“…has much to say that is sensible and profound.” (Financial Times, 27th May 2004)
The Value Mindset: Returning to the First Principles of Capitalist Enterpriseby Erik Stern
A groundbreaking book on building long-term wealth for stakeholders
As creator of the Wealth Added Index (WAI), Stern Stewart's Erik Stern has become a beacon for creating shareholder value within the current storm of corporate malfeasance and poor performance. The Value Mindset shows readers how to develop this way of thinking by blending individual manager… See more details below
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A groundbreaking book on building long-term wealth for stakeholders
As creator of the Wealth Added Index (WAI), Stern Stewart's Erik Stern has become a beacon for creating shareholder value within the current storm of corporate malfeasance and poor performance. The Value Mindset shows readers how to develop this way of thinking by blending individual manager incentives with the proper corporate structure and the willingness to pursue value discipline over the long term. Filled with practical concepts that have proved themselves in the real world, this book shows readers how they can transform a company into an organization that can deliver value and returns to its shareholders. The Value Mindset helps readers develop this mindset-as well as implement it-by detailing the metrics that are necessary for any manager to measure and monitor value creation within the firm.
Erik Stern (London, UK) is a Senior Vice President at Stern Stewart&Co., based in London. He has designed and implemented programs for companies in several industries in the United States and Europe. Mike Hutchinson (London, UK) is a Vice President at Stern Stewart&Co., based in London. He worked previously for the BBC and the Consumers' Association.
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The Value MindsetReturning to the First Principles of Capitalist Enterprise
By Erik Stern Mike Hutchinson
John Wiley & SonsISBN: 0-471-65029-3
Chapter OneA REVOLUTION IN VALUE
Revolution is a much-abused word. Its accepted meaning is "complete change." In fact, a revolution is, as the word suggests, a return to the original. There is a world of difference between a revolt and a revolution.
The value mindset is a revolutionary concept, in that it returns to the very roots of capitalism: the concept of investing resources in order to generate a return based on the risk taken. Jesus Christ's Parable of the Talents takes the idea back two millennia. Likewise, the value mindset was not alien to the original capitalists who despatched galleons to the Spice Islands or raised satanic mills on England's green and pleasant land. These capitalists managed directly for value. The money risked was theirs, and the rewards that flowed from taking that risk-after sharing the booty with surviving sailors or paying the mill workers-came directly to them.
Fast forward to the present. What do we see? Like government, companies grow big, diversify, cross subsidize, bloat, and stagnate. As with government, goal seeking and politics compromise the quest for value. Creating value is in practice a "take it or leave it" option-either you create value, or you do not. There is no half way. And yet shareholder value has become a mantra, much repeated.When challenged, every chief executive will claim value lies at the heart of everything he or she does and close to the heart of every manager in the enterprise. The finance director will provide reams of numbers in support of this laudable assertion, showing how the company has met or exceeded last quarter's or last year's self-imposed targets. Discussion over. Is it any wonder that each feels obligated to goal seek outcomes and massage the numbers? As legendary investor Warren Buffett put it, those who make the numbers are eventually tempted to make up the numbers. Goal seeking in soccer is straightforward; goal seeking in business is not.
Two value champions of recent years illustrate the kind of mindset that focuses fully and completely on value. They are the prophets of our revolution. The first is Isadore Sharp of the Four Seasons hotel chain, who has taken steps toward the kind of specialization we would expect of a company that reconfigures in the way we shall explore in more detail later. The second is Roberto Goizueta, the late chief executive of Coca-Cola.
Isadore Sharp is probably the doyen of the world of service. Trained as an architect, he emigrated from Israel to Canada, where he built motels throughout the 1950s. In 1961, he opened the first of his Four Seasons hotels in downtown Toronto; a second opened its doors in London in 1970. Four Seasons Hotels and Resorts now operates 57 properties in 26 countries. Even during the dark days following September 11, 2001, Four Seasons remained profitable. In many ways, it is an exemplar of good business practice.
Its secret? Four Seasons is the only company in the world to focus exclusively on midsize luxury hotels and resorts of exceptional quality. As what purports to be the world's premier luxury hospitality company, Four Seasons instills in its employees an ethic of personal service that is second to none. And yet it owns few hotels.
Indeed, if Four Seasons had its way, it would not be burdened with ownership of hotels at all. For sure, it manages and owns hotels, but it clearly wishes it were otherwise:
It is Four Seasons' objective to maximize the percentage of its operating earnings from the management operations segment, and generally to make investments in the ownership of hotels, resorts and Residence Clubs only where required to secure additional management opportunities or to improve the management agreements for existing properties.
In other words, here is a hotel chain that would rather not own hotels. What is going on? All is explained a little later in the company's key document for 2002:
Four Seasons is principally a management company. Under its management agreements, Four Seasons generally supervises all aspects of the day-to-day operations of its hotels and resorts on behalf of the owners, including sales and marketing, reservations, accounting, purchasing, budgeting and the hiring, training and supervising of staff.
In addition, at the corporate level, Four Seasons may provide strategic management services, including developing and implementing sales and marketing strategies, operating a central reservations system, recommending information technology systems, and developing database applications. It assists, where required, with sourcing financing for and developing new hotels and resorts. It advises on the design or construction of new or renovated hotels and resorts, helps with refurbishment, and purchases goods centrally.
And yet, to stress the point, it owns few hotels. Indeed, it would own no hotels if it had its way. Where, then, does the money come from? For providing a range of management services, Four Seasons generally receives a variety of fees and levies a range of charges, including a base fee, an incentive fee, a sales and marketing charge, a reservation charge, and purchasing and preopening fees. The base fee is calculated as a percentage of the gross revenues of each hotel and resort that it manages. The incentive fee, which Four Seasons is entitled to collect from the majority of the properties it manages, is calculated based on the operating performance of the hotel or resort.
Four Seasons' fee revenues fell by $12.8 million Canadian dollars (C$), from C$160.7 million in 2001 to C$147.9 million in 2002-a decline of 8 percent. But in the first full year after September 11, 2001, given the worldwide slowdown in business and leisure travel that resulted, such figures are hardly shameful, contributing as they did to net earnings of C$21.2 million in 2002. Four Seasons' Wealth Added-a more complete measure of value that we shall explore in more detail later-in the 15 years to the end of 2000 was some C$1.8 billion. The company's focus on managing hotels, at the expense of owning them, is highlighted by the results from each activity. Management fees yielded C$82 million in revenues in 2002-down C$13.3 million, or 13.9 percent, from 2001. But over the same period, losses from ownership rose by C$9.4 million to C$19.6 million. Four Seasons clearly knows where its competitive advantage lies, and it is not in owning or managing a real estate portfolio.
Why is this important? Because the focus of Four Seasons on what it does best-service-in an industry where we might reasonably expect it also to own and control property, provides one of the starting points for our exploration of strategic reconfiguration. Instead of owning hotels and managing them, Four Seasons has measured up its core competencies and stepped back from the standard paradigm. This holds a lesson for all companies, and indeed for all industries, a lesson that is not confined to a split between service provision and property management. The implications spread much wider and involve the "creative destruction" envisaged by the great Austrian economist Joseph A. Schumpeter across a range of industries-indeed, on the grandest of scales.
Before we leave Four Seasons, the company holds one further lesson that will be useful in the journey to come. As we noted, for its management services, Four Seasons receives a range of fees and levies a number of charges. Of most interest to us at this point is the incentive fee. The base fee is contractual, like the basic wages earned by an individual. What provides the spur to excellence is the incentive fee. Incentive fees were earned from 32 of the company's 57 hotels and resorts and from one of the two residence clubs managed by the corporation in 2002, compared with 35 of its 53 hotels and resorts and both residence clubs in 2001. That clearly reflects how the travel and hospitality trades suffered over this period. What is important is not the figures themselves but their nature as incentives. Key to our theme is the use of incentives to encourage the creation of value-which brings us to Coca-Cola, at least under our second value champion, Roberto Goizueta.
The world is full of businesses that vow to become Number One, but Coca-Cola is Number One, or at least was when Coca-Cola's then chief executive and chairman, Roberto Goizueta, made that claim. The previous year, 1996, Coke had topped the Stern Stewart/Fortune value ranking, beating General Electric and Microsoft to top place with value creation of $2.6 billion. And the achievement was very largely Goizueta's. He took Coke's market value from a mere $4.3 billion in 1981, when the company appointed him chief executive, to $180 billion in 1997. In that same year, just months after making his Number One claim, he became a victim of lung cancer.
Goizueta, the son of a wealthy Cuban sugar magnate, became an impoverished immigrant when he fled to the United States following Castro's rise to power in 1959. Between them, he and his wife had $40 and 100 shares in Coca-Cola. Earlier, having graduated with a degree in chemical engineering, the young independent-minded Goizueta had answered a newspaper ad and landed a job as an entry-level chemist with Coca-Cola. He joined on July 4, 1954, and the company offered him a job in its new Miami office in October 1960. He stayed with the company for the rest of his life.
When Goizueta became chairman and chief executive of Coke on March 1, 1981, he reportedly knew the cost of every cent of capital Coke had invested anywhere in the world-in other words, the rate of return investors could expect for investing in a basket of companies of similar risk. Therein lay his secret. As journalist John Huey put it, recalling his first meeting with Goizueta:
Basically, he said, the company now had a strategy that would focus entirely on increasing long-term share-owner value (he hated the word "shareholder" because he said it wasn't precise enough). He planned to reduce the percentage of earnings paid out in dividends from almost 60 percent to around 35 percent, he explained, and for the first time Coke would take on debt. This would free the company to explore new opportunities and-very important-lower its cost of capital. He would divest businesses that weren't likely to pay off for shareholders, and there would be no sacred cows. Performance would be rewarded; perfect attendance would not. It was the only time a CEO ever explained to me a strategy so simple that it seemed almost naïve, and I, along with everyone else outside the company, was sceptical.
At the time, Huey pointed out, Coke was in disarray. It had lost significant momentum to hard-charging Pepsi and had yielded only a 1 percent compound annual return to shareholders for an entire decade. Its culture was one of entitlement and arrogance. It was locked in a paralyzing war with its own bottlers. And to compound its problems, the company had no communication with Wall Street and unusually hostile relations with the business press.
The key to Goizueta's success was what was to become gospel to almost everyone who worked at Coca-Cola-that the name of the game was creating wealth for what Goizueta himself called share-owners. The key to that was efficient allocation of capital. As Goizueta warned his managers, "Don't even come to us with a project that doesn't yield more money than the cost of money.... You'll get no hearing, much less a 'No.'"
Goizueta's maternal grandfather Marcelo Cantera, a significant influence on his life, had been a great believer in cash flow. Earnings was a manmade convention, as the saying went, but cash was cash. The larger a company was, the less it understood cash flow. The smaller the business, the better it understood cash flow.
That insight is something to which we will return. Meanwhile, how did Goizueta put into practice Coca-Cola's publicly stated mission-to create value over time for the owners of the business? Goizueta recognized that Coca-Cola was essentially two things: (1) the flavored drink developed a century earlier by Atlanta pharmacist John Styth Pemberton, and (2) its image, which was to be transformed into the world's most powerful brand. He concentrated on these, single-mindedly. A previous acquisition of Columbia Pictures was reversed, bringing a cash windfall. Shares were bought back at what turned out to be bargain prices, in a classic move approved by Warren Buffett, who joined Coke's board. Incentive pay was linked to value creation, making millionaires of even lower-level managers. And, in the name of creating value, the highest debt rating-AAA-was abandoned.
All of these activities will become familiar by the time we complete our examination of strategic configuration for value. But perhaps the most interesting of Goizueta's actions was effectively to relinquish ownership and control of Coca-Cola's bottlers. Once you place assets on the balance sheet, as you should do to reveal their value potential, he reasoned, the onus is on them to earn their full return on capital. Viewed through this lens, many companies peripheral to Coke's core business, such as bottling, destroyed value. Goizueta's argument was that Coca-Cola should not be in bottling. Would it, for instance, bottle its competitors' products? No. The company divested its capital-intensive bottling assets, taking enough in the way of a stake to be able to influence activities, without having to burden its balance sheet. That way, Coke was able to control its bottling needs without tying up as much capital. Table 1.1 compares Coke's and Pepsi's capital employed in the last three years of Goizueta's stewardship and demonstrates the company's zeal.
It may not be irrelevant that, at university, Goizueta majored in chemical engineering. His stringent control of capital has a quality of small-scale, detailed focus to it. Neither is it irrelevant that he took the oath of allegiance to the U.S. flag after fleeing Cuba. He had the same straight-up-and-down loyalty to his shareholders throughout his career at the helm of Coca-Cola, an alignment with his owners' thinking that was perhaps fostered by growing up in a family business.
We work for our share-owners. That is literally what they have put us in business to do. That may sound simplistic. But I believe that just as oftentimes the government tries to expand its role beyond the purpose for which it was created, we see companies that have forgotten the reason they exist-to reward their owners with an appropriate return on their investment....
They may, in the name of loyalty, prevent change from taking place, or they may assume their business must be all things to all stakeholders. In the process, these companies totally miss their primary calling, which is to stick to the business of creating value.
Excerpted from The Value Mindset by Erik Stern Mike Hutchinson Excerpted by permission.
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Meet the Author
ERIK STERN is managing director of European operations and a senior vice president at Stern Stewart & Co., based in London. He has designed and implemented EVA® programs for companies in industries throughout the United States and Europe. Erik coauthored the EVAluation report on cascading EVA to shop-floor employees, The Capitalist Manifesto, and has written for a range of publications, including the Financial Times and Sunday Times in the UK, Berlingske Tidende in Denmark, El Mundo in Spain, and The Marker in Israel. Erik has appeared on TV, including Sky Business News and Bloomberg. He has an MBA from the University of Chicago and a BA from Brown University.
MIKE HUTCHINSON is a professional writer who worked previously as vice president, marketing, for Stern Stewart & Co. in Europe, as well as for the BBC and Consumers’ Association. He has written for a range of publications throughout Europe and the UK, including the Financial Times, Sunday Times, and the Mirror, and has appeared on TV. He has an MA from Trinity College, Cambridge.
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