A cheetah hunts for food . For a cheetah mother , a type I error can lead to the death of her offspring . The fact the species has been successful for eons demonstrates that cheetahs , as a species , have not committed too many type I errors . A type II error for a cheetah would mean not chasing prey it should have . This would leave the cheetah and maybe even her babies hungry , but they would all live to see another day .
data that amply demonstrates the incompetence of incumbent management , are willing to bet their clients ’ money on the hope that this same management will suddenly morph into industry beaters in the near future . More often than not , the dream scenario hyped up by the management morphs into a nightmare .
Avoid Debt
Corporate finance theory has a thing for leverage . For those who are not familiar with it , finance academics claim that companies need to have an “ optimal ” level of leverage to improve returns . If a company can borrow money to purchase assets , its return on equity and earnings per share would improve . Mathematically , this is undoubtedly true . Realistically , this is undoubtedly dangerous .
What could be more important than improving short-term return on equity and earnings per share for a business ?
Two things . First , survival . There is no point in improving return on equity by a few percentage points if it compromises long-term survival . The COVID-19 crisis demonstrated clearly that the companies caught with their pants down were the ones with substantial leverage .
The second reason to avoid leverage is this : debt diminishes strategic flexibility and , hence , long-term value creation . For a day-trader or even an investor whose holding period ranges from 3-5 years , a reasonable level of leverage may not matter . But for a permanent owner , any constraint that does not allow a business to take calculated strategic bets is undesirable .
The notion of “ optimal ” capital structure that requires companies to have leverage and is espoused by corporate finance theorists is not just wrong , but dangerous . A strong balance sheet is not the one that maximizes debt to minimize the cost of capital , but the one that minimizes debt to maximize the safety of capital .
Ignore M & A Junkies
Nothing happens in well-oiled businesses on a day-to-day basis . Sorry , a lot happens , but it ’ s largely mundane , repetitive , uninteresting , dull , monotonous . What would be the best way for such a business — or any business for that matter — to get reported in the Wall Street Journal or the Financial Times ? M & A . In industry parlance , “ mergers and acquisitions .” For some reason , the media loves the news of one business merging with or acquiring another one . The investment bankers and financiers who make fat fees love them even more . The CEO is also typically then invited to a CNBC interview where they will extol the virtues of “ strategic fit ,” “ synergies ” and other boiler-plate platitudes uttered in every single M & A . They are almost always wrong . Most mergers and acquisitions fail .
There is a lot of literature available on the high failure rate of M & As . A study by Great Prairie Group cites studies from
14 FINANCIAL HISTORY | Spring 2023 | www . MoAF . org