
Regulated Utilities 0.86 3.2
Software & Services 0.85 12.3
Automobiles & Components 0.83 5.2
Telecommunication Services 0.83 6.1
Technology Hardware & Equipment 0.82 6.8
Utilities 0.82 4.1
Insurance 0.81 8.5
Energy 0.78 5.7
Materials 0.78 4.9
Semiconductors & Semiconductor Equipment 0.77 6.6
Real Estate 0.77 4.6
Banks 0.76 9.3
Diversified Financials 0.73 9.0
Source: Bryant Matthews and David A. Holland, “HOLT Industry Profitability Handbook,” Credit Suisse HOLT Market Commentary, October 4, 2016.

November 1, 2016
Bringing It All Back Together
Stock prices reflect expectations for future financial performance. Accordingly, an investor’s task is to
anticipate revisions in those expectations. A firm grasp of the prospects for value creation is a critical facet of
this analysis. But value creation by itself does not lead to superior stock price performance if the market fully
anticipates that value creation.
The expectations investing process has three parts:83
1. Estimate price-implied expectations. We first read the expectations embedded in a stock with a long-
term discounted cash flow model (DCF). We use a DCF model because it mirrors the way the market
prices stocks.
2. Identify expectations opportunities. Once we understand expectations, we apply the appropriate

strategic and financial tools to determine where and when revisions are likely to occur. A proper
expectations analysis reveals whether a stock price is most sensitive to revisions in a company’s sales,
operating costs, or investment needs so that investors can focus on the revisions that matter most. The
strategic analysis in this report is the heart of security analysis and provides the surest means to
anticipate expectations revisions.
3. Buy, sell, or hold. Using expected-value analysis, we are now in a position to make informed buy, sell,
or hold decisions.
A thorough analysis of a company’s prospects for sustainable value creation is essential. This analysis can
then intelligently inform a financial model to determine whether or not a particular stock offers prospects for
superior returns.

November 1, 2016
Warren Buffett on Economic Moats
What we refer to as a “moat” is what other people might call competitive advantage . . . It’s something
that differentiates the company from its nearest competitors – either in service or low cost or taste or
some other perceived virtue that the product possesses in the mind of the consumer versus the next best
alternative . . . There are various kinds of moats. All economic moats are either widening or narrowing –
even though you can’t see it.
Outstanding Investor Digest, June 30, 1993
Look for the durability of the franchise. The most important thing to me is figuring out how big a moat
there is around the business. What I love, of course, is a big castle and a big moat with piranhas and
crocodiles.
Linda Grant, “Striking Out at Wall Street,” U.S. News & World Report, June 12, 1994
The key to investing is not assessing how much an industry is going to affect society, or how much it will
grow, but rather determining the competitive advantage of any given company and, above all, the
durability of that advantage. The products or services that have wide, sustainable moats around them are
the ones that deliver rewards to investors.
Warren Buffett and Carol Loomis, “Mr. Buffett on the Stock Market,” Fortune, November 22, 1999
We think of every business as an economic castle. And castles are subject to marauders. And in
capitalism, with any castle . . . you have to expect . . . that millions of people out there . . . are thinking
about ways to take your castle away.
Then the question is, “What kind of moat do you have around that castle that protects it?”
Outstanding Investor Digest, December 18, 2000
When our long-term competitive position improves . . . we describe the phenomenon as “widening the
moat.” And doing that is essential if we are to have the kind of business we want a decade or two from
now. We always, of course, hope to earn more money in the short-term. But when short-term and long-
term conflict, widening the moat must take precedence.
Berkshire Hathaway Letter to Shareholders, 2005
A truly great business must have an enduring “moat” that protects excellent returns on invested capital.
The dynamics of capitalism guarantee that competitors will repeatedly assault any business “castle” that
is earning high returns . . . Our criterion of “enduring” causes us to rule out companies in industries prone
to rapid and continuous change. Though capitalism’s “creative destruction” is highly beneficial for society,
it precludes investment certainty. A moat that must be continuously rebuilt will eventually be no moat at
all . . . Additionally, this criterion eliminates the business whose success depends on having a great
manager.
Berkshire Hathaway Letter to Shareholders, 2007

November 1, 2016
Appendix A: Checklist for Assessing Value Creation
Overview
In what stage of the competitive life cycle is the company?
Is the company currently earning a return above its cost of capital?
Are returns on invested capital increasing, decreasing, or stable? Why?
What is the trend in the company’s investment spending, including mergers and acquisitions?
Lay of the Land
What percentage of the industry does each player represent?
What is each player’s level of profitability?
What have the historical trends in market share been?
How stable is the industry?
How stable is market share?
What do pricing trends look like?
What class does the industry fall into—fragmented, emerging, mature, declining, international, network,
or hypercompetitive?
The First Three of the Five Forces
How much leverage do suppliers have?
Can companies pass price increases from their suppliers on to their customers?
Are there substitute products available?
Are there switching costs?
How much leverage do buyers have?
How informed are the buyers?
Barriers to Entry
What are the rates of entry and exit in the industry?
How will the incumbents react to the threat of new entrants?
What is the reputation of incumbents?
How specific are the assets?
What is the minimum efficient production scale?
Does the industry have excess capacity?
Is there a way to differentiate the product?
What is the anticipated payoff for a new entrant?
Do incumbents have precommitment contracts?
Do incumbents have costly licenses or patents?
Are there benefits from the learning curve?
Rivalry
Is there pricing coordination?
What is the industry concentration?
What is the size distribution of firms?
How similar are the firms in incentives, corporate philosophy, and ownership structure?
Is there demand variability?
Are there high fixed costs?
Is the industry growing?

November 1, 2016
Disruption and Disintegration

Is the industry vulnerable to disruptive innovation?
Do new innovations foster product improvements?
Is the innovation progressing faster than the market’s needs?
Have established players passed the performance threshold?
Is the industry organized vertically, or has there been a shift to horizontal markets?
Firm Specific
Does the firm have production advantages?

Is there instability in the business structure?
Is there complexity requiring know-how or coordination capabilities?
How quickly are the process costs changing?
Does the firm have any patents, copyrights, trademarks, etc.?
Are there economies of scale?
What does the firm’s distribution scale look like?
Are assets and revenue clustered geographically?
Are there purchasing advantages with size?
Are there economies of scope?
Are there diverse research profiles?
Are there consumer advantages?
Is there habit or horizontal differentiation?
Do people prefer the product to competing products?
Are there lots of product attributes that customers weigh?
Can customers only assess the product through trial?
Is there customer lock-in? Are there high switching costs?
Is the network radial or interactive?
What is the source and longevity of added value?
Are there external sources of added value (subsidies, tariffs, quotas, and competitive or
environmental regulations)?
Firm Interaction—Competition and Coordination
Does the industry include complementors?
Is the value of the pie growing because of companies that are not competitors? Or, are new companies
taking share from a pie with fixed value?
Brands
Do customers want to “hire” the brand for the job to be done?
Does the brand increase willingness to pay?
Do customers have an emotional connection to the brand?
Do customers trust the product because of the name?
Does the brand imply social status?
Can you reduce supplier operating cost with your name?

November 1, 2016
Appendix B: Profit Pool Analysis for Health Care
Our profit pool example in the body of this report showed one of the most value-destructive industries (airlines).
Here, we conduct a similar exercise for the U.S. health care sector, which has consistently created value, as
well as pharmaceuticals, the sector’s largest constituent industry. We begin by using Credit Suisse HOLT data
to examine the returns across various activities in the health care value chain. (See Exhibit 35.)
Exhibit 35: U.S. Health Care Sector Profit Pools by Activity, 2005-2015
2005
15
HC providers
12
& services Life
HC equipment
Pharmaceuticals sciences
& supplies
9
HC
tech
6 Biotech
0
100%
2010
15
HC providers
12 & services Life
HC equipment sciences
& supplies
HC
9 tech
Pharmaceuticals
6 Biotech
0
100%
2015 Life
sciences
15 HC providers
& services HC
HC equipment tech
12 & supplies
9 Biotech
Pharmaceuticals
6
0
100%

November 1, 2016
We see from the horizontal axis that each activity’s share of the industry’s total investment has shifted slightly
over the past decade, with pharmaceuticals shrinking and health care equipment & supplies and biotech
growing. The vertical axis tells a similar story, with economic returns falling for pharmaceuticals and rising for
biotech, indicating that biotech is capturing a much greater share of the value pie within the overall sector.
We can demonstrate this with some simple calculations. By summing the area of each of the blocks, we find
that the total value pie for the sector was roughly $100 billion in 2005, $120 billion in 2010, and $190 billion
in 2015. The pharmaceutical industry saw its share of that pie fall from roughly one-half in 2005 to about
one-third in 2015, while the biotechnology industry rose from about one-tenth to one-quarter.
We can zoom in on the U.S. pharmaceuticals industry. (See Exhibit 36). Creating a narrative to explain the rise
and fall of the various competitors can provide important clues about what it takes to generate sustainable
value creation. At a group level, it is clear that the pharmaceuticals industry has consistently earned above its
cost of capital. However, those returns have fallen over the last decade due in part to a dearth of blockbuster
drugs and increased generic competition following some key patent expirations.84

November 1, 2016
Exhibit 36: U.S. Pharmaceuticals Industry Profit Pools by Company, 2005-2015

2005
35
CFROI minus Discount Rate (Percent) 30
25 Actavis
Allergan,
20 Inc
Valeant
J&J
15 Schering-
Pfizer Plough
10 Wyeth Bristol-
Merck Eli Lilly Myers
5 Other
0
100%
2010
35
30
25
Actavis
20
Valeant
15
Allergan,
Inc
10 J&J Eli Lilly
Pfizer Merck Bristol-
Myers Other
5
0
100%
2015
35 Valeant
30
25
Allergan
20
PLC
15
10 J&J
Bristol-
Pfizer Myers Other
5 Merck
Eli Lilly
0
100%
Note: J&J = Johnson & Johnson.

November 1, 2016
Another thing that stands out is the consolidation and declining returns at the top of the industry. The largest
three firms increased their overall share of the industry substantially, due largely to merger activity. But over
that time, their economic returns fell more sharply than did the returns of the smaller firms in the industry.
We can also determine the total size of the profit pool by measuring and summing the value of each block.
The total economic profit of the industry rose from roughly $50 billion in 2005 to $53 billion in 2010, and rose
to $60 billion in 2015. The top three firms represented 61 percent of the industry’s total economic value in
2015, down from 72 percent in 2005.

November 1, 2016
Endnotes
1
Bartley J. Madden, CFROI Valuation: A Total System Approach to Valuing the Firm (New York: Butterworth-
Heinemann, 1999); Michael Mauboussin and Paul Johnson, “Competitive Advantage Period (CAP): The
Neglected Value Driver,” Financial Management, Vol. 26, No. 2, Summer 1997, 67-74; Alfred Rappaport,
Creating Shareholder Value: A Guide for Managers and Investors – Revised and Updated (New York: Free
Press, 1998); William E. Fruhan, Jr., Financial Strategy: Studies in the Creation, Transfer, and Destruction of
Shareholder Value (Homewood, Il.: Richard D. Irwin, Inc., 1979); Merton H. Miller and Franco Modigliani,
“Dividend Policy, Growth, and the Valuation of Shares,” The Journal of Business, Vol. 34, October 1961,
411-433. For empirical research, see Brett C. Olsen, “Firms and the Competitive Advantage Period,” Journal
of Investing, Vol. 22, No. 4, Winter 2013, 41-50 and Michael J. Mauboussin, Dan Callahan, and Darius Majd,
“The Base Rate Book: Integrating the Past to Better Anticipate the Future,” Credit Suisse Global Financial
Strategies, September 26, 2016.
2
David Besanko, David Dranove, Mark Shanley, and Scott Schaefer, Economics of Strategy-6th Ed.
(Hoboken, NJ: John Wiley & Sons, 2013), 294-295.
3
Horace Secrist, The Triumph of Mediocrity in Business (Evanston, IL: Bureau of Business Research,
Northwestern University, 1933); Pankaj Ghemawat, Commitment: The Dynamic of Strategy (New York: Free
Press, 1991), 82; and Bartley J. Madden, “The CFROI Life Cycle,” Journal of Investing, Vol. 5, No. 2,
Summer 1996, 10-20.
4
Robert R. Wiggins and Timothy W. Ruefli, “Schumpeter’s Ghost: Is Hypercompetition Making the Best of
Times Shorter?,” Strategic Management Journal, Vol. 26, No. 10, October 2005, 887-911; Robert R.
Wiggins and Timothy W. Ruefli, “Sustained Competitive Advantage: Temporal Dynamics and the Incidence
and Persistence of Superior Economic Performance,” Organizational Science, Vol. 13, No. 1, January-
February 2002, 82-105; Richard A. D’Aveni, Beat the Commodity Trap: How to Maximize Your Competitive
Position and Increase Your Pricing Power (Boston, MA: Harvard Business Press, 2010); Rita Gunther
McGrath, The End of Competitive Advantage: How to Keep Your Strategy Moving as Fast as Your Business
(Boston, MA: Harvard Business Review Press, 2013).Wiggins and Ruefli find evidence of sustained
competitive advantage not as the result of one main advantage but rather of smaller, concatenating
advantages. Consistent with this is Kuo-Feng Huang, Romano Dyerson, Lei-Yu Wu, and G. Harindranath,
“From Temporary Competitive Advantage to Sustainable Competitive Advantage,” British Journal of
Management, Vol. 26, No. 4, October 2015, 617-636. See also Tammy L. Madsen and Michael J. Leiblein,
“What Factors Affect the Persistence of an Innovation Advantage? Journal of Management Studies, Vol. 52,
No. 8, December 2015, 1097-1127.
5
Bryant Matthews and Raymond Stokes, “Fade and the Persistence of Corporate Returns,” Credit Suisse
HOLT Notes, Credit Suisse, November 2012; Bartley J. Madden, “The CFROI Life Cycle,” Journal of
Investing, Vol. 5, No. 2, Summer 1996, 10-20.
6
Estimates for the cost of equity capital come from Aswath Damodaran, a professor of finance. See
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/implpr.html.
7
For expectations, see Alfred Rappaport and Michael J. Mauboussin, Expectations Investing: Reading Stock
Prices for Better Returns (Boston, MA: Harvard Business School Press, 2001), 51-52. For sustained value
creation and excess returns, see Adelina Gschwandtner and Michael Hauser, “Profit Persistence and Stock
Returns,” Applied Economics, Vol. 48, No. 37, February 2016.
8
Outstanding Investor Digest, December 18, 2000; Outstanding Investor Digest, June 30, 1993; Also,
economic moats are a key investment theme for Morningstar, which offers research aimed at uncovering
companies with wide and stable or improving economic moats. See: Matthew Coffina, “The Morningstar Guide
to Wide-Moat Stock Investing,” Morningstar Stock Investor, April 2013; Paul Larson, “Moats: Sources and
Outcomes – Not all moats are created equal, and we delve into the differences,” Morningstar Equity
Research, June 2012; and Heather Brilliant and Elizabeth Collins, Why Moats Matter: The Morningstar
Approach to Stock Investing (Hoboken, NJ: John Wiley & Sons, 2014).

November 1, 2016
9
Peter Lynch, with John Rothchild, One Up On Wall Street: How To Use What You Already Know To Make
Money in the Market (New York: Penguin Books USA, 1989), 121.
10
For a study based on total shareholder returns, see Richard Foster and Sarah Kaplan, Creative Destruction:
Why Companies That Are Built to Last Underperform the Market – and How to Successfully Transform Them
(New York: Doubleday, 2001). This work addresses a different question than the one we pose here.
11
Thomas Fritz, The Competitive Advantage Period and the Industry Advantage Period: Assessing the
Sustainability and Determinants of Superior Economic Performance (Wiesbaden, Germany: Gabler, 2008);
Anita M. McGahan and Michael E. Porter, “The emergence and sustainability of abnormal profits,” Strategic
Organization, Vol. 1, No. 1, February 2003, 79-108; Anita M. McGahan and Michael E. Porter, “How Much
Does Industry Matter, Really?” Strategic Management Journal, Vol. 18, Summer Special Issue 1997, 15-30;
Thomas C. Powell, “How Much Does Industry Matter? An Alternative Empirical Test,” Strategic Management
Journal, Vol. 17, No. 4, April 1996, 323-334; Richard P. Rumelt, “How Much Does Industry Matter?”
Strategic Management Journal, Vol. 12, No. 3, March 1991, 167-185; Richard Schmalensee, “Do Markets
Differ Much?” American Economic Review, Vol. 75, No. 3, June 1983, 341-351.
12
Anita M. McGahan and Michael E. Porter, “The emergence and sustainability of abnormal profits,” Strategic
Organization, Vol. 1, No. 1, February 2003, 79-108. In Ekaterina V. Karniouchina, Stephen J. Carson,
Jeremy C. Short, and David J. Ketchen Jr., “Extending the Firm Vs. Industry Debate: Does Industry Life Cycle
Stage Matter?” Strategic Management Journal, Vol. 34, No. 8, August 2013, 1010-1018, the researchers
find that the influence of the industry on the variance in firm performance is progressively stronger as the
industry moves from growth to maturity to decline. In David Schröder and Andrew Yim, “Industry Effects in
Firm and Segment Profitability Forecasting: Corporate Diversification, Industry Classification, and Estimate
Reliability,” Working Paper, March 2016, the authors find considerable industry effects, but only for focused
firms.
13
Strategy (New York: Portfolio, 2005), 52-54.
14
Lauren Cohen and Andrea Frazzini, “Economic Links and Predictable Returns,” Journal of Finance, Vol. 63,
No. 4, August 2008, 1977-2011. Also, Yuyan Guan, M. H. Franco Wong, and Yue Zhang, “Analyst
Following Along the Supply Chain,” Review of Accounting Studies, Vol. 20, No. 1, March 2015, 210-241.
15
Orit Gadiesh and James L. Gilbert, “Profit Pools: A Fresh Look at Strategy,” Harvard Business Review,
May-June 1998, 139-147; Orit Gadiesh and James L. Gilbert, “How To Map Your Industry’s Profit Pool,”
Harvard Business Review, May-June 1998, 149-162; Also Bryant Matthews, David A. Holland, Michael J.
Mauboussin, and Dan Callahan, “Global Industry Profit Pools,” Credit Suisse HOLT Market Commentary, July
2016.
16
Michael E. Porter, “The Five Competitive Forces that Shape Strategy,” Harvard Business Review, January
2008, 78-93.
17
International Air Transport Association, "Profitability and the air transport value chain," IATA Economics
Briefing No. 10, June 2013, 19-20; Pankaj Ghemawat, Strategy and the Business Landscape-3rd Ed.
(Upper Saddle River, NJ: Prentice-Hall, Inc., 2009).
18
International Air Transport Association, “Industry Profitability Improves,” Press Release No. 27, June 2,
2016.
19
Andrew Frye and Dakin Campbell, “Buffett Says Pricing Power More Important than Good Management,”
Bloomberg, February 18, 2011. For more on pricing strategy, see Andreas Hinterhuber and Stephan Liozu,
“Is It Time to Rethink Your Pricing Strategy?” MIT Sloan Management Review, Summer 2012.
20
The Free Press, 1980).
21
Joan Magretta, Understanding Michael Porter: The Essential Guide to Competition and Strategy (Boston,
MA: Harvard Business Review Press, 2012); Michael E. Porter, “The Five Competitive Forces That Shape
Strategy,” Harvard Business Review, January 2008, 78-93.
22
This section relies heavily on Rappaport and Mauboussin, 54-57.

November 1, 2016
23
Brian Headd, Alfred Nucci, and Richard Boden, “What Matters More: Business Exit Rates or Business
Survival Rates?” BDS Statistical Brief, U.S. Census Bureau, 2010; Glenn R. Carroll and Michael T. Hannan,
The Demography of Corporations and Industries (Princeton, NJ: Princeton University Press, 2000), 51-52;
Deborah Gage, “The Venture Capital Secret: 3 Out of 4 Start-Ups Fail,” Wall Street Journal, September 20,
2012. For a distinction between closure and failure, see Brian Headd, “Redefining Business Success:
Distinguishing Between Closure and Failure,” Small Business Economics, Vol. 21, No. 1, August 2003, 51-
61.
24
Steven Klepper, Experimental Capitalism: The Nanoeconomics of American High-Tech Industries (Princeton,
NJ: Princeton University Press, 2016); Steven Klepper, “Entry, Exit, Growth, and Innovation over the Product
Life Cycle,” American Economic Review, Vol. 86, No. 3, June 1996, 562-583; Steven Klepper, “Industry Life
Cycles,” Industrial and Corporate Change, Vol. 6, No. 1, January 1997, 145-181; Steven Klepper and
Elizabeth Graddy, “The evolution of new industries and the determinants of market structure,” RAND Journal
of Economics, Vol. 21, No. 1, Spring 1990, 27-44; Rajshree Agarwal and Serguey Braguinsky, “Industry
Evolution and Entrepreneurship: Steven Klepper’s Contributions to Industrial Organization, Strategy,
Technological Change, and Entrepreneurship,” Strategic Entrepreneurship Journal, Vol. 9, No. 4, December
2015, 380-397; Robin Gustafsson, Mikko Jääskelainen, Markku Maula, and Juha Uotila, “Emergence of
Industries: A Review and Future Directions,” International Journal of Management Reviews, Vol. 18, No. 1,
January 2016, 28-50; and Mariana Mazzucato, Firm Size, Innovation and Market Structure: The Evolution of
Industry Concentration and Instability (Northampton, MA: Edward Elgar Publishing, 2000), 34.
25
Timothy Dunne, Mark J. Roberts, and Larry Samuelson, “Patterns of firm entry and exit in U.S.
manufacturing industries,” RAND Journal of Economics, Vol. 19, No. 4, Winter 1988, 495-515 and Timothy
Dunne, Shawn D. Klimek, Mark J. Roberts, and Daniel Yi Xu, “Entry, Exit, and the Determinants of Market
Structure,” The RAND Journal of Economics, Vol. 44, No. 3, Fall 2013, 462-487.
26
Here we follow closely the presentation format of Besanko, Dranove, Shanley, and Schaefer, 197-198.
27
Bryant Matthews and Raymond Stokes, “Fade and the Persistence of Corporate Returns,” Credit Suisse
HOLT Notes, Credit Suisse, November 2012; Richard Disney, Jonathan Haskel, and Ylva Heden, "Entry, Exit
and Establishment Survival in UK Manufacturing," Journal of Industrial Economics, Vol. 51, No. 1, March
2003, 91-112.
28
We base this discussion on Sharon M. Oster, Modern Competitive Analysis (Oxford: Oxford University
Press, 1999), 57-82.
29
A similar example is the competition between CSX and Norfolk Southern to deliver coal to Gainesville,
Florida. See Adam M. Brandenburger and Barry J. Nalebuff, Co-opetition: 1. A Revolutionary Mindset That
Combines Competition and Cooperation. 2. The Game Theory Strategy That’s Changing the Game of
Business (New York: Doubleday, 1996), 76-80. For a survey of the research on co-opetition, see Ricarda B.
Bouncken, Johanna Gast, Sascha Kraus, and Marcel Bogers, “Coopetition: a Systematic Review, Synthesis,
and Future Research Directions,” Review of Managerial Science, Vol. 9, No. 3, July 2015, 577-601 and
Stefanie Dorn, Bastian Schweiger, and Sascha Albers, “Levels, Phases and Themes of Coopetition: A
Systematic Literature Review and Research Agenda,” European Management Journal, Vol. 34, No. 5,
October 2016, 484-500.
30
Besanko, Dranove, Shanley, and Schaefer, 119-120.
31
Brandenburger and Nalebuff, 72-76.
32
Besanko, Dranove, Shanley, and Schaefer, 77-78.
33
Carl Shapiro and Hal R. Varian, Information Rules: A Strategic Guide to the Network Economy (Boston, MA:
Harvard Business School Press, 1999), 173-225. Also, Michael J. Mauboussin, “Exploring Network
Economics,” Mauboussin on Strategy, October 11, 2004.
34
Frank Linde, Maurice Kock, and Alexandra Gorges, “Network Effects of Digital Information Goods: A
Proposal for the Operationalization of Direct and Indirect Network Effects,” International Journal of Business
Research, Vol. 12, No. 3, July 2012; Allan Afuah, “Are Network Effects Really All About Size? The Role of
Structure and Conduct,” Strategic Management Journal, Vol. 34, No. 3, March 2013, 257-273.

November 1, 2016
35
Robert Smiley, “Empirical Evidence on Strategic Entry Deterrence,” International Journal of Industrial
Organization, Vol. 6, No. 2, June 1988, 167-180; J. Anthony Cookson, “Anticipated Entry and Entry
Deterrence: Evidence from the American Casino Industry,” Working Paper, December 2015; and Austan
Goolsbee and Chad Syverson, “How Do Incumbents Respond to the Threat of Entry? Evidence from the Major
Airlines,” Quarterly Journal of Economics, Vol. 123, No. 4, November 2008, 1611-1633.
36
Colin Camerer and Dan Lovallo, “Overconfidence and Excess Entry: An Experimental Approach,” American
Economic Review, Vol. 89, No. 1, March 1999, 306-318. Other relevant papers on entry and exit include
Daniel W. Elfenbein, Anne Marie Knott, and Rachel Croson, “Equity Stakes and Exit: An Experimental
Approach to Decomposing Exit Delay,” Strategic Management Journal, Forthcoming and Daylian M. Cain,
Don A. Moore, and Uriel Haran, “Making Sense of Overconfidence in Market Entry,” Strategic Management
Journal, Vol. 36, No. 1, January 2015, 1-18.
37
Daniel Kahneman and Amos Tversky, “On the Psychology of Prediction,” Psychological Review, Vol. 80,
No. 4, July 1973, 237-251. Also Michael J. Mauboussin, Dan Callahan, and Darius Majd, “The Base Rate
Book: Integrating the Past to Better Anticipate the Future,” Credit Suisse Global Financial Strategies,
September 26, 2016.
38
Michael J. Mauboussin, Think Twice: Harnessing the Power of Counterintuition (Boston, MA: Harvard
Business Press, 2009), 1-16.
39
Oster, 33-34.
40
Kewei Hou and David T. Robinson, “Industry Concentration and Average Stock Returns,” Journal of
Finance, Vol. 61, No. 4, August 2006, 1927-1956.
41
John Asker, Joan Farre-Mensa, and Alexander Ljungqvist, “Corporate Investment and Stock Market Listing:
A Puzzle?” European Corporate Governance Institute (ECGI) - Finance Research Paper Series, April 22,
2013.
42
Clayton M. Christensen, The Innovator’s Dilemma: When New Technologies Cause Great Companies to
Fail (Boston, MA: Harvard Business School Press, 1997). For additional discussion (including criticism) of the
model, see Clayton M. Christensen, Michael E. Raynor, and Rory McDonald, “What Is Disruptive Innovation?”
Harvard Business Review, December 2015; Andrew A. King and Baljir Baatartogtokh, “How Useful Is the
Theory of Disruptive Innovation,” MIT Sloan Management Review, Vol. 57, No. 1, Fall 2015; Juan Pablo
Vázquez Sampere, Martin J. Bienenstock, and Ezra W. Zuckerman, “Debating Disruptive Innovation,” MIT
Sloan Management Review, Spring 2016. A game called Colonel Blotto has some interesting parallels with
the disruptive innovation model. See Michael J. Mauboussin, The Success Equation: Untangling Skill and
Luck in Business, Sports, and Investing (Boston, MA: Harvard Business Review Press, 2012), 179-185.
43
Christensen, 32.
44
Clayton M. Christensen and Michael E. Raynor, The Innovator’s Solution: Creating and Sustaining
Successful Growth (Boston, MA: Harvard Business School Publishing, 2003), 43-46.
45
Clayton M. Christensen, Michael E. Raynor, and Scott D. Anthony, “Six Keys to Building New Markets by
Unleashing Disruptive Innovation,” Harvard Management Update, January 2003.
46
Clayton M. Christensen, Matt Verlinden, and George Westerman, “Disruption, Disintegration and the
Dissipation of Differentiability,” Industrial and Corporate Change, Vol. 11, No. 5, November 2002, 955-993;
Carliss Y. Baldwin and Kim B. Clark, Design Rules: The Power of Modularity (Cambridge, MA: The MIT
Press, 2000).
47
Michael J. Mauboussin, Think Twice: Harnessing the Power of Counterintuition (Boston, MA: Harvard
Business Press, 2009), 89-91.
48
Joseph L. Bower and Clark G. Gilbert, From Resource Allocation to Strategy (Oxford: Oxford University
Press, 2005); Robert A. Burgelman, Strategy Is Destiny: How Strategy-Making Shapes a Company’s Future
(New York: Free Press, 2002); William P. Barrett, The Red Queen among Organizations: How Competition
Evolves (Princeton, NJ: Princeton University Press, 2008).
49
Michael E. Porter, “What is Strategy?” Harvard Business Review, November-December 1996, 61-78;
Richard P. Rumelt, Good Strategy Bad Strategy: The Difference and Why It Matters (New York: Crown

November 1, 2016
Business, 2011). On trade-offs, see Frances Frei and Anne Morriss, Uncommon Service: How to Win by
Putting Customers at the Core of Your Business (Boston, MA: Harvard Business Review Press, 2012).
50
Adam M. Brandenburger and Harborne W. Stuart, Jr., “Value-Based Business Strategy,” Journal of
Economics & Management Strategy, Vol. 5, No.1, Spring 1996, 5-24.
51
Adam M. Brandenburger and Barry J. Nalebuff, Co-opetition: 1. A Revolutionary Mindset That Combines
Competition and Cooperation. 2. The Game Theory Strategy That’s Changing the Game of Business (New
York: Doubleday, 1996), 16-19.
52
Magretta, 73-84.
53
Ibid., 21-28.
54
Mae Anderson, “From idea to store shelf: a new product is born,” Associated Press, March 4, 2012;
Procter & Gamble Q3 2011 earnings call, April 28, 2011.
55
Jeffrey Williams, “How Sustainable Is Your Competitive Advantage?” California Management Review, Vol.
34, No. 3, 1992, 29-51.
56
Adam M. Brandenburger and Harborne W. Stuart, Jr., “Value-Based Business Strategy,” Journal of
Economics & Management Strategy, Vol. 5, 1, Spring 1996, 5-24.
57
Richard E. Caves and Pankaj Ghemawat, “Identifying Mobility Barriers,” Strategic Management Journal, Vol.
13, No. 1, 1992, 1-12.
58
For example, see http://flowingdata.com/2013/06/26/grocery-store-geography/.
59
Jim Kling, “From Hypertension to Angina to Viagra,” Modern Drug Discovery, Vol. 1, No. 2, November-
December 1998.
60
Bruce Greenwald and Judd Kahn, “All Strategy Is Local,” Harvard Business Review, September 2005, 94-
104.
61
Bruce C. N. Greenwald, Judd Kahn, Paul D. Sonkin and Michael van Biema, Value Investing: From Graham
to Buffett and Beyond (New York: John Wiley & Sons, 2001), 77-78. For interesting, if controversial,
research on brand preference, see: Samuel M. McClure, Jian Li, Damon Tomlin, Kim S. Cypert, Latané M.
Montague, and P. Read Montague, “Neural Correlates of Behavioral Preference for Culturally Familiar Drinks,”
Neuron, Vol. 44, No. 2, October 14, 2004, 379-387.
62
Everett M. Rogers, The Diffusion of Innovations (New York: Free Press, 1995). Also, Michael J.
Mauboussin and Dan Callahan, “Total Addressable Market: Methods to Estimate a Company’s Sales,” Credit
Suisse Global Financial Strategies, September 1, 2015.
63
For a more complete discussion, see Oster, 326-346.
64
A survey by McKinsey shows that companies don’t react to competitive threats as management theory
suggests they should. See “How Companies Respond to Competitors: A McKinsey Global Survey,” McKinsey
Quarterly, April 2008.
65
For an excellent resource see http://plato.stanford.edu/entries/prisoner-dilemma/.
66
“Stern Stewart EVA Roundtable,” Journal of Applied Corporate Finance, Vol. 7, No. 2, Summer 1994, 46-
70.
67
Pankaj Ghemawat, Strategy and the Business Landscape-3rd Ed. (Upper Saddle River, NJ: Prentice-Hall,
2009), 69-72.
68
Robert Axelrod, The Evolution of Cooperation (New York: Basic Books, 1985).
69
Rappaport and Mauboussin, 57.
70
Avinash K. Dixit and Barry J. Nalebuff, The Art of Strategy: A Game Theorist’s Guide to Success in
Business and Life (New York: W. W. Norton & Co., 2008); Joshua S. Gans and Michael D. Ryall, “Value
Capture Theory: A Strategic Management Review,” Rotman School of Management Working Paper, February
2016.
71
Pankaj Ghemawat, Strategy and the Business Landscape-3rd Ed. (Upper Saddle River, NJ: Prentice-Hall,
2009), 74-77.
72
John Robert Stinespring and Brian T. Kench, “Explaining the Interbank Loan Crisis of 2008: A Teaching
Note,” February 1, 2009. See: http://ssrn.com/abstract=1305392. For a fascinating connection between

November 1, 2016
the Prisoner’s Dilemma and the financial crisis of 2007-2008, see: John Cassidy, “Rational Irrationality,” The
New Yorker, October 5, 2009.
73
Interbrand, “Best Global Brands 2012: The definitive guide to the 100 Best Global Brands.”
74
Clayton M. Christensen, Taddy Hall, Karen Dillon, and David S. Duncan, Competing Against Luck: The
Story of Innovation and Customer Choice (New York: HarperBusiness, 2016); Clayton M. Christensen, Taddy
Hall, Karen Dillon, and David S. Duncan, “Know Your Customers’ ‘Jobs to Be Done’,” Harvard Business
Review, September 2016; and Clayton M. Christensen, Scott D. Anthony, Gerald Berstell, and Denise
Nitterhouse, “Finding the Right Job For Your Product,” MIT Sloan Management Review, Spring 2007, 2-11.
75
Jerker Denrell, Christina Fang, Chengwei Liu, "Perspective—Chance Explanations in the Management
Sciences," Organizational Science, Vol. 26, No. 3, May-June 2015, 923-940.
76
Michael E. Raynor, The Strategy Paradox: Why Commitment to Success Leads to Failure (and What to Do
About It) (New York: Currency Doubleday, 2007).
77
Jim Collins, Good to Great: Why Some Companies Make the Leap . . . and Others Don’t (New York:
Harper Business, 2001).
78
Jerker Denrell, “Vicarious Learning, Undersampling of Failure, and the Myths of Management,” Organization
Science, Vol. 14, No. 3, May–June 2003, 227–243.
79
Jerker Denrell, Christina Fang, and Zhanyun Zhao, “Inferring Superior Capabilities from Sustained Superior
Performance: A Bayesian Analysis,” Strategic Management Journal, Vol. 34, No. 2, February 2013, 182-
196.
80
Michael E. Raynor and Mumtaz Ahmed, The Three Rules: How Exceptional Companies Think (New York:
Penguin Books, 2013), 42-45.
81
Michael E. Raynor and Mumtaz Ahmed, “Three Rules for Making a Company Truly Great,” Harvard
Business Review, April 2013, 108-117. In categorizing the companies, the probability the results were due to
luck had to be lower than 10 percent. The qualifying length of time depended on the company’s life span. For
example, to be a Miracle Worker, a company with 10 years of data was required to be in the top 10 percent
for every year, but a company with 45 years of data was required to be in the top 10 percent for only 16 years.
82
Michael E. Raynor, Mumtaz Ahmed, and Andrew D. Henderson, “A Random Search for Excellence: Why
‘Great Company’ Research Delivers Fables and Not Facts,” Deloitte Research, December 2009; and Andrew
D. Henderson, Michael E. Raynor, and Mumtaz Ahmed, “How Long Must a Firm Be Great to Rule Out Luck?
Benchmarking Sustained Superior Performance Without Being Fooled By Randomness,” Academy of
Management Proceedings, August 2009, 1–6.
83
Rappaport and Mauboussin, 7-8.
84
George Eliades, Michael Retterath, Norbert Hueltenschmidt, and Karan Singh, “Heathcare 2020,” Bain &
Company Research, 2012.

November 1, 2016
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®
HOLT
Capital Allocation Outside the U.S.

Evidence, Analytical Methods, and Assessment Guidance
November 15, 2016
Authors
Dan Callahan, CFA

Darius Majd
Capital allocation is a senior management team's most fundamental

responsibility. The problem is that many CEOs don't know how to allocate
capital effectively. The objective of capital allocation is to build long-term
value per share.
In this report we examine the sources and uses of capital for Japan,
Europe, Asia/Pacific excluding Japan, and Global Emerging Markets. This
extends our analysis beyond the United States, which we discussed in a
prior report.
Countries or regions with a high return on invested capital (ROIC) can fund
a substantial percentage of investment internally whereas those with low
ROICs must rely more on external financing.
Capital allocation is also determined by the largest sectors in a country’s or
a region’s economy, the stage of economic development, cultural norms,
and regulations.
We provide a framework for assessing a company's capital allocation
skills, which includes examining past behaviors, understanding incentives,
and considering the five principles of capital allocation.
November 15, 2016
Table of Contents
Executive Summary .............................................................................................................................. 3
Summary of Global Capital Allocation ...................................................................................................... 4
Introduction .......................................................................................................................................... 6
Part I: Groundwork – Where Does the Money Come From and Where Has It Gone? ................................... 8
Sources of Capital..................................................................................................................... 9
Uses of Capital ....................................................................................................................... 11
Mergers and Acquisitions ............................................................................................... 11
Capital Expenditures ...................................................................................................... 11
Research and Development ............................................................................................ 12
Net Working Capital ...................................................................................................... 13
Divestitures .................................................................................................................. 13
Dividends ..................................................................................................................... 14
Share Buybacks ............................................................................................................ 15
Part II: Capital Allocation by Region

Japan .................................................................................................................................... 18
Europe................................................................................................................................... 30
Asia/Pacific excluding Japan (APEJ) ........................................................................................ 42
Global Emerging Markets (GEM) .............................................................................................. 54
Part III: Assessing Management’s Capital Allocation Skills ....................................................................... 66

Past Spending Patterns ........................................................................................................... 66
Calculating Return on Invested Capital and Return on Incremental Invested Capital......................... 66
Incentives and Corporate Governance ....................................................................................... 67
Five Principles of Capital Allocation ........................................................................................... 68
Conclusion ......................................................................................................................................... 70
Acknowledgment ................................................................................................................................ 71
Appendix: The List of Countries Included in the Data for Each Region ...................................................... 72
Endnotes ........................................................................................................................................... 73
References ........................................................................................................................................ 79
Books .................................................................................................................................... 79
Articles and Papers ................................................................................................................. 81
Capital Allocation Outside the U.S. 2

November 15, 2016
Executive Summary
We extend our analysis of capital allocation beyond the United States to other major world regions,
including Japan, Europe, Asia/Pacific excluding Japan (APEJ), and Global Emerging Markets (GEM). For
the most recent report, see Michael J. Mauboussin, Dan Callahan, and Darius Majd, “Capital Allocation:
Evidence, Analytical Methods, and Assessment Guidance,” Credit Suisse Global Financial Strategies,
October 19, 2016.
Capital allocation is the most fundamental responsibility of a senior management team of a public
corporation. The problem is that many CEOs, while almost universally well intentioned, generally don’t
know how to allocate capital effectively. The proper goal of capital allocation is to build long-term value per
share. The emphasis is on building value and letting the stock market reflect that value. Companies that
dwell on boosting their short-term stock price frequently make decisions that are at odds with building
value.
Regions and countries vary in the source of funding for capital. In general, high return on investment is
associated with an ability to internally fund a substantial percentage of investments. Countries that largely
finance investments internally include the U.S., the U.K., and Germany. Countries that require a higher
proportion of external financing include France, Japan, and China.
Academic research shows that rapid asset growth is associated with poor total shareholder returns in most
regions of the world. Further, companies that contract their assets often create substantial value per
share. But these findings are more robust in developed markets than in developing markets. Making
investments that earn a return in excess of the opportunity cost is the key to creating value.
Ultimately, the answer to all capital allocation questions is, “It depends.” Most actions are either foolish or
wise based on the price and value. Similar to investors, companies tend to buy when times are good and
retreat when times are challenging, failing to take advantage of gaps between price and value.
Past spending patterns are often a good starting point for assessing future spending plans. Once you
know how a company spends money, you can dig deeper into management’s decision-making process.
Further, it is useful to calculate return on invested capital and return on incremental invested capital.
These metrics can provide a sense of the absolute and relative effectiveness of management’s spending.
Understanding incentives for management is crucial. Assess the degree to which management is focused
on building value and addressing agency costs.
The five principles of capital allocation include: zero-based capital allocation; fund strategies, not projects;
no capital rationing; zero tolerance for bad growth; and know the value of assets and be prepared to take
action.

November 15, 2016
Summary of Global Capital Allocation
Mergers and acquisitions (M&A), capital expenditures, research and development (R&D), and net working
capital are the uses of capital for internal investment. How companies invest internally varies substantially
by region. (See Exhibit 1.) Here are some of the main observations based on spending in recent decades:
 M&A is the largest use of capital in the U.S., Europe, APEJ, and GEM, and the third largest use in
Japan. The rarity of M&A in Japan is of particular note.
 Capital expenditures are the largest use of capital in Japan and the second largest use in the U.S.,
Europe, AJEJ, and GEM. The range in spending, measured as a percentage of sales, was five times
as large for M&A as it was for capital expenditures.
 R&D is the second largest use of capital in Japan, the third largest in the U.S. and Europe, and the
fourth largest in APEJ and GEM. Developed markets spend substantially more on R&D than
developing markets do.
 Net working capital is the third largest use of capital in APEJ and GEM, and the smallest use in the
U.S., Japan, and Europe. This disparity likely reflects the differences in the businesses in the
respective economies.
Divestitures play a significant role in all of the regions except for Japan, constituting roughly one-third the
level of total M&A outside of Japan. They are also larger than dividends and share buybacks in all regions
but Japan.
Dividends substantially exceed share buybacks in all regions except the U.S., where they have been
roughly equivalent on average. Buybacks are fairly limited in Europe, APEJ, and GEM and insignificant in
Japan.
Share buybacks have been meaningful in countries that embrace the Anglo-Saxon model and
inconsequential in nearly all other regions. This pattern reflects cultural and regulatory constraints.
Exhibit 1: Capital Deployment – Historical Averages for U.S., Japan, Europe, APEJ, and GEM
Uses of Capital (As a Percentage of Sales) Economic Returns and Growth
Internal Return of Cash
R&D Net Working Gross Real Asset
M&A Capex Expense Capital Divestitures Dividends Buybacks CFROI* Growth Rate
U.S. 10.6% 7.1% 2.2% 0.8% 3.4% 2.2% 2.3% 9.1% 5.7%
Japan 1.3% 4.6% 2.2% 1.1% 0.3% 0.7% 0.2% 3.0% 3.8%
Europe 11.4% 7.0% 2.0% 1.3% 4.2% 2.2% 0.6% 6.9% 4.2%
APEJ 12.7% 10.6% 0.8% 2.6% 5.0% 2.7% 0.4% 6.4% 9.6%
GEM 15.8% 12.0% 0.4% 3.3% 6.3% 3.2% 0.5% 6.0% 7.5%
Source: Credit Suisse HOLT® and Thomson Reuters.

Note: For uses of capital, historical averages are based on the following years: U.S. (1980-2015), Japan (1985-2015), Europe (1985-2015), APEJ (1992-
2015), GEM (1992-2015), For CFROI® and Real Asset Growth Rates, historical averages are based on the years 1996-2015 for all regions.
®

Cash Flow Return on Investment, or CFROI, is a registered trademark in the United States and other countries (excluding
the United Kingdom) of Credit Suisse Group AG or its affiliates.

Percent Percent
0
2
4
6
8
10
12
14
0
5
10
15
20
25
30
35
40
45
1992 1992
1993 1993
GEM
APEJ
APEJ
GEM
1994 1994
1995 1995
1996 1996
1997 1997
1998 1998
1999 1999
2000 2000
2001 2001
2002 2002
2003
M&A
2003
Capital Allocation Outside the U.S.

2004 2004
2005 2005
Divestitures
2006 2006
2007 2007
2008 2008
2009 2009
2010 2010

2011 2011
2012 2012
2013 2013
2014 2014
2015 2015
US
US
JPN
JPN
EUR
EUR
GEM
GEM
APEJ
APEJ
Percent Percent
0
2
4
6
8
10
12
14
16
0
1
2
3
4
5
1992 1992
1993 1993
1994 1994
1995 1995
1996 1996
1997 1997
1998 1998
1999 1999
2000 2000
2001 2001
2002 2002
2003 2003
Capex
2004 2004
Dividends
2005
APEJ
2005
GEM
2006 2006
2007 2007
2008 2008
2009 2009
2010 2010
2011 2011
2012 2012
2013 2013
2014 2014
2015 2015
US
US
JPN
JPN
EUR
EUR
GEM
GEM
APEJ
APEJ
Percent Percent
0.0
0.5
1.0
1.5
2.0
2.5
3.0
0
1
2
3
4
5
6
1992 1992
1993 1993
1994 1994
1995 1995
1996 1996
1997 1997
Exhibit 2: Uses of Capital for U.S., Japan, Europe, APEJ, and GEM, 1992-2015 (As a Percentage of Sales)
1998 1998
1999 1999
2000 2000
2001 2001
2002 2002
2003 2003
R&D
2004 2004
2005 2005
2006 2006
Gross Buybacks
2007 2007
2008 2008
2009 2009
2010 2010
2011 2011
2012 2012
2013 2013
2014 2014
2015 2015
US
US
JPN
JPN
EUR
EUR
November 15, 2016
GEM
GEM
5
APEJ
APEJ
November 15, 2016
Introduction
Capital allocation is the most fundamental responsibility of a senior management team of a public corporation.
Successful capital allocation means converting inputs, including money, things, ideas, and people, into
something more valuable than they would be otherwise. The net present value (NPV) test is a simple,
appropriate, and classic way to determine whether management is living up to this responsibility. Passing the
NPV test means that $1 invested in the business is worth more than $1 in the market. This occurs when the
present value of the long-term cash flow from an investment exceeds the initial cost.
Why should value determine whether a management team is living up to its responsibility? There are two
reasons. The first is that companies must compete. A company that is allocating its resources wisely will
ultimately prevail over a competitor that is allocating its resources foolishly. The second is that inputs have an
opportunity cost, or the value of the next best alternative. Unless an input is going to its best and highest use,
it is underperforming relative to its opportunity cost.
The process of making inputs more valuable has a number of aspects. A logical starting point is a strategy.
Properly conceived, a strategy requires a company to specify the trade-offs it will make to establish a position
in the marketplace that creates value. A strategy also requires a company to align its activities with its
positioning and to execute effectively.1
Since a company’s strategy is often already in place when a new chief executive officer (CEO) takes over,
capital allocation generally becomes his or her main responsibility. While a proper and comprehensive
discussion of capital allocation requires a consideration of intangible and human resources, our focus here is
on how companies spend money.
The problem is that many CEOs, while almost universally well intentioned, don’t know how to allocate capital
effectively. Warren Buffett, chairman and CEO of Berkshire Hathaway, describes this reality in his 1987 letter
to shareholders. He discusses the point of why it is beneficial for Berkshire Hathaway’s corporate office to
allocate the capital of the companies it controls. Buffett is worth quoting at length:2
This point can be important because the heads of many companies are not skilled in capital
allocation. Their inadequacy is not surprising. Most bosses rise to the top because they have excelled in
an area such as marketing, production, engineering, administration or, sometimes, institutional politics.
Once they become CEOs, they face new responsibilities. They now must make capital allocation
decisions, a critical job that they may have never tackled and that is not easily mastered. To stretch the
point, it’s as if the final step for a highly-talented musician was not to perform at Carnegie Hall but,
instead, to be named Chairman of the Federal Reserve.
The lack of skill that many CEOs have at capital allocation is no small matter: After ten years on the job,
a CEO whose company annually retains earnings equal to 10% of net worth will have been responsible
for the deployment of more than 60% of all the capital at work in the business.
CEOs who recognize their lack of capital-allocation skills (which not all do) will often try to compensate
by turning to their staffs, management consultants, or investment bankers. Charlie [Munger] and I have
frequently observed the consequences of such “help.” On balance, we feel it is more likely to
accentuate the capital-allocation problem than to solve it.
In the end, plenty of unintelligent capital allocation takes place in corporate America. (That's why you
hear so much about “restructuring.”)

November 15, 2016
Intelligent capital allocation requires understanding the long-term value of an array of opportunities and
spending money accordingly. It also includes knowing the value of a firm’s individual assets and being willing
to sell them when they are worth more to others.
We believe that long-term growth in value per share should guide capital allocation decisions. A necessary
corollary is that there is a time when shrinking the business is the most beneficial course for ongoing
shareholders. In some cases, for instance, buying back shares is a wiser choice than expanding by means of
capital expenditures or acquisition.
Capital allocation is a dynamic process, so the correct answer to most questions is, “It depends.” Sometimes
acquiring makes sense and other times divesting is the better alternative. There are times to issue equity and
times to retire it. Because the components that determine price and value are changing constantly, so too
must the assessments that a CEO makes. As Buffett says, “The first law of capital allocation—whether the
money is slated for acquisitions or share repurchases—is that what is smart at one price is dumb at another.”3
Buffett also discusses what he calls the “institutional imperative,” a force that is also pertinent.4 The force has
multiple aspects as he describes it, but a pair of them are relevant here. One is that subordinates will readily
create spreadsheets and studies to support the business craving of the leader. Another is that companies will
“mindlessly” imitate one another, whether in M&A or executive compensation.
The message here should be clear. A decision isn’t good just because someone in the organization can justify
it or because some other company is doing it. Proper capital allocation requires a sharp analytical framework
and independence of mind.
In our experience, very few CEOs, and chief financial officers for that matter, have what we call the “North
Star of value.” The North Star is not the brightest star, but it doesn’t move much throughout the night or year.
As a result, it provides a reliable sense of direction. Likewise, companies that have a North Star of value have
an unwavering view of value no matter what is going on. It is common for executives to solicit input from a
range of stakeholders, hear varying points of view, and walk away confused and unsure about the proper
course of action. This doesn’t happen to executives with the North Star of value, especially since they may
have better information about their company’s prospects than the market does.
Incentives are another barrier to proper capital allocation. An executive who is paid to deliver a target based on
short-term earnings per share may well act very differently than an executive who is focused on building long-
term value per share. In assessing management, ask a fundamental question: If there is a conflict between
maximizing a reward based on the incentive plan and creating long-term value per share, which route will the
executive select?
William Thorndike’s excellent book, The Outsiders: Eight Unconventional CEOs and Their Radically Rational
Blueprint for Success, inspired our reports on capital allocation.5 Thorndike shares the stories of eight CEOs
who created tremendous value per share during their tenures. One theme that comes out clearly in the book,
and is explicit in the subtitle, is that these CEOs appeared out of step with conventional wisdom as they were
building value. The North Star of value guided their decisions and they had the independence of mind to make
the best choices.

November 15, 2016
This report has three parts:
1. Groundwork. This part starts by showing the sources of capital by region. We then specify a
framework for considering the economic virtue of each form of capital allocation based on academic
research.
2. Capital allocation by region. This section documents capital allocation by region, providing historical
context, CFROIs and rates in asset growth, and the trends in capital allocation.
3. Assessing a company’s capital allocation skills. This part discusses methods to assess past
capital allocation choices, how to evaluate incentives, and the five principles of capital allocation.
Part I: Groundwork – Where Does the Money Come From and Where Has It Gone?
If the job of management is to deploy capital so as to add value, it makes sense to start with a discussion of
where capital comes from and how management teams have spent it in the past. The sources of capital
include the cash the business generates and access to the capital of claimholders, including debtors and
shareholders. A company can also sell an asset, which is a one-time realization of the cash flow the asset is
expected to generate over its life.
Businesses that grow rapidly generally require a sizeable amount of investment. For example, imagine a
restaurant concept that is highly successful. To satiate demand that firm must build lots of restaurants and
hence invest a substantial sum in expansion. The rate of return on incremental capital is the maximum growth
rate in operating profit a business can reach without external financing. By extension, a company with a return
on invested capital (ROIC) greater than its growth rate will generate surplus capital.6
Companies that cannot fund their growth internally must access cash externally, either by borrowing or selling
equity. The pecking order theory is an idea in corporate finance that says that managers of companies will
typically choose to fund investments first with cash that the company generates internally, next with debt, and
finally with equity.7 One essential tenet of thoughtful capital allocation is that all capital has an opportunity cost,
whether the source is internal or external.
The uses of capital are where the money goes. Executives can invest in the business through capital
expenditures, increases in working capital, research and development, or mergers and acquisitions. These
investments allow a company to grow. But growth, in and of itself, is never the goal of a thoughtful capital
allocator. The proper metric of success is an increase in long-term value per share.
A company can also return cash to debt and equity holders. Debt repayment, a return of some or all principal
and interest a company owes, is straightforward. A company can return cash to shareholders either by paying
a dividend, where all holders receive the same amount, or by buying back stock. In a buyback, shareholders
sort themselves. Those who want cash sell their shares and those who want to increase their stake in the
company hold their shares. A dividend treats all shareholders the same no matter what the stock price.
In a buyback, selling shareholders benefit at the expense of ongoing shareholders if the stock is overvalued,
and ongoing shareholders benefit at the expense of selling shareholders if the stock is undervalued. All
shareholders are treated uniformly only if the stock price is at fair value.8
Exhibit 3 summarizes the sources and uses of financial capital. These follow closely the alternatives and
choices that Thorndike specifies in The Outsiders.
November 15, 2016
Exhibit 3: Sources and Uses of Financial Capital

Capital sources Capital allocation
Operational cash flow Working capital
Business Business
Asset sales Mergers/acquisitions
Cash dividends
Access cash Equity issuance Return cash
Share buybacks
from claimholders Debt issuance to claimholders
Debt repayment
Sources of Capital
Internal financing, or the cash generated by the businesses, is the largest source of capital for most countries
and regions and typically falls in the range of 60 to 90 percent. Issuance of new debt is the next most
significant source of capital. The issuance of equity varies a great deal by region, and companies in developed
economies commonly retire as much equity as they issue.
The ratio of internal financing to the total source of capital tends to correlate with the underlying return on
invested capital for the country. A country with a high ROIC can fund a higher percentage of its investments
with internally-generated cash than can a country with a low ROIC. Exhibit 4 shows this correlation, using cash
flow return on investment (CFROI) as a measure of return on investment. The data reflect the average of the
ten years ended 2015.9
There are pros and cons to having internal financing represent a high percentage of investment funding. The
pro is that companies are earning high returns on capital in general and need not rely on capital markets to
fund their growth. The con is that companies can deploy internally-generated funds into value-destroying
investments. The need to raise money from the capital markets creates a check on management’s spending
plans.
Indeed, Peter Bernstein, the renowned financial historian and economist, once suggested that all companies
should be required to pay out 100 percent of their earnings and then appeal to the markets when they want
funds for investment. He argued that markets are more effective than companies at allocating capital, and as
a result the overall effectiveness of capital allocation would improve if left to the devices of the market.10

November 15, 2016
Exhibit 4: Relationship between CFROI and Internal Financing Capability (2006-2015 Average)
110 r = 0.71
Internal Financing (Percentage of Total)

105 U.S.
100
95
90 Denmark
Germany
85 Spain Netherlands
80 Finland Austria
75 Italy
70 Portugal
65
France
60
4 5 6 7 8 9 10
CFROI (Percent)
Source: Europe: Eurostat European Sector accounts; U.S.: Board of Governors of the Federal Reserve System, Division of Research and Statistics,
Flow of Funds Accounts Table F.103; Credit Suisse.
Before delving into each of the specific uses of capital, it is worth considering what the academic research
says about capital allocation. A key finding is that asset growth rates are strong predictors of future abnormal
returns to shareholders in countries with developed financial markets. The effect is weaker, if present, in
developing economies.11
More specifically, developed markets firms with low asset growth rates earn substantially higher shareholder
returns, after adjusting for risk, than firms with high asset growth rates. Further, companies that contract their
assets tend to generate higher shareholder returns than companies that expand their assets.
High returns to shareholders tend to follow events such as spin-offs, dividend initiations, share repurchases,
and debt prepayments, whereas low returns to shareholders generally follow events such as acquisitions and
stock and debt issuance.
A global study of 40 countries reveals that from 1982-2010 the relationship between asset growth and
shareholder results was strong in Europe, with 14 of the 17 countries in the study showing the relationship
(Greece, Italy, and Portugal were the exceptions). The economies in APEJ also overwhelmingly exhibit the
asset growth effect, including 10 of the 13 countries in the study (the result didn’t hold for China, Taiwan, or
the Philippines).
Unlike most developed countries, developing economies do not demonstrate a significant asset growth effect.
Of the 14 developing economies in the study, only 2 exhibited a strong asset growth effect.
The academic research also supports the point that growth is not inherently good. We must recognize that
context is very important. The correct answer to almost every capital allocation question is, “It depends.” We
need to look beyond base rates, as informative as they are, to understand what truly drives or impedes value
creation.

November 15, 2016
Uses of Capital
We now turn to the details of the major uses of capital. We discuss how to assess each alternative from an
economic standpoint and summarize the findings of the empirical research. The subsequent part reviews the
details of the historical trends for the uses of capital in each region.
Mergers and Acquisitions. M&A is a major source of redistribution of corporate resources. For many
companies, M&A is the most significant means to pursue strategic goals and the most costly way to do so.
Nearly all companies and investment portfolios will feel the effect of M&A at some point. Consider that over
the past twenty years, M&A volume as a fraction of the total equity market capitalization has averaged 14
percent in Europe, 11 percent in GEM, 10 percent in APEJ, 9 percent in the U.S., and 3 percent in Japan.
M&A tends to follow the stock market closely, with more M&A activity when the stock market is up. It comes as no
surprise that companies that act early in an M&A cycle tend to generate higher returns than those that act later.
The first movers in an M&A wave enjoy the benefits of a larger pool of acquisition targets and cheaper valuations
than companies that acquire later in the cycle. Later acquirers are encouraged to act based on bandwagon effects,
or what Buffett calls the institutional imperative, and an accommodating environment for financing.12
One of the most effective ways to assess the merit of a deal is to compare the present value of incremental
cash flow, the result of synergy, to the premium the acquirer agrees to pay.13 If the synergy exceeds the
premium, the deal will add value for the buyer. If the synergy is less than the premium, the buyer will see its
shares decline. The relationship between synergy and premium is more explanatory than the measures that
companies and investors commonly use, including earnings accretion or dilution.14
Here’s an example. Assume that the market capitalization is $2,000 for the buyer and $800 for the seller.
The buyer bids $1,000 for the seller, representing a $200 premium. If the synergy is only $100, the market
capitalization of the buyer will slump to $1,900 and the seller will receive $1,000. If, on the other hand, the
synergy is $300, the market capitalization of the buyer will rise to $2,100 as the seller receives $1,000.
Although the key factors in judging M&A are the synergy and the premium, only the premium is explicit. While
companies today generally provide some guidance for expected synergy, the investor must still assess the
likelihood that the company will achieve the objective. M&A creates value in the aggregate as the combined
value of the buyer and target is almost always higher after a deal is announced than before. But buyers
commonly overpay, which means the seller’s shareholders often capture the value of the synergy.
Capital Expenditures. Capital expenditures have been the largest source of investment in Japan and APEJ, and
are a large percentage of spending in GEM. As a broad rule of thumb, spending on capital expenditures, measured
as a percentage of sales, is larger in developing countries than in developed countries. Further, the growth in capital
expenditures tends to come with low variance, which means that executives want to keep the spending steady.
Executives and investors frequently distinguish between “maintenance” capital expenditures and total capital
expenditures. Maintenance spending is the minimum required to maintain or replace the long-term assets in
place. We can assume that capital expenditures beyond the maintenance level are in pursuit of growth.
Depreciation expense serves as a rough proxy for maintenance capital spending.15 Measured as a percentage
of sales, growth capital expenditures range from one-fifth to one-half of overall capital expenditures across the
different regions. That maintenance capital expenditures are essential explains a good deal of the stability of
spending. Further, it suggests that in assessing the value creation prospects of capital expenditures, you are
best served to focus on the component that supports growth.

November 15, 2016
The stock market tends to favorably greet increases in capital expenditures for companies that have attractive
returns on invested capital and a good record of past spending. The market expresses skepticism at increases
for low return on capital businesses or businesses that are at or near a cyclical peak.16
Research and Development. Unlike M&A and capital expenditures, R&D is an expense on the income
statement rather than invested capital on the balance sheet. Accountants expense R&D in the period the
company incurs it, notwithstanding the potential long-term benefits, because they deem the outcomes too
uncertain and difficult to quantify. We can define R&D as a set of activities that seeks to develop new
products or the tools to create new products.
In the U.S., businesses account for about 70-75 percent of total R&D spending, with the government and
academia splitting the other 25-30 percent. The industries that spend the most include information technology,
healthcare, materials, and aerospace and defense. Technology and healthcare combined represent more than
two-thirds of all R&D spending in the U.S., and technology R&D spending is roughly 1.6 times that of
healthcare.
R&D spending averages about two percent of revenues in developed economies including the U.S., Japan,
and Europe. That ratio is less than one percent in APEJ and GEM. The U.S., China, and Japan together
represent more than half of global R&D spending, and ten countries account for about 80 percent of the total.
At current rates of funding and growth, China will surpass the U.S. as the largest spender on R&D by the year
2026.17
The academic research on the effectiveness of R&D spending is somewhat equivocal, in part because of the
measurement challenges and the decline in R&D productivity in the pharmaceutical industry. One of the best
ways to study the market’s reaction to any form of investment is to examine unexpected changes. In one such
study, finance professors studied more than 8,000 unexpected increases in R&D spending over a 50-year
period ended in 2001 and found that the stocks of those companies rose.18 Other researchers conclude that
the returns to R&D are positive and higher than other capital investments.19
A reasonable question is whether the stock market effectively reflects R&D spending. One large study found
that the market does it well. This means that companies that spend a large percentage of sales on R&D
realize similar stock market returns as companies that spend a small percentage of sales on R&D. The
researchers came to similar conclusions for advertising expenses, which are about one-half as large as R&D
expenses in the aggregate.20
Academics have also found that larger companies that acquire their R&D by buying businesses that are R&D
intensive tend to fare poorly in the stock market.21 This is consistent with the view that the value of R&D in an
acquisition ultimately accrues to the seller, not the buyer. That said, companies with strong execution
capabilities can create value by enhancing R&D effectiveness.22
One study focused specifically on Japan found that the stock market properly reflected R&D spending.
Specifically, it showed that companies that spent a large percentage of sales on R&D realized similar total
shareholder returns as companies that spent a small percentage.23
Some recent research suggests that the technology companies in the U.S. that are in the bottom one-third of
R&D spending as a percentage of sales deliver higher returns to shareholders than those in the top third. 24
This finding underscores how tricky it is to assess R&D spending because a number of technology companies
have benefitted from R&D that was funded by the government.

November 15, 2016
Mariana Mazzucato, a professor of economics at the University of Sussex, addresses this issue in her
provocative book, The Entrepreneurial State.25 Her thesis is that the government funds a great deal of high-
risk R&D that companies go on to exploit commercially.
She uses the vivid example of the iPhone from Apple Inc., a company that has created a huge amount of
shareholder value in the past decade. Four of the main technologies inside the iPhone, including the Global
Positioning System (GPS), the Internet, touch screen, and voice recognition software, were developed by the
U.S. government. As Mazzucato notes, Apple did a brilliant job of integrating these technologies, designing an
attractive and intuitive product, and marketing effectively. But it did not develop some of the key technologies
inside the phone, which means the company’s shareholders did not have to shoulder those expenses.
Net Working Capital. Net working capital is the capital a company requires to run its day-to-day operations.
It is defined as current assets minus non-interest-bearing current liabilities. The primary components of net
working capital include inventory, accounts receivable, and accounts payable. Interest-bearing current liabilities,
which include short-term debt and the current maturities of long-term debt, are a form of financing and are
therefore not part of net working capital.
For the purpose of capital allocation, we analyze the change in net working capital. Net working capital is a
substantially larger use of capital in developing markets than in developed markets. For instance, changes in
net working capital have averaged 3.3 percent of sales in GEM and 2.6 percent in APEJ compared to less
than 1.5 percent of sales in Europe, Japan, and the U.S.
Divestitures. Companies use divestitures to adjust their business portfolio. Actions include the sale of
divisions, spin-offs, and equity carve-outs. A company will divest an operation when it perceives the value to
another owner to be higher, or if the divestiture adds focus to the parent and hence improves results.
There are a few considerations in assessing divestitures. First, research has established that most of the value
creation for a typical company comes from a relatively small percentage of its assets. 26 This means that most
companies have businesses or assets that do not earn the cost of capital and that may be more valuable to
another owner.
Divestitures can lead to “addition by subtraction” when a company that divests an operation with a low return
on invested capital receives more than what the business is worth as an ongoing part of the firm. So there’s
an addition to value even as there’s a subtraction from the size of the firm.
Second, we have already reviewed the evidence showing that M&A creates value in the aggregate but that
acquirers struggle to capture much, if any, of that value. This suggests that it is better to be a seller than a
buyer on average. This point is particularly relevant when there are multiple bidders for an asset. Contested
deals frequently lead to what economists call the “winner’s curse.”27 When this occurs, the “winner” of the
bidding pays too much for the asset, hence the “curse.” The winner’s curse means that there is a wealth
transfer, above and beyond the value of the asset, from the buyer to the seller.
Finally, most companies have a natural tendency to want to grow rather than shrink. As companies grow and
diversify, capital allocation and strategic control can become more challenging. When a CEO who understands
capital allocation takes the helm of a company with underperforming assets, there is a great opportunity to
create value through divestitures.28

November 15, 2016
Notwithstanding their significance in capital allocation, divestitures have received substantially less attention
than M&A in the academic literature. Research for the most part concludes that divestitures create value. A
meta-analysis of nearly 100 studies on divestitures concludes: “In the broadest possible terms, our results
suggest that on average, divestiture actions are associated with positive performance outcomes for the
divesting parent firm.”29
Analysis also shows that spin-offs create value for the spin-offs themselves as well as the corporate parents.30
Researchers who did a meta-analysis of more than 25 papers in the spin-off literature summed up their
findings this way: “The main conclusion is consistent: spin-offs are associated with strongly significant
abnormal returns.”31 They suggest the factors that explain these wealth effects include sharpened focus,
better information, and in some cases tax treatment.
Dividends. A dividend is a cash payment to a shareholder that is generally paid from profits. Dividends and
share buybacks are the main ways companies return cash to shareholders. Companies can also return cash to
shareholders by selling the company for cash.
The most profound difference between buybacks and dividends may be the attitude of executives. Most
executives believe that once a dividend is established, paying it is on par with investment decisions such as
capital spending. In contrast, they tend to view buybacks as something to do with residual cash flow after the
company has made all investments that are appropriate.32
There are a couple of consequences of this difference in attitude. The first is that dividend payments are vastly
less volatile than buybacks. Indeed, of all the capital allocation options, dividends have among the lowest
standard deviation in growth.
How should investors assess dividends? First, dividends are useful to consider in the context of cash flow. To
sustain a cash dividend, a company has to generate cash flow beyond the basic needs to maintain the
business and support its growth. So an investor should gauge a company’s cash flow prospects in order to
anticipate a company’s ability to pay dividends.33
Second, dividends can play an important role in the capital accumulation rate, also known as total shareholder
return (TSR). From time to time you hear that dividends provide the bulk of shareholder returns for equities in
the long run. That assertion is wrong if you assume the goal of an investor is to accumulate capital. In fact,
price appreciation is the only source of investment return that increases accumulated capital over time. 34
The equity rate of return is a one-period measure and is simply the sum of stock price appreciation and the
dividend. The capital accumulation rate, or TSR, is a multi-period measure that assumes all dividends are
reinvested in the stock. Knowing price appreciation and dividend yield, the following equation allows you to
calculate TSR:
Total shareholder return (TSR) = Price appreciation + [(1 + price appreciation) * dividend yield]
The value of the compounding reinvested dividends means that the equity rate of return is always lower than
the TSR as long as price appreciation is positive. For example, assume price appreciation of 7 percent and a
dividend yield of 2 percent. The equity rate of return is 9 percent (.07 + .02) and the TSR is 9.14 percent (.07 +
[(1 + .07)*.02]).
The key is that for an investor to actually earn the TSR, all of the dividends they receive must be reinvested back
into the stock. That’s why price appreciation only determines the TSR.

November 15, 2016
It’s crucial to acknowledge that almost no one earns the full TSR because most individuals do not reinvest the
dividends they receive, and dividends are generally taxable. While there are no clear-cut data on the topic, it
appears that only one-tenth of all dividend proceeds are reinvested. Naturally, investors can use dividends to
consume. But if they do, they can’t earn the TSR.
Further, most investors must pay taxes on the dividends they receive. The TSR declines when you assume
that only a fraction is reinvested in the stock. Academic research supports the view that the tax rate on
payouts affects shareholder returns.35
Academic research on dividends supports a few points. To begin, older companies are more likely to pay
dividends than younger companies. So any analysis of dividend yields must take into account the maturity of
the population of companies under consideration.36
Second, dividends provide a strong signal about management’s commitment to distribute cash to shareholders
and its confidence in the future earnings of the business. This is consistent with the managerial attitude that
dividends are sacrosanct once declared. For this reason, companies are very deliberate about the decision to
initiate a dividend.37
Dividend payouts are generally more generous in developing markets than in developed markets. Dividends as
a percentage of sales averaged 3.2 percent in GEM and 2.7 percent in APEJ in the past couple of decades,
higher than the 2.2 percent in the U.S. and Europe. Japan’s payout rate has been consistently below the
average of other regions of the world, with dividends as a percentage of sales of 0.7 percent in the past 30
years.
Share Buybacks. A share buyback is the second way that a company can return cash to its shareholders.
Whereas all shareholders are treated equally with a dividend, only shareholders who sell to the company
receive cash. This means that shareholders realize very different outcomes based on whether they choose to
sell or hold the stock when they deem it to be overvalued, fairly valued, or undervalued.
When assessing a repurchase program, investors and executives should consider the golden rule of share
buybacks, which states: A company should repurchase its shares only when its stock is trading below its
expected value and when no better investment opportunities are available.38
The golden rule addresses both absolute and relative value. Companies should only invest where they
anticipate a payoff that has a positive net present value. This is a fancy way of saying “you will get more than
what you pay for.” This absolute benchmark applies to all of a company’s capital allocation decisions, including
M&A, capital expenditures, and R&D.
The rule also addresses relative value when it emphasizes that companies should prioritize higher return
internal investment opportunities over buybacks. Ideally, executives should rank their investment opportunities
by expected return and fund them from highest to lowest. A company should expect that all of the investments
it funds will earn above the cost of capital. There can be cases when buybacks are more attractive than
investing in the business.39
The second aspect of assessing a buyback is its impact on various shareholders under different conditions.
Only if a stock trades exactly at intrinsic value do buybacks and dividends treat all shareholders the same. If a
stock is overvalued or undervalued, the effect of a buyback is different for selling shareholders than it is for
those who continue to hold.

November 15, 2016
From the company’s standpoint, corporate value is conserved no matter how the company chooses to pay out
cash. What differs is who wins and who loses as the result of buying stock below or above intrinsic value.
Since management should focus on building value per share for continuing shareholders, it should always try
to buy back shares that are undervalued.
To be more concrete, if a company buys back shares that are overvalued the selling shareholders gain at the
expense of ongoing shareholders. The premium to intrinsic value accrues to the sellers and the value per
share for the ongoing holders goes down accordingly.
If a company buys back shares that are undervalued the selling shareholders lose at the expense of ongoing
shareholders. The discount to intrinsic value accrues to the ongoing shareholders and the selling shareholders
fail to realize value.
This analysis suggests a couple of points that investors commonly overlook. First, if you are the shareholder of
a company that is buying back stock, doing nothing is doing something. By choosing to hold the shares
instead of selling a pro-rated amount, you are effectively increasing your percentage ownership in the
company. One alternative is to sell shares in proportion to your stake, creating a homemade dividend and
maintaining a steady percentage ownership in the business.
Second, it is logical that you would prefer that the companies you hold in your portfolio buy back stock rather
than pay a dividend. If you own shares of companies that you think are undervalued, buybacks will increase
value per share by definition. The only instance where this may not be true is if you believe that a dividend
would provide a more powerful signal to the market, hence creating more value than a buyback.
Tying together these thoughts, there are basically three schools of thought regarding buybacks: fair value,
intrinsic value, and accounting-motivated. The intrinsic value school is where you want to be if possible.
The fair value school takes a steady and consistent approach to buybacks. Management believes that over
time it will buy back shares when they are both overvalued and undervalued, but for the most part when they
are about fairly priced. This approach offers shareholders substantial flexibility as it allows them to hold shares
and defer tax liabilities or create homemade dividends by selling a pro-rated number of shares.
The fair value school is consistent with the free cash flow hypothesis, which says that managers who have
excess cash will invest it in projects with a negative net present value. By disbursing cash, a company buying
back its shares reduces the risk of doing something foolish with the funds.40 Research suggests that most
companies would have been better off buying back stock consistently versus their actual behavior of buying
heavily in some periods and lightly, or not at all, in others.41
The intrinsic value school believes a company should only buy back shares when it deems them to be
undervalued. A company must have asymmetric information or beliefs, as well as analytical prowess, to
profitably pursue this approach. Asymmetric information means that company management has information
that the stock price fails to reflect. Differing beliefs occur when management has the same information as the
market but comes to different conclusions about what that information means.
Analytical prowess means that the executives at the company know how to translate their differential view into
an estimate of the relationship between the stock price and intrinsic value. Investors should not assume that
management has this ability. Indeed, surveys consistently show that executives believe their stock to be cheap.

November 15, 2016
Management can act on its conviction by being bold with its buyback program, buying back a substantial
percentage of the shares or even buying them at a premium to the prevailing price through a tender offer.42
This school fits the signaling hypothesis, which suggests that companies buy back shares when they deem
them to trade below intrinsic value. Further, it is important to focus on actual share buybacks versus buyback
announcements. The evidence supporting the signaling hypothesis is mixed, but 85 percent of CFOs believe
that their buyback decision conveys information.43
Boosting short-term accounting results, especially earnings per share (EPS), is what motivates the final
school.44 When surveyed, three-fourths of CFOs cite increasing EPS as an important or very important factor
in the decision to buy back shares. Two-thirds of CFOs say that offsetting the dilution from option or other
stock-based programs is important. This underscores another essential point: you should consider buybacks
net of equity issuance.
The problem with the accounting-motivated school is that its actions are not necessarily aligned with the
principle of value creation.45 For example, there may be a case where buying back overvalued stock boosts
EPS and helps management reach a financial objective that prompts a bonus. In this case the motivation is
impure because management’s proper goal is to allocate capital in an economically sound fashion for
shareholders.
Investors assessing companies buying back stock should make an effort to determine which school the
management is in. It can be the case that management buys back stock for the right reason and realizes
accounting benefits as a result. That’s fine. But investors should be on the lookout for companies that make
decisions based on the accounting results without sufficient regard for the economic merits.
A couple of findings from the academic research are worth highlighting. The first is that it appears companies
are increasingly using buybacks as a substitute for dividends.46 As a result, total shareholder yield (sum of
dividends and buybacks divided by equity market capitalization) may be a better indicator of a company’s
proclivity to pay out than a simple dividend yield.
Second, a global study found that share buybacks generate positive excess returns on balance, but that the
results differed across regions. Buybacks led to positive excess returns in Japan, APEJ, and several
prominent GEM countries, but did not do so in Europe. The researchers suggest the source of the positive
returns is the ability of management teams to take advantage of undervalued stock prices.47
We now turn to capital allocation by region. Before we do, here’s a quick comment on currency. Credit Suisse
HOLT® converts the numbers based on local currencies into U.S. dollars using year-end exchange rates. This
applies to R&D, capital expenditures, buybacks, dividends, and net working capital data. For M&A and
divestitures, Thomson Reuters Datastream converts values in local currencies into U.S. dollars as of the
effective date of the deal.

November 15, 2016
Part II: Capital Allocation by Region
Japan
Uses of Capital. Exhibit 5 shows how the top 1,000 companies in Japan, excluding companies in the
particular year, the ranking reasonably reflects how companies in Japan have allocated capital over time.
Exhibit 5: Japan Capital Deployment, 2015

Capital Capital
Expenditures Expenditures
Research & Research &
Development Development
Mergers & Mergers &
Acquisitions Acquisitions
Dividends Dividends
Gross Share Gross Share

Repurchases Repurchases
Change in Net Change in Net
Working Capital Working Capital
-50 0 50 100 150 200 250 300 -1% 0% 1% 2% 3% 4% 5% 6%
Note: R&D, capital expenditures, buybacks, dividends: exclude financial companies and regulated utilities; M&A, divestitures: include all industries.
Exhibit 6 shows the breakdown of spending by source from 1985-2015. This graph excludes changes in net
working capital because those values are negative in many years.
Exhibit 6: Japan Capital Deployment, 1985-2015

100%
Gross buybacks
90%
80%
70% Dividends
60% Divestitures
50%
40%
30%
20%
10%
Mergers & acquisitions
0%
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015


November 15, 2016
Similar to 2015, capital expenditures and R&D are the largest uses of capital over time. An examination of the
changes from 1985 through 2015 reveals some noteworthy patterns:
Capital expenditures are by far the largest use of capital. Historically, capital expenditures have been
more than double the level of R&D spending and nearly four times that of M&A. Capital expenditures
have been fairly steady over time. In 2015, they were 5.1 percent of total sales, slightly above the long-
term average. But the fraction of capital expenditures to the total sum that companies allocate has
declined over the decades. This reflects a change in the composition of the economy, with businesses
that require less capital investment replacing those that require more. (See Exhibit 7.) For example, the
energy, materials, and industrial sectors represented 42 percent of the market capitalization of the top
1,000 companies in the Japanese market in 1985 but just 26 percent in 2015.
R&D spending has shown a gradual rise from 1.6 percent of sales in 1985 to 2.4 percent in 2015.
These levels make Japan one of the world’s leaders in R&D spending, and the ratio has been steady
over the years. Japan’s large presence in R&D-intensive sectors explains its level of spending.
M&A plays a much smaller role in Japan than it does in other major countries and regions. M&A volume
was only 1.9 percent of sales in 2015, slightly above its long-term average. Legal and cultural factors
explain why M&A was negligible until the late 1990s. For much of Japan’s history, society frowned on
M&A and gaining approval for deals was difficult because of the interlocking and diffuse ownership
structure of corporations. M&A activity picked up when Japan instituted new laws to increase investor
protection and as the legacy corporate ownership structure began to change.
The return of cash to shareholders through dividends and buybacks was paltry before Japan adopted a
series of regulatory reforms in the 1990s. The government first made buybacks legal in 1994 and then
made their tax treatment less punitive a few years later. Further, corporate governance reforms that were
friendly to investors spurred more M&A activity and boosted corporate payouts overall. The buyback yield
(buybacks as a percentage of total market capitalization) went from zero in 1985-1999 to 0.7 percent in
2000-2015, while the dividend yield rose from 0.8 percent to 1.5 percent.
Exhibit 7: Japan Sector Composition, 1985-2015

100%
Financials
90%
Utilities
80% Telecom
70% Information Technology
60% Healthcare
Consumer Staples
50%

30%
20%
Industrials
10%
Materials
0% Energy
1986
1997
2008
2014
1985
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2009
2010
2011
2012
2013
2015

Note: Data for telecom sector not available for 1985-1987.

November 15, 2016
Exhibit 8 shows a detailed history of capital deployment from 1985-2015. It is worth noting that the standard
deviations of the growth rates, which appear in the bottom row, are small for R&D, capital spending, and
dividends, relative to those of M&A, buybacks, and divestitures. Standard deviation is a measure of how much
something varies from an average. These standard deviations provide a glimpse into how managers think
about each use of capital. The lower the standard deviation, the more sacrosanct management deems that
investment. Exhibit 9 represents the same deployment numbers as a percentage of sales.

Total Amount (in Millions of U.S. Dollars, Nominal)
Net Working Gross
M&A Capex R&D Expense Capital Buybacks Divestitures Dividends
1985 16 38,496 19,099 0 195 4,422
1986 490 42,730 24,484 87,980 0 1,506 5,621
1987 641 63,820 33,685 175,007 0 4,317 8,032
1988 2,318 84,896 40,447 90,158 0 8,050 10,185
1989 29,187 103,277 39,010 58,522 0 7,563 10,410
1990 14,157 141,554 45,561 95,500 0 616 11,765
1991 6,563 167,919 53,691 80,070 0 2,453 13,206
1992 4,366 150,053 54,694 -10,372 0 152 12,804
1993 6,461 154,769 61,339 60,199 0 407 13,487
1994 5,211 170,529 70,282 105,383 0 1,345 15,523
1995 40,145 178,394 72,428 30,481 0 3,150 16,653
1996 7,243 189,254 67,992 -93,943 28 965 15,907
1997 12,137 163,797 63,918 -72,460 86 4,338 14,697
1998 14,007 189,027 76,821 104,206 659 2,795 16,133
1999 200,822 201,998 90,754 50,727 4,281 16,909 17,224
2000 109,833 187,602 86,566 -163,369 5,384 11,358 17,515
2001 57,431 161,668 78,165 -135,745 9,411 11,836 14,245
2002 43,404 160,447 88,300 44,506 21,763 9,377 17,600
2003 64,785 179,140 102,430 84,360 19,864 12,944 22,559
2004 110,422 211,123 111,561 71,232 22,066 17,567 30,721
2005 173,550 209,458 102,992 -60,476 19,879 12,896 33,924
2006 97,072 230,097 107,615 47,059 22,702 19,943 40,854
2007 126,149 264,734 119,845 73,001 31,212 24,624 50,662
2008 78,958 309,317 147,117 223,318 32,396 19,406 54,391
2009 93,196 225,912 129,959 -600 3,747 21,706 42,747
2010 93,167 247,074 153,610 204,503 9,920 18,664 56,833
2011 77,663 282,760 162,664 124,007 16,651 24,077 63,729
2012 79,817 281,213 146,056 -70,500 14,364 27,395 61,475
2013 81,895 245,962 127,000 -150,673 12,963 36,381 59,861
2014 63,450 225,933 115,171 -58,859 20,151 31,190 60,648
2015 94,353 247,565 118,385 -7,618 32,989 46,890 66,113
CAGR 33.6% 6.4% 6.3% NA 45.2% 20.1% 9.4%
St. Dev. 628.2% 16.1% 13.3% NA 192.7% 175.1% 15.3%
Note: Dollar amounts not inflated. R&D, capital expenditures, buybacks, dividends: exclude financial companies and regulated utilities; M&A,
divestitures: include all industries. The CAGR and standard deviation for buybacks covers 1996-2015.

November 15, 2016

Recent Trends in Cash Flow Return on Investment and Asset Growth. The maximum earnings growth
rate a company can achieve through internal funding is a function of its ROIC and payout ratio. High ROICs
and low payout ratios allow for higher achievable growth rates than low ROICs and high payout ratios. Low
ROIC or high payout businesses can certainly grow but need to access debt or equity capital to do so.
Part of the explanation for Japan’s low payout ratio is the country’s low CFROI. CFROI measures the cash
return a business earns on the investments it makes. Since CFROI is also adjusted for inflation, it is an ideal
tool for comparing results over time. Exhibit 10 shows that today’s CFROI of 2.9 percent is close to the
twenty-year average of 3.0 percent. But Japan’s CFROI is well below the 20-year average of 9 percent in the
U.S. and 7 percent in Europe. Further, Japan’s current CFROI remains below the peak years of the mid-
2000s.

November 15, 2016
Exhibit 10: Japan CFROI, 1996-2015

5
Average
3
Percent
0
1998
2006
2014
1996
1997
1999
2000
2001
2002
2003
2004
2005
2007
2008
2009
2010
2011
2012
2013
2015
Note: Japanese industrial firms, weighted by net assets.
Exhibit 11 shows the annual rate of asset growth, adjusted for inflation, over the past twenty years. In recent
years, some easing of regulatory burdens for companies along with stimulative fiscal and monetary policy has
encouraged companies to grow. Asset growth in 2015 was particularly weak as the result of slow economic
growth in China, a large trading partner, and a persistently strong yen.
Exhibit 11: Japan Real Asset Growth Rate, 1996-2015

10
5
Percent
4 Average
-1
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015

Note: Japanese industrial firms, weighted by gross investments.

November 15, 2016
Exhibit 12 shows that at 13 percent, today’s cash as a percentage of assets is slightly above the long-term
average of 12 percent.
Exhibit 12: Japan Cash as a Percentage of Total Assets, 1996-2015

15%
Average
12%
9%
6%
3%
0%
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
Note: Top 1,000 industrial firms.
Mergers and Acquisitions. Exhibit 13 shows the dollar amount of M&A as well as M&A as a percentage of
sales from 1985 to 2015. M&A volume was only 1.9 percent of total sales in 2015, slightly above its long-
term average of 1.3 percent. M&A plays a much smaller role in Japan than it does in other regions. For
example, M&A averaged 11 percent of sales in the U.S. and Europe over the same period. A look at the
relative dollar amounts is also revealing. In 2015, M&A volume in Japan was just one-twentieth the level of the
U.S. and one-tenth that of Europe.
In Japan, M&A displays cyclicality at times—note the peaks in 1999 and 2005, two strong years for the
Nikkei. But legal and cultural factors have played a larger role in explaining the country’s M&A activity. 48 M&A
was negligible until the late 1990s because it was not societally accepted. The interlocking and diffuse
ownership structure of corporations, known as keiretsu, made it difficult to get approval for deals. Spurred in
part by a sputtering economy and a declining stock market, Japan instituted new laws to increase investor
protection and to finance deals. At the same time, the keiretsu system eroded and banks began to restructure,
paving the way for more M&A activity.

November 15, 2016
Exhibit 13: Japan Mergers and Acquisitions, 1985-2015

Dollar amount
5%

200,000
4%
150,000
$ Millions
3%
100,000
2%
50,000
1%
0 0%
1987
1991
1985
1986
1988
1989
1990
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
Note: Dollar amounts not inflated. Japan announced domestic mergers; excludes debt tender offers, equity carve-outs, exchange offers, loan
Capital Expenditures. Exhibit 14 shows capital expenditures, as well as capital expenditures as a

percentage of sales, in Japan from 1985 to 2015. Capital expenditures have been fairly steady over time. In
2015, they were 5.1 percent of sales, slightly above the long-term average of 4.6 percent. Notwithstanding
the recent rise in M&A, spending on capital expenditures in 2015 was nearly three times that of M&A. Even
though capital expenditures are Japan’s largest use of capital, that form of investment still lags other regions
when measured as a percentage of sales.
Exhibit 14: Japan Capital Expenditures, 1985-2015

Dollar amount
300,000
5%
250,000
4%
$ Millions
200,000
3%
150,000
2%
100,000
50,000 1%
0 0%
1995
2015
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014

Note: Top 1,000 industrial firms. Dollar amounts not inflated.

November 15, 2016
Exhibit 15 shows capital expenditures net of depreciation. Measured as a percentage of sales, growth capital
expenditures have averaged roughly one-sixth of overall capital expenditures.
Exhibit 15: Japan Capital Expenditures Net of Depreciation, 1985-2015

Dollar amount
80,000 4%

60,000 3%
$ Millions
40,000 2%
20,000 1%
0 0%
-20,000 -1%
-40,000 -2%
1986
1997
2008
1985
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2009
2010
2011
2012
2013
2014
2015
Research and Development. Exhibit 16 shows the dollar amount of R&D since 1985 as well as R&D as a
percentage of sales. R&D doesn’t typically shift much from year to year in Japan, but shows a gradual rise
from 1.6 percent of sales in 1985 to a peak of 2.6 percent of sales from 2009-2011, only to settle slightly
lower at 2.4 percent in 2015.
Japan is one of the world leaders in R&D spending. In Japan, businesses account for 78 percent of total R&D
spending, with the government, academia, and private nonprofit companies accounting for the other 22
percent. Its R&D spending as a percentage of sales is equal to that of the U.S. at 2.2 percent, slightly above
Europe at 2.0 percent, and well above APEJ at 0.8 percent and GEM at 0.4 percent.
Japan’s large presence in sectors that are R&D intensive, such as automobiles and electronics, explains these
levels of spending. Japan’s R&D spending has been stable in recent years despite the fact that information
technology, the country’s most R&D-intensive sector, went from roughly 20 percent of the country’s market
capitalization in 1999 to half that amount today.

November 15, 2016
Exhibit 16: Japan Research and Development, 1985-2015

Dollar amount
180,000 As a percentage of sales 3.0%
160,000
2.5%

140,000
120,000 2.0%
$ Millions
100,000
1.5%
80,000
60,000 1.0%
40,000
0.5%
20,000
0 0.0%
1992
2003
1985
1986
1987
1988
1989
1990
1991
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
Net Working Capital. Net working capital, current assets minus non-interest-bearing current liabilities, is the
capital a company requires to run its day-to-day operations. Net working capital equals about one-quarter of
assets, on average, for companies in Japan.
Exhibit 17 shows the annual change in net working capital from 1985 through 2015. At year-end 2015, net
working capital stood at $1.2 trillion for the top 1,000 public firms in Japan. We consider changes in net
working capital as opposed to the absolute amount, because changes are what you should consider to be an
incremental investment. Net working capital investments are highly volatile in Japan, albeit smaller in absolute
size than capital expenditures and R&D.
Exhibit 17: Japan Change in Net Working Capital, 1985-2015

Dollar amount
200,000 8%
150,000 6%
100,000 4%
50,000 2%
$ Millions
0 0%
-50,000 -2%
-100,000 -4%
-150,000 -6%
-200,000 -8%
-250,000 -10%
1985
1987
1989
1991
1986
1988
1990
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015


November 15, 2016
Our definition of net working capital includes cash. The picture changes dramatically if we exclude cash. At
the end of 2015, net working capital excluding cash was about $485 billion for the top 1,000 Japanese
industrial companies, roughly two-fifths of the total net working capital sum. Exhibit 18 shows the change in
net working capital excluding cash.
Exhibit 18: Japan Change in Net Working Capital Excluding Cash, 1985-2015
Dollar amount
80,000 4%

40,000 2%
$ Millions
0 0%
-40,000 -2%
-80,000 -4%
-120,000 -6%
1987
1993
1985
1986
1988
1989
1990
1991
1992
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
Divestitures. Exhibit 19 shows the magnitude of divestitures from 1985-2015. Similar to M&A, divestiture
activity varies a lot from year to year, ranging from none in 1985 to a high of 1.0 percent of sales in 2015.
Overall, divestitures have averaged 0.3 percent of sales, which is below all other alternatives except buybacks.
These low levels are not surprising considering Japan’s modest M&A activity. Since divestitures are correlated
with M&A, many of the same legal and cultural factors that constrained M&A also limited divestitures.
Exhibit 19: Japan Divestitures, 1985-2015

Dollar amount
45,000
1.0%
40,000
35,000
0.8%
30,000
$ Millions
25,000 0.6%
20,000
0.4%
15,000
10,000
0.2%
5,000
0 0.0%
2004
2005
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
Source: Thomson Reuters and Credit Suisse.

Note: Announced divestitures; excludes debt tender offers, equity carve-outs, exchange offers, loan modifications, and open market repurchases;
Dollar amounts not inflated.

November 15, 2016
Dividends. Exhibit 20 shows the annual amount of dividends on common and preferred stock for the top
1,000 companies in Japan, excluding the financial services and regulated utility industries, from 1985 to 2015.
The average dividend payout ratio, or dividends as a percentage of net income, was roughly 35 percent. The
average dividend yield, or dividend payment as a percentage of total market capitalization, was 1.2 percent.
In general, dividends do not move around too much from year to year in Japan, but they do show a notable
uptick beginning in the early 2000s. From 1985-1999, the average dividend yield was only 0.8 percent. From
2000-2015, that figure almost doubled to 1.5 percent.
The corporate governance reform that led to greater M&A activity also unleashed a surge in corporate
payout.49 These legislative reforms, which gained momentum in 1999, created a better environment for
companies and shareholders, including new laws that increase investor protection. The result has been more
generous dividends and buybacks across the board. However, keiretsu firms still continue to favor dividends
over buybacks, and their payouts remain more sensitive to fluctuations than those of non-keiretsu companies.
Exhibit 20: Japan Common and Preferred Dividends, 1985-2015

Dollar amount
70,000 As a percentage of net income 100%
90%

60,000
80%
50,000 70%
60%
$ Millions
40,000
50%
30,000
40%
20,000 30%
20%
10,000
10%
0 0%
1999
2000
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015

Share Buybacks. Exhibit 21 shows the annual amount of gross buybacks for the top 1,000 companies in
Japan from 1985 to 2015. Buybacks totaled roughly 10 percent of net income over the full period. The
average buyback yield, or buybacks as a percentage of total market capitalization, was 0.4 percent, well below
the 1.2 percent dividend yield.
But the average belies the fact that buybacks were virtually nonexistent until the late 1990s because they
were illegal until 1994. Even after the government legalized buybacks, significant tax disadvantages and
regulatory hurdles remained for several years. Only the removal of these limitations and a wave of
shareholder-friendly corporate governance reforms led to the recent surge in buybacks.
The numbers tell the story. From 1985-1999, the average buyback yield was zero. From 2000-2015, it was
0.7 percent. This yield is less than one half the 1.5 percent dividend yield during the same period, but the
disparity is far less. The balance remains in favor of dividends because the keiretsu firms are reluctant to
embrace buybacks.

November 15, 2016
The rise in buybacks also appears tentative. As the exhibit demonstrates, buybacks rose considerably through
the early 2000s but plummeted after Japan fell into a recession in 2008. Buybacks are also much more
cyclical than dividends, consistent with the attitude many executives adopt that a company should fund a
buyback only with cash that’s left over after the company has exhausted all other uses, including dividends.
Exhibit 21: Japan Gross Share Buybacks, 1985-2015

Dollar amount
90%

30,000
80%
25,000 70%
60%
$ Millions
20,000
50%
15,000
40%
10,000 30%
20%
5,000
10%
0 0%
1992
1985
1986
1987
1988
1989
1990
1991
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015

November 15, 2016
Europe
Uses of Capital. Exhibit 22 shows how the top 1,000 companies in Europe, excluding companies in the
particular year, the ranking reasonably reflects how companies in Europe have allocated capital over time. The
appendix provides a full list of the countries included.
Exhibit 22: Europe Capital Deployment, 2015

Mergers & Mergers &

Capital Capital
Dividends Dividends

-200 0 200 400 600 800 1,000 1,200 -2% 0% 2% 4% 6% 8% 10% 12% 14%

Exhibit 23 shows the breakdown of spending by source from 1985-2015. Again, we exclude changes in net
working capital.
Exhibit 23: Europe Capital Deployment, 1985-2015

100% Gross buybacks
90%
Dividends
80%
70% Divestitures
60%
50%
40%
30%
20% Mergers & acquisitions
10%
0%
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015


November 15, 2016
M&A has been the biggest use of capital over time but capital expenditures are not far behind. An examination
of the results from 1985 through 2015 reveals some noteworthy patterns:
M&A has been the largest use of capital, but it is very cyclical. M&A has been in a range of 2 percent of
sales in 1985 to 44 percent at the peak in the late 1990s. M&A activity in Europe substantially lagged
that of the U.S. in the late 1980s, but has since closed the gap as the result of political and economic
factors. The introduction of the euro, globalization, and privatization stimulated M&A activity, especially for
cross-border deals within the region. Greater participation from countries in Continental Europe also
pushed volumes higher.
Capital expenditures have been in a tight range of roughly 6 percent to 9 percent over the period. In
2015, they were 6.5 percent of total sales, modestly below the long-term average of 7 percent. One
explanation for this stability is that the composition of the economy has been steady over time. (See
Exhibit 24.) For example, the energy, materials, and industrial sectors, which tend to require more capital
investment, represented roughly one quarter of the market capitalization in 1985 and 2015.
Share buybacks were extremely rare until the mid-1990s as the result of legal bans and strict regulations
on implementation and disclosure. European governments have largely overturned these bans and
loosened the constraints, although many restrictions remain in place regarding the timing, price, and
allowed amounts of buybacks. Companies have shifted their method of payouts following these changes,
but they still heavily favor dividends. The volume of buybacks reached 60 percent of dividends in 2007,
but has since retreated to one-quarter in 2015.
R&D expenditures have been between 1.6 percent and 2.4 percent of sales, and have averaged 2.0
percent of sales over the full period. This level is below both the U.S. and Japan. Europe’s small
information technology sector contributes to the gap. Historically, IT has constituted just 4 percent of
Europe’s economy, compared to 15 percent in the U.S. and 12 percent in Japan. European corporations
only account for about 60 percent of the overall R&D spending for their economy, well below the roughly
70 percent in the U.S. and 80 percent in Japan.
Exhibit 24: Europe Sector Composition, 1985-2015

100%
90% Financials
80%
Utilities
70% Telecom
60% Healthcare
50%
Consumer Staples
40%
20% Industrials
10% Materials
Energy
0%
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015

November 15, 2016
Exhibit 25 shows a detailed history of capital deployment from 1985-2015. Again we see that the standard
deviations of the growth rates are small for R&D, dividends, and capital spending relative to those of buybacks,
M&A, and divestitures. Exhibit 26 represents the same deployment numbers as a percentage of sales.

Net Working Gross
1985 16,662 51,238 13,471 2 9,754 10,093
1986 33,808 65,985 20,295 56,626 188 24,306 13,550
1987 65,232 108,459 33,842 150,040 1,261 37,010 21,852
1988 104,214 129,725 37,890 65,969 1,734 58,737 25,338
1989 159,389 158,871 45,982 102,405 5,351 82,534 31,695
1990 218,826 208,944 59,903 136,096 2,770 87,466 43,159
1991 174,250 208,988 63,954 33,221 725 73,203 45,227
1992 183,669 181,877 59,083 -66,150 1,525 68,216 37,957
1993 149,698 160,905 60,250 19,003 1,254 70,518 40,639
1994 162,171 187,299 68,456 76,236 4,859 66,455 53,727
1995 291,123 229,789 77,732 86,579 1,894 94,819 67,927
1996 330,036 257,615 78,036 -40,532 5,149 116,461 71,929
1997 508,297 254,741 78,461 -73,694 11,376 173,901 72,644
1998 651,058 317,619 84,471 55,578 23,565 214,310 90,245
1999 1,603,022 318,600 83,726 -65,844 14,824 315,300 79,356
2000 1,084,162 361,923 89,379 37,690 30,068 366,695 87,558
2001 616,255 312,910 88,137 -42,687 36,527 212,952 81,642
2002 486,506 306,200 97,725 75,032 34,019 218,067 93,381
2003 525,864 331,063 112,529 180,472 31,728 204,620 122,585
2004 726,985 372,818 121,892 59,894 74,003 260,856 160,632
2005 1,003,253 396,084 114,455 -31,319 97,624 388,490 197,317
2006 1,581,377 525,870 134,255 91,782 136,240 534,357 231,068
2007 1,998,658 609,750 153,463 149,527 169,045 582,720 283,614
2008 1,275,512 651,345 150,330 -150,346 119,446 537,522 247,106
2009 648,258 570,716 151,716 56,958 22,733 218,811 237,979
2010 681,855 552,499 153,156 33,108 45,815 306,375 266,072
2011 726,898 592,406 157,707 21,766 81,639 332,065 273,497
2012 806,880 639,341 169,266 109,497 57,706 349,769 283,112
2013 585,370 646,343 176,334 51,861 95,222 319,509 288,725
2014 1,047,796 575,711 162,666 -120,131 77,431 479,130 274,210
2015 1,003,722 516,309 154,823 -88,106 69,713 375,948 264,032
CAGR 14.6% 8.0% 8.5% NA 42.0% 12.9% 11.5%
St. Dev. 47.1% 17.3% 16.1% NA 1815.0% 38.2% 17.7%
divestitures: include all industries.

November 15, 2016


November 15, 2016
Recent Trends in Cash Flow Return on Investment and Asset Growth. Today’s CFROI is below the
long-term average of 6.9 percent, and well below the peak years of the mid-2000s. (See Exhibit 27.)
Exhibit 27: Europe CFROI, 1996-2015

9
8
Average
7
5
Percent
0
1998
2006
2014
1996
1997
1999
2000
2001
2002
2003
2004
2005
2007
2008
2009
2010
2011
2012
2013
2015
Note: European industrial firms, weighted by net assets.
Exhibit 28 shows the annual rate of asset growth, adjusted for inflation, over the past twenty years. Asset
growth was very low in 2015, reflecting the reluctance of companies to invest. Asset growth in 2015, at 2.4
percent, was well below the long-term average of 4.2 percent, and asset growth in the past decade is also
below average.
Exhibit 28: Europe Real Asset Growth Rate, 1996-2015

12
10
6
Average
Percent
-2
-4
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015

Note: European industrial firms, weighted by gross investments.

November 15, 2016
Exhibit 29 shows that at 10 percent, today’s cash as a percentage of assets is exactly at the long-term
average, but just below the peak of 11 percent in 1996.
Exhibit 29: Europe Cash as a Percentage of Total Assets, 1996-2015

12%
10% Average
8%
6%
4%
2%
0%
1997
2006
1996
1998
1999
2000
2001
2002
2003
2004
2005
2007
2008
2009
2010
2011
2012
2013
2014
2015
Mergers and Acquisitions. Exhibit 30 shows the dollar amount of M&A as well as M&A as a percentage of
sales from 1985 to 2015. M&A volume was 12.5 percent of total sales in 2015, above its long-term average
of roughly 11 percent. Over the full period, M&A in Europe and the U.S. has been equivalent as a percentage
of sales.
While comparable as a fraction of sales, the absolute level of M&A in Europe still lags that of the U.S. From
1985 to1989, M&A volume in Europe was less than one-third the level of the U.S., but has since risen to
nearly three-fourths the level of the U.S. in recent years.
M&A in Europe has followed the stock market but research shows that several factors, including the
introduction of the euro, globalization, deregulation, and privatization, have stoked the general rise since the
late 1980s. In particular, these factors helped drive cross-border deals within Europe.50
Greater participation from countries in Continental Europe also drove the increased deal activity. The U.K.
once dominated total European M&A volume, accounting for roughly two-thirds of the total volume in the late
1980s. But in recent years (2010-2015), the U.K. accounted for just one-quarter of the total volume in
Europe. Countries on the continent with the largest M&A activity in 2015 included France at 10 percent of the
total, Germany at 9 percent, and Italy, Ireland, and Switzerland at 6 percent.

November 15, 2016
Exhibit 30: Europe Mergers and Acquisitions, 1985-2015

Dollar amount
2,500,000 As a percentage of sales 50%
45%

2,000,000 40%
35%
1,500,000 30%
$ Millions
25%
1,000,000 20%
15%
500,000 10%
5%
0 0%
2012
2015
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2013
2014
Note: Dollar amounts not inflated. Europe announced domestic mergers; excludes debt tender offers, equity carve-outs, exchange offers, loan
Capital Expenditures. Exhibit 31 shows the dollar amount of capital expenditures, as well as capital
expenditures as a percentage of sales, from 1985 to 2015. Capital expenditures were 6.5 percent of total
sales in 2015, below the long-term average of 7.0 percent. In 2015, capital expenditures were the second
largest use of capital in Europe behind M&A. Measured as a ratio of sales, Europe’s capital expenditure
spending exceeds that of Japan, is roughly in line with the U.S., and is well below that of APEJ and GEM.
The exhibit reveals that capital expenditures are fairly steady from year to year.
Exhibit 31: Europe Capital Expenditures, 1985-2015

Dollar amount
9%
600,000
8%
500,000 7%
6%
$ Millions
400,000
5%
300,000
4%
200,000 3%
2%
100,000
1%
0 0%
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015


November 15, 2016
expenditures have averaged roughly one-third of overall capital expenditures.
Exhibit 32: Europe Capital Expenditures Net of Depreciation, 1985-2015

Dollar amount
300,000

4%
250,000
3%
$ Millions
200,000
150,000
2%
100,000
1%
50,000
0 0%
1987
2002
1985
1986
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
Research and Development. Exhibit 33 shows the dollar amount of R&D since 1985 as well as R&D as a
percentage of sales. The ratio jumped to a peak of 2.4 percent of sales in 1987, then steadily declined to 1.6
percent in 2008, and rebounded slightly to 1.9 percent in 2015. This level is below both that of the U.S. and
Japan at 2.2 percent. Sector composition largely explains the difference. Europe has a very low concentration
in IT, the most R&D-intensive sector, and a higher concentration in industries that rely more heavily on capital
investments. Academic research supports this conclusion.51
Yet, sector composition isn’t the whole story. R&D as a percentage of sales has fallen since the late 1980s
despite a modest rise in R&D-intensive sectors. For example, healthcare, one of the most R&D-intensive
sectors, grew considerably during the period, while IT expanded to a lesser extent.
Based on 2015 figures, European countries with companies that spent the most on R&D as a percentage of
sales included Switzerland at 5.4 percent (heavily influenced by the pharmaceutical industry), Israel (grouped
within Europe) at 3.9 percent, Sweden at 2.8 percent, and Germany at 2.7 percent. Notable laggards
included Spain at 0.6 percent of sales, Italy at 0.8 percent, and the U.K. at 1.1 percent.
In European countries, businesses account for just over 60 percent of total R&D spending on average, with
the government, academia, and private nonprofit companies sharing the balance.52 Corporations in Europe
account for a smaller share of the total R&D spending than they do in the U.S. and Japan, where businesses
spend around 70-80 percent. The business share of total R&D spending ranges from a low of 34 percent in
Greece to a high of 73 percent in Ireland. Among larger European economies, the business share of R&D
spending is 64 percent in the U.K., 65 percent in France, and 68 percent in Germany.

November 15, 2016
Exhibit 33: Europe Research and Development, 1985-2015

Dollar amount
180,000
2.5%

160,000
140,000
2.0%
120,000
$ Millions
100,000 1.5%
80,000
1.0%
60,000
40,000
0.5%
20,000
0 0.0%
1989
1995
1985
1986
1987
1988
1990
1991
1992
1993
1994
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
Net Working Capital. Net working capital is about 15 percent of assets, on average, for companies in
Europe. Exhibit 34 shows the annual change in net working capital from 1985 through 2015. At year-end
2015, net working capital stood at $1.1 trillion for the top 1,000 public firms in Europe. We consider changes
in net working capital as opposed to the absolute amount, because changes are what you should consider to
be an incremental investment. Net working capital investments are highly volatile in Europe and are a smaller
sum than M&A, capital expenditures, or R&D.
Exhibit 34: Europe Change in Net Working Capital, 1985-2015

Dollar amount
250,000
200,000 10%
150,000
100,000 5%
$ Millions
50,000
0 0%
-50,000
-100,000 -5%
-150,000
-200,000 -10%
1985
1987
1989
1991
1986
1988
1990
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015


November 15, 2016
The situation changes significantly if we exclude cash. At the end of 2015, net working capital excluding cash
was actually negative, at -$33 billion for the top 1,000 European industrial companies, -3 percent of total net
working capital. Exhibit 35 shows the change in net working capital excluding cash.
Exhibit 35: Europe Change in Net Working Capital Excluding Cash, 1985-2015
Dollar amount
80,000 4%

40,000 2%
$ Millions
0 0%
-40,000 -2%
-80,000 -4%
-120,000 -6%
1987
1993
1985
1986
1988
1989
1990
1991
1992
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
Divestitures. Exhibit 36 shows divestitures from 1985-2015. Similar to M&A, divestiture activity varies a
great deal from year to year, ranging from a low of 1 percent of sales in 1985 to a high of 9 percent in 2000.
While divestitures generally draw less attention than M&A, they represent a substantial component of capital
allocation. Overall, divestitures have averaged 4.2 percent of sales over time, which is slightly more than one-
third the level of M&A and much higher than gross buybacks, dividends, and R&D spending.
Exhibit 36: Europe Divestitures, 1985-2015

Dollar amount
9%
600,000
8%
500,000 7%
6%
$ Millions
400,000
5%
300,000
4%
200,000 3%
2%
100,000
1%
0 0%
1993
1994
2015
1985
1986
1987
1988
1989
1990
1991
1992
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014


November 15, 2016
1,000 companies in Europe, excluding the financial services and regulated utility industries, from 1985 to
2015. Dividends are very stable in Europe and were particularly resilient during the recent financial crisis.
The average dividend payout ratio, or dividends as a percentage of net income, was roughly 50 percent from
1985-2015. The average dividend yield, or dividend payment as a percentage of total market capitalization,
was 2.7 percent over the same period. In 2015, the dividend yield was 2.9 percent. Countries with yields that
were above average in 2015 included Norway at 4.3 percent, Finland at 4.1 percent, the Netherlands at 3.6
percent, and the UK at 3.5 percent. Countries with below-average yields included Denmark at 1.6 percent,
Spain at 2.1 percent, and Germany at 2.3 percent.
Academic research shows that the trend in dividend policy in Europe and the U.S. is similar.53 In both regions, there
has been a decline in the fraction of firms paying dividends. In Europe, that fraction has fallen from 88 percent in
1989 to 51 percent in 2005. In the U.S., that fraction fell from more than 80 percent in the 1950s to roughly 20
percent in 1999. At the same time, dividends are becoming more concentrated among fewer firms in both regions.
Exhibit 37: Europe Common and Preferred Dividends, 1985-2015

Dollar amount
90%

300,000
80%
250,000 70%
60%
$ Millions
200,000
50%
150,000
40%
100,000 30%
20%
50,000
10%
0 0%
1988
1989
2011
1985
1986
1987
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2012
2013
2014
2015

Share Buybacks. Exhibit 38 shows the annual gross buybacks for the top 1,000 companies in Europe from
1985 to 2015. Buybacks were negligible until the late 1990s, rose considerably through 2007, and fell
sharply during the ensuing recession. Similar to the results in other regions, buybacks are much more cyclical
than dividends. The ratio of buybacks to dividends peaked in 2008 at approximately 60 percent and declined
to 28 percent in 2015.
Buybacks have totaled roughly 10 percent of net income, on average, from 1985-2015. The average
buyback yield, or buybacks as a percentage of total market capitalization, was 0.6 percent over the same
period, well below the 2.7 percent dividend yield. In 2015, the buyback yield was 0.8 percent. Countries with
above-average buyback yields in 2015 included Spain at 1.7 percent, Denmark at 1.6 percent, and
Switzerland at 1.6 percent. Countries with below-average yields included Italy at 0.2 percent, Germany at 0.3
percent, and the UK and Sweden at 0.5 percent.

November 15, 2016
Whereas the propensity for European firms to pay dividends has fallen, the fraction of firms repurchasing
shares has risen. Similar to dividends, share repurchases are becoming concentrated among fewer firms in
Europe.
Buybacks have been smaller in Europe than in the U.S. due to legal bans as well as stricter regulations on
how companies have to implement and disclose them.54 For example, open market share repurchases were
not legal until 1981 in the U.K., until 1992 in Switzerland, and until 1998 in Germany. In France, buybacks
were very difficult to implement until a change in the law in 1998.
In addition, whereas board approval is sufficient to initiate a buyback program in the U.S., companies must
obtain shareholder approval for open market repurchases in the U.K., France, Germany, Italy, the Netherlands,
and Switzerland. Even then, significant restrictions remain regarding the terms of timing, price, and amount of
buybacks. Finally, companies in many of these countries also have additional reporting requirements on top of
basic disclosure in financial statements.
Exhibit 38: Europe Gross Share Buybacks, 1985-2015

Dollar amount
160,000 90%

140,000 80%
70%
120,000
60%
$ Millions
100,000
50%
80,000
40%
60,000
30%
40,000 20%
20,000 10%
0 0%
2002
2015
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014


November 15, 2016
Asia/Pacific excluding Japan (APEJ)
Uses of Capital. Exhibit 39 shows how the top 1,000 companies in APEJ, excluding companies in the
particular year, the ranking reasonably reflects how companies in APEJ have allocated capital over time. The
appendix provides a full list of the countries included.
Exhibit 39: APEJ Capital Deployment, 2015

Mergers & Mergers &

Capital Capital
Dividends Dividends

-200 0 200 400 600 800 1,000 1,200 1,400 -4% 0% 4% 8% 12% 16% 20%
Exhibit 40 shows the breakdown of spending by source from 1992-2015. Again, we exclude changes in net
working capital.
Exhibit 40: APEJ Capital Deployment, 1992-2015

100% Gross buybacks
Dividends
90%
80% Divestitures
70%
60% Capital expenditures
50%
40%
30%
20%
10%
0%
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015


November 15, 2016
Similar to 2015, capital expenditures and M&A are by far the largest uses of capital over time. An examination
of the changes from 1992 through 2015 reveals some noteworthy patterns:
M&A is the largest use of capital but it is very cyclical, ranging from a low of 6.3 percent of sales in 2012
to a high of 26.7 percent in 2000. The long-term average is roughly 13 percent, modestly higher than
the levels of the U.S. and Europe. China really stands out, as its share of the region’s total M&A went
from less than 5 percent in the early 1990s to more than one-half in recent years.
Capital expenditures are the second largest use of capital. Capital expenditures were 9 percent of total
sales in 2015, below the long-term average of 10.6 percent. Measured as a percentage of sales,
APEJ’s capital expenditures greatly exceed those of the U.S., Japan, and Europe.
R&D spending has slowly trended higher over time but remains well below that of the U.S., Japan, and
Europe both on an absolute basis and relative to sales. R&D rose steadily from 0.5 percent of sales in
1992 to 1.1 percent of sales in the mid-2000s, then dipped slightly before rebounding to an all-time high
of 1.2 percent in 2015. This rise reflects the change in the composition of the market, with the
information technology sector growing from just 1 percent of the market in 1992 to roughly 10 percent in
recent years. (See Exhibit 41.)
Share buybacks have historically been very modest and remain a small component of corporate payouts.
Buybacks have averaged just 0.3 percent of total market capitalization over time, well below dividends at
2.1 percent. Regulatory constraints have contributed to the lower level of buybacks, particularly in the
earlier years. For example, the governments didn’t legalize buybacks in Australia until 1989 and in Hong
Kong until 1991. These are among the largest economies in the region. In 2015, buybacks in China,
India, and Taiwan were negligible.
Exhibit 41: APEJ Sector Composition, 1992-2015

100%
90%
Financials
80%
70%
Utilities
60%
Telecom
Healthcare
40%
Consumer Staples
20% Industrials
10% Materials
Energy
0%
1995
2004
2013
1992
1993
1994
1996
1997
1998
1999
2000
2001
2002
2003
2005
2006
2007
2008
2009
2010
2011
2012
2014
2015

November 15, 2016
deviations of the growth rates are small for R&D, dividends, and capital spending relative to those of buybacks,
M&A, and divestitures. Exhibit 43 represents the same deployment numbers as a percentage of sales.

Net Working Gross
1992 29,972 29,978 1,410 622 12,904 7,338
1993 48,463 30,603 1,769 28,212 346 18,969 9,766
1994 45,067 45,164 2,628 31,043 171 17,402 13,175
1995 80,930 88,094 3,800 56,435 1,756 36,282 17,168
1996 95,100 109,830 4,574 25,838 1,367 34,334 18,958
1997 119,857 90,646 3,553 -21,558 1,918 52,570 16,713
1998 105,544 88,362 5,075 -3,886 2,712 45,954 15,401
1999 158,467 82,366 6,329 18,230 5,075 62,646 20,005
2000 252,438 109,887 9,407 27,022 8,154 91,934 23,194
2001 171,880 106,357 9,555 3,495 6,708 71,804 25,824
2002 144,868 120,959 12,670 11,942 8,340 61,453 34,992
2003 146,320 154,390 16,352 63,785 8,073 59,018 46,719
2004 190,113 217,346 21,799 80,023 15,655 68,002 69,229
2005 241,276 265,044 25,367 70,280 15,194 84,246 76,437
2006 423,042 322,494 28,964 70,765 20,942 120,308 90,829
2007 511,954 417,027 31,918 186,276 24,522 190,329 121,314
2008 499,634 457,946 33,236 -9,925 17,628 173,867 104,394
2009 443,115 477,212 39,850 150,571 3,656 154,602 117,840
2010 583,008 556,155 46,891 245,088 6,643 287,629 153,207
2011 464,887 628,469 52,133 194,090 25,665 186,335 163,810
2012 462,895 677,202 61,093 124,121 13,428 189,556 167,397
2013 497,434 683,831 69,629 62,086 8,603 243,500 178,513
2014 764,660 638,655 74,166 148,397 11,238 341,440 181,543
2015 1,210,271 561,767 75,066 -79,593 23,495 514,217 164,578
CAGR 17.4% 13.6% 18.9% NA 17.1% 17.4% 14.5%
St. Dev. 32.6% 24.3% 17.1% NA 202.3% 36.6% 17.6%

November 15, 2016


November 15, 2016
Recent Trends in Cash Flow Return on Investment and Asset Growth. CFROI today in the APEJ region
is below the long-term average, and well below the peak years of the mid-2000s. (See Exhibit 44.) The
current level of 5.2 percent is below the historical average of 6.4 percent over the past twenty years.
Exhibit 44: APEJ CFROI, 1996-2015

9
7 Average
5
Percent
0
1998
2006
2014
1996
1997
1999
2000
2001
2002
2003
2004
2005
2007
2008
2009
2010
2011
2012
2013
2015
Note: APEJ industrial firms, weighted by net assets.
Exhibit 45 shows the annual rate of asset growth, adjusted for inflation, over the past twenty years. In 2014
and 2015, growth was very low relative to the long-term average. Asset growth of 7.2 percent in 2014 and
5.9 percent in 2015 was below the average of 9.6 over the past twenty years. Asset growth in this region is
the highest in the world.
Exhibit 45: APEJ Real Asset Growth Rate, 1996-2015

16
14
12
10 Average
Percent
0
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015

Note: APEJ industrial firms, weighted by gross investments.

November 15, 2016
Exhibit 46 shows that today’s cash as a percentage of assets of 13 percent is above the long-term average of
11 percent. The level of cash relative to assets shows a clear upward trend.
Exhibit 46: APEJ Cash as a Percentage of Total Assets, 1996-2015

16%
14%
12% Average
10%
8%
6%
4%
2%
0%
1997
2006
1996
1998
1999
2000
2001
2002
2003
2004
2005
2007
2008
2009
2010
2011
2012
2013
2014
2015
Mergers and Acquisitions. Exhibit 47 shows the dollar amount of M&A, as well as M&A as a percentage of
sales, from 1992 to 2015. M&A is very cyclical, ranging from a low of 6.3 percent of sales in 2012 to a high
of 26.7 percent in 2000. On an absolute basis M&A volume shattered the all-time record in 2015. Measured
as a percentage of sales, M&A volume was 20 percent, well above the long-term average of 13 percent. This
historical average is modestly higher than the levels of the U.S. and Europe. The absolute level of M&A in
APEJ is still only roughly one-half that of the U.S., but it surpassed that of Europe for the first time in 2015.
One notable difference across the regions is that absolute M&A volumes recovered more rapidly following the
financial crisis in APEJ than it did in the U.S. and Europe. Only in 2015 did worldwide deal volume return to
the level of 2007.
On a country basis, China leads the deal making in APEJ. Its share of the region’s total M&A went from less
than 5 percent in the early 1990s to more than one-half in recent years. Hong Kong, Australia, and South
Korea were the next biggest contributors in 2015, representing 12 percent, 9 percent, and 6 percent of the
region’s total M&A, respectively. India’s M&A activity has not kept pace with China, with volume equal to just
2 percent of the region’s total in 2015.
The trend in M&A activity in the region has been largely positive owing to economic growth and business
reforms. In particular, China’s rapid growth and its shift toward a more free market economy have driven deal
activity.55 But while M&A has been strong between Chinese companies, government restrictions aimed at
ensuring Chinese companies maintain control of certain industries have limited cross-border deals.

November 15, 2016
Exhibit 47: APEJ Mergers and Acquisitions, 1992-2015

Dollar amount
1,200,000 25%

1,000,000
20%
$ Millions
800,000
15%
600,000
10%
400,000
200,000 5%
0 0%
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
Note: Dollar amounts not inflated. APEJ announced domestic mergers; excludes debt tender offers, equity carve-outs, exchange offers, loan
Capital Expenditures. Exhibit 48 shows the dollar amount of capital expenditures as well as capital
expenditures as a percentage of sales from 1992 to 2015. Capital expenditures were 9.1 percent of total
sales in 2015, below the long-term average of 10.6 percent. Measured as a fraction of sales, APEJ’s capital
expenditure ratio is much higher than that of the U.S., Japan, and Europe, and is slightly below that of GEM.
Exhibit 48: APEJ Capital Expenditures, 1992-2015

Dollar amount
700,000 14%
600,000 12%
500,000 10%
$ Millions
400,000 8%
300,000 6%
200,000 4%
100,000 2%
0 0%
1996
1998
1992
1993
1994
1995
1997
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015


November 15, 2016
expenditures have averaged roughly one-half of overall capital expenditures.
Exhibit 49: APEJ Capital Expenditures Net of Depreciation, 1992-2015

Dollar amount
350,000 9%

8%
300,000
7%
250,000 6%
$ Millions
200,000 5%
150,000 4%
3%
100,000
2%
50,000 1%
0 0%
2000
2013
1992
1993
1994
1995
1996
1997
1998
1999
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2014
2015
Research and Development. Exhibit 50 shows the dollar amount of R&D, as well as R&D as a percentage
of sales, since 1992. R&D rose steadily from 0.5 percent of sales at the beginning of the period to 1.1
percent of sales in the mid-2000s, then dipped slightly before rebounding to an all-time high of 1.2 percent in
2015. R&D spending has risen substantially off of a low base, but remains well below the levels of the U.S.,
Japan, and Europe relative to sales. The rise in R&D during the full period reflects the change in the
composition of the market. During this time, information technology, the most R&D-intensive sector, grew
from 1 percent to 10 percent of the market.
Based on 2015 figures, the APEJ countries that spent the most on R&D as a percentage of sales were Korea
at 2.6 percent and Taiwan at 2.1 percent. Notable laggards included Singapore and Thailand at 0.0 percent
and Australia at 0.3 percent. China and India were in the middle at 1.1 percent and 0.7 percent, respectively.
Businesses in APEJ countries account for roughly one-half of total R&D spending, with the government,
academia, and private nonprofit companies contributing the rest.56 Corporations in APEJ account for a smaller
share of the total R&D spending than they do in the U.S. and Japan, which are around 70-80 percent, and in
Europe, which is just above 60 percent. The business share of total R&D spending ranges from a high of 78
percent in Korea to a low of 26 percent in Indonesia. Among larger APEJ economies, the business share of
R&D spending is 77 percent in China, 45 percent in Hong Kong, 56 percent in Australia, and 35 percent in
India.

November 15, 2016
Exhibit 50: APEJ Research and Development, 1992-2015

Dollar amount
70,000 1.2%

60,000
1.0%
50,000
$ Millions
0.8%
40,000
0.6%
30,000
0.4%
20,000
10,000 0.2%
0 0.0%
1999
2012
1992
1993
1994
1995
1996
1997
1998
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2013
2014
2015
Net Working Capital. Net working capital is roughly 15 percent of assets on average for companies in
APEJ. Exhibit 51 shows the annual change in net working capital from 1992 through 2015. At year-end 201,
net working capital was $1.5 trillion for the top 1,000 public firms in APEJ. We consider changes in net
incremental investment. Net working capital investments are an important use of cash in APEJ and are larger
than R&D on average but smaller than M&A and capital expenditures.
Exhibit 51: APEJ Change in Net Working Capital, 1992-2015

Dollar amount
250,000 10%
200,000 8%
150,000 6%
$ Millions
100,000 4%
50,000 2%
0 0%
-50,000 -2%
-100,000 -4%
2001
2002
2003
1992
1993
1994
1995
1996
1997
1998
1999
2000
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015


November 15, 2016
The picture changes dramatically when we exclude cash. At the end of 2015, net working capital excluding
cash was about $200 billion for the top 1,000 APEJ industrial companies, roughly 13 percent of the total net
working capital sum. Exhibit 52 shows the change in net working capital excluding cash.
Exhibit 52: APEJ Change in Net Working Capital Excluding Cash, 1992-2015
Dollar amount
80,000 4%

40,000 2%
$ Millions
0 0%
-40,000 -2%
-80,000 -4%
-120,000 -6%
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
Divestitures. Exhibit 53 shows the magnitude of divestitures from 1992-2015. Similar to M&A, divestitures
vary a great deal from one year to the next, and were in a range of 2.6 percent of sales in 2012 to 9.7
percent in 2000. Divestitures have averaged 5.0 percent of sales over time, two-fifths the level of M&A and
much higher than buybacks, dividends, or R&D spending.
Exhibit 53: APEJ Divestitures, 1992-2015

Dollar amount
500,000 10%
400,000 8%
$ Millions
300,000 6%
200,000 4%
100,000 2%
0 0%
1995
1996
1992
1993
1994
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015


November 15, 2016
Dividends. Exhibit 54 shows the annual dividends on common and preferred stock for the top 1,000
companies in APEJ, excluding the financial services and regulated utility industries, from 1992 to 2015.
Dividends are very stable in APEJ.
The average dividend payout ratio, or dividends as a percentage of net income, was roughly 40 percent from
1992-2015. The average dividend yield was 2.1 percent over the same period. In 2015, the dividend yield
was 2.0 percent. Countries with above-average yields included Taiwan at 4.5 percent, Australia at 4.3 percent,
and Singapore at 3.9 percent. Countries with below-average payouts included China at 1.2 percent, India at
1.3 percent, and Korea at 1.7 percent.
Exhibit 54: APEJ Common and Preferred Dividends, 1992-2015

Dollar amount
180,000

160,000 45%
140,000
120,000 40%
$ Millions
100,000
80,000 35%
60,000
40,000 30%
20,000
0 25%
2003
2004
2005
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
Share Buybacks. Exhibit 55 shows the annual gross buybacks for the top 1,000 companies in APEJ from
1992 to 2015. Similar to other regions, we see cyclicality. Buybacks rose throughout most of the 2000s but
fell sharply in 2008-2010. Overall, buybacks remain a very small component of the corporate payout in APEJ.
Buybacks have been roughly six percent of net income, on average, from 1992-2015. The average buyback
yield, or buybacks as a percentage of total market capitalization, was 0.3 percent over the same period,
significantly below the 2.1 percent dividend yield. In 2015, the buyback yield was 0.3 percent. The Philippines,
Australia, and Korea were the only countries in the region with relevant buyback yields, at 2.1 percent, 1.7
percent, and 1.1 percent, respectively. China and India had a zero yield, Taiwan had a 0.1 percent yield, and
Hong Kong had a 0.2 percent yield.
Regulatory constraints contributed to the lower level of buybacks in the earlier years. For example, the
government of Australia did not legalize buybacks until 1989 and Hong Kong did not legalize them until 1991.
These are two of the largest economies in the region.57

November 15, 2016
Exhibit 55: APEJ Gross Share Buybacks, 1992-2015

Dollar amount

25,000 12%
10%
20,000
$ Millions
8%
15,000
6%
10,000
4%
5,000 2%
0 0%
1992
2010
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2011
2012
2013
2014
2015

November 15, 2016
Global Emerging Markets (GEM)
The countries in the GEM region overlap substantially with those in the APEJ region. This overlap helps
explain why some of the trends in capital deployment are similar. In 2015, the shared countries constituted
roughly two-thirds the market capitalization of each region. China and India alone, which are mutual
constituents, made up more than one-half the market capitalization of each region in 2015. The appendix
provides a full list of the countries included.
Uses of Capital. Exhibit 56 shows how the top 1,000 companies in GEM, excluding companies in the
particular year, the ranking reasonably reflects how companies in GEM have allocated capital over time.
Exhibit 56: GEM Capital Deployment, 2015

Mergers & Mergers &

Capital Capital
Dividends Dividends

-200 0 200 400 600 800 1,000 -4% 0% 4% 8% 12% 16% 20% 24%
Exhibit 57 shows the spending by source from 1992-2015. Again, we exclude changes in net working capital.
Exhibit 57: GEM Capital Deployment, 1992-2015

100% Gross buybacks
Dividends
90%
80% Divestitures
70%
60% Capital expenditures
50%
40%
30%
20%
10%
0%
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015


November 15, 2016
M&A and capital expenditures are by far the largest uses of capital over time. An examination of the changes
from 1992 through 2015 reveals some noteworthy patterns:
M&A is very cyclical, ranging from a low of 8 percent of sales in 2013 to a high of 33 percent of sales in
1998. The long-term average of 16 percent of sales exceeds the 11 percent level shared by the U.S. and
Europe and the 13 percent level of APEJ. The absolute level of M&A in GEM has grown considerably
since the early 1990s as the result of strong economic growth and business reforms. The BRIC countries
(Brazil, Russia, India, and China) now dominate M&A activity in the region. Together they accounted for
88 percent of the total in 2015, up from a share of 10 percent in 1992. China alone accounted for 78
percent of the total in 2015.
Capital expenditures are the next largest use of capital. Capital expenditures were 10 percent of total
sales in 2015, moderately below the long-term average of 12 percent. This long-term average exceeds
levels in the U.S., Europe, Japan, and APEJ. A logical explanation for this gap is the composition of GEM
economies. (See Exhibit 58.) Capital-intensive industries such as energy, materials, and industrials
represent a greater share of the economy in GEM than in any other region.
R&D spending is very modest and remained in a narrow band of 0.3 to 0.5 percent of sales until recently.
That figure rose to 0.6 percent in 2014 and 0.8 percent in 2015. Despite the rise, this level is still well
below that of the U.S., Japan, and Europe. Again, sector composition plays a key role, as GEM has a very
low concentration in information technology and healthcare, the most R&D-intensive sectors, and a high
concentration in industries that rely on capital investments for growth. Relative to the other regions, GEM
companies also spend less on R&D.
Share buybacks have been a very minor use of capital. Buybacks have averaged just 0.4 percent of total
market capitalization over time, which compares to dividends at 2.3 percent. BRIC countries in particular
spend very little on buybacks. Buyback activity was extremely low until the mid-2000s, rose sharply in
2007, then plummeted in the ensuing years. Dividends have been far more stable.
Exhibit 58: GEM Sector Composition, 1992-2015

100%
90%
80%
Financials
70%
60% Utilities
Telecom
Healthcare
30%
Industrials
20%
Materials
10%
Energy
0%
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015

November 15, 2016
deviations of the growth rates are small for R&D, capital spending, and dividends relative to those of buybacks,
divestitures, and M&A. Exhibit 60 represents the same deployment numbers as a percentage of sales.

Net Working Gross
1992 20,803 17,397 367 74 12,772 3,168
1993 36,328 18,054 463 7,381 99 14,164 3,999
1994 35,700 26,170 610 19,573 221 12,032 6,573
1995 52,985 43,370 1,048 33,526 1,453 22,437 9,768
1996 70,802 59,404 1,247 23,770 1,539 22,577 11,934
1997 117,802 59,420 1,392 768 2,431 51,792 12,216
1998 147,640 63,113 1,532 -2,797 2,623 53,558 12,895
1999 122,881 60,190 2,172 37,348 2,360 33,562 13,668
2000 195,092 72,897 3,297 42,626 6,279 83,991 20,745
2001 115,398 92,886 3,685 -5,614 5,640 33,601 25,405
2002 104,515 90,218 3,923 10,071 3,313 44,802 24,950
2003 121,878 120,317 4,671 50,256 7,142 42,488 41,347
2004 134,907 159,722 5,513 84,922 13,599 57,347 59,333
2005 217,319 219,294 5,788 59,856 16,279 93,804 78,474
2006 338,195 292,607 7,486 124,987 24,974 121,651 101,992
2007 463,815 443,490 10,875 163,257 57,534 176,111 130,305
2008 475,132 490,627 12,734 21,854 25,250 197,150 119,504
2009 320,386 530,841 16,397 116,412 8,282 117,969 136,749
2010 616,540 588,639 20,840 207,154 11,886 278,840 166,576
2011 509,002 653,749 25,793 166,153 27,387 188,950 185,871
2012 511,422 697,530 27,493 80,785 18,165 260,641 189,201
2013 498,514 684,751 29,977 11,306 14,860 254,223 181,397
2014 651,543 587,004 33,639 11,858 9,428 310,731 164,793
2015 988,786 477,495 36,050 -77,730 12,287 393,328 123,823
CAGR 18.3% 15.5% 22.1% NA 24.9% 16.1% 17.3%
St. Dev. 36.2% 21.8% 16.7% NA 127.9% 55.7% 24.0%

November 15, 2016
Source: Credit Suisse HOLT, Thomson Reuters Datastream, and Credit Suisse.

November 15, 2016
Recent Trends in Cash Flow Return on Investment and Asset Growth. The current level of CFROI, at
4.2 percent, is the lowest in twenty years and is well below the average of 6.0 percent. (See Exhibit 61.)
Exhibit 61: GEM CFROI, 1996-2015

9
7
Average
6
5
Percent
0
1998
2006
2014
1996
1997
1999
2000
2001
2002
2003
2004
2005
2007
2008
2009
2010
2011
2012
2013
2015
Note: GEM industrial firms, weighted by net assets.
Exhibit 62 shows the annual rate of asset growth, adjusted for inflation, over the past twenty years. In the past
five years growth has been weak relative to the long-term average, and it was negative in 2015 for only the
second time in the past twenty years. That said, the average is much higher than it is in developed economies.
Exhibit 62: GEM Real Asset Growth Rate, 1996-2015

25
20
15
10
Percent
Average
-5
-10
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015

Note: GEM industrial firms, weighted by gross investments.

November 15, 2016
Exhibit 63 shows that at 13 percent, today’s cash as a percentage of assets is well above the long-term
average of 10 percent. The level of cash relative to assets exhibits a clear upward trend.
Exhibit 63: GEM Cash as a Percentage of Total Assets, 1996-2015

14%
12%
Average
10%
8%
6%
4%
2%
0%
1997
2006
1996
1998
1999
2000
2001
2002
2003
2004
2005
2007
2008
2009
2010
2011
2012
2013
2014
2015
Mergers and Acquisitions. Exhibit 64 shows the dollar amount of M&A, as well as M&A as a percentage of
sales, from 1992 to 2015. M&A volume was 21 percent of sales in 2015, well above the long-term average
of about 16 percent. This long-term average exceeds the 11 percent level shared by the U.S. and Europe and
the 13 percent level of APEJ. In absolute dollars, M&A in GEM in 2015 was still only one-half that of the U.S.,
reflecting the difference in the sizes of the economies. The total market capitalization of GEM is slightly more
than one-third that of the U.S.
The BRIC countries dominate M&A activity in the region. Together they accounted for 88 percent of the total
in 2015, up considerably from 10 percent in 1992. In 2015, China was 78 percent of the deal volume,
followed by Brazil at 5 percent, South Africa at 4 percent, and India at 3 percent. The biggest declines came
from Mexico, Indonesia, and Malaysia. The combined share for those countries dropped from 60 percent in
1992 to only 4 percent in 2015.
M&A in GEM has risen sharply since the early 1990s as the result of strong economic growth and business-
friendly reforms. In recent years, a number of governments in the emerging markets have sold off state-
owned businesses. These companies often go on to merge with other companies, prompting M&A activity.
And notably, some large emerging market companies have pursued major deals outside their borders.58

November 15, 2016
Exhibit 64: GEM Mergers and Acquisitions, 1992-2015

Dollar amount
35%
1,000,000

30%
800,000
25%
$ Millions
600,000 20%
15%
400,000
10%
200,000
5%
0 0%
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
Note: Dollar amounts not inflated. GEM announced domestic mergers; excludes debt tender offers, equity carve-outs, exchange offers, loan
Capital Expenditures. Exhibit 65 shows the dollar amount of capital expenditures, as well as capital
expenditures as a percentage of sales, from 1992 to 2015. In 2015, capital expenditures were GEM’s
second largest use of capital behind M&A, which was extremely strong. Capital expenditures were 10 percent
of total sales in 2015, below the long-term average of 12 percent. This long-term average exceeds the levels
in the U.S., Europe, Japan, and APEJ. A logical explanation for this gap is the composition of GEM
economies. The energy, materials, and industrial sectors represent roughly 30 percent of the region’s market
capitalization, which is above that of the other regions.
Exhibit 65: GEM Capital Expenditures, 1992-2015

Dollar amount
700,000 14%
600,000 12%
500,000 10%
$ Millions
400,000 8%
300,000 6%
200,000 4%
100,000 2%
0 0%
1996
1998
1992
1993
1994
1995
1997
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015


November 15, 2016
expenditures have averaged roughly one-half of overall capital expenditures.
Exhibit 66: GEM Capital Expenditures Net of Depreciation, 1992-2015

Dollar amount
400,000

10%
350,000
300,000 8%
$ Millions
250,000
6%
200,000
150,000 4%
100,000
2%
50,000
0 0%
2000
2013
1992
1993
1994
1995
1996
1997
1998
1999
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2014
2015
Research and Development. Exhibit 67 shows the dollar amount of R&D since 1992, as well as R&D as a
percentage of sales. R&D has been in a narrow band of 0.3 to 0.5 percent of sales until recently. That figure
rose to 0.6 percent in 2014 and 0.8 percent in 2015. A logical explanation for this increase is the changing
composition of GEM economies. IT and healthcare, the most R&D-intensive sectors, were roughly 10 percent
of total market capitalization in 2015, up from just 1 percent in the early 1990s.
Despite the rise, R&D spending as a fraction of sales is nevertheless well below that of the U.S., Japan, and
Europe, which are all slightly above 2 percent. Sector composition also plays a key role. GEM still has a lower
concentration in information technology and healthcare compared to the other regions, and a higher
concentration in industries that rely more heavily on capital investments.
In GEM countries, businesses account for 44 percent of total R&D spending on average, with the government,
academia, and private nonprofit companies spending the other 56 percent.59 Corporations in GEM account for
a smaller share of the total R&D spending than they do in the U.S. and Japan (70-80 percent), Europe (about
60 percent), and APEJ (roughly 50 percent).
Among larger GEM economies, the business share of R&D spending is 77 percent in China, 60 percent in
Russia, 39 percent in Mexico, and 35 percent in India. The business share of R&D spending is particularly low
in Latin American countries at 30 percent on average. One notable change is in China, where the corporate
share of R&D spending has risen from just 43 percent in 1996 to 77 percent today as the country continues
to move toward a more market-based economy.

November 15, 2016
Exhibit 67: GEM Research and Development, 1992-2015

Dollar amount
35,000 0.7%

30,000 0.6%
25,000 0.5%
$ Millions
20,000 0.4%
15,000 0.3%
10,000 0.2%
5,000 0.1%
0 0.0%
1999
2012
1992
1993
1994
1995
1996
1997
1998
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2013
2014
2015
Net Working Capital. Net working capital equals roughly 15 percent of assets on average for companies in
GEM. Exhibit 68 shows the annual change in net working capital from 1992 through 2015. At year-end 2015,
net working capital stood at $1.2 trillion for the top 1,000 public firms in GEM. We consider changes in net
incremental investment. Net working capital investments are a large use of cash in GEM, greater on average
than R&D but smaller than M&A or capital expenditures.
Exhibit 68: GEM Change in Net Working Capital, 1992-2015

Dollar amount
250,000
200,000 10%
150,000
100,000 5%
$ Millions
50,000
0 0%
-50,000
-100,000 -5%
-150,000
-200,000 -10%
2001
2002
2003
1992
1993
1994
1995
1996
1997
1998
1999
2000
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015


November 15, 2016
We have defined net working capital to include cash. The picture changes dramatically if we exclude cash. At
the end of 2015, net working capital excluding cash was about $260 billion for the top 1,000 GEM industrial
companies, roughly one-fifth the total net working capital sum. Exhibit 69 shows the change in net working
capital excluding cash.
Exhibit 69: GEM Change in Net Working Capital Excluding Cash, 1992-2015
Dollar amount
80,000 4%

40,000 2%
$ Millions
0 0%
-40,000 -2%
-80,000 -4%
-120,000 -6%
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
Divestitures. Exhibit 70 shows divestitures from 1992-2015. Similar to M&A, divestiture activity varies a lot
from year to year, ranging from a low 3 percent of sales in 2009 to a high of 13 percent in 1997. Overall,
divestitures have averaged 6.3 percent of sales over time, which is roughly two-fifths the level of M&A and
much higher than dividends, buybacks, and R&D spending.
Exhibit 70: GEM Divestitures, 1992-2015

Dollar amount
400,000
12%
350,000
10%
300,000
$ Millions
250,000 8%
200,000 6%
150,000
4%
100,000
2%
50,000
0 0%
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015


November 15, 2016
1,000 companies in GEM, excluding the financial services and regulated utility industries, from 1992 to 2015.
Dividends are very stable in GEM.
The average dividend payout ratio was roughly 35 percent from 1992-2015. The average dividend yield was
2.3 percent over the same period. In 2015, the dividend yield was 1.8 percent. Countries with above-average
yields in 2015 included Colombia at 7.4 percent, Saudi Arabia at 5.1 percent, Russia at 4.0 percent, and
Thailand at 3.4 percent. Countries with below-average yields included China at 1.1 percent and India at 1.3
percent. While their economies are a relatively small share of GEM overall, the oil producing countries of the
Middle East in particular have very high dividend yields.
Exhibit 71: GEM Common and Preferred Dividends, 1992-2015

Dollar amount
180,000

50%
160,000
140,000
45%
120,000
$ Millions
100,000 40%
80,000
35%
60,000
40,000
30%
20,000
0 25%
2003
2004
2005
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015

Share Buybacks. Exhibit 72 shows the annual amount of gross buybacks for the top 1,000 companies in
GEM from 1992 to 2015. Buyback activity was extremely low until the mid-2000s, rose sharply in 2007, and
then plummeted in the ensuing years. But even at their peak in 2007, buybacks were still less than 15
percent of net income.
Overall, buybacks have totaled roughly six percent of net income from 1992-2015. The average buyback yield
was 0.4 percent, far below the 2.3 percent dividend yield. In 2015, the buyback yield was 0.2 percent.
Countries with above-average buyback yields in 2015 included Russia at 1.4 percent and Mexico at 1.3
percent. Excluding Russia, the three other BRIC countries spend very little on buybacks. In 2015, the buyback
yield was 0.7 percent in Brazil and zero in both India and China.

November 15, 2016
Exhibit 72: GEM Gross Share Buybacks, 1992-2015

Dollar amount
14%

60,000
12%
50,000
10%
$ Millions
40,000
8%
30,000
6%
20,000
4%
10,000 2%
0 0%
1992
2010
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2011
2012
2013
2014
2015

November 15, 2016
Part III: Assessing Management’s Capital Allocation Skills
“All roads in managerial evaluation lead to capital allocation.”60
The final part of this report provides a framework for assessing a management team’s capital allocation skills.
This framework has four components. First, you want to study how a company has allocated capital in the
past. Next, you need to examine the company’s return on invested capital and, more importantly, return on
incremental invested capital. Third is a careful consideration of incentives and corporate governance. And
finally, you can compare management’s actions to the five principles of capital allocation. You can find a more
detailed version of this discussion in Michael J. Mauboussin, Dan Callahan, and Darius Majd, “Capital
Allocation: Evidence, Analytical Methods, and Assessment Guidance,” Credit Suisse Global Financial
Strategies, October 19, 2016.
Past Spending Patterns. The first step in assessing a company’s capital allocation skills is to see how
management has allocated capital in the past. You should break the analysis into two parts, one dealing with
investments in the operations (M&A, capital expenditures, R&D, and working capital) and the other with
returning cash to claimholders (dividends, buybacks, and debt repayment).
The value of a business is the present value of future free cash flow (FCF).61 Free cash flow is defined as net
operating profit after tax (NOPAT), a measure of the cash earnings of the business that assumes no financial
leverage, minus investment (I) in future growth:
FCF = NOPAT – I
NOPAT is determined by sales and sales growth, operating profit margins, and the cash tax rate. Investment
(I) is determined by changes in working capital, capital expenditures net of depreciation, and acquisitions net
of divestitures. The product of this analysis is a clear understanding of profitability (sales, sales growth, and
operating profit margins) and the investment choices the company has made (changes in working capital,
capital expenditures, and M&A).
Such an examination is also useful to assess the change in practices from one CEO to the next. One CEO
may seek to grow primarily organically, which will raise one set of analytical issues. Another may focus on
profitability and emphasize cost cutting. Yet another may be more acquisitive, raising a separate set of issues.
Assuming past behaviors provide some basis for anticipating future behavior, this analysis is very useful.
The second component of this analysis is to understand how and why management has returned cash to
claimholders. This also requires considering a company’s capital structure and whether it can or should
change. The key is to understand the rationale and motivation for the decisions management makes to
understand whether they are consistent with the principles of building long-term value per share.
Calculating Return on Invested Capital and Return on Incremental Invested Capital. The second
component to assessing capital allocation is determining the output of management’s decisions through an
analysis of return on invested capital (ROIC) and return on incremental invested capital (ROIIC). ROIC provides
a picture of the company’s overall performance while ROIIC dwells on the efficiency of incremental spending.
Our report, “Calculating Return on Invested Capital: How to Determine ROIC and Address Common Issues,”
provides details on how to calculate ROIC and ROIIC and includes case studies.62 Here’s a quick summary.

November 15, 2016
NOPAT is the numerator of ROIC. Because NOPAT assumes no financial leverage, the sum is the same
whether a company is highly levered or free of debt. This is essential for comparability within and across
industries.
Invested capital is the denominator of ROIC. You can think of invested capital in two ways that are equivalent.
First, it’s the amount of net assets a company needs to run its business. Alternatively, it’s the amount of
financing a company’s creditors and shareholders need to supply to fund those net assets. These approaches
are the same since dual-entry accounting requires that both sides of the balance sheet equal one another.
You can evaluate ROIC a number of ways. First and most fundamentally, companies that create value
generate an ROIC above the cost of capital over time. This simply says that the company is earning in excess
of the opportunity cost of capital. Second is the magnitude of the spread between ROIC and the cost of
capital as well as how much a company can invest at a given spread. Companies with wide spreads that have
limited investment opportunity may be less valuable than companies with narrower spreads but ample growth
prospects.
Having defined and discussed ROIC, we must now emphasize that it’s not the absolute ROIC that matters but
rather the change in ROIC. Or, even more accurately, what’s crucial is the expectation for changes in ROIC.
Needless to say, the market is not always perfect at anticipating change in ROIC, so having a sense of where
ROIC is going can be of great value.63
One potentially useful measure is return on incremental invested capital, or ROIIC. ROIIC properly recognizes
that sunk costs are irrelevant and that what matters is the relationship between incremental earnings and
incremental investments.
The definition of ROIIC is as follows:
ROIIC = ____Year2 NOPAT – Year1 NOPAT________

Year1 invested capital – Year0 invested capital
In words, ROIIC compares the change in NOPAT in a given year to the investments made in the prior year.
Let’s say a company’s Year0 invested capital is $2,000 and it invests $200 during the year (making Year1
invested capital $2,200). Further, NOPAT from Year1 to Year2 climbs from $300 to $350. Given these
assumptions, ROIIC is 25 percent [($350-300)/($2,200-2,000)].
It is preferable to calculate ROIIC on a rolling three- or five-year basis for businesses with investments or
NOPAT that are lumpy. At the other extreme, you can take quarterly changes and annualize them if you want
to see if there are any recent trends or improvements. Obviously these results will be the most volatile, but
they can give you some insights into how the business is doing.
Incentives and Corporate Governance. One of the essential lessons of economics is that incentives matter.
But it is also the case that incentives designed to achieve one objective can lead to unintended
consequences.64 The goal of this section is to consider whether the incentives a company has in place
encourage judicious capital allocation. Most of these incentives address compensation.
Agency theory is the classic way to explain why the managers of a company may not act in the interests of the
shareholders.65 The idea is that conflicts can arise when there is a separation between ownership and control
of a firm. There are three areas where these conflicts tend to arise.66

November 15, 2016
The first is that while it is clear that shareholders want management to maximize the value of their holdings,
management may derive benefits from controlling resources that don’t enrich shareholders. For example, if
remuneration is roughly correlated with the size of the firm, management may seek to do value-destroying
M&A deals to grow.
The second area of conflict is with tolerance for risk. Since shareholders tend to hold stocks as part of a
diversified portfolio and managers are disproportionately exposed to their own company, managers may seek
less risk than shareholders would deem appropriate.
The final conflict is with time horizon. To the degree that compensation plans have a shorter time horizon than
the period shareholders use to assess the merit of an investment, there can be a mismatch. So managers may
dwell on short-term boosts in earnings. Indeed, research shows that a large majority of managers are willing to
forego value-creating investments to deliver near-term earnings.67
So what elements should you look for in an effective incentive program? The key is to look for a company that
seeks to build long-term value per share with the belief that the stock market will ultimately follow that value. If
the market fails to reflect that value, management can take action by sharpening communication or buying
back stock.
There are three elements to an incentive compensation program that supports judicious capital allocation.68
The first is to compensate senior executives with stock options or restricted stock units that are indexed to
either the market overall or an appropriate peer group. Presuming that exogenous factors affect peers in a
similar fashion as the target firm, indexing takes a large step toward isolating management skill and reducing
the role of luck. Only individuals who can influence the stock price should be paid in equity, which limits the
number of eligible executives.
Second, executives who run operating units, as well as front line employees, should be paid for exceeding
long-term goals for the operating value drivers. These include sales growth, operating profit margins, and
some measure of return on invested capital. Broader value drivers can be further broken down into leading
indicators of value, performance measures that roll up to the value drivers.
Finally, recognize that the debate about the short term versus the long term is an empty one.69 Instead,
acknowledge that the goal is to maximize long-term value per share. This applies to activities that
management expects to pay off quickly or in the distant future.70
Five Principles of Capital Allocation. In their book, The Value Imperative, James McTaggart, Peter Kontes,
and Michael Mankins describe four principles of resource allocation that apply readily to our discussion about
capital allocation.71 We added one to expand the list to five and believe that these principles are a sound
benchmark that you can use to measure management’s mindset regarding their capital allocation practices. 72
1. Zero-based capital allocation. Companies generally think about capital allocation on an incremental
basis. For example, a study of more than 1,600 U.S. companies by McKinsey & Company, a global
consulting firm, found that there was a 0.92 correlation between how much capital a business unit
received in one year and the next. For one-third of the companies, that correlation was 0.99.73 In other
words, inertia appears to play a large role in capital allocation.
The proper approach is zero-based, which simply asks, “What is the right amount of capital (and the right
number of people) to have in this business to support the strategy that will create the most wealth?”74
There is no reference to how much the company has already invested in the business, only how much
should be invested.

November 15, 2016
Research by McKinsey suggests that those companies that showed a zero-based allocation mindset, and
hence were the most proactive in reallocating resources, delivered higher TSRs than the companies that
took more of an incremental approach.75 Further, academic research shows that those companies that are
good at internal capital allocation tend to be good at external allocation as well.76
2. Fund strategies, not projects. The idea here is that capital allocation is not about assessing and
approving projects, but rather assessing and approving strategies and determining the projects that
support the strategies. Practitioners and academics sometimes fail to make this vital distinction.77 There
can be value-creating projects within a failed strategy, and value-destroying projects within a solid strategy.
Another reason to be cautious about a project approach is that it is easy to game the system. It is
common for companies to have thresholds for project approval. For instance, a plant manager can
approve small projects, business unit heads larger ones, the CEO bigger ones still, and the board of
directors the largest investments. But at each level, analysts can manipulate the numbers to look good.
One of the aspects of the institutional imperative, as Buffett describes it, is, “Any business craving of the
leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared
by his troops.”78
The key to this principle is recognizing that a business strategy is a bundle of projects and that the value of
the bundle is what matters. The CEO and board must evaluate alternative strategies and consider the
financial prospects of each.
3. No capital rationing. The attitude at many companies, which the results of surveys support, is that
capital is “scarce but free.” The sense is that the business generates a limited amount of capital which
makes it “scarce,” but since it comes from within it is “free.”
The primary source of capital for companies in the U.S. is the cash they generate. The patterns of
spending on the various uses of capital indicate the attitude of managements. Capital expenditures, R&D,
and dividends receive priority, and M&A and share buybacks are considered when economic results are
good. Internal capital allocation tends to be very stable from year to year, and inertia plays a large role.
Business units may jockey for more capital but, as we have seen, the changes in year-to-year allocation
tend to be modest. These observations are consistent with the “scarce but free” mindset.
A better mindset is that capital is plentiful but expensive. There are two sources of capital companies can
tap beyond the cash generated internally. The first is redeploying capital from businesses that do not earn
sufficient returns. Management can execute this inside the company or sell the underperforming
businesses and redeploy the proceeds. The second is the capital markets. When executives have value-
creating strategies that need capital, the markets are there to fund them in all but the most challenging
environments.
The notion that internally generated capital is free is also problematic. Thoughtful capital allocators
recognize that all capital has an opportunity cost, whether the source is internal or external. As a
consequence, managers should explicitly account for the cost of capital in all capital allocation decisions.
Too frequently, companies select actions that add to earnings or earnings per share without properly
reckoning for value.
The limiting resource for many companies is not access to capital but rather access to talent. Finding
executives with the proper skills for success, including an aptitude for allocating capital, is not easy. This is
a valid challenge but relates to recruiting and development, not access to capital.

November 15, 2016
4. Zero tolerance for bad growth. Companies that wish to grow will inevitably make investments that do
not pay off. The failure rate of new businesses and new products is high. Seeing an investment flop is no
sin; indeed it is essential to the process of creating value. What is a sin, in our view, is remaining
committed to a strategy that has no prospects to create value, hence draining human and financial
resources.
Executives who follow this principle invest in innovation but are ruthless in cutting losses when they see
that a strategy is unlikely to pay off. Many companies have the opportunity to create substantial value by
exiting businesses where they have no advantage. This reduces cross-subsidization within the organization
and allows for the best managers to work for the businesses that create the most value.
5. Know the value of assets, and be ready to take action to create value. Intelligent capital allocation
is similar to managing a portfolio of stocks in that it is very useful to have a sense of the difference, if any,
between the value and price of each asset. This includes the value of the company and its stock price.
Naturally, such analysis must include considerations such as taxes.
With a ready sense of value and price, management should be prepared to take action to create value.
Sometimes that means acquiring, other times that means divesting, and frequently there are no clear gaps
between value and price. As we have seen, managers tend to prefer to buy than to sell, even though the
empirical record shows quite clearly that sellers fare better than buyers, on average.
As we mentioned in the introduction, the answer to most capital allocation questions is, “It depends.”
Managers who adhere to this final principle understand when it makes sense to act on behalf of long-term
shareholders.
Conclusion
Capital allocation is one of management’s prime responsibilities. Yet few senior executives are versed or
trained in methods to allocate capital most effectively. Further, incentive programs frequently encourage
behaviors that are not in the best interests of long-term shareholders. We believe that the goal of capital
allocation is to build long-term value per share.
This report had three parts. First we discussed the sources and uses of capital at a high level. In general,
countries or regions with high returns on invested capital are in a position to fund a substantial percentage of
investment. We also noted the differences for the major regions of the world. The differences reflect the
nature of the underlying economy, stage of development, cultural norms, and regulations.
The second part examined the sources and uses of capital for Japan, Europe, Asia/Pacific excluding Japan,
and Global Emerging Markets. The patterns in the U.S. and Europe are similar, with relatively strong spending
on R&D, solid capital expenditure levels, active M&A, and a relatively generous shareholder yield.79 The CFROI
in the U.S. is substantially higher. Japan has a low CFROI and relatively modest growth. M&A is also muted,
and shareholder yield is low—although there has been improvement in recent years. Developing markets
spend an above-average amount on capital expenditures and working capital. But they have low shareholder
yields and allocate little to R&D.
Finally, we set out a framework to assess the capital allocation practices of a management team. This
framework includes examining past behavior, calculating return on invested capital, weighing incentives, and
considering the five principles of thoughtful capital allocation.

November 15, 2016
Acknowledgment
We thank the Credit Suisse HOLT team for their essential contributions to this research. In particular, we
appreciate the assistance of Ron Graziano, Tom Hillman, David Matsumura, Bryant Matthews, and Chris
Morck. We could not have done this analysis without their aid.

November 15, 2016
Appendix: The List of Countries Included in the Data for Each Region
Europe
For capital expenditures, R&D, net working capital, share buybacks, and dividends: Austria, Belgium,
Denmark, Finland, France, Germany, Greece, Iceland, Ireland, Israel, Italy, Luxembourg, Netherlands, Norway,
Portugal, Spain, Sweden, Switzerland, and United Kingdom.
For M&A and divestitures: Albania, Andorra, Austria, Belarus, Belgium, Bosnia and Herzegovina, Bulgaria,
Croatia, Cyprus, Czech Republic, Czechoslovakia, Denmark, East Germany, Estonia, Faroe Islands, Finland,
France, Georgia, Germany, Gibraltar, Greece, Greenland, Guernsey, Hungary, Iceland, Isle of Man, Italy,
Jersey, Latvia, Liechtenstein, Lithuania, Luxembourg, Macedonia, Malta, Moldova, Monaco, Montenegro,
Netherlands, Norway, Poland, Portugal, Republic of Ireland, Romania, Russian Federation, San Marino,
Serbia, Serbia and Montenegro, Slovak Republic, Slovenia, Soviet Union, Spain, Sweden, Switzerland, Turkey,
Ukraine, United Kingdom, and Yugoslavia.
Asia/Pacific excluding Japan
For capital expenditures, R&D, net working capital, share buybacks, and dividends: Australia, Bangladesh,
China, Hong Kong, India, Indonesia, Korea, Malaysia, New Zealand, Pakistan, Philippines, Singapore, Taiwan,
Thailand, and Vietnam.
For M&A and divestitures: Afghanistan, American Somoa (United States), Armenia, Australia, Azerbaijan,
Bangladesh, Bhutan, Brunei, Cambodia, China, Cook Islands, Federated States of Micronesia, Fiji, French
Polynesia, Guam (United States), Hong Kong, India, Indonesia, Kazakhstan, Kiribati, Kyrgyzstan, Laos, Macau,
Malaysia, Maldives, Marshall Islands, Mongolia, Myanmar(Burma), N. Mariana Islands(United States), Nepal,
New Caledonia(France), New Zealand, Niue(New Zealand), Norfolk Islands(Australia), North Korea, Pakistan,
Palau, Papua New Guinea, Philippines, Singapore, Solomon Islands, South Korea, Sri Lanka, Taiwan,
Tajikistan, Thailand, Timor-Leste, Tonga, Turkmenistan, Uzbekistan, Vanuatu(New Hebrides), Vietnam, and
Western Somoa.
Global Emerging Markets
For capital expenditures, R&D, net working capital, share buybacks, and dividends: Argentina, Bangladesh,
Brazil, Chile, China, Colombia, Croatia, Czech Republic, Hungary, India, Indonesia, Jordan, Kuwait, Malaysia,
Mexico, Morocco, Oman, Pakistan, Peru, Philippines, Poland, Qatar, Russia, Saudi Arabia, Slovenia, South
Africa, Thailand, Turkey, United Arab Emirates, and Vietnam.
For M&A and divestitures: Brazil, Chile, China, Colombia, Hungary, India, Indonesia, Malaysia, Mexico, Peru,
Philippines, Poland, Russian Federation, South Africa, Thailand, and Turkey.

November 15, 2016
Endnotes
1
Michael E. Porter, “What is Strategy?” Harvard Business Review, November-December, 1996, 61-78. For a
more in-depth discussion, see Joan Magretta, Understanding Michael Porter: The Essential Guide to
Competition and Strategy (Boston, MA: Harvard Business Review Press, 2012).
2
3
4
5
for Success (Boston, MA: Harvard Business Review Press, 2012). For another text that describes capital
allocation, see Justin Pettit, Strategic Corporate Finance: Applications in Valuation and Capital Structure
6
Michael J. Mauboussin and Dan Callahan, “What Does a Price-Earnings Multiple Mean? An Analytical Bridge
between P/Es and Solid Economics,” Credit Suisse Global Financial Strategies, January 29, 2014.
7
Stewart C. Myers and Nicholas S. Majluf, “Corporate Financing and Investment Decisions When Firms Have
221.
8
Michael J. Mauboussin and Dan Callahan, “Disbursing Cash to Shareholders: Frequently Asked Questions
about Buybacks and Dividends,” Credit Suisse Global Financial Strategies, May 6, 2014.
9
For Europe, see Eurostat European Sector accounts. For U.S., see Board of Governors of the Federal
Reserve System, Division of Research and Statistics, Flow of Funds Accounts Table F. 103. Also, Stephen A.
Ross, Randolph W. Westerfield, Jeffrey F. Jaffe, Corporate Finance – Sixth Edition (Boston, MA: McGraw-
Hill/Irwin, 2002), 385, and Credit Suisse HOLT.
10
Jason Zweig, “Peter’s Uncertainty Principle,” Money Magazine, November 1994, 143-149.
See http://money.cnn.com/2004/10/11/markets/benstein_bonus_0411/index.htm.
Here is Zweig’s question and Bernstein’s answer:
Q: Hugh Liedtke, the former CEO of Pennzoil, used to joke that he believed in the “bladder theory”:
Companies pay dividends so that management can’t p--s all the money away.
A: It’s hard to improve on that. In the 1960s, in “A Modest Proposal,” I suggested that companies should be
required to pay out 100% of their net income as cash dividends. If companies needed money to reinvest in
their operations, then they would have to get investors to buy new offerings of stock. Investors would do that
only if they were happy both with the dividends they’d received and the future prospects of the company.
Markets as a whole know more than any individual or group of individuals. So the best way to allocate capital
is to let the market do it, rather than the management of each company. The reinvestment of profits has to be
submitted to the test of the marketplace if you want it to be done right.
For academic research supporting this point, see Jeffrey Wurgler, “Financial Markets and the Allocation of
Capital,” Journal of Financial Economics, Vol. 58, Nos. 1-2, 2000, 187-214.
11
Returns,” Journal of Finance, Vol. 63, No. 4, August 2008, 1609-1651. Also, Eugene F. Fama and Kenneth
R. French, “A Five-Factor Asset Pricing Model,” Journal of Financial Economics, Vol. 116, No. 1, April 2015,
1-22. Also, Adriana S. Cordis and Chris Kirby, “Capital Expenditures and Firm Performance: Evidence from a
Cross-Sectional Analysis of Stock Returns,” Accounting & Finance, Forthcoming, 2016. For non-U.S. results,
see Akiko Watanabe, Yan Xu, Tong Yao, and Tong Yu, “The Asset Growth Effect: Insights for International
Equity Markets,” Journal of Financial Economics, Vol. 108, No. 2, May 2013, 259-263. Also, Sheridan
Titman, K. C. John Wei, and Feixue Xie, “Market Development and the Asset Growth Effect: International
Evidence,” Journal of Financial and Quantitative Analysis, Vol. 48, No. 5, October 2013, 1405-1432. A

November 15, 2016
separate study that examined the Japanese market found no significant relationship between capital
expenditures and subsequent stock returns. See Sheridan Titman, K. C. John Wei, and Feixue Xie, “Capital
Investments and Stock Returns in Japan,” International Review of Finance, Vol. 9, Nos. 1-2, March 2009,
111-131.
12
Peter J. Clark and Roger W. Mills, Masterminding the Deal: Breakthroughs in M&A Strategy and Analysis
(London: Kogan Page, 2013). Also, Gerry McNamara, Jerayr Haleblian, and Bernadine Johnson Dykes, “The
Performance Implications of Participating in an Acquisition Wave,” Academy of Management Journal, Vol. 51,
No. 1, February 2008, 113-130. Also, Matthew Rhodes-Kropf and S. Viswanathan, “Market Valuation and
Merger Waves,” Journal of Finance, Vol. 59, No. 6, December 2004, 2685-2718.
13
Mark L. Sirower, The Synergy Trap: How Companies Lose the Acquisition Game (New York: Free Press,
1997). For a tutorial and spreadsheet that guides this analysis, see
www.expectationsinvesting.com/tutorial10.shtml.
14
Companies – Sixth Edition (Hoboken, NJ: John Wiley & Sons, 2015), 587. Also, Connor Lynagh, “Does the
Market Reward Accretive Deals? An Investigation of Acquirer Performance and Earnings per Share Accretion,”
Glucksman Institute for Research in Securities Markets Working Paper, April 1, 2014.
15
For a more detailed, and likely more accurate, approach see Bruce C. N. Greenwald, Judd Kahn, Paul D.
Sonkin, and Michael van Biema, Value Investing: From Graham to Buffett and Beyond (Hoboken, NJ: John
Wiley & Sons, 2001), 96. Specifically, they recommend three steps: 1. Calculate the ratio of gross property,
plant, and equipment (PPE) to sales for each of the past five years and find the average; 2. Use this to
indicate the dollars of PPE it takes to support each dollar of sales; 3. Multiply this ratio by the growth (or
decrease) in sales dollars the company achieved in the current year. The result of that calculation is capital
expenditures dedicated to growth.
16
See J. Randall Woolridge and Charles C. Snow, “Stock Market Reaction to Strategic Investment Decisions,”
Strategic Management, Vol. 11, No. 5, September 1990, 353-363; John J. McConnell and Chris J.
Muscarella, “Corporate Capital Expenditure Decisions and the Market Value of the Firm,” Journal of Financial
Economics, Vol. 14, No. 3, September 1985, 399-422; Kee H. Chung, Peter Wright, and Charlie
Charoenwong, “Investment Opportunities and Market Reaction to Capital Expenditure Decisions,” Journal of
Banking & Finance, Vol. 22, No. 1, January 1998, 41-60; and Sheridan Titman, K. C. John Wei, and Feixue
Xie, “Capital Investments and Stock Returns,” Journal of Financial and Quantitative Analysis, Vol. 39, No. 4,
December 2004, 677-700.
17
“2016 Global R&D Funding Forecast,” R&D Magazine, Winter 2016.
18
Allan C. Eberhart, William F. Maxwell, and Akhtar R. Siddique, “An Examination of Long-Term Abnormal
April 2004, 623-650.
19
Bronwyn H. Hall, Jacques Mairesse, and Pierre Mohnen, “Measuring the Returns to R&D,” in Bronwyn H.
Hall and Nathan Rosenberg, eds., The Handbook of the Economics of Innovation—Volume 2 (Amsterdam:
Elsevier, 2010), 1033-1082. Also, Missaka Warusawitharana, “Research and Development, Profits, and Firm
Value: A Structural Estimation,” Quantitative Economics, Vol. 6, No. 2, July 2015, 531-565.
20
Louis K. C. Chan, Josef Lakonishok, and Theodore Sougiannis, “The Stock Market Valuation of Research
21
Mohsen Saad and Zaher Zantout, “Over-Investment in Corporate R&D, Risk, and Stock Returns, Journal of
22
Tom Hillman and Chris Morck, “Using the HOLT Framework to Assess Acquisition Skill,” Credit Suisse
23
Pascal Nguyen, Sophie Nivoix, and Mikiharu Noma, “The Valuation of R&D Expenditures in Japan,” 22nd
Australasian Finance and Banking Conference, August 24, 2009.
24
Patrick Seitz, “Top Tech Stocks Not Big R&D Spenders, Surprising Study Shows,” Investors.com, July 7,
2014.

November 15, 2016
25
Mariana Mazzucato, The Entrepreneurial State: Debunking Public vs. Private Sector Myths (London:
Anthem Press, 2013). Also, see Mariana Mazzucato, “The Innovative State: Governments Should Make
Markets, Not Just Fix Them,” Foreign Affairs, January/February 2015, 61-68.
26
James M. McTaggart, Peter W. Kontes, and Michael C. Mankins, The Value Imperative: Managing for
Superior Shareholder Returns (New York: Free Press, 1994), 241.
27
Richard H. Thaler, “Anomalies: The Winner’s Curse,” Journal of Economic Perspectives, Vol. 2, No. 1,
Winter 1988, 191-202.
28
Robert E. Hoskisson and Thomas A. Turk, “Corporate Restructuring: Governance and Control Limits of the
Internal Capital Market,” Academy of Management Review, Vol. 15, No. 3, July 1990, 459-477. For a
discussion of the type of proceeds from divestitures and TSRs, see Myron B. Slovin, Marie E. Sushka, and
John A. Polonchek, “Methods of Payment in Asset Sales: Contracting with Equity versus Cash,” Journal of
Finance, Vol. 60, No. 5, October 2005, 2385-2407. For a discussion of investment of proceeds from
divestitures, see Thomas W. Bates, “Asset Sales, Investment Opportunities, and the Use of Proceeds,”
Journal of Finance, Vol. 60, No. 1, February 2005, 105-135. Also, Pascal Nguyen, “The Role of the Seller’s
Stock Performance in the Market Reaction to Divestiture Announcements,” Journal of Economics and Finance,
Vol. 40, No. 1, January 2016, 19–40.
29
Donghum “Don” Lee and Ravi Madhavan, “Divestiture and Firm Performance: A Meta-Analysis,” Journal of
30
Patrick J. Cusatis, James A. Miles, and Randall Woolridge, “Restructuring through Spinoffs: The Stock
Market Evidence,” Journal of Financial Economics, Vol. 33, No. 3, June 1993, 293-311. Also, Hemang
Desai and Prem C. Jain, “Firm Performance and Focus: Long-Run Stock Market Performance Following
Spinoffs,” Journal of Financial Economics, Vol. 54, No. 1, October 1999, 75-101. For a non-academic
treatment, see Joel Greenblatt, You Can Be a Stock Market Genius (Even if you’re not too smart!): Uncover
the Secret Hiding Places of Stock Market Profits (New York: Fireside, 1997).
31
For the recent performance of spin-offs, see Dani Burger, “Cold Spell Ends for Spinoffs as Rising Market
Aids Activist Tool,” Bloomberg News, October 10, 2016. For the research that explains the contributing
factors, see Chris Veld and Yulia V. Veld-Merkoulova, “Value Creation through Spinoffs: A Review of the
Empirical Evidence,” International Journal of Management Reviews, Vol.11, No. 4, December 2009, 407-420.
32
33
Douglas J. Skinner and Eugene Soltes, “What Do Dividends Tell Us About Earnings Quality?” Review of
34
Alfred Rappaport, “Dividend Reinvestment, Price Appreciation and Capital Accumulation,” Journal of
Portfolio Management, Vol. 32, No. 3, Spring 2006, 119-123.
35
Bo Becker, Marcus Jacob, and Martin Jacob, “Payout Taxes and the Allocation of Capital,” Journal of
36
Ali Fatemi and Recep Bildik, “Yes, Dividends are Disappearing: Worldwide Evidence,” Journal of Banking &
37
Jayant R. Kale, Omesh Kini, and Janet D. Payne, “The Dividend Initiation Decisions of Newly Public Firms:
April 2012, 365-396. Also, Doron Nissim and Amir Ziv, “Dividend Changes and Future Profitability,” Journal
of Finance, Vol. 56, No. 6, December 2001, 2111-2133.
38
Returns (Boston, MA: Harvard Business School Press, 2001), 174.
39
For details on calculating the rate of returns for buybacks, see Mauboussin and Callahan, “Disbursing Cash
to Shareholders.”
40
Michael C. Jensen, “Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers,” American

November 15, 2016
41
Alice A. Bonaimé, Kristine W. Hankins, and Bradford D. Jordan, “The Cost of Financial Flexibility: Evidence
from Share Repurchases,” Journal of Corporate Finance, Vol. 38, June 2016, 345-362. Also, Chao Zhuang,
“Share Repurchases, Market Timing, and the Distribution of Free Cash Flow,” Working Paper, March 10,
2015.
42
Jin Wang and Lewis D. Johnson, “Information Asymmetry, Signaling, and Share Repurchase,” Working
43
Gustavo Grullon and David L. Ikenberry, “What Do We Know about Share Repurchases?” Journal of
Applied Corporate Finance, Vol. 13, No. 1, Spring 2000, 31-51. For the survey result, see Brav, Graham,
Harvey, and Michaely, 2005.
44
While buybacks do boost the EPS of individual companies, they don’t enhance value. See Jacob Oded and
Allen Michel, “Stock Repurchases and the EPS Enhancement Fallacy,” Financial Analysts Journal, Vol. 64, No.
4, July/August 2008, 62-75. Further, buybacks have a negligible impact on the S&P 500 Index. Howard
Silverblatt, a senior index analyst at S&P Dow Jones Indices, writes, “The S&P index weighting methodology
adjusts for shares, so buybacks are reflected in the calculations. Specifically, the index reweights for major
share changes on an event-driven basis, and each quarter, regardless of the change amount, it reweights the
entire index membership. The actual index EPS calculation determines the index earnings for each issue in
USD, based on the specific issues’ index shares, index float, and EPS. The calculation negates most of the
share count change, and reduces the impact on EPS.” See Howard Silverblatt, “Buybacks and the S&P 500®
EPS,” Indexology Blog, March 7, 2014.
45
Heitor Almeida, Vyacheslav Fos, and Mathias Kronlund, “The Real Effects of Share Repurchases,” Journal
of Financial Economics, Vol. 119, No. 1, January 2016, 168-185. Also, Konan Chan, David L. Ikenberry,
Inmoo Lee, and Yanzhi Wang, “Share Repurchase as a Potential Tool to Mislead Investors,” Journal of
Corporate Finance, Vol. 16, No. 2, April 2010, 137-158.
46
Gustavo Grullon and Roni Michaely, “Dividends, Share Repurchases, and the Substitution Hypothesis,”
47
Alberto Manconi, Urs Peyer, Theo Vermaelen, “Buybacks Around the World,” European Corporate
Governance Institute - Working Paper Series in Finance No. 436/2014, August 2014.
48
In Japan, popular culture regards companies as social institutions as much as commercial institutions.
Keiretsu corporate groups thrived for decades in the country. Translated literally, keiretsu means headless
combine. But as a form of corporate structure, it consisted of interlocking share ownership between Japanese
companies, especially between banks and their corporate clients. Managers generally supported this system
as they found it effective in preventing hostile takeovers. See “M&A in Japan: Land of the rising sums,”
Economist, July 12, 2007; Gregory Jackson and Miyajima Hideaki, “Varieties of Capitalism, Varieties of
Markets: Mergers and Acquisitions in Japan, Germany, France, the U.K. and USA,” RIETI Discussion Paper
07-E-054, June 2007.
49
Abhinav Goyal and Cal Muckley, “Corporate Payout Policy in Japan,” UCD Geary Institute Discussion Paper
Series Working Paper, March 1, 2011.
50
Martina Martynova and Luc Renneboog, “Mergers and Acquisitions in Europe,” ECGI – Finance Working
Paper No. 114/2006, January, 2006.
51
Pietro Moncada-Paterno-Castello, Constantin Ciupagea, Keith Smith, Alexander Tubke, and Mike Tubbs,
“Does Europe Perform too little corporate R&D? A comparison of EU and non-EU corporate R&D
performance,” Research Policy, Vol. 39, No. 4, May 2010, 523-536.
52
UNESCO Institute for Statistics. While European governments have set ambitious goals for increasing R&D
spending, the region’s businesses have been slow to increase their R&D intensity. See Moncada-Paterno-
Castello et al., and Nora Albu, “Research and Development Spending in the EU: 2020 growth strategy in
perspective,” SWP Working Paper, December 2011.
53
Henk von Eije and William L. Megginson, “Dividends and Share Repurchases in the European Union,”
Journal of Financial Economics, Vol. 89, No. 2, August 2008, 347-374.

November 15, 2016
54
For an overview of regulations surrounding open market repurchases in ten countries, including six
European countries, see Jaemin Kim, Ralf Schremper, Nikhil Varaiya, “Open Market Repurchase Regulations:
A cross-country examination,” Corporate Finance Review, Vol. 9, No. 4, 29-38, 2004.
55
Mike W. Peng, “Making M&A Fly in China,” Harvard Business Review, March 2006, 26-27. Also, Patrick A.
Gaughan, Mergers, Acquisitions, and Corporate Restructurings – Fifth Edition (Hoboken, NJ: John Wiley &
Sons, 2011).
56
UNESCO Institute for Statistics.
57
There is limited academic research, however, surrounding buybacks in many of the APEJ countries. For a
study on Australia, see Asjeet Lamba and Ian Ramsay, “Share Buy-Backs: An Empirical Investigation,” Centre
for Corporate Law and Securities Regulation Research Report, May 2000. For a study that includes Hong
Kong, see Kim et al.
58
Jianhong Zhang, Chaohong Zhou, and Haico Ebbers, “Completion of Chinese Overseas Acquisitions:
Institutional Perspectives and Evidence,” International Business Review, Vol. 20, No. 2, April 2011, 226-238.
59
UNESCO Institute for Statistics.
60
Michael J. Mauboussin, More Than You Know: Finding Financial Wisdom in Unconventional Places –
Updated and Expanded (New York: Columbia Business School Publishing, 2008), 64.
61
Free Press, 1986), 51-55.
62
Michael J. Mauboussin and Dan Callahan, “Calculating Return on Invested Capital: How to Determine ROIC
and Address Common Issues,” Credit Suisse Global Financial Strategies, June 4, 2014.
63
Michael J. Mauboussin and Dan Callahan, “Economic Returns, Reversion to the Mean, and Total
64
Canice Prendergast, “The Provision of Incentives in Firms,” Journal of Economic Literature, Vol. 37, No. 1,
March 1999, 7-63.
65
Michael C. Jensen and William H. Meckling, “Theory of the Firm: Managerial Behavior, Agency Costs, and
Ownership Structure,” Journal of Financial Economics, Vol. 3, No. 4, October 1976, 305-360. For the
empirical validity of agency theory, see Kathleen M. Eisenhardt, “Agency Theory: An Assessment and Review,”
Academy of Management Review, Vol. 14, No. 1, January 1989, 57-74.
66
Richard A. Lambert and David F. Larcker, “Executive Compensation, Corporate Decision Making, and
Shareholder Wealth: A Review of the Evidence,” in Fred K. Foulkes, ed., Executive Compensation: A
Strategic Guide for the 1990s (Boston, MA: Harvard Business School Press, 1991), 98-125.
67
John R. Graham, Campbell R. Harvey, and Shiva Rajgopal, “Value Destruction and Financial Reporting
68
This discussion borrows heavily from Alfred Rappaport, “Ten Ways to Create Shareholder Value,” Harvard
Business Review, September 2006, 66-77.
69
Michael J. Mauboussin and Dan Callahan, “A Long Look at Short-Termism: Questioning the Premise,”
Credit Suisse Global Financial Strategies, November 18, 2014.
70
Alfred Rappaport, Saving Capitalism from Short-Termism: How to Build Long-Term Value and Take Back
Our Financial Future (New York: McGraw Hill, 2011), 140-142.
71
McTaggart, Kontes, and Mankins, 239-255.
72
We believe that these principles, when coupled with the discussion in part two, are consistent with what
Thorndike calls “The Outsider’s Checklist.” See Thorndike, 218-220.
73
Stephen Hall, Dan Lovallo, and Reiner Musters, “How to Put Your Money Where Your Strategy Is,”
McKinsey Quarterly, March 2012.
74
McTaggart, Kontes, and Mankins, 243.
75
Research shows that public companies do a better job of allocating capital to growth opportunities than
private companies do. See Sandra Mortal and Natalia Reisel, “Capital Allocation by Public and Private Firms,”
Journal of Financial and Quantitative Analysis, Vol. 48, No. 1, February 2013, 77-103. For an academic

November 15, 2016
discussion of the functioning of internal capital markets, see Jeremy C. Stein, “Internal Capital Markets and
the Competition for Corporate Resources,” Journal of Finance, Vol. 52, No. 1, March 1997, 111-133.
76
Meng Ye, “Efficiency of Internal Capital Allocation and the Success of Acquisitions,” University of New
77
Clayton M. Christensen, Stephen P. Kaufman, and Willy C. Shih, “Innovation Killers: How Financial Tools
78
Buffett, 1989.
79
Jacob Boudoukh, Roni Michaely, Matthew Richardson, and Michael R. Roberts, “On the Importance of
2007, 877-915.

November 15, 2016
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November 15, 2016
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November 15, 2016
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Thoughts on Dividends and Buybacks

The conventional wisdom that dividends make a crucial contribution to

Dividends are the major contributor to capital accumulation over time;

Buybacks destroy value or waste money;

Shareholders can be passive with regard to share buyback policy.

Price Appreciation and Dividends

𝑇𝑜𝑡𝑎𝑙 𝑠ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟 𝑟𝑒𝑡𝑢𝑟𝑛 = 𝑔 + (1 + 𝑔)𝑑

Thoughts on Dividends and Buybacks 2

The Value Conservation Principle

Thoughts on Dividends and Buybacks 3

Doing Nothing Is Doing Something

Thoughts on Dividends and Buybacks 4

Thoughts on Dividends and Buybacks 5

Thoughts on Dividends and Buybacks 6

Appendix B: Recent Trends in Dividends and Buybacks

Exhibit 1: Breakdown of Buyback Yield for the S&P 500 (2015)

Exhibit 2: Breakdown of Dividend Yield for the S&P 500 (2015)

Thoughts on Dividends and Buybacks 7

Exhibit 4: Buybacks and Dividends for the S&P 500 (1999-2015)

Thoughts on Dividends and Buybacks 8

Thoughts on Dividends and Buybacks 9

Thoughts on Dividends and Buybacks 10

Thoughts on Dividends and Buybacks 11

Michael Mauboussin, Credit Suisse

Bill Gurley, General Partner, Benchmark Capital

Pedro Domingos, Professor of Computer Science, University of Washington

Cade Massey, Professor of Operations, Information and Decisions, University of Pennsylvania

Please join me in welcoming Bill Gurley.

escape by making fewer disclosures than as a publicly traded one.”

Michael: Pedro, do you have a thought on that?

Bill: [Laughs] Is that a question?

hand, it’s never been easier to go public.

Bill: Thought of hedging?

Question: . . . Hedging, or how do you take the other side?

Please join me in welcoming Professor Pedro Domingos.

that imitate what genetics does.

sophisticated way they do this is via genetic programming.

This is actually what the concept of the singularity is.

Question: Do you see AI advancing to a point where it becomes a danger?

Pedro: Oh, yes, there are examples galore.

Question: What are we learning from that?

Please join me in welcoming Professor Cade Massey.

can learn and improve over time.

“informed, thoughtful modeler.” We pimp the model a little bit.

things, numbers four and five.

Nebraska to coordinate their scheduling.”

Note: No transcript available.

Value trigger Value factor Value driver Financial leverage Earnings

“Analysts’ usual optimism, their tendency to forecast in a narrow and

Exhibit 1: Framework for Assessing Operating Leverage

Price & mix Operating Financial

Exhibit 2: Cost Structure Composition and Operating Profit Scalability

20 25% Fixed / 75% Variable

Exhibit 3: Fixed Assets to Total Assets by Sector

0.0 0.1 0.2 0.3 0.4 0.5 0.6

Exhibit 4: Drivers of Operating Profit for Top 1,000 Companies (1950-2014)

Source: Credit Suisse HOLT®.

Annual Real Sales Growth (Percent)

Exhibit 6: Sales Growth versus U.S. GDP Growth by Sector (1950-2014)

Annual Sales Growth (Percent)