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Nature uses only the longest threads to weave her pattern, so each small piece of the

fabric reveals the organization of the entire tapestry.


Richard P. Feynman
I Could Do That
Life magazine created a stir in the late 1940s when it openly questioned whether
Jackson Pollock (1912-1956) was the greatest living painter in the United States.
Pollock wasnt a standard paint-and-palette guyhe created his abstract art by
dripping paint onto huge canvases. While some of his pieces sold for millions, one
skeptic suggested his art is like a mop of tangled hair I have an irresistible urge to
comb out.
1
Some critics deridingly implied that they could recreate Jacksons work by
randomly splashing paint on a surface.
2
Exhibit 1 shows a Pollock painting from the
late 1940s.
Still, Pollocks work has draw. In an effort to understand the aesthetic appeal of
Pollocks paintings, physicist Richard Taylor turned to the world of math. He found that
Pollocks paintings, while seemingly haphazard, exhibit pleasing fractal patterns. A
fractal is a geometric shape that can be separated into parts, each of which is a
reduced-scale version of the whole.
3
In spite of the skeptical sneers, Taylor showed
that fractal patterns are by no means an inevitable consequence of dripping paint.
Fractals are ubiquitous in naturetrees, clouds, and coastlines are but a few
examplesand as a result are visually familiar to humans.
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One critical feature of a
fractal pattern is its fractal dimensionor degree of complexity (a line has a fractal
dimension of 1.0, while a filled space has a dimension of 2.0). Taylor and his
collaborators found that humans have a preference for fractals with dimensions
between 1.3 and 1.5, whether those fractals are natural or manmade. Many of
Pollocks paintings fall within, or near, this range. As a consequence, scientists can
quickly distinguish between a Pollock and non-Pollock.
5
Because fractals are so common in nature, scientists often associate them with self-
organized systems. Since economics deals largely with these types of systems, we
might expect to see fractals in economic systems as well. And indeed we do.
Just as we have to analyze a Pollock painting or a coastline to appreciate the
underlying fractal pattern, we must take a fresh look at economic systems as well.
Order is often hidden.
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Michael J. Mauboussin
212-325-3108
michael.mauboussin@csfb.com
Kristen Bartholdson
212-325-2788
kristen.bartholdson@csfb.com
July 29, 2003
Volume 2, Issue 15
Stairway to Shareholder Heaven
Exploring Self-Affinity in Return on Investment
Page 2
Exhibit 1: Jackson PollockNumber 8
Source: Jackson Pollock, Number 8, 1949, Neuberger Museum, State University of New York (WebMuseum, Paris: http://www.ibiblio.org/wm/).
Stairway to Shareholder Heaven
Self-affinity, or the resemblance of the parts to the whole, is another crucial feature of a fractal. Think
of a tree. The whole tree, a large branch, and a small branch all visually resemble one another. Stock
price changes are also fractal: after some adjustments, the data look the same whether you look at
month-to-month, week-to-week, or day-to-day changes.
7
Our analysis suggests that distributions of the spread between returns on investment and cost of
capital show self-affinity across five levels: country, industry, company, firm, and division. The best
way to assess this point is to visually inspect Exhibit 2 (following page). Across all levels, we tend to
see the same pattern of value creation, value neutrality, and value destruction. To be sure, some of
the distributions skew toward value creation and others toward value destruction, but both sides of the
spectrum are consistently represented.
While we show only one industry (diversified chemicals), we can look at any industry and see a similar
array of value performance. Ditto for an individual company. So there is nothing unique about the
country, industry, company, division, or business line we selected (besides availability of the data).
Making the Art Less Abstract
The usefulness of this observation may appear, on the surface, as abstract as a Pollock painting. But
we believe these distributions present at least five concrete implications for investors:
1. Consider why returns are less than the cost of capital. Generating poor returns is clearly not
desirable, but it is important to consider why the returns are low. For example, a company that
is early in its life cycle may have depressed returns because it is investing heavily, but its
economic future may be bright. Current weak returns may belie a strong outlook.
In contrast, a mature company may have poor returns because competitive forces have wrung
out all the attractive opportunities, and the industry may be plagued with excess capacity.
Companies also invest in new businesses where they have little chance of gaining a
competitive advantage. So some insight into the nature of poor returns is very useful.
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Exhibit 2: Self-Similarity of ROI on Multiple Levels
Country
-4%
-3%
-2%
-1%
0%
1%
2%
3%
4%
C
F
R
O
I
-
C
o
s
t
o
f
C
a
p
i
t
a
l
Industry
-20%
-15%
-10%
-5%
0%
5%
10%
15%
20%
C
F
R
O
I
-
C
o
s
t
o
f
C
a
p
i
t
a
l
Company
-6%
-4%
-2%
0%
2%
4%
6%
8%
C
F
R
O
I
-
C
o
s
t
o
f
C
a
p
i
t
a
l
Division
-5%
0%
5%
10%
15%
20%
25%
C
F
R
O
I
-
C
o
s
t
o
f
C
a
p
t
i
a
l
Business Line
-25%
-20%
-15%
-10%
-5%
0%
5%
10%
C
F
R
O
I
-
C
o
s
t
o
f
C
a
p
i
t
a
l
Country
-4%
-3%
-2%
-1%
0%
1%
2%
3%
4%
C
F
R
O
I
-
C
o
s
t
o
f
C
a
p
i
t
a
l
Industry
-20%
-15%
-10%
-5%
0%
5%
10%
15%
20%
C
F
R
O
I
-
C
o
s
t
o
f
C
a
p
i
t
a
l
Company
-6%
-4%
-2%
0%
2%
4%
6%
8%
C
F
R
O
I
-
C
o
s
t
o
f
C
a
p
i
t
a
l
Division
-5%
0%
5%
10%
15%
20%
25%
C
F
R
O
I
-
C
o
s
t
o
f
C
a
p
t
i
a
l
Business Line
-25%
-20%
-15%
-10%
-5%
0%
5%
10%
C
F
R
O
I
-
C
o
s
t
o
f
C
a
p
i
t
a
l
Source: CSFB HOLT.
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2. Look for changes in returns (both positive and negative) not anticipated by the market.
Empirical evidence shows that changes in returns are strongly correlated to stock price
changes. Companies with the greatest return improvement, on average, tend to significantly
outperform the companies with the largest return degradation. These data suggest that the
market does not fully anticipate the full degree of return changes.
8
Investors should carefully gauge market expectations, and try to determine whether or not
those expectations are likely to change. Failure to properly measure and consider market
expectations remains conspicuously absent in many investment processes.
9
3. Judge the likely longevity of excess returns. Reversion to the mean is a powerful force with
company-level returns. High-return businesses face competition that drive down their returns,
and capital tends to flee low-return business, allowing returns to drift up. Discerning how long
it is likely to take for excess returns to be competed away is essential.
10
The stock market tends to equilibrate shareholder returns via valuation (allowing for risk
differences). High-return businesses receive high price-to-book ratios, and low-return
businesses garner low ratios. For this reason, good companies are not always good stocks.
4. Strategy matters. From a companys perspective, strategy is about pursuing a set of activities
that allow it to generate returns above the cost of capital. Successful strategies typically put a
company in a unique position, either with a differentiated offering or a low production cost.
Strategy is about trade-offsdeciding what to do and what not to do.
One noteworthy finding of this work is that even the worst industries include value-creating
companies, and the best industries, value-destroying companies. This evidence suggests
strongly that competitive strategy matters. A thorough strategy assessment should be
integral to a long-term investors process.
11
5. How does management allocate its time? Since exceptional, talented managers are so rare,
investors must determine how a company allocates its managerial talent. Often, companies
assign their best managers to turnaround or fix ailing businesses, instead of letting them
drive value at the strongest divisions. For this reason, investors should try to understand the
value breakdown of various businesses (which may be in stark contrast to sales or operating
income contributions) and judge whether or not the company is intelligently allocating
managerial resources.
Order and Disorder
Better data and computational tools are allowing researchers to see order in systems previously
perceived to be disorderly or random. We suspect that the self-affinity evident in return spreads is
symptomatic of the self-organizing properties of global business. While this general observation is
intellectually exciting, it also has practical, investment-related relevance. And you dont have to be a
Jackson Pollock fan to see it.
Page 5
1
Jennifer Quellette, Jackson PollockMathematician, The Fine Arts Magazine, January 25, 2002.
See http://www.sierra-arts.net/ArticlesEssaysJacksonPollock.html.
2
One example is the childrens book character, Olivia. See Ian Falconer, Olivia (New York: Atheneum
Books for Young Readers, 2000).
3
Benoit B. Mandelbrot, A Multifractal Walk Down Wall Street, Scientific American, February 1999, 71.
4
Richard P. Taylor, et al., The Visual Complexity of Pollocks Dripped Fractals, Proceedings of the
International Conference of Complex Systems, 2002.
See http://materialscience.uoregon.edu/taylor/art/TaylorlCCS2002.pdf.
5
Richard P. Taylor, Order in Pollocks Chaos, Scientific American, December 2002.
See http://materialscience.uoregon.edu/taylor/art/scientificamerican.pdf.
6
Robert L. Axtell, Zipf Distribution of US Firm Sizes, Science, vol. 293, September 7, 2001; Lee et al.,
Universal Features in the Growth Dynamics of Complex Organizations, Physical Review Letters,
vol. 81, no. 15, October 12, 1998. See http://polymer.bu.edu/hes/articles/lacms98.pdf.
7
Mandelbrot. Stock price changes are more accurately described as multifractal. Multifractals
accommodate some adjustments to get to statistical similarity on various levels. For example, for asset
prices time (the horizontal axis) is lengthened or shortened to show level similarity.
8
Bartley J. Madden, Michael J. Mauboussin, John D. Lagerman, and Samuel T. Eddins, Business
Strategy/Life Cycle Framework: Positioning Firm Strategy as the Primary Cause of Long-Term CFROIs
and Asset Growth Rates, Credit Suisse First Boston Equity Research, April 22, 2003.
9
Alfred Rappaport and Michael J. Mauboussin, Expectations Investing (Boston: Harvard Business
School Press, 2001).
10
Michael J. Mauboussin, Alexander Schay, and Patrick McCarthy, Competitive Advantage Period: At
the Intersection of Finance and Competitive Strategy, Credit Suisse First Boston Equity Research,
October 4, 2001.
11
Michael J. Mauboussin and Kristen Bartholdson, Measuring the Moat: Assessing the Magnitude and
Sustainability of Value Creation, Credit Suisse First Boston Equity Research, December 16, 2002.
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