From Quarterdeck to Forecastle: Welcome to the Class of 2016

[This afternoon, I welcomed the Darden Class of 2016 to the school. What follows are approximately my remarks.]

On vacation some years ago, I signed on as a crew member of a tall ship in the North Sea. This was a reproduction of an 18th Century frigate: three masts, a great deal of rigging, and cramped quarters. We stood watch, four hours on and four hours off, so it was impossible to get a good night’s sleep. When the wind changed, everyone was put to work hoisting sails or stowing them—this had to be done, in good weather and bad. I’m not wild about heights, especially when on a rope ladder high above a rolling ship. The food, prepared by a cook, was mediocre at best. By the end of the week I was exhausted.

When I returned from vacation, I told a friend that I had had a great experience. He shook his head in disbelief and said, “What was great about it? You’re a leader at Darden but you spent the whole week as an unpaid laborer who had to take orders from the captain. Lots of shouting; do this and do that. There was no rest and relaxation. What were you thinking?” My reply to him contains some ideas that are relevant as you embark on your own journey at Darden.

I should say that my reflections on that experience have continued over time. Ann Landers, the advice columnist, famously said that in school you get the lesson first and then the test; but in life, you get the test first and then the lesson. That sailing experience was a real test. And the learnings have followed.

In Herman Melville’s novel, Moby-Dick, the main character explains why he wants to go to sea as an ordinary sailor. The year is maybe 1850 and the voyage is to be on a whaler. It is hard and dangerous work. Why would someone do this? The lead character explains,

I always go to sea as a sailor, because of the wholesome exercise and pure air of the fore-castle deck. …for the most part the Commodore on the quarter-deck gets his atmosphere at second hand from the sailors on the forecastle. He thinks he breathes it first; but not so. In much the same way do the commonalty lead their leaders in many other things, at the same time that the leaders little suspect it.

Think about it. Melville is saying that the folks away from the seat of power know something more than do the leaders. To go down from the important place you are used to, to a place at the front of the ship teaches you things that you can’t get on the quarterdeck.

The post on the frigate that I liked best was standing watch at the bowsprit, the forward-most point of the ship. You are there all alone looking forward through the fog, trying to understand what you are sailing into and then communicating it in a way that the people back on the quarterdeck can understand. You are the first person to get a glimpse of the future. This is a view that can’t be had elsewhere on the boat. And the experience is magical. The playwright, Eugene O’Neill, wrote,

I lay on the bowsprit, with the water foaming into spume under me, the masts with every sail white in the moonlight towering above me. I became drunk with the beauty and singing rhythm of it, and for a moment lost myself. Actually lost my life. I was set free—dissolved in the sea, became white sails and flying spray, became beauty and rhythm and the high dim-starred sky—I belonged within a unity and joy to life itself.”

To feel “lost,” “drunk,” and “dissolved in the sea” is akin to what many artists, athletes, and leaders have described as the sense of flow: fully immersed, energized, and feeling intense joy of being at the head of their field, the top of their game, at the point of the bowsprit. It’s easy to see why flow might happen at the bowsprit: it’s where one is looking out to the wider world, looking ahead, and indeed, looking inside oneself. At that kind of moment, you are fully invested in what you do.

Metaphorically, the bowsprit and forecastle represent the frontier of your field or your enterprise. It’s the place where one learns the most. Today, so much of what we value about business and capitalism—such as invention, efficiency, effectiveness, adaptability—depends on how organizations and people learn. Melville challenges us that the best learning may not be on the quarterdeck (at the back of a ship), but rather on the forecastle (toward the front).

The big idea here is that from time to time in one’s life, one must step down from the quarterdeck in order to take risks, get out in front, learn, and grow as a leader. The quarterdeck can be its own little world, freighted with tradition, security, and old assumptions about how the world works. From the back of the ship, it is certainly more difficult to look out ahead.

I’m telling you this because you-all are like me on the frigate: most of you have left interesting and comfortable circumstances to get out to the frontier of ideas and learning. You’ve been here one week and are probably wondering what you’ve gotten yourselves into.

This is the right time in your lives to be here. Many graduates have volunteered that Darden was a transformational experience; it changed their lives for the better. I believe you will say the same.

So, to conclude the story, what I replied to my astonished friend went something like this: “It was a great experience because of what I learned about myself and others; I grew in confidence. And I gained an incredible new perspective on teamwork and nature that couldn’t be obtained any other way. I learned that followers can lead the leaders. When you lose yourself in a worthy challenge, you can actually find yourself. And I found that the forecastle can be a better place than the quarterdeck. I had to live the experience to learn those insights.”

My experience on the frigate suggests the frame of mind you will need so that 21 months from now, you can say that Darden was a “great experience.”

· Trust the process. Trust that the questioning by the professors is leading you somewhere. They want to help. And you came to study with the world’s best teachers. So, form a relationship with them that feeds your development. Don’t look for grandiose speeches, easy answers, or compliments; look for wise and candid feedback. Accept and admire professors who demand your very best.

· Be present. I saw a sign once at a Las Vegas casino. It was hanging over the roulette table and said, “You must be present to win.” This meant that you could not place your bets and then leave the table to get a drink or see a friend, and return later to pick up your winnings. You had to be present when the winnings were declared, in order to get them. So it is at Darden. You must be present to win. “Being present” means being mindful: self-aware of your state of mind and your impact on others. And it means being socially aware of what’s going on around you. You can’t “zone out” and get the rich transformational experience that Darden offers. Mindfulness is one of the top attributes of high-performing leaders. So this is good practice for your future. When I describe Darden as a “high touch” community, I’m referring to a community where students, faculty, and staff are present and engaged actively in the learning process. “Being present” also means engaging others who may be very different from yourself—a different race, nationality, sexual orientation, or gender for instance. Make a serious effort to see the world through their eyes. Befriend those people. Share the Darden experience with them. If you find yourself drawn constantly to a few classmates just like yourself, you aren’t really present. If you don’t test your assumptions about people different from yourself, you aren’t really present. If at the end of two years, your comfort zone is no larger than it is today, you have not been really present.

· It’s a marathon, not a sprint. Pace yourself. There are lots of enticing activities at Darden. And you don’t need to do them all at once. Find your sustainable stride and patiently head toward the finish line.

One final reflection: the bowsprit and forecastle are vivid metaphors for me yet today. As most of you know, in 11 months, I’ll make a transition from the quarterdeck of the Dean’s office to go back to the forecastle of faculty and staff. I’m content and think this makes great sense for Darden and for my life at this point.

So if I can model something for you this year, it is the virtue of periodically stepping down from the quarterdeck and moving to the forward-most point of your environment or enterprise. Being Dean has been tremendously fulfilling. And I’d like to get back on the bowsprit, looking forward through the fog. In the next 21 months, you and I will be there together.

I believe that you will succeed beyond your dreams if you commit very deeply to the experience head of you. Godspeed and good luck.

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Pricey U.S. Equities—Implied Innovation?

What are we to make of the following graphs? Figure 1 presents the long historical view of the Price-to-Earnings ratio on the S&P500 Index. Figure 2 presents a similar view, adjusting the P/E ratio for the impact of inflation on earnings.

Figure 1

Standard Price/Earnings Ratio for the S&P500 Index (average of all companies)
clip_image002

Source: Multipl.com
Current S&P 500 PE Ratio: 19.04 -0.19 (-0.97%)

4:29 pm EDT, Tue Aug 5

Mean: 15.52  
Median: 14.56  
Min: 5.31 (Dec 1917)
Max: 123.73 (May 2009)

Price to earnings ratio, based on trailing twelve month “as reported” earnings.
Current PE is estimated from latest reported earnings and current market price.
Source: Robert Shiller and his book Irrational Exuberance for historic S&P 500 PE Ratio.

Figure 2

Cyclically-Adjusted Price-Earnings Ratio for the S&P500 Companies


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Source: Multipl.com
Current Shiller PE Ratio: 25.39 -0.25 (-0.97%)
4:29 pm EDT, Tue Aug 5

Mean: 16.54  
Median: 15.93  
Min: 4.78 (Dec 1920)
Max: 44.19 (Dec 1999)

Shiller PE ratio for the S&P 500.

Price earnings ratio is based on average inflation-adjusted earnings from the previous 10 years, known as the Cyclically Adjusted PE Ratio (CAPE Ratio), Shiller PE Ratio, or PE 10 — FAQ.

Data courtesy of Robert Shiller from his book, Irrational Exuberance.

Against these measures, stock prices today seem high. Looking over the last 130 years, you see big spikes in P/E ratios suggesting bubbles “irrational exuberance” in advance of capital market instability (1929 stock market crash, the Internet bust of 2000, and the Panic of 2008). Apart from those extreme events, the P/E ratios of 19x to 25x are relatively high. Is this a run-up to another bubble? What questions should the canny observer ask about high P/E ratios?

Let me frame a (wonkish) reply in terms of finance theory, which suggests that the size of a multiple is driven by two main factors: risk and expected growth. For instance, the widely-used Price/Earnings multiple can be decomposed into two factors:

Stock Price/E(EPS) = 1/r + PVGO/E(EPS)

E(EPS) is the earnings per share expected to be reported next year. The factor “r” is the required return on equity, which is determined by risk. And PVGO [1] is the present value of growth opportunities per share, an estimate of today’s value of investments expected to be made in the future. The term, “growth company,” is not defined by the growth rate of sales, earnings or assets, but by the size of PVGO relative to the market value of equity.

In other words, the P/E ratios of “growth firms” are typically sizable, and driven significantly by attractive future growth opportunities. One can decompose other ratios in a similar fashion. But the key idea is that multiples reflect important economic phenomena. To judge whether a multiple is appropriate, one should look into the underlying economic fundamentals and critically evaluate the assumptions of the model. [2]

So, let’s consider the possibilities. Suppose that “r” is 10%, the going risk-adjusted rate of equity return for the average low-growth firm, such as a public utility. Therefore, 1/r would equal 10.0. Compared to the average P/E ratios for the S&P500 (either 19 or 25), this implies that the present value of growth opportunities these days is simply enormous, accounting for 45-60% of the value of the S&P500. What might explain this huge growth component?

One possibility that you hear mooted on financial talk shows is that the market is “overheated,” “getting ahead of its skis,” and even, “a bubble.” We’ve certainly seen frothy conditions before and shouldn’t be surprised to see them again. The problem is that you could summon up some kind of psychological explanation for market conditions virtually any time. Psychology is always useful as a warning flag; but it won’t tell the investor exactly what to do. Generally, if you think that the market is getting overheated, you might cash out, buy put options, or sell short. But research suggests that trying to time the market by trading actively is an easy way to lose money.

A second possibility is that investors embrace some realistic growth phenomena that justify these huge PVGOs. If so, the canny investor should try to identify the source of these growth opportunities. One helpful resource will be this year’s University of Virginia Investing Conference —November 13-14—the theme of which will be “Investing in Innovation.” Innovation is perhaps the most important foundation for growth, and PVGO. The conference will offer insights about growth prospects in fields such as information technology, energy, health care, and monetary policy. Once again, we are booking an impressive collection of speakers. As of today, speakers will include these (additional speaker are in the offing):

  • Charles R. Cory (MBA ’82), Chairman of Global Technology Investment Banking & Managing Director, Morgan Stanley
  • Richard Fisher, President & CEO, Federal Reserve Bank of Dallas (schedule pending)
  • W. Barnes Hauptfuhrer (MBA/JD ’81), Chief Executive Officer, Chapter IV Investors
  • Robert J. Hariri, Founder, Chairman & Chief Scientific Officer, Celgene Cellular Therapeutics
  • Ned Hooper (MBA ’94), Partner, Centerview Capital
  • Robert J. Hugin (MBA ’85), Chairman & CEO, Celgene Corporation
  • Samuel D. Isaly, Managing Partner, OrbiMed
  • Nancy Lazar, Partner, Cornerstone Macro
  • John Siegel, Partner, Columbia Capital
  • Michael Sola, Portfolio Manager, T. Rowe Price
  • Kathy Warden, Corporate Vice President and President, Northrop Grumman Information Systems

“Early bird” registration discounts end tomorrow, August 8th. Sign up this week to get the highest return on your conference investment.

In all probability, today’s high P/E multiples are due to a blend of buoyant investor psychology and genuine growth opportunities. If so, this puts a high premium on thinking critically about investment themes, trends, and market sentiment. Conferences are one excellent means of sharpening your own thinking. Join us in November!

  1. Stewart Myers originally suggested the important role of growth options in the valuation of the firm. See his paper, “Determinants of Corporate Borrowing,” Journal of Financial Economics, 5:146-175 (1977). The decomposition of P/E presented here is discussed more fully by Myers in his book with Richard Brealey and Franklin Allen, Principles of Corporate Finance. []
  2. Though widely used, and simple to use, investing on the basis of P/E multiples is vulnerable to several potential problems, such as the dependence on GAAP accounting practices, which afford managers rather wide latitude in reporting the financial results of the firm. Also, the P/E ratio can be computed using backward-looking or forward-looking earnings. For growing firms, the difference in financial performance between the year just past and the year ahead will be material. In addition, a focus on Earnings per Share ignores important effects of capital investment, investment in working capital, and depreciation. []
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Should I work for this company?

The summer is a time of endings and beginnings. We’re about to enroll the Darden Class of 2016,
among whom many students are looking to end one career path and embark on another. Alums I’ve been
speaking with recently, took vacations, found the time to stop and reflect, and confronted the itch to
change employers. And for the Darden Class of 2015, who have had summer internships, this week is
probably the closing act: companies will start to make full-time offers. About two-thirds of Darden’s
summer interns get offers of permanent employment from their summer jobs. Common to all of these groups is a fundamental question: “Should I work for this company?”  Let me help you reflect on this. [1]

How not to decide

Start by dispensing with some of the most frequently-heard—and worst—reasons to sign on, such as money, power, fame, convenience, or lifestyle. Mind you, these aren’t trivial; and a partner or mentor may place them at the head of the parade. But these considerations can prompt one to make a decision that seems justified in the short run, but that in the long run may be regretted.

Where to start

The way to begin is to start with a sense of purpose, or intent, or calling. As Stephen Covey once wrote, you must “start with the end in view.” For a few people, this “end” will entail a clear vision of exactly what one will be doing in a few decades. But for most of us, the “end” will amount to an intuition about the kind of impact one wants to make, the kind of legacy one would want to leave, or the help one would want to give to others. If you have a vision or intuition about your “end” in view, everything else will be noise. As the Psalmist said, “Without a vision, the people wander.” If you don’t know where you’re going, any road will take you there.

The guiding principle

If you address the question of where to work with the end in view, then you get focused on how to get there. This focus drives you to one overarching principle: You should go where you believe that you can you do your best work. Thinking in terms of one’s “best work” necessarily focuses on the impact of one’s life and helps to define priorities. I don’t mean to suggest that defining one’s focus and priorities is easy. But finding the signal despite the noise is indispensable to charting a course. Think about the implications of this principle:

  • Go. This begs you to reflect on how you will leave where you are now, and how you will gain access to the place you should be. Is now the time to go? Is your team depending on you to finish some vital work? Will you slam the door behind you, and leave bitter co-workers behind? Leaving well is one of the hardest challenges in a career.
  • Where. In what sense is your best work you contingent on a place? Is it a physical location, close to friends and family? A virtual space that grants you connectivity to people who amplify your talents? A spiritual space that gets you in the zone for great work?
  • You. Are you waiting for someone else to decide for you? You must own the issue. Are you straining over the decision because you simply don’t want to face it?
  • Believe. This takes courage. When you decide to work for a company you must embrace a lot of uncertainty about the industry, company, your supervisor, and even yourself. Have you thoroughly assessed all of these uncertainties? Some are certainly groundless. But there may be good cause for doubts, and perhaps some fears. Ultimately, to decide requires a stroke of faith. Some people gain that faith through serendipity, “signs,” or a feeling of being called, a nagging idea that just won’t go away.
  • Work. What is the work that you want to do? Like to do? Are prepared to do? Will this company let you do it? Or at least grow into it? And let’s not define “work” too narrowly. Your life’s work could also include serving a community, nurturing loved ones, or repairing some nagging interpersonal problem. Think about the balance of all of these possible demands over the course of your life.
  • Best. This is the most important word in the whole question. You shouldn’t settle for just any old work. Life is too short for that. One wants to have an impact with one’s life and arrive at a good end. The notion of “best” should trigger some deep reflection on how you define success. If you start with some sense of the end in view, your best work will start to define itself.

Conclusion

“You should go where you believe that you can do your best work.” Spoken plainly, this principle seems obvious, hardly a slap-the-forehead insight. Yet in my decades of working with students, alums, and searchers of all kinds, I observe how slowly people come around to this conclusion. Often late in life, they will wrap their career choices based on money, power, fame, convenience and lifestyle in some rationalization about “best work”–but it always sounds hollow.

It is better to start with the end in view. That way, the steps to get there tend to define themselves.

  1. Those interns who are in the home stretch and really hope to gain an offer might find some of my past
    advice helpful. There is a range of things one can do to improve the odds of getting an offer:

    A. Actually ask for the job. Too many summer interns simply don’t “close the sale” (see this.)

    B. Become known. “Lean in,” in Sheryl Sandberg’s parlance. Too many summer interns lean back and fade out (see href="http://blogs.darden.virginia.edu/deansblog/2010/07/a-question-for-summer-interns-who-are-you/">this.)

    C. Finish at a sprint; don’t coast to the end. Research suggests that the most recent perceptions are very influential to decision-makers. Even if you’re finished with your summer project, walk around and volunteer to help anyone else (see this.)

    D. Quell any sense of entitlement; you must earn the offer. In most settings, arrogance damages, rather than strengthens, career prospects (see this.)

    E. Even if the news isn’t good, exit gracefully. (See this.)

    []

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