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Financial statements help tell the story


Last week I wrote a piece on Warren Buffett’s decision to invest in H.J. Heinz.

Over the years, Buffett has been given many names, including the Oracle of Omaha. The word oracle has many meanings, including a prophecy usually revealed through allegory or story.

Of course, as I pointed out in the last column, Buffett’s success is based on buying investments in good companies. The story that he depends on is the story that the company’s financial statements tell him.

In the world of finance we attempt to predict the future through the lens of what is referred to as “efficient markets hypothesis.” It’s a theory that has both proponents and opponents, but essentially states that if all investors have the same information about an investment, no one person should be able to make a higher return than the average.

What efficient markets hypothesis does not do as a theory is help us to project the future in a efficient manner, and thus predict winners and losers.

Think of recent history in Alberta. No one really saw oil at $140 a barrel, and both its positive and negative impacts on the Alberta economy.

Efficient markets hypothesis did not force us to, in the words of author Jim Harris, “think the unthinkable.” It only allows us to project the future based on the past.

For sure Steve Jobs did not use the past in designing the iPad. He created the future by thinking beyond the past to the “unthinkable.” In essence, he solved the problem to an unfulfilled demand in the marketplace.

Jobs began by understanding that you cannot solve a problem with the same thinking that got you into the problem.

Everyone in the personal computer industry was focused on meeting a clearly defined need — the personal computer. Jobs, on the other hand, focused on defining needs by thinking the unthinkable: What if people had access to a “smaller” device that met both a social and a business need?

Similarly, Lee Iacocca’s team at Chrysler solved the problem of how to get a bunch of kids to soccer, gymnastics and hockey by starting fresh and not extrapolating from the past. For their industry, at that time, they thought the unthinkable: What if we took the features of a small truck, and applied them to solving the modern family’s transportation needs?

Other companies have not taken this approach, and failed. Kodak is a recent example.

Senior management thought that they understood their market — producing film and developing it. For them, the “Kodak moment” was a physical product. It was unthinkable that the Kodak moment could ever be shared instantly with digital cameras or even cellphones.

So what does this mean to us as investors and business people?

First, we need to think about the future in ways that break from the past, because our normal human tendency is to default to old assumptions.

Second, we need to ensure that management in the companies that we invest in do not assume that their Kodak moment will always hold true.

Financial history is replete with examples that teach us to not assume that past performance guarantees future returns.

If you are interest in hearing more about these ideas, the Donald School of Business is hosting its inaugural Distinguished Speakers Series with author and strategic management thinker Jim Harris on March 5. For information go to www.rdc.ab.ca/future_students/DSB/Pages/dsb_speaker_series.aspx.

Easy Money is written by Patrick O’Meara, an instructor at Red Deer College’s Donald School of Business. He can be contacted at Patrick.O’Meara@rdc.ab.ca.

 
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