May

19

Wealth Creation by Bartley Madden provides a systematic way of looking at the performance of individual stocks. He believes that values are determined by 4 things. The return on past capital, the growth of assets, the rate of drift from innovation versus competiton, and the stock price itself. He gives examples of how to apply these measures to Apple, Bethlehem Steel, Digital Equipment, Eastman Kodak, IBM, Kmart, Nucor, Medtronic, Walgreen, Donaldson Company. He believes that lean management is one of the keys to success and contrasts Toyota with Bethlehem as examples of the best in lean versus the worst. In 1950, 7 of the top 10 highest paid executives in America worked for Bethlehem. The vice presidents had office windows in two directions. Union rules made them uncompetitive.

He applied these methods at a Hold affiliate which was bought by Credit Suisse. His methods are apparently widely used by many institutions as well as by Credit Suisse. All his ratios which he suggests be considered I n a feedback look must be tested. The Schumpeterian drift from competition is hard to measure. As is the return on future assets. However, the ideas make a lot of sense and provide a good template for analyzing a company.

He is a champion of free enterprise and the benefits that competition and innovation can bring to stockholders and consumers. There are interesting references to behavioral biases and shortcoming in the capital asset model. He recommends for example a visit to the San Francisco Museum of Science to see all the Ames exhibits on lapes in visual perception. I have followed his career for some 47 years when I first noticed him as a star at Berkeley.

Bartley Madden responds: 

As to discount rates, the key idea in the Wealth Creation book is on p.89 … "This systems mindset leads one to the conclusion that the assignment of a discount rate is dependent on the procedures used to forecast [firm's long-term] net cash receipts. This is particularly relevant to models incorporating standard ways of forecasting future fade rates based on company characteristics. In contrast, mainstream finance relies on CAPM-based calculation for the discount rate.. these discount rates are then parachuted into valuation models without regard to how users make net cash receipt forecasts.."

I am arguing that the same market-derived discount approach for bonds (yield-to-maturity) be applied to stocks. Hard part is to maintain a monitored database of forecasts of firms' future net cash receipts .. obviously easy for bonds since we know the anticipated net cash receipts (interest and principal). Long term future fade rates of economic returns (return on capital) and reinvestment rates can be assigned based on firms' observable characteristics. For example, all else equal high return companies with higher reinvestment rates fade (regress to cost of capital) faster than low growth firms.

All of this is easy for bonds and we see that all else equal, higher (lower) credit rating (based on observable characteristics) leads to lower (higher) discount rates. For stocks, high debt loads and lower liquidity tend to result in higher demanded discount rates. This approach is rarely attempted in the academic literature because it requires enormous effort to build a database suitable for this type research.

Bart Madden 


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