The Value Mindset – Explained
At the core of the Value Mindset are the principles of value investing. Essentially it can all be boiled down to one simple statement “pay a fair price for proven outcomes and compound the results over time.” As simple as this sounds, it is often elusive for investors, and quite frankly the statement is far too simple to accommodate the needs of an executive looking to make value based decisions.
Within this entry, we will review some of the common value investing principles, specially tailored for the Value Mindset, to focus on strategic choice making. We will discuss the common methods for evaluating and measuring value (i.e. Valuation and Appraisal Approaches). These methods should be deployed depending on the situation and scenario, however, in most cases, value based evaluation will be based on cash flows, income, or relative cost. And finally, we will discuss a few considerations which will help frame up how choices are determined, evaluated, and selected.
Value Mindset Principles:
- Value is a function of price and return. This gets to the heart of whether a choice is expensive or cheap. If you drive down the street, you may drive past 2 gas stations, one which is offering a gallon of gasoline for $3 and another which is offering an equivalent product for $2.90. In this example you have a pretty clear understanding of which gas is cheap and which is expensive – it is plain as day. Or is it? If I then articulated that the $3 per gallon would get you an additional 3 miles per gallon because it is higher octane, then you may completely reassess the value proposition. Understanding “what you get” is the most important thing when comparing the price / cost of choices. This same concept applies to almost any strategic choice. Don’t be afraid to spend a little more if the benefits are substantially greater.
- Value is a function of quality. People generally understand the concept of value when making choices in their personal lives but this notion of quality is often overlooked when it comes to strategic choices in the enterprise. When picking between two seemingly equivalent pieces of furniture, you can check the hinges, the handles, the wood, the seals, facets, and binding materials – when it comes to a strategic choice – sniff tests look a little bit different. For strategic choices, quality should be based on the reliability of the prospects of your choice. Ask yourself…For others who have made similar choices, have they yielded consistent returns over time? Are my returns protected or are they at-risk to competition? What is the certitude of positive outcomes for my choices?
- Value is a function of time. A great speculator can probably make a sizeable profit in a short amount of time; however, I firmly believe that time is the great equalizer. It makes both the exceptional and underperformers seem average. With that in mind, each executive has a different time horizon by which they evaluate a series of choices. Big bet choices can take as many as a decade or two to realize positive returns. Occasionally choices may deliver results in a relatively short period of time. When comparing options, it is important to adjust for duration. I believe the adage is “a bird in the hand is worth two in the bush.” For the most part this is true but also consider that the value of the bird anecdote is also relative to the time and potential of your ‘birds in the bush’.
- Value is a function of risk. In value investing, investors often try to isolate alpha. In other words, isolating the risk or opportunity that is specific to an investment over another investment. Typically, it is referred to as firm specific risk. Properly framing the risks and opportunities of a specific choice or series of choices helps to narrow the field of vision and properly adjust for shortcomings. When analyzing risk there are a variety of different methods which can be deployed including adjusting for confidence, establishing risk adjusted returns, factoring in market / financial risk into your discount rates, and modeling out stress test scenarios that may threaten your decision. This one is typically often overlooked in the world of consulting because often time capturing risk adjusted returns may have a significant impact on each of the choices. Creating a substantial margin of safety in the financial case helps to overcome both known and unknown risks which are either inestimable or unfathomable. Also, know that black-swan events exist, protect against their impact, but don’t overburden your case for things with unbounded liability.
- Value is a function of analytical integrity. Being honest with the prospects of a choice or series of choices is often the most difficult thing to do. It is easy to change an assumption here or there, round a figure up or down, or over project positive benefits and understate risks. Often certain choices cannot be validated based on the numbers but are the right thing to do. Understanding the qualitative benefits and how those can also be measured is important to helping make the value case when frankly the numbers may not add up. The worst thing to do, however, is to manipulate the numbers to tell a false story.
- Value is a function of management and ability to execute. While I don’t’ believe that management can overcome all, the difference between good management and bad management becomes apparent when things don’t go as planned – as they undoubtedly will from time to time. Not only is good management essential for deploying the Value Mindset when making choices, it is also essential to ensuring that value is realized once the decision has been made. Often decisions are made and many of those individuals who were part of the process move on. Someone must carry the torch. That responsibility typically falls on management. Also, transferable management principles also help to ensure continuity of value realization.
Value Mindset Methods:
- Income: The most common analysis for the Income Method is a discounted cash flow or DCF analysis. This typically identifies the net cashflows associated with a decision projects them forward and discounts them back to the present. A cost based equivalent of a DCF is a business case model which considers one-time costs, recurring costs / savings, time, and the firm cost of capital. Both types are effective at estimating the economic prospects of a choice. This is encouraged in pretty much all situations when comparing options – particularly those with different time horizons and risk profiles.
- Market: When evaluating investments, there are typically public and private markets available that you can use to compare prices and valuation based metrics. For strategic choices, this is often a bit more challenging, however, using 3rd Parties, Consultants, Financial Statements, and Press Releases, leadership can identify market signals from competitors and other firms who have already started the pathway of executing a choice. This helps to provide some market perspective on the value and potential areas of improvement to better estimate, plan, and execute a choice. For things that are not entirely identical, you can use sample cases as a proxy for value to measure yourself against and even to test / validate assumptions of value.
- Cost: The Cost Method aims to determine what it would cost to replace an asset or investment (as it stands today less accumulated depreciation). For example, if you bought a house built in the 1950’s that was refurbished, how much would it cost you to actually replace it today? Occasionally, choices can be evaluated by assessing whether you have a specific cost advantage (adjusted for capability) relative to what it would cost to replicate your choice elsewhere? If you already have elements of a choice implemented or capabilities built, then replicating that choice may be prohibitively more expensive. That has value.
Value Mindset Considerations
- Income vs. Market vs. Cost Method. Selecting the method for evaluating is probably one of the easier considerations of the Value Mindset. At a minimum, you should do an income based analysis and augment this with both a market and cost based method. This provides both an inside out and outside in estimation of value for your choices and helps to affirm or invalidate assumptions and known risks. Where asset appreciation is the primary driver of value then more market based methods should be deployed.
- Retained vs. Distributed. Determining if the returns need to be retained and reinvested or distributed is important to making a choice. If a choice is a multi-step function, the it is important to articulate the use and need of the benefits and when they may be able to be returned to shareholders – if at all. Knowing what your stakeholders expect regarding accumulation of value and how that value is deployed is essential – particularly, for complex choice cascades that are complex multi-step-functions.
- Consensus vs. Contrarianism. Determining if a choice is in alignment with the broader market sentiment or if it is contrarian is important. Justifying choices which are often not part of the standard or status quo are often viewed as “risky” despite the fact that they may be inherently less risky. Understanding the enterprise position and dynamics between consensus and dynamism is important before making choices. Knowing stakeholder expectations and your own personal style in this regard is also important to understand before self-selecting options.
- Diversification vs. Concentration. Understanding when to put your eggs all in one basket versus when to diversify choices is a critical consideration. Imagine if you invested all your time and resources into a major financial transformation and neglected to invest more broadly in choices that would drive innovation and other operational productivity benefits. Warren Buffett often says, “I put all my eggs in one basket, and watch the basket.” Most if any, don’t have the true autonomy to make those kind of large scale bets – and quite frankly it likely doesn’t make sense to do so.
- Short-termism vs. Long-termism. Evaluating the appropriate time horizon for realization of returns is really all dependent on the nature of the choices that you are evaluating. Again, certain long-lived assets require substantial investment periods before they accrete value and therefore your returns must reflect the deferred nature investment – account for all associated risks. It is important though to properly understand the true duration of a choice and not just the period analyzed. Often with technology, it is very easy to evaluate an investment over a very short life span, however, true technical capabilities do have lives that extend upwards and beyond 10 years.
- Market vs. Liquidity vs. Economic Catalysts. Understanding what if anything will make your choice valuable is important as part of the evaluation and assessment process. A market event like sizeable reduction or increase in the cost of steel may significantly affect your choice. Similarly, changes in your ability to transact, or buy / sell an asset may also affect your prospects. Additionally, things like monetary and economic policy could have sizeable impacts on your analysis if not properly assessed up front. A catalyst without real potential is just a risk.
- Singular vs. Cascades. Understanding which choices will drive economic benefit on their own and which require other choices to maximize value is important. It is very rare that a singular choice or decision ultimately results in the outcome. Additionally, be prepared to evaluate and re-evaluate along the way to ensure that as information is gathered learnings can be applied to refining the plan and the analysis. Complex choice cascades may require pivots in a different direction as they are validated and invalidated in the market.
In the next section, we will explore a few anecdotal examples to determine how the Value Mindset can be applied. Think of this as just the starting point. A juncture to ground yourself in how to think about choices and how they accrete value. Unlike value investing, the Value Mindset offers a framework to define the intercepts between complex, interrelated strategic choices, and the decisions that are required to deliver results.