Giant Cheerio

"Oh my god. Brian, there's a message in my alphabits. It says 'oooooo'." ~ Peter
"Peter, those are Cheerios." ~ Brian, Family Guy

Miranda's team was in the General Mills competition and she mentioned an idea that was critisized as a "Giant Cheerio".

One of her team mates decided to carry the joke a little further. It was delicious.

It was by far the most clever and delicious thing I've ever seen anyone make out of anything ever.

Integrative Thinking Practium - Agent Based Modeling

At the beginning of the course I was a bit confused. At first I thought I didn't really understand what was happening. And then our class today started by describing a model of sand falling on a table. I was further confused as to how this was in any way related to business.

With a few changes in our frame of mind, "sand falling on a table" became a metaphor (or analogy?) for customer arrivals at a business. Pile height became analogous to company capacity constraints and pile location became geographic properties of companies.

Suddenly, we actually had a working model for the growth of an industry into equilibrium which encompassed such ideas as customer movement from one business to another. With a few more tweaks, the model was even able to show the decline of an industry (and death of underperforming companies).

I think my favourite part of this class was that it showed us in a very intuitive way how the models of our business work in more practical sense which are based in math, but don't require formulas.

I do apologize for my explanation as I don't feel it truly does justice to the class, but it encorporated topics we had learned in economics, operations management, managerial accounting, strategy I and II (Prof Ryall even made references to Anita McGahan's research).

Gravity as a Analogy to Globalization

Our professor just used one of the most clever analogies for international trade I've ever seen. It's surprising how much the physics of gravity can model relationships involving size and proximity.

The formula for the physics of gravity is:

Force = Gravitational Constant x Mass 1 x Mass 2 / Distance ^ 2

In this analogy:

• Force -> Strength of trade relationship
• Gravitational Constant -> Trade coefficient <-- trade barriers / regulations / tarrifs?
• Mass 1 -> Size (GDP as proxy?) of country 1
• Mass 2 -> Size (GDP as proxy?) of country 2
• Distance -> Distance

Our professor, Blum, took it a step further and did a logarithmic deconstructed the formula to further show how changing different values of each variable (pulling different strings) results in intuitive changes in the relationship. For example: Decreasing distance between countries increases. He even quotes his research (2004). This is his criticism of the idea that the world is truly "flat".

Imagine the game theory implications also. If you could use this relationship to predict how countries would trade and grow, you could build a model with multiple components (countries) to see how they'd develop.

So... It turns out that when Roger Martin tells us that Rotman has a world class research faculty which impacts the material we learn in our classes, he certainly wasn't lying.

Non-Leveraged Accretive Mezzanine Financing

I was looking over my CFA Level II materials for corporate finance this weekend when I looked at the CFA's definition of different types of risk. For instance:

Sales (Business / Industry risk)
- Operating Expenses (Operating Leverage)
- Interest Expense (Financial Leverage)
_____________
Cash flow

The definition of any type of leverage (operational or financial) is increasing your fixed cost component but reducing your variable component.

It got me thinking, is it possible to have an instrument which doesn't increase leverage and solvency ratios, but also provides accretion for common equity holders? For instance, if you want to deleverage, the general strategy is to purchase debt with equity (which results in dilution because cost of equity is higher than cost of debt due to risk concerns etc). I don't know if this is possible, but I asked myself about a preferred share with very particular characteristics.

Fixed income instruments (coupon paying bonds, dividend paying preferred shares) increase the fixed payments required which technically increase leverage.

Accretive
Is it possible to have a preferred share that, rather than paying a fixed predetermined dividend (similar to dividend yield based on price), that pays a percentage of net income (similar to a stated dividend payout ratio). Because it is more senior than common equity, the cost of this capital would be less than the cost of equity (accretive if used in a refinancing / capital restructuring).

No Leverage
But the payout would also be variable based on NI meaning that it isn't technically leverage according to the CFA definition (plus it would be classed as equity rather than debt on the books). If earnings are low, the payout is low. If the earnings are high, payout is high. It rises and falls as a variable component rather than a stated fixed component.

The problem with this model of an instrument is that I don't think you could get a "senior" level instrument to payout variable to net income with a cost of capital less than common equity because they technically face the same level of risk (percent of NI).

Also, because earnings can be manipulated, perhaps the payout would work if it was stated as a percentage of EBT or some other higher quality form of earnings? At first I thought EBITDA, but then I realized that doesn't make sense. It would have to be paidout after EBIT (because interest should be a more senior form of financing and paid first). However, EBT is often modeled with a fixed tax rate to go to NI (so a % of EBT is really a % of NI since tax rate is usually constant).

Perhaps it could be payed out as a % of EBITDA which is paid out after interest?

This would justify the instrument being more senior and paying a lower cost of capital.

Q3 Grades

Q3 grades came out today (just in time for the weekend). After this much "official academic" feedback, the world between expectations and reality are starting to collide for most so there were no major surprises.

Personally, my grades are about the same (only a 0.02 change in GPA) and I am happy to say that I did particularly well in the courses where I expect to have my future career.

As I said last quarter, my grades seem to be reaffirming the fact that I'm really enjoying what I'm doing, learning a lot and having a great time.

Why isn't my deal accretive?

I'm building an M&A model for two firms in the same industry and I noticed that the deal I was modeling wasn't accretive. However, the PE for the target was lower (marginally) than the PE of the acquirer and I was using a capitalization structure that was similar for both (both had about the same debt to equity ratios implying similar capital structures). Both also paid about the same interest rate on their debt.

According to simplification and a common interview question, as I mentioned before: buying a high return equity with a low return equity means you should get to "keep the difference". So in this case, when I modeled an acquirer with implied cost of equity lower than the target, I couldn't figure out why my model was telling me the deal was dilutive!

Turns out, I had forgotten about my asset write ups. What I had done was allocated 25% (not sure if this is a reasonable number - I don't have practical experience yet and I also don't have intimate / insider knowledge of the company being modeled) of my good will to writing up intangible assets. What does that mean?

Often a company develops intangible assets (brand value, patents). Companies are generally not allowed to record the value of their own internally developed intangible items on the books (because this would be a very subjective exercise). However, when companies are purchased, the value above book value is recorded as goodwill. Companies can further allocate portions of this good will (not sure the legal or accounting regulations, although I'm sure there are plenty) on the books as intangible assets and amortize them over time.

So what happened in my model? I merged two companies that had similar capital structures and costs of capital (with the target returning *slightly* more), but these synergies were being offset (at least temporarily in the short run) by the increase in D&A expense due to the write up of intangible assets resulting in an apparently dilutive deal.

Note, however, that for an owner with "foresight" (that is to say, not earnings focused), having a higher write up value increases the D&A expense which results in an increase in cash flow (from the tax shield of a non-cash expense) and also reduces debt and interest payments in the long term (model assumes a sweep with a portion of debt financed in a revolver). That is if you can stomach the low to negative earnings results in the short run. The deal would look more dilutive in the short run, but actually be much more accretive in the long run.

GBC Elections for Second Year

The GBC is currently holding elections for all it's Executive Positions. There are some very strong candidates running who are very motivated and excited for the next year.

Because I'll be gone for half the year on exchange, I don't qualify for running for any of the GBC positions nor many of the clubs positions (a sacrifice I knew I'd have to make and acknowledged in my exchange interview).

However, I will still be around and helping students out in my own little way, either if people want help with prepping for jobs or in classes (I'm considering being a Rotman Scholar perhaps). I know that our year has been doing very well both academically and in our career hunts and that is very much a function of the support we received, especially from second year students.

Already, I have a few friends I know are coming to Rotman next year and I hope that my year can be as useful to them as the second years were to us.

Operating Leverage

Anita McGahan once explained to us the nuances in a decomposition of the DuPont formula. Where:

ROE = ROA x FLA

In non-math terms: The profitability of a company is a function of it's operating strategy (ROA) and it's financial strategy (FLA).

We've been looking more at this topic (focusing on Operating Strategy) in Operations Management and were introduced to a very interesting idea: Operating Leverage.

Operating Leverage, put simply, is loading up fixed costs to reduce variable costs. Another way of looking at it is similar to capitalized leases versus operating leases. Like financial leverage, increasing operating leverage also increases risk, but increases potential reward.

While debt provides the lever in the financial leverage analogy (and interest expense provides the potential downside), in operating leverage the lever is fixed cost (and sunk cost is the potential downside).

If the volume of quantity demanded isn't equal to the break even amount, there is a significant loss. If the volume of quantity demanded is higher, there is a relatively amplified effect on the profit base through the cost side of the equation.

Excluding the effect of taxes, a basic formula for profit is:

Profit = Revenue - Costs
Profit = (P x Q) - (FC + VC x Q)
= Q (P - VC) - FC

Break even (BE) is when Profit = 0 so

FC = Q (P - VC), where P - VC is contribution margin, CM (profit per unit sold)

Therefore the break even quantity, Q, is defined as:
Q = FC / CM

Using financial leverage as an analogy, I would suggest that it is only truly increasing "operating margin" if the BEQ increases (risk increases). This would only happen if the percentage change in FC is greater than the percentage change in CM (very similar to elasticity).

I believe this would be analogous to a type of operating accretion? In finance, deals are accretive if the cost of capital of the source is cheaper than the cost of capital of the use (buying high return instruments with low return instruments) and is the foundation of financial leverage.

Also, because CM is defined as P - VC, there is an inherent leverage relationship as well as it relates to cost in the same way a commodities based company has a leveraged exposure to it's underlying commodity price. If CM is anchored on one end (P), a change in VC has an amplified effect.

Getting a Job in Asset Management

Previously, I was asked to write a post about getting a job in the Asset Management industry. While I myself am not that well versed on the buy side, I interviewed and got advice from other people who know more than I and were successful in getting interviews / offers. This is of course, beyond what is expected in any capital markets job, and this is what they had to say:

Application Materials

As always, you have to get your initial application materials in order with the hope of getting that first round interview. At the application stage, asset management companies have been known to ask for typical materials such as resume, cover letter and transcript as well as:

• Writing samples
• Sample stock pitches

Networking

As always networking is an important part of getting that first interview. Before you start networking, you should already be very polished, particularly on the topics of:

• Their fund strategy and your style / fit
• Know their holdings and weightings
• Diversification - know the focus of the fund

To get this information:

• Hedge funds tend to be proprietary and it will be more challenging to get info
• Mutual funds holdings are generally public

Either way, go go onto Capital IQ / Bloomberg and find out as much as possible. Read manager's letter about their performance and strategy. Know their best performing success stories as well as their dog holdings. Know where their exposures are and what strategies they are using.

If you impress them at the outset with a networking or informational interview, that improves your chances of getting that first round interview.

Interview

For the interview, they will probably ask you a few fit questions. I've been told buyside will not ask you too much technical stuff on valuation (i.e. walk me through a DCF) because these are expected. If your resume doesn't show some experience in capital markets, I'm told you have a much lower chance of being interviewed.

Have a view of the market and ensure congruency in your view. A great piece of advice was to really understand the "off balance sheet items". The reasoning for this is because these are the items that are more difficult to value and provide you a potential differentiation advantage. If you are able to better interpret this information, this is your potential competitive advantage in the market.

Also, the "stock pitch" component of this interview is generally more intense than in other finance jobs. I've heard it described as the interview was just "10 stock pitches". Having said that, while most finance interviews usually require 2 longs and a short, it's been suggested that you have a mix of 10 long and short positions, with a mix of long and short companies and industries. Also, you have to make sure that there is congruency in your view as well as your story.

For instance, one example from an interview was: "I see that you've recommended this stock because you think the industry is strong. If that is true, why not buy an ETF of that industry rather than cherry pick stocks? What if the one or two companies you buy in that industry turn out to be dogs?"

Asset management is much more than just "buying and selling stocks" as any portfolio manager will tell you. There are many aspects that portfolio managers are responsible for in funds including:

• Risk Management and protection or hedging strategies
• Investment style
• Investment objectives and goals
• Liquidity requirements

It is important to comprehensively understand and prepare as much as possible so that you can maximize your chances of getting a successful result in your interviews.

Business Design Competition - 3rd Place

I spent to better part of yesterday afternoon and this morning participating in the Business Design Competition. Our team was composed of myself, Yan, Mark, Justin and Xinxin. It was an interesting challenge. We were introduced to the business design process and given an open problem and carte blanche to find an appropriate solution.

We had a great team dynamic and every member contributed according to their strengths. At the end, I think we all learned something new, picked up more skills and experience which we can certainly apply to other aspects of our business careers.

The competition was judged by several industry professionals including a strong showing from Monitor Consulting.

After the first round presentation, when we discovered that we had made it to the second round, I think our group took the criticism of the judges very well. Even before our ranking was announced, I had told my team that I was exceptionally happy with the improvement we had made as a group in refining our presentation skills on the fly.

Investment Challenge - 3rd Place

Yesterday, we participated in the Investment Challenge hosted by the Rotman Asset Management Association. Shree, Petar, Natalia and myself presented to a panel of judges from industry who critiqued our fund's performance, benchmark, goals, execution etc. There were teams from the Rotman MBA as well as the Masters of Financial Economics (MFE) program.

We made it to the final round and placed 3rd overall. More importantly, I learned a lot while in this competition about the practical side of asset management beyond the academic theory. And it is certainly more than just "trading stocks".

It was absolutely a pleasure to work with our team members. Shree is particularly passionate about asset management and it shows when you speak to him about stocks and what is happening in the economy. I learned a lot from him in terms of the practical side of asset allocation, risk management, company analysis etc.

I've been mentioning this to several people, but I think it is absolutely critical to participate in competitions and activities. Rotman does a decent job of trying to mix up the groups and have as much interaction as possible between the incoming 265 students every year. There is your 1st semester section of 65 people and team of 5, 2nd semester section of 65 people and team of 5, your 24 hour strategy comp team of 5 or 6, your markstrat team of 5 or 6 etc.

One of the most valuable experiences in the MBA is take advantage of these opportunities to work with smart driven people on interesting challenges and topics they are passionate about. Also, the open bars don't hurt.

Managerial Accounting / Operations - Capacity Management

One interesting topic which has surfaced in our introductory classes of Managerial Accounting (this morning) and Operations (yesterday) is the idea of capacity management. This is a topic I've been very interested in for a variety of reasons, particularly focusing on the idea of stock-outs and capacity planning.

For example, the ideal scenario is to create *just enough* inventory to satisfy's the period's needs. Creating any more (assuming a perishable good) results in inflated costs related to waste and/or inventory carrying costs. Creating any less results in lost revenue related to stock-outs.

However, in real life, it is unrealistic to assume perfect inventory planning all the time, so chances are there will be some days with over stock and some days with stock-outs.

The basic formula for profit is: Profit = Revenue - Costs

and

Profit Margin = Marginal Revenue - Marginal Cost or Marginal Revenue - Variable Cost

We know that we will incur some sort of inefficiency or uncertainty cost in the form of over / under stocking as mentioned above. However, the idea is to minimize this "capacity cost" we have to understand how operations affect these costs. For example:

A bakery sells donuts for $1.00. Donuts cost 10c to make. Therefore, over-stocking results in a cost of 10c per donut due to wastage. However, stock-outs cost $1.00 per donut due to lost sales. Therefore there is a 10 to 1 cost per unit on either side of the ideal capacity target. Let's say on any given day, the average sales is approximately 1000 donuts.

To minimize the cost side of the profit equation, we have to look at the probability of capacity distributions above and below the target.

Let's make a HUGE assumption (for simplicity) and say that there is a uniform distribution about the target (not normal, but uniform). Let's say there is a 10% chance of the actual daily sales being:

1. 950
2. 960
3. 970
4. 980
5. 990
6. 1000
7. 1010
8. 1020
9. 1030
10. 1040

How many donuts should the bakery produce?

I would propose that you should overlay the capacity with the associated cost of capacity management. What do I mean? If you produced 1000 donuts and you only sold 950, you're capacity related costs would be amount of capacity variance x cost per unit of variance. Generally this would be expressed as:

Capacity Related Cost = Capacity Variance x Cost per unit of Variance

So in this case:

Capacity Related Cost = 1000-950 x (10c)

=$5.00

What about baking 1000 donuts and then selling all 1000, but having an additional 20 donut customers who go unserved? Then:

Capacity Related Cost = 1000-1020 x ($0.90)

= $20.00

Notice that for a smaller number of donuts not sold, there is a much larger effect on Capacity Related Costs. This is a reflection on the profit margin (profit from one lost sale = marginal revenue - variable cost). That is to say, it is much worse to not sell 1 donut rather than have 10 donuts go stale.

To optimize planning (create a capacity level which will optimize profits) it would make sense to minimize the Capacity Related Costs. Since we have the probabilities of the capacity distribution and the associated costs with under production, what target capacity creates the minimal expected capacity related cost? Below is a chart outlining the capacity related costs for given target and actual production levels.

You'll notice that the optimal production level is actually 1040 or 1030. This sort of makes sense as the costs for missed sales are so high. Generally, because of the structure of the model, there are two major factors affecting the end result for capacity planning:

• Volatility and variablity of demand
• Profit margin (difference between cost of wastage and cost of lost sales)

GBC Quarterly Chat

Today we had our GBC Q4 and last quarterly chat. The major topic of discussion was courses. I didn't realize this, but most MBA schools (like Rotman) have a bidding process for second year electives. 2nd year MBAs are given a maximum of 1000 points on which to allocate and bid for courses they want to take in their final year.


For those of us going on exchange, we lose half our points because we will be at other schools. International Study tours also count as a course as well.


I have a particularly interesting dilemma. Because I'm going on exchange at LBS and have done study two tours (Middle East and Latin America), I am now entering bidding with the least number of bid points possible: 300 out of a possible 1000.


Although I only have a few bid points (and only technically need to take three courses in the first semister), I'm thinking of "overloading" and taking a few extra courses in the first semister anyways (possibly bringing me back up to as many as 5 courses). After all, Rotman is a great school (and it also isn't cheap to come here).


Not to mention that I missed "Negotiations" to do the Middle East tour and again to do Latin America (Normally, 1st years would take the course in May if they missed it in Jan). Apparently, I'm told that I'll have to take Negotiations with the part-timers at the end of August before the start of school.

Global Management Perspective and the Start of Q4

Today we started Q4 with Global Management Perspective. It promises to be an interesting class. Prof. Blum was a guest speaker at our Latin America class (he's Brazilian) and gave us his perspective on the interesting developments in that part of the world, focusing on Brazil, Argentina and Chile.

I think Prof. Blum gave a very fair and balanced perspective of globalization. While most capitalists would tout the praises of globalization and competition, he gave what I think is a fair criticism of globalization along with his description of the underlying economics. The key take away summarized (in my humble opinion):

"Globalization will create more wealth, but does not guarantee that it will be
distributed evenly."

It is NOT a zero sum game - I noticed that this is especially prevalent anywhere "efficiency" is involved. Advocates of globalization will often quote "comparative advantage" as one of the primary benefits of globalization even negating the benefits of size. For instance:

Country A (a larger country) can create:

• Computers at a rate of 50 per year
• Bread at a rate of 100 per year
• or any linear combination of the two (Computers are worth 2 bread)

Country B can create:

• Computers at a rate of 10 per year
• Bread at a rate of 30 per year
• or any linear combination of the two (Computers are worth 3 bread)

Country B is much better at creating bread than computers, so using it's comparative advantage it should create bread and trade with Country A for the computers it needs. Even though Country A can "out-manufacture" Country B in any category because of it's size, Country B can more efficiently create certain goods which it can trade with Country A.

It is fairly undisputed that globalization utilizes comparative advantage to increase the total wealth of all countries involved. However, as was brought up by our professor, this does not account for distribution of wealth. Regulations and other mechanisms are needed to ensure income equity. His comment was that criticism on this line against the WTO and globalization in general was certainly valid, whereas criticsm citing globalization as not wealth creating was economically falacious.

It's like in our strategy class when we talked about "double marginalization" where in vertical integration, two companies (as seperate entities) will optimize their cost and pricing structure in order to maximize their individual profits. However, from a more macro view, there is the potential for companies to gain synergies by vertical integration and earn margins that are optimal from a more wholistic view (which makes the case for the acquisition of a supplier or distribution channel by a company).

Ian Schnoor - Financial Modeling 3, LBO's

Just arrived back from March Break and "warming up" to classes again in Ian Schnoor's third financial modeling module: LBO's. Before leaving for the break, he had come and done his second module: Valuations which talked about understanding the operations and finances of a company.

While module 1: Buiding a Financial Model, was a free lesson (I believe it's paid for by PACE at Rotman), Module's 2 and 3 cost $100 each, well worth the cost (again, I believe it's subsidized by PACE at Rotman).

The CFA charges quite a bit more if I'm not mistaken (but I'm lead to suspect that the CFA courses are also subsidized, though maybe not as much).

Having these financial modeling courses under your belt gives you a very good practical understanding of how to apply financial concepts learned in class beyond purely theoretical or academic textbook knowledge.