I have just completed the CFA Level 1 exam (and I promise to stop talking about it just as soon as I find out that I pass).
One of the take away lessons from the CFA curriculum is that the conventional method of valuing an investment is to determine the present value of expected future cashflows. One way of doing this would be to use the constant growth dividend discount model, which estimates the value of a stock by assuming that dividends grow at a constant rate … forever. If the present value of expected cash inflows exceeds the cost of the investment, then we should invest.
I hope this model of investment valuation concerns you. It certainly concerns me. It basically tells us that we should make an investment decision based on the most likely expected future.
If we are happy to agree that (1) it is not possible to predict the future and (2) past performance does not guarantee future performance, then this colour by numbers method of investment valuation leaves much to be desired.
The businesses that will prosper in the Global Financial Crisis are the ones that have flexible business plans. These are the businesses that looked into the future and saw uncertainty. These businesses understood that the state of the world in ten or even one years time is not only uncertain, but unknowable, and planned accordingly.
One company that comes to mind is Microsoft, which has a cash stockpile of some US$25 billion. In the past, Microsoft has received considerable criticism for failing to either invest its vast cash reserves, or distribute them to shareholders. Microsoft’s “conservative” approach now puts it in a strong position to acquire competitors who “strategically invested” their cash reserves in more prosperous times.
To quote the McKinsey Quarterly:
Corporate leaders might consider [using] robust business models incorporating some slack and flexibility instead of the models most common today, which aim to optimise value in the most likely future scenario and thus leave companies exposed when conditions change dramatically.
An exam day overview
I did the CFA Level 1 Exam yesterday. If you haven’t heard of the CFA Exam before, see the article “CFA Exam – What is it? Why do it? How to prepare.”
It is definitely one of the most exhausting tests I have undertaken, a gruelling six hour 240 question multiple choice exam. The CFA Institute recommends 250 hours of study for the test, and I only managed to notch up about 120 hours at best. Needless to say, I found it to be quite a tough exam.
If the pass mark for the exam were a simple 50%, I would be confident about passing. Each multiple choice question had three possible answers, so the expected result from blind guessing is a healthy 33%. A bit of common sense, some clever educated guessing, and my background in economics and econometrics would probably be enough to push me above the 50% mark.
Unfortunately, the pass mark for the exam is somewhere around 70%. So, success is by no means assured.
The examination supervisors are called “proctors” and, as I sat down in the exam hall, the head proctor’s voice boomed over the audio system, “All electronic devices, including mobile phones, must be switched off and surrendered. We have systems in place to detect the use of any electronic device within the examination hall. If a mobile phone is discovered in your possession during the timed portion of the examination, it will be confiscated and a written report will be submitted to the CFA Institute”. Wow, the power had really gone to his head. We were under the control of a 60-something year old power hungry proctor.
As it turned out, the Salvation Army were holding their National Congress right next to the examination hall . Trumpets, trumbones, drumming, and a chorus of voices filled the exam hall for the entire first half of the exam. Did God not know I was trying to concentrate? I can only hope that this highly inopportune spiritual distraction was a positive omen.
Thirty minutes into the test, the choir continued to sing, and I read my first economics question: “If the supply of money decreases which of the following is least likely to result in an increase to …” Decrease, least likely, increase … sorry?
Some kind of miracle may be required.
When posed with a business problem, there is always a temptation to accept the first solution that adequately addresses the problem.
However, the “adequate” solution is usually not the only solution, and often not the best one.
Adopting the first solution that “works” may get us from A to B and, once we have a solution, there is a temptation to stop searching. However, this is just the time to ask more questions:
- Is there a faster way?
- Is there a cheaper option?
- Can we make the journey more comfortable?
- Could we include some entertainment?
- Why are we going from A to B? Would it not be better to go from A to C?
If we are happy not to look for alternatives this means that we are happy not to think.
If we want to make progress, it is important that we continue to think, ask questions and look for alternatives. To quote an old Jewish saying:
If there are two ways of doing something, you should always take the third.
Given my lack of time lately, I thought that writing a short post on worker productivity would be amusingly appropriate. I am working 10/11 hour days, studying for the CFA, and writing this blog, among other things. Fun times!
I recently stumbled across an idea called the “Hawthorne Effect”, which I thought it would be interesting to share.
1. The Hawthorne Experiments (1924-1933)
The Hawthorne Effect is named after one of the most famous series of experiments in industrial history.
In the 1920′s and early 1930′s Elton Mayo, a professor of Industrial Management at Harvard Business School, led a series of experiments at Western Electric’s factory at Hawthorne, Chicago (the “Hawthorne Experiments“).
The original purpose of the Hawthorne Experiments was to study the effect of physical working conditions on productivity.
Initially interested in the effect of lighting levels on worker productivity, the researchers improved the lighting in the work area for one group of workers (the “Experimental Group”) and kept the lighting levels unchanged for another group of workers. Interestingly, the researchers found that the productivity of workers in the Experimental Group increased significantly.
The Experimental Group’s working conditions were then changed in other ways (e.g. working hours, rest breaks) and, each time a change was made, the Experimental Group’s productivity improved.
Most interestingly, the Experimental Group’s productivity even improved when the lighting was dimmed to its original level.
By the time the Hawthorne Experiments were completed, and the working conditions for the Experimental Group were returned to normal, productivity was at record highs.
Obviously, the improvements in productivity could not be explained by the changes made to working conditions. So, what caused the productivity improvements?
The researchers concluded that the improvements in productivity resulted from the simple fact that the workers felt that they were being attended to and that someone was taking an active interest in their workplace.
Although, subsequent analysis has placed some doubt on these conclusions.
2. The Hawthorne Effect
The Hawthorne Effect is the idea that people will alter their behavior in response to being observed. In psychology this phenomenon is referred to as reactivity.
The Hawthorne Effect indicates that productivity in the workplace is reactive and social. The productivity and performance of an employee is influenced in a meaningful way by attention received from management.
Jeffrey Sonnenfeld notes that the Hawthorne Experiments brought to light ideas concerning motivational influences, job satisfaction, resistance to change, group norms, worker participation, and effective leadership. All ground breaking concepts in the 1930′s. (A New Vision, Essay by Professors Michel Anteby and Rakesh Khurana)
1. The golden ratio
The golden ratio is believed to have aesthetically pleasing properties. The golden ratio is a naturally occurring number that has been the subject of interest since ancient Greek times, and has been used in architecture, art, books and music since at least the time of the Renaissance. For example, artists have used the golden rectangle to select the most aesthetically appealing canvas dimensions.
If the golden rectangle is aesthetically pleasing, then it makes sense to use the golden rectangle when preparing images to be inserted in presentations, proposals, reports, blog posts, etc. The image above has the dimensions of a golden rectangle and, more interestingly, the shape of the spiral above the street lamp is a golden spiral.
Denoted by the Greek letter phi, Φ, the golden ratio is an irrational number equal to:
2. The golden rectangle
The golden rectangle is the name given to any rectangle for which the ratio of the longer side ‘a’ to the shorter side ‘b’ is the golden ratio.
Interestingly, if the two sides of a rectangle are in the golden ratio then the ratio between the sum of the two sides and the larger side is the same as the ratio between the larger side and the smaller side.
