Buyers must master art of the particular

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If stock-picking fails to beat the index, why should picking companies? It won’t, unless mergers carefully match the firms involved.

Many modern chief executives see themselves as meta fund-managers. They oversee a portfolio of businesses, just as an investment adviser oversees a portfolio of shares. The board of the modern corporation hopes to add value by judicious acquisitions and disposals, just as investment managers hope to add value through their effective judgement of companies, industries and markets.

In the markets, there are many investment professionals all trying to add value in this way.

Hence the efficient-market hypothesis. All publicly available information is already in the price. It is true that the demand for mobile phones is expanding faster than the market for tobacco, true that Vodafone can expect more rapid earnings growth than Imperial Tobacco. But everyone knows these things, which is why the price earnings ratio for Vodafone is seventy and for Imperial it is ten.

The only way you can add value through stock picking is either by having access to information which other people don’t have, or by interpreting public information more intelligently than others do. The first of these is often illegal and the second is difficult, especially since many others are investing resources to achieve the same result.

So most active fund managers fail to beat the market, once their fees and transactions costs are included. Their clients would be better off if they did nothing at all, which is why passive investment management and index-tracking funds have become so popular.

But if the market for company shares is efficient, then the market for companies themselves is also likely to be efficient. If you cannot make money on the stock exchange through such insights as ‘e-commerce will grow rapidly’ or ‘there is over- capacity in the steel industry’, why should you be able to make money this way in an effectively functioning market for corporate control? These supposed insights are already reflected in the share prices of these companies, and therefore also incorporated both in the values of the businesses you might buy and sell and in the volume of new investment in these activities.

This logic is broadly supported by the evidence.

Although there is some indication that fast growing markets are more profitable than declining ones, but the effect is not large. And even that result should be viewed with some scepticism. It is always profitable to be in a market that has turned out better than everyone expected, and unprofitable to be in one that is worse than everyone expected. Since we can only measure both growth and profitability after the event, the fast growing markets we see include markets that people did not expect to grow rapidly as well as those they did. It is not surprising that this category as a whole is a bit more profitable than the average.

While it is possible to make money in new sectors like e-business or biotechnology, it is also easy to lose it, as investors are suddenly remembering. Some of the safest, secure returns over the years have been made in dull old economy activities such as brewing and tobacco.

The corollary to the efficient-market hypothesis is what we might call the efficient-industry hypothesis. You cannot expect to make money out of buying and selling businesses, or planning new investments, if you do so on the basis of information that is widely known and arguments that are widely understood. Indeed it is harder to profit in this way in the market for corporate control than the stock exchange, because the transactions costs of buying companies are much higher than the transactions costs of buying shares.

It will hardly ever make sense to make investments or acquisitions on the basis of wholly general arguments – arguments such as ‘electronics is a growth business’, ‘China is an expanding market’. The general law of business economics, that opportunities available to everyone are usually profitable for no-one, holds good.

The first test of the case for changing a business portfolio is whether both the case and the portfolio are company-specific. The question for a company’s board is not whether an acquisition or disposal is a good or a bad business, but whether it is a good or a bad business for that company.

This observation is in itself enough to dismiss techniques like the BCG portfolio matrix, which classifies businesses as dogs, stars, cows or question marks. Everyone would identify the same business as a dog or a cow (or would if the method had objective validity) so the price of dogs and cows will reflect their relative values, just as it does in the livestock market.

Business choices should be based on an assessment of competitive and comparative advantage, not objective attractiveness. Competitive advantages in acquisitions and disposals are the result of distinctive capabilities, and the well constructed business portfolio for a company is the one that gives most scope to the company’s unique attributes and attaches assets and activities that are complementary to it. Your dog is my star, my cow is your question mark.

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