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July 31, 2007

Kaptain Karl's Test: an Icahn-like Inventory of Enterprise Performance

A prior post looked at Carl Icahn's (Kaptain Karl) views on enterprise performance, which he found broadly deficient through too many nice guys moving up the hierarchy thru political management rather than focusing on what their companies needed to do to perform and create value. Or at least that's my reading-between-the-lines interpolation (the video is posted, please feel free to review it).

For several years now I've been tracking those companies which make the headlines for performance problems (and occaisional successes - unfortunately the former dramatically out-number the latter). But stop and consider for a moment...since the beginning of the year how many companies have made major earnings announcements and executive changes based on strong earnings and positive strategic outlooks ? We have whole industries just beginning to go through major transformations after, literally, decades of denial.

What names come to mind for you ? How about Dell, Wal-Mart, JP Morgan, Citigroup, Microsoft ? And more ? We're talking here about the bluest of blue-chip companies that not to far back, say 3-4 years, were the poster children of doing it right. All the bizz schools, trade press and general business press were lauding these folks for the strategies, operational execution, delivered customer value and postitive outlooks. Why just yesterday the WSJ had a major front-page story on MSFT's struggles with innovation ( Behind Microsoft's Bid To Gain Cutting Edge  ).

Let me offer up a chart (actually two) that's a snapshot that gets updated and refreshed from time-to-time, of companies and their status. Take a look and see what you think. Suggestions and emmendations (in the comments) would be welcome.

The categories (somewhat arbitrary but best judgement) are Criminal Malfeasance, Bad Leadership/Malfeasance, Bad Leadership/Poor Performance, Adjustment Failure/Internal Agendii, Internal Friction/Adjustment-Innovation Failure. The numbers in parens (x) are sequences show a (1) means that's the first entry while as a company evolves it might move to a different column, or even the next chart on good-performance.

Each company is its' own individual case. In fact we ended up starting a detailed review sequence of HD and have several posts starting with Nardelli's dismissal and working on up to a suggestion of Six Major Strategic Initiatives. In their case the executive change was a good thing and they appear to be doing the right things but the jury is still out. Far out actually. And some of the entries are probably dated, both good and bad. But some are not. For example Chuck Prince took over a badly faltering Citi which was facing serious charges and had major performance problems. He seems to have cleaned those up but at the same time, and despite the spinoff/sale of many of the acquired operations, Citi still isn't either getting the most out of any division that I can tell. And certainly not getting the sum is greater than the parts synergies. Ditto for Time-Warner. And so on and so on.

The other side of the coin is those enterprises showing either improved or sustained performance. Frankly that was a lot harder a chart to build - perhaps because my sampling method was based on headlines ? Anyway the categories are Strugglers & Stragglers, Recovery Road, Renewal & Growth, Sustainers and Next Big Thing (NBT) Potentials. The last category is more a list of industries which show significant promise for the future from now to the near-term to much farther out. So, for example, right now we don't see any major industry coming forward with the same sorts of major structural innovations that lead to the origination and creation of the Pharmaceutical or Electronics & Computer Industries. On the other hand there are several going thru huge transformational re-builds as the underlying technology changes, e.g. Telecom, Consumer Electronics and Entertainment. As before feel free to argue with my candidates and placements.

For example the initial entry for Dell(1) was in the Sustainers category because their strategy and business model looked sustainable in their niche (business PC supplier) but also extensible to other major product lines (Servers, Printers, Services (?), Communications, Consumers) and geographies (Europe, LA, Asia/China). That's turned out not to be true. And worse yet their core value proposition, like HD's, was heavily dependent on good value (low price for decent functionality) combined with superb customer service. When Dell began cutting customer service expenses several years ago and getting very bad feedback on product quality they weren't just facing a cost management and margin problem. They were depreciating their fundamental soft asset - Service & Support - and the trust of their customer base. Rather like HD under Nardelli. Again Michael Dell may be starting to turn things around. Contrawise Chuck Scwab's return to Schwab led to a complete reset of strategy, offerrings, and execution. Hence Schwab's migration from a company with performance problems to Recovery Road.

But, at the end of the day, it's applying the Kaptain's test of enterprise performance and value delivery that determines classification. And profit, return and general appeal - the test questions: would you want to work for which companies ? And put money in which as an investor ? Take it to Buffett's Test - imagine yourself an owner, then which are targets and which to be avoided ? Which are opportunities with the right re-working ?

Kaptain Karl Speaks: Performance, Executives & Outlook

A couple of weeks ago the WSJ held its' "Deals & Deal-Makers" Conference and put up several of the interviews on it's web site. Two of the most interesting, at least from our perspective here of being focused on total enterprise performance, were with Carl Icahn. One of his key, much-repeated themes was the lack of executive accountability for performance through a focus on the wrong things. One of the videos is embedded so you can reach your own interpretation but Kaptain Karl, as I've called him in reference to an earlier post on how to balance leadership, rewards and employee commitment (the Pirate's Code) starts to address these issues. At the other end of the spectrum the implications of the buyout and buyback liquidity-driven boom is that executive management is holding up earnings by NOT investing in their companies long-term development. Stop and consider for a minute, if the Kaptain is right, about the future outlook for rapidly growing worldwide competition, escalating earnings pressure and liquidity-driven valuations what that means for re-thinking enterprise performance.
An earlier post (On Being a Boiled Frog) talked about the strategic outlook for US industries and enterprises and, hopefully, made the major point that business as usual - tending to internal agendii and quarterly earnings - is not a recipe for success. Rather it's a recipe for declining performance without a fundamental re-thinking of value, strategy, execution and performance. Which is the point the Kaptain makes to my mind. The final conference interview with Icahn is here and the panel interview with Alan Murry below. See what you think:

Foggy Market Breakdown: GDP Component Changes

We just finished looking at the YoY% changes in GDP (inflation adj. real, not nominal) and found that the pickup wasn't quite as good as the headline as usual. More importantly though Consumption rose only 1.3% in the quarter verses the Q1 increase of 3.7%, on a QtoQ basis. YtoY it was better. So with the "organic" parts of the economy not doing well and GDP being held up by Net Exports and a smaller decline in Housing, as well as (allegedly - we'll see) Inventory re-building, the question then becomes what did the major components do ? And what are the implications ? Aside from general macrotrends the component breakdown may have some real issues to be considered for specific industries, firms and therefore their stakeholders.

Below we borrow a very good chart on QtQ changes to show the breakdowns and follow up with our preferred YoY delta analysis by looking at the Q1/Q2 deltas individually and cumulatively. After you take a look at the charts we also ask a couple of interesting questions about the implications for key industries and enterprises peformance pressures. 

Let's start by looking at a very nice chart showing QtQ changes from the Mess Greenspan Made via the BigPicture (it's worth clicking on thru to get the discussion):

 Notice that, except for the Katrina impact in Q305, Consumption made the smallest contribution in 3 years, while the other components were important positive contributors as well. Even Investment made a small positive contribution for the first time in several quarters.

Now, let's switch our perspective back to the YoY% changes and compare Q1 & Q2 changes between this year and last. Below is a chart of the major components of GDP and a table of all the numbers is at the bottom so you can see the data for youself if you care to kick it around a bit.

The charts are probably better labeled YoY Changes but they show the delta in each quarter in each category between '06 and '07. They also show the sub-components of Consumption (Durables, Non-durables, Services), Investment (Capex, Residential), Inventory, Net Exports (Imports-Exports) and Gov't spending. So, for example, Durables spending increased $57.2B in Q1 and $58B in Q2 while Services spending went from a gain of $154.1B and decreased to $124.3B. Despite both the headlines and better discussion in the mainstream press Capex didn't in fact show much improvement though Housing declines decreased. In particular, on this analysis, Inventory didn't show much contribution though both Exports and Gov't spending did. In fact the US as an exporting economy is actually one of the few major positive stories around - now if only we'd had a national energy policy in place for the last couple of decades :).

If we want to see the contribution of each of the components we can look at the relative buildup in each quarter. In Q1 there was a $216.4B, or 1.55%, increase in GDP while in Q2 there was a smaller increase of $201.2B but a larger YoY% improvement of about 1.8%. Now how can that be ? Recall that the economy was slowing last Spring, partly do to decling spending and partly due to high and rising oil prices. So if we break it down chartwise it looks like this:

The numbers won't tie out because the Residual adjustment used to bring things together isn't thrown in but, trust me, these are the gov't numbers as reported. A closer look at the chart shows several things, including the continuing role of Consumption as the primary engine but also it's aggregate slowing in absolute terms. Relatively speaking Capex, Housing and Inventory don't appear to help make things much better. It's only Exports and Gov't spending that do. While exports may continue favorable because for the first time in decades the US Economy is not the sole engine of worldwide growth the positive impact is not that great. And the Gov't spending impact is both small and a 1-time event.

Taking a look at this chart suggests our earlier conclusion is still on track - that is Consumer spending is slowing and there doesn't appear to be anything much in the way of alternatives to pick up the slack.

So, FWIW, here's the numbers breakdown showing the YtY changes, YtY% changes and % contribution to the total GDP number. You ought to be able to look at some of these and not only get a clearer picture of the structure and direction of some of the changes. But also to ask what the demand for various industries might be. For example with Capex not doing particular well how does that break down in terms of Technology spending ? Or with services decreasing are consumers cutting back on entertainment, eating out, etc. etc. ? Food for thought, perhaps ? It also suggests a couple of other things as well.
  1. First, from an investment perspective what industries would appear to be under growing demand pressures ?
  2. And second, if you're involved in a company as employee, executive, investor or supplier/customer what are they doing to adjust to and anticipate these pressures ?

July 30, 2007

Reality Checks: the Latest GDP Report and Outlack ?

Well Friday saw the release of the first guestimates of the Q207 GDP and the headline number was pretty good at 3.4% but for the first time in a couple of years the press writers have noticed Consumer Spending isn't doing well (in fact very much in line with our expectations). Of course that's QtoQ comparisons instead of the YtoY examination of real data instead of nominal. The reasons are discussed in What's Really Going On. But progress nonetheless ! Take what we can get, always.

Below, before diving into our preferred analysis, we present a totally confusing and nearly impossible to interpret version of QtQ numbers just to reinforce the point before diving into the real structural changes and looking at GDP & Consumption followed by closer looks at Employment and Real Wages. The latter are particularly important because they are the foundation of future consumer spending which in turn drives all else. But before diving into our analysis let's take a peek at what the reporters are saying (at last, at last):

 

Fears Intensify On Economy, Despite Growth

Behind the picture of strong second-quarter economic growth are new worries: Fears that the continuing housing slump, higher gasoline prices and tumbling financial markets could damp consumer spending and blunt the U.S. economy's momentum in the second half. The economy grew at an annual rate of 3.4% in the quarter, reversing the anemic 0.6% growth in the first quarter, the Commerce Department said. Increases in exports and government spending drove much of the improvement. A rise in commercial construction spending and building of inventories offset a drag from housing and sluggish consumer spending. Fed officials haven't changed their expectations for moderate growth for the rest of the year, but persistence of the housing slump underscores the downside risks -- particularly to consumer spending. The combination of a sour housing market and rising energy prices reduced growth in consumer spending to a very slow 1.3% pace in the second quarter after the first quarter's downwardly revised 3.7%.

So let's dive into our charts and analysis. The accompanying chart shows the QtQ% changes in the big three indicators (GDP, Consumption, Investment), not annualized, in the real data. If you look closely you can sorta see the relationships and that GDP turned up in Q2 over Q1 because Investment did. In a follow-on post we'll break down the changes more but it turns out to be primarily due to a DECREASE in the size of the negative Residential Invesment. How encouraging. But Consumption turned down - oops. Hence the reporters observations. We should also take note of the fact that the general run of commentators still looks for a 2nd Half pickup overall.

Shifting gears let's take a look at the YtY% changes which makes the timing, trend and turning point patterns much....much clearer.  The first thing to notice is that the "improvement" in GDP wasn't all that good - in fact in went from a 1.55% increase to a 1.78% increase. Bearing in mind that we need growth of 3.2-3.5% to be at the economy's speed limit we're far below that. The Fed by-the-way (BTW) has lowered its' estimate of the speed limit AND its' outlook for the year and maybe the next two. And while you can still the GDP uptick coming from Investment the slow-motion slowdown appears to be accelerating with Consumption slowing as well. Industrial Production - the harbinger of future business demand as well as current corporate activity, continues to slow.

The mantra is Consumption drives GDP while Investment is the accelerator and the drivers of consumer spending - in addition to being able to borrow against/liquidate assets (MEW, Stocks) - are jobs and wages. In other words if we'd like to know how the consumer is holding up we need to look at how Employment is doing as well as real wages.

The answer is not very well. A couple of things to notice, also. First, looking at turning points, Employment is a lagging indicator. Next, we never got a return to the robust 2.5% YoY growth of the late 90s. Instead we ceilinged off around 1.5%+ and it's been trending down since early '06. Historically high profits and earnings are all well and good but you have to ask if it's organic or based on cost-cutting and other factors (which we did in fact take a look at here and found buybacks now exceed capex spending !). In fact Employment growth decreased from 1.52% to 1.45%. We'll see what the next round of Payroll data tells us but the bottom-line is that there is no resevoir of future demand lurking in job growth. And hasn't been thruout this entire recovery. Worse, it's getting weaker.

The accompanying chart is a little busy but to a constructive purpose so please take a moment with it. It shows Consumption (PCE), real Retail Sales and real weekly average Wages (plus the trend of the latter). This is to let PCE link back to the earlier charts and show the relation as well as show how Retail Sales and Consumption relate. Notice - perhaps the most important thing - that Wages turn before Consumption and Retail Sales. The latter follows Consumption but is more volatile.

Next, another key point is that Wages were in a longer-term downtrend beginning in late '97 and continuing, essentially, thru the middle of '06. There was a big runup in real wages last summer and fall which is THE explanation for why the downturn in the economy that was being anticipated last Spring didn't come about. Now, notice they have turned sharply downward indeed. Interesting - one wonders what that's all about ? Wait - oh year. There was a big downturn in Oil Prices which caused the headline CPI to also turn down. Guess what - oil prices are back big time and it shows in wages.

So, bottomlining again, the key drivers of future Consumption growth are weakening rapidly.

If consumers can't continue to borrow against their houses (MEW) or sell stocks in buyouts and buybacks they'll lack any source of liquidity to maintain spending. Consumer debt btw has been climbing rapidly in the last two quarters.

So take a look at the charts and come to your own conclusions. My interpretation is that consumer spending will continue slowing and we've just barely seen the first 1/3 of the housing mess (the various industries sources btw have JUST started talking about a "recovery" in '09 or later). Comments, objections or alternative interpretations are welcome. On the whole I'd be happy to be wrong about this but don't think it likely.

July 28, 2007

Reader for Jul29: Markets, Economy & Business

Whew, what a week. With the big drop in the markets, the constant flow of news on credit and LBO financing problems we’ve split this weeks’ Reader into two sections, with a separate post on all the Markets & Investments news. Below you’ll find selected – in the inundation of valuable and interesting news – articles on the economy, the great credit contraction, the strategic outlook for the buyout ( & by implication buyback) game. In addition to the key articles in the Special section I highly recommend reading Northern Trust’s end-of-week Daily Commentary, which dissects the structure and outlook for all the major GDP components as well as anything. And goes on to relate both consumer spending to the low-rate credit environment and discuss the outlook for real profits. Also the articles on Sovereign Wealth Funds are worth reviewing, as they are harbingers of a major shift in foreign investment patterns away from Treasuries into other assets. This is potentially a huge change. And there are interesting articles on the major challenges facing Detroit, how Boeing is doing and several key articles on the Technology Industry and players therein.

Happy reading or skimming as the case may be.

General & Special

Subprime could create global crisis, economist says The problems in the U.S. subprime mortgage market could spiral out of control into a global financial crisis, economist Mark Zandi said Thursday. With a "high level of angst" in the financial markets about who will take the losses from more than $1 trillion in risky mortgages, we could be just one hedge-fund collapse away from a global liquidity crisis, said Zandi, chief economist for Moody's Economy.com. A global meltdown is not likely, but the risks are growing, Zandi emphasized in a conference call with reporters following the release of a new study on subprime debt that concludes that the housing crisis could be deeper and last longer than investors now believe. Read the latest data on home sales. And it could spread. "Mounting mortgage delinquencies and defaults now pose the most serious threat to the global financial system and economy," Zandi said in his report.

The Great Credit Contraction of 2007

Last month, I noted 6 reasons why rising yields were a threat to equity prices:

Valuation
The M&A/LBO Put
Competition
Profits
Share buybacks
Consumer spending

As of late, we have seen the threat of two of these issues increase dramatically: The M&A/LBO Put and Share buybacks are being pressured by the increasingly expensive credit. 

Takeout Guessing Game Is Over, Analyst Says : Trying to pick the next takeover target has been one of Wall Street’s favorite sports over the past year or so. But Richard Bernstein, Merrill Lynch’s chief investment strategist, is blowing the whistle. In his latest market commentary, Mr. Bernstein suggests that the ongoing search for “takeover premiums” and “L.B.O. takeout values” shows that some equity investors in deep denial — “behaving as though the real economy has no connection with the financial economy.” Mr. Bernstein is just the latest market watcher to suggest that the troubles in the credit market could bleed over to the stock market, in the form of reduced takeover premiums. Dozens of companies have experienced elevated stock prices lately because of speculation that they could be swept up in the flood of leveraged buyouts.

Investment & Markets

The next generation of winning stocks: Small-cap growth stocks ready for supersize growth are getting increasingly hard to find. But a little digging has turned up new ones for my Future Fantastic 50 Portfolio. There's a shortage of great young growth companies right now, says MSN Money's Jim Jubak. But things are changing. The second quarter of 2007 was the best for new startups since 2001, and the hottest sectors are medical devices, information technology and communications.

Countrywide: "Home price depreciation at levels not seen since the Great Depression": An amazing conference call with Countrywide Financial (CFC), the largest US mortgage underwriter. It was beyond ugly. Here are some notable quotables from Chief Executive Angelo Mozilo

Keep your T-bonds, we'll take the bank The governments of China and Singapore take stakes in Barclays, giving some clues about how sovereign investors plan to operate. Although CDB is a state-owned bank, most governments buy their foreign assets through state-run investment pools, known as sovereign-wealth funds. These funds are getting bigger and bolder. They have some $1.5-2.5 trillion to play with, according to America's Treasury, a sum expected to grow fast. Although sovereign funds began investing conservatively, the Barclays deal shows that they can provide an attractive source of funding for mergers and acquisitions. Some sovereign funds are also getting into the buy-out business. Delta Two, a fund backed by the government of Qatar, is currently bidding for Sainsbury's, a British supermarket. Yet despite making their presence felt in financial markets, little is known about these funds. To understand them, it helps to think about where their money comes from. Many emerging markets, notably China, have built up vast reserves of foreign exchange. Such reserves are traditionally invested in liquid assets like Treasury bonds, which could be sold quickly if the central bank had to prop up the currency. But many countries have far more reserves than they need for this purpose. And China is in any case protected by capital controls. That leaves the government free to buy more exciting things where it might make a better return. Earlier this year China decided to set up a sovereign fund.

Economy

Kansas City Shadow Fed / Maine Fishing Trip Recap

I wanted to give y'all a recap of the "Kansas City Shadow Fed Meeting" up in Grand Stream Lake, Maine. Here's a bit of quirkiness: My outlook on the US economy was probably the most bearish of the entire group; at the same time, I probably had the most fully invested investment posture in terms of our managed accounts versus the rest of the fund managers. Kinda weird . . . A few other interesting items worth relating (Economics, Politics, Markets, The Fed, BLS):

China's Exported Inflation May Signal Interest-Rate Pressures The rising cost of goods the U.S. imports from China may be an early warning signal that central bankers from the U.K. to India are about to pay a price for a cause they've championed: globalization. China, a source of cheap manufactured products for the past two decades, may be starting to export inflation as the world economy grows at the fastest pace in a generation. Prices rose 0.3 percent again in June, the biggest back- to-back increase since record-keeping began in December 2003. With monetary policy makers struggling to contain pressures from other forces beyond their control -- increased trade, faster capital flows and record commodity prices --officials including Bank of England Governor Mervyn King and New Zealand's central bank Governor Alan Bollard may have to raise interest rates or maintain them at higher levels for longer than they might prefer.

The increasing integration of the world's economies isn't fully understood, even by those who have benefited the most from expanding international trade and investment. Fed Chairman Ben S. Bernanke has said it may complicate policy making, and the benefits of cheaper imported goods are, at least, countered by higher costs for raw materials and energy. Booming global demand is already forcing up food and commodity prices and squeezing spare productive capacity at a time when more investment from abroad weakens central banks' grip on the supply of money in their economies. The International Monetary Fund predicts that the amount of slack will shrink to 0.1 percent of global gross domestic product in 2008 from 0.4 percent last year.

Cracks in the Great Wall of China China's economic growth surged to an 11-year high of 11.9% in the second quarter. Asia's new economic giant is on course to chalk up its fifth straight year of double-digit percentage growth. And after leapfrogging the United Kingdom in 2005 to become the world's fourth-largest economy, China is set to overtake Germany for the No. 3 spot by the end of this year. Eye-popping economic growth rates notwithstanding, China's reputation for economic invincibility has taken a serious knock in recent weeks. The media barely noticed when Chinese-made drugs contaminated with diethylene glycol led to the deaths of dozens of people in Panama last year.

U.S. Economy Probably Quickened Last Quarter on Factory Pickup The U.S. economy probably grew last quarter at the fastest pace in more than a year as manufacturing rebounded and exports improved, economists said before a government report today. The 3.2 percent annual pace of growth for gross domestic product is the median estimate of 85 economists surveyed by Bloomberg News. The growth rate would follow a 0.7 percent gain in the first quarter that was the weakest since 2002. Factories ramped up to rebuild inventories and fill orders from Europe and Asia, overcoming a drop in homebuilding and slower consumer spending. The report may also show price pressures cooled, providing some comfort to Federal Reserve policy makers who consider inflation their predominant concern.

  • Northern Trust Daily Commentary (July 27):Rebound in GDP Growth Likely Temporary. The Past Year's Stock Market Rally Has Not Been Economically Driven
  • Northern Trust Daily Commentary (July 23): Q2 Real GDP Growth Forecast:  Chicago Fed at 2.7%; Consensus at 3.2%

$100 Oil May Be Months Away, Not Years, Say CIBC, Goldman The $100-a-barrel oil that Goldman Sachs Group Inc. said would prevail by 2009 may be only a few months away.

Falling US dollar puts pressure on the buying power of Opec nations

The falling US dollar is lowering the Organisation of the Petroleum Exporting Countries' purchasing power by up to a third, making the powerful oil cartel more reluctant to increase production and cut prices. Although oil is trading near last August's record price of $78.65 a barrel, Opec calculations show that when adjusted for currency fluctuations and inflation, oil prices have fallen in the past year. The adjusted price averaged only $43.60 a barrel in June this year, compared with $44.30 abarrel in the same month last year, according to the latest Opec monthly report. Growing trade between Opec members, especially those in the Middle East and north Africa, and the European Union, is aggravating the problem because the value of the pound and the euro has risen against the dollar.

Business

Detroit Shrinks to Survive (Asset Sales Could Help Fund UAW Health-Care Trust):The Big Three U.S. auto makers are hanging for-sale signs on more prime assets as they hunt for cash to finance a deal with the United Auto Workers to ease the burden of retiree health-care liabilities. General Motors Corp. and Ford Motor Co. have moved in recent months to pare assets and build up cash as they seek answers for their loss-plagued North American auto operations. Potentially adding to the moves, people familiar with the matter said over the weekend that Ford is considering selling its Volvo car unit, a profitable business expected to receive considerable interest from other car companies and financial buyers such as private-equity firms. GM, meanwhile, agreed to sell its Allison Transmission unit for $5.6 billion after nearly 80 years of ownership. It has also raised more than $10 billion in recent months in credit markets, all of which was won by pledging assets essential to running its automotive business.

·         At Ford, the 'Outsider' Is Optimistic (In a Town of Pessimists, CEO Mulally Tells Everyone 'It's Going to Be OK'). When former Boeing Co. executive Alan Mulally took over as Ford Motor Co.'s chief executive officer last September, Ford was on the way to losing $12.6 billion for 2006. It doesn't project a return to profitability until 2009. High gasoline prices are hammering sales of the sport-utility vehicles that once drove Ford's U.S. profit. The new CEO also confronted the complexity of running a family-controlled company that had long operated as a collection of fiefdoms.

Boeing seen swinging to profit as jet deliveries Boeing's success selling jets laid the groundwork for sharply higher earnings in the second quarter, say analysts, who are anticipating the company will raise its outlook for future quarters.

Think, Play, Do: Technology, Innovation, and Organization

In my opening remarks I focused on the opportunities to leverage the huge advances in technologies, standards and communications to enable us to look at a whole organization - an enterprise, an industry eco-system or an economy - as a holistic, integrated system, linking together processes, information and people.  Needless to say, these are incredibly complex systems. The tools we are using to design, build and manage them today are quite primitive, and they thus require considerable labor-based services.

We need breakthrough innovations to enable us to better deal with these increasingly complex organizational systems.  Engineering has done a very good job developing advanced tools and methodologies - e.g., CAD/CAM, simulations, models, etc - to help us deal with very complex physical systems, like airplanes, skyscrapers and microprocessors.  This has enabled very high quality and productivity in the production of physical objects. 

Our challenge and opportunity now is to develop similarly sophisticated tools and methodologies to deal with complex organizational systems like those found across industries and economies.  Compared to what we’ve done so far, this is hard, - very, very hard.

How IT Departments Are Spending: One CTO’s View

U.S. information-technology spending appears to be on the upswing, but the way your company’s IT department is using its money may be changing. Consumer tech spending has been growing for some time, and now businesses are starting to open up their wallets as well, according to an article in Saturday’s Journal. Spending by IT departments should grow seven percent this year, Stephen Minton, an analyst at market-research firm IDC, tells the Journal.

Geoff Endris, chief technology officer at Capital Assurance Corp., an insurance company based in Prospect, KY, tells the Business Technology Blog that there are two interconnected reasons for the shift: 1) Companies have finished with the projects that they needed to do to comply with federal regulations – in particular the Sarbanes-Oxley Act, which requires companies to have tight controls over the processes they use for financial reporting. “Money for tech got spent on compliance,” Endris tells this blog. “Now companies can reallocate it to business investments,” most of which have some IT component; 2) Companies have spent the last several years improving their technology infrastructures. Now they are in a position to buy more sophisticated software that takes advantage of this.

  • Does Your Company Suffer From Tech Addiction? Information technology has increased the rate of work and improved our ability to communicate. But is that a good thing? One IT head says addiction to tech can lead to sloppy work and bad decisions. IT is having a dangerous sociological effect on businesses, says Tracey Baetzel, director of information services for the law firm Honigman Miller Schwartz and Cohn LLP. “Technology controls us more than we control it,” she tells the Business Technology Blog.

Instant Messaging Invades the Office During the preholiday crush last December, a computer maker asked staffing company Adecco SA for 300 additional factory workers -- immediately. Using an instant-messaging program, Senior Vice President Steve Baruch tapped managers in three states to line up the workers within hours. If he had relied on email and phone calls, Mr. Baruch says, the same process could have taken him as long as three days. Instant messaging is invading and changing the workplace. Employees started to sneak instant messaging into the office in the late 1990s, but now more companies are endorsing it. Faster and more casual than email, instant messaging can foster broader collaboration among employees even as it further blurs the boundaries between work and life.

Microsoft Q&Q. Old News is Good News ? I think mainstream financial analyst questions at quarterly conference calls must be designed to support day trading. They don’t appear to be much help when it comes to investing. The back and forth at the recent Microsoft quarterly conference call was just another example. I heard a dozen trivia questions about old news like client and server software and only one (there might have been another technical modeling thing) about the future, Microsoft’s online division. What I did hear in the formal presentation and in the carefully scripted answers to the carefully backwards-looking questions was all good. Even the stuff in the seams between the carefully scripted pauses was good news: 1) The guidance does not yet include the boost that the aQuantive advertising/publishing applications will give the online division, and 2) the estimate of what enterprises will do in general in FY 2008 is conservative. There could be upside from the already raised expectations.

Tax Break Used by Drug Makers Failed to Add Jobs Two years ago, when companies received a big tax break to bring home their offshore profits, the president and Congress justified it as a one-time tax amnesty that would create American jobs. Drug makers were the biggest beneficiaries of the amnesty program, repatriating about $100 billion in foreign profits and paying only minimal taxes. But the companies did not create many jobs in return. Instead, since 2005 the American drug industry has laid off tens of thousands of workers in this country. And now drug companies are once again using complex strategies, many of them demonstrably legal, to shelter billions of dollars in profits in international tax havens, according to their financial statements and independent tax experts. In one popular accounting move, companies declare their foreign markets as far more profitable than their American businesses — even though drug prices are typically higher in the United States than anywhere else in the world.

 

Apple whacked by iPhone worries: One day before the company is due to report earnings, its shares slide after AT&T says fewer iPhones than expected were activated in the second quarter.

·         iPhone Review Concluded: Memo to Motorola…Whatever You’re Working on, Stop

Bear Stearns Shares Show Cayne's Dummy `Body Blow' Won't Hurt :When Bear Stearns Cos. Chief Executive Officer James E. ``Jimmy'' Cayne told the New York Times the failure of the firm's hedge funds was a ``body blow of massive proportion,'' he may have been using a tactic honed in three decades of championship bridge. Bear Stearns, the biggest U.S. broker to hedge funds, doesn't expect to lose even a dime on the bailout, according to a July 17 statement to clients. Most analysts say the debacle is unlikely to have anything but a negligible impact on profit and book value. Only two of 16 have cut their estimates for Bear Stearns earnings in the past four weeks.

External affairs Old assumptions are being challenged as the outsourcing industry matures For a start, the industry is growing less rapidly than before. Offshore work is a component of most outsourcing contracts, but jobs no longer flow only from richer countries to poorer ones. Cost savings are still the principal motivation to outsource, but performance is becoming the main battleground between providers. Even the language is changing. Vendors refer to themselves as partners. Labour arbitrage is out; “intellectual arbitrage” is in. Some even recoil from the word “outsourcing” itself. “It gives the impression of just throwing something over the wall,” says Ross Perot Jr, chairman of Perot Systems, a computer-services firm based in Plano, Texas. Start with the numbers. The latest quarterly report on the state of global outsourcing from TPI, a consultancy, was published earlier this month. It showed that both the number and value of contracts awarded during the first half of this year had declined in comparison with the same period in 2006. In 2007 the total value of contracts awarded in the first six months was the lowest since 2001 (see chart).

Weekly Reader for Jul29: Markets and Investments

Whew what a week for the markets. What I feel is a long overdue correction got underway with a vengeance.  Since this market has been financially driven for some time the re-pricing of risk and adjustments in the credit markets are creating huge ripple effects in all markets, assets & instruments and sectors. The odd thing is that several insightful observers from CalculatedRisk to Bill Gross have been predicting these adjustments in one form or another for some time. The real question is, is this just a correction or something more severe ? Time will tell of course and this next week or so will be particularly revealing. My feeling is that one the one hand we’re just seeing the beginnings of facing up to realities, on the other hand there’s still a huge divide between the major of Street-based prognosticators who see a 2nd half return to higher growth and earnings – despite, for example Bernake and the Fed revising both their outlook and sense of the upper limits to sustainable growth (the “speed limit” or natural rate of full-employment growth) down this week.

 

Articles marked with * are particularly worth reading  and thinking about.

 

I’d say happy reading but it isn’t so …valuable reading ?

Investment & Markets

A Short-Lived Golden Age: Private Equity Highlights Shift in Market Sentiment; Correction or Far Worse? Henry Kravis said in April that we are in private equity's "golden age." Market sentiment has clearly changed. But why are these buyout kings, along with an increasing array of other financial luminaries, acknowledging the problems? Surely it would be in their interest to deny there was anything wrong, particularly if, like KKR, they are on the point of launching a huge initial public offering. In fact, they are already arguably behind the curve. When Mr. Kravis spoke of a golden age, investors were already fretting about troubles in the U.S. subprime-mortgage market. The doubts increased as the losses became concrete, most notably last week's wipeout of one fund managed by Bear Stearns Cos. Meanwhile, credit spreads have widened, conditions on new leveraged-buyout loans are tighter, and banks are finding it hard to shift $40 billion of LBO debt for the likes of Chrysler and Alliance Boots PLC, the U.K. retailer. Even the enthusiasm for emerging markets has faded: OAO Rosneft, the Russian oil giant, earlier this month pulled a $2 billion bond offering.

·         DealTalk: KKR plays hard ball and Wall St. winces Kohlberg Kravis Roberts & Co., the legendary leveraged buyout firm known for its tough deal tactics, is living up to its image, to the growing frustration of Wall Street. KKR, with four major buyout deals in the debt pipeline, is refusing to budge on lending terms agreed to with investment banks, even as debt investors show a weakening appetite. That tough stance amid shaky debt markets means banks will have to shoulder all the risk and perhaps take significant losses on the massive loans. With other private equity shops willing to renegotiate with banks, KKR's position is starting to fuel ill-will with Wall Street, sources close to the firm say. Bitter bankers are hardly what KKR wants in the days before its planned initial public offering. Of course, if the LBO climate steadies or returns to being robust, then any bad feelings will quickly be forgotten. But should the debt markets continue to decline, some on Wall Street think KKR's hard ball tactics could come back to bite them.

  • Sperling Says Debt Crunch Could Tighten PE Purse Strings Private-equity firms recently have been paying sky-high prices for the companies they buy, but their generosity won’t last long. That at least is the view of Scott Sperling, co-president of the venerable Thomas H. Lee Partners and a veteran of the private-equity business. Deal Journal tracked down Sperling to ask him about the recent turmoil in the debt markets (which Sperling will have to tap to complete his firm’s $19.5 billion buyout of Clear Channel Communications). His conclusion? The debt crunch will force PE firms to tighten their purse strings.
  • Calling an End to the Buyout Boom The failure of investment bankers to find buyers for debt backing big leveraged buyouts on either side of the Atlantic today has the Financial Times predicting that the end of the greatest LBO boom in history may be upon us. The double whammy of delays of debt sales for both Alliance Boots and Chrysler has Marek Gumienny, a honcho at U.K. private-equity firm Candover, talking about a denouement for the private-equity drama. Echoing what many bankers in the U.S. are saying privately, Gumienny tells the FT that a number of investment banks, loaded up with high-yield paper they can’t move, were said to have “shut the door” to new lending for LBOs on the continent.

KKR, Homeowners Face Funding Drain as CDO Sales Slow The Wall Street money-machine known as collateralized debt obligations is grinding to a halt, imperiling $8.6 billion in annual underwriting fees and reducing credit for everyone from buyout king Henry Kravis to homeowners. Sales of the securities -- used to pool bonds, loans and their derivatives into new debt -- dwindled to $9.1 billion in the U.S. this month from $42 billion in June, analysts at New York-based JPMorgan Chase & Co. said in a report yesterday. The market, which was ``virtually shut'' earlier this month, is showing ``signs of life,'' the bank said. Investors are shunning CDOs after the near-collapse of two hedge funds run by Bear Stearns Cos. that owned the securities. Standard & Poor's downgraded bonds from 75 CDOs as mortgages to people with poor credit defaulted at record rates. Concern about losses on home loans are rattling investors across the credit spectrum. Investors are demanding yields 10 percentage points higher than benchmark rates to compensate for the risk of losses on some of the lower investment-grade rated parts of CDOs, up from 4 percentage points at the start of the year, according to data compiled by Morgan Stanley in New York.

  • Basis Capital Fund Management Ltd. hired Blackstone Group LP as an adviser after the Australian hedge fund manager was battered by losses in the U.S. subprime mortgage market. The losses at the fund, which recorded an average annual return of 15.5 percent for the past five years, underscores the global impact of the subprime shakeout. Federal Reserve Chairman Ben S. Bernanke said July 19 there will be ``significant financial losses'' from risky mortgages, pointing to estimates as high as $100 billion. Basis Capital had assets of $1 billion as recently as May, before reporting its Aust-Rim Opportunity Fund and the Yield Fund lost 9 percent and 14 percent respectively in June. The funds ran into trouble by investing in the unrated, riskiest portions of collateralized debt obligations. These portions, also known by bankers as ``toxic waste,'' are first in line for any losses when borrowers fall short on mortgage payments.

(**) Pimco's Gross says weakness in subprime, junk bonds is spreading Weakness in junk bonds and subprime-mortgage markets could lead to as much as a double-digit correction in U.S. stock markets, respected bond-fund manager Bill Gross warned on Tuesday. Investors should watch the impending sale of DaimlerChrysler AG for clues as to how far an ongoing meltdown in subprime lending could spread, he added. From what he hears, Gross says yields on the paper being issued to help finance the deal will be around 9%. But some pieces of that placement could reach yields of close to 12%, he added.

  • Chrysler's Bankers May Take On Debt: Chrysler's attempt to tap debt markets for $20 billion hit a critical juncture as bankers began discussing the likelihood that they will have to step up with a large part of the money because investor demand hasn't been strong enough. The financing is being watched closely in Detroit because the Big Three and a horde of auto-parts suppliers have depended on tapping debt markets for low-interest loans and bonds in a wave of restructuring and asset sales.
  • Bankers Postpone Chrysler Debt Sale Bankers raising $20 billion in loans for Chrysler Group have postponed a sale of $12 billion in debt for the auto company and are planning to fund the bulk of that debt from their own pockets for the time being, according to a person familiar with the matter.
  •   KKR Banks Fail to Sell $10 Billion of Boots Loans (Update2) Kohlberg Kravis Roberts & Co.'s banks, led by Deutsche Bank AG, failed to sell 5 billion pounds ($10 billion) of senior loans to fund the leveraged buyout of Alliance Boots Plc, two people with direct knowledge of the deal said. KKR's eight underwriters will offer higher interest rates to sell 1.75 billion pounds of junior loans, said the people who declined to be identified because the discussions are private. The banks will keep the senior loans on their balance sheets, the people said.
  • Chrysler Throws Salt in Citigroup’s Wounds Citigroup is one of the banks that will, at least temporarily, be left holding the bag after investors took a pass on the sale of $10 billion of loans at Chrysler’s auto unit for the company’s leveraged buyout. (The others include J.P. Morgan Chase, Goldman Sachs Group, Bear Stearns and Morgan Stanley.)

·        It’s the biggest chunk of paper forced on investment banks since debt- buyers decided last month to stop financing buyouts with easy terms. It isn’t good news for either the banks or the buyout firms. There will come a point, if we aren’t there already, when banks refuse to make new loan commitments. That’s because they’re too occupied getting rapidly- accumulating paper off their books. (The giant Alliance Boots deal in Europe also is now headed down the same path — though Citigroup doesn’t appear to have a primary role there.)

Bond Risk Soars by Record as Investors Flee Corporate Debt The risk of owning corporate bonds increased by the most ever in Europe and Asia on concern banks and hedge funds face widening losses on subprime mortgages and leveraged buyouts, according to credit-default swap traders. A sell-off in the U.S., Asia and emerging markets extended to Europe, where the cost to protect company debt approached the record high in 2005 when General Motors Corp. and Ford Motor Co. lost their investment-grade credit ratings. Deutsche Bank AG's risk premium jumped to five times the amount on June 1. Investor wariness caused more than 40 companies worldwide to reorganize or abandon borrowing plans in the past month. The retreat forced banks to take on $20 billion of LBO loans they had planned to sell for Kohlberg Kravis Roberts & Co. and Cerberus Capital Management LP this week.

M&A Boom: 'I'm Not Dead Yet'

In the world of deal making, who are the real kings – private equity or corporations?

Once upon a time, the answer was simple – strategic buyers. Armed with cost-cutting synergies, conventional Wall Street wisdom held that strategic buyers always outspent private equity.But with the credit markets tightening for LBO-related issuance, are strategic buyers making a comeback? Ok, sure. Corporate buyers never really went anywhere — they still account for the vast majority of deals. While strategic buyers are doing more than 10 times as many deals as private equity and accounted for 75% of the total announced deal volume from June 1 to July 25, private-equity’s buying frenzy appears unabated. For the period, total deal volume was $941 billion, with leverage buyouts accounting for 25% of that. By comparison, LBOs accounted for 23% of the of the year-earlier period’s volume and 22% of deal volume in the first half of 2007, according to Dealogic. Buyout volume jumped to $231 billion, up 80% from the year-earlier June-July period. That jump was powered by the largest buyout ever (BCE) and Blackstone’s takeout of Hilton Hotels for about $20 billion. In fact, the top five deals accounted for almost 40% of the leverage buyout deal volume. (See the chart at the bottom of this post.) A look at the average premiums paid in the top five buyouts and the top five strategic deals (by no means a comprehensive analysis) suggests private equity continues to be willing to spend to get their targets. In the top five LBOs, the average premium paid was 16.7%; in the five largest strategic deals, it was 14.9%.

Look to financials for market movement clues: The carnage in this space 8% declines in a five-session span by some of the largest financial institutions in the world is the principal point of concern. The market is pricing in the potential for a broader contagion given our debt dependency, tightening credit parameters and an interwoven financial fabric with $370 trillion in underlying derivatives. A "tail event," such as a contagion, is by definition a low-probability affair. To our earlier point, however, the event itself doesn't have to occur to impact market psychology. Perception is reality on Wall Street, and the slightest whiff of fear will affect a crowded tape with a slimming margin for error. That's the nuts and guts of where we stand, and the financials remain the truest proxy for this dynamic. If they bounce, they'll quickly shift sentiment and trigger a sharp squeeze. If they continue slide lower, they'll pull the equity spectrum along for the downside ride.

July 23, 2007

Cusp Points & Consequences: a Little High Frequency Data

Well this week will bring some eagerly awaited economic data - particularly on home sales and the advanced GDP guestimates. The latter in particularly tends to get revised severely so it'll be hard to put too much stock even though it will be taken that way on it. There are a couple of critical crossing points that will start to surface here though.

Update:Northern Trust Daily Commentary (July 23):

  • Q2 Real GDP Growth Forecast:  Chicago Fed at 2.7%; Consensus at 3.2%
  • Inflation Expectations:  Tolerance Threshold is Tough

One way to approach this is to look at the higher frequency montly data and see what it tells us about the outlook for consumer spending, now and in the future, as well as the business outlook. Let's start with a little table of the key variables and then take a look at some charts - which always help me see things a little more clearly. 

 But before diving into the high-frequency data let's set the table by reviewing the basic consensus that has emerged and key points therein:

  1. First, the general consensus is that growth (& therefore/thereby profits and earnings) is slowing but decent for the last half of the year. In fact the expectation is for something between 3-3.5% annualized growth even though everyone admits consumer spending is slowing. The expectation is that business investment will make up the difference along with an improving trade picture. The problem (as we discussed in an earlier post looking at relative contribution and performance of the various components) is that a lot of ground might have to be made up. Of course this gets even more interesting when the Fed's implicit growth rate has been lowered as it was last week.
  2. Part of the problem is that while it's being grudingly conceeded that GDP growth might be lower than expected that the impact of housing, MEW and the ripple effects of a widening credit crunch are likely being under-estimated. We've been hearing for well over a year that the end of the housing downturn is in sight only to be surprised by yet another set of homebuilders announcements and housing data. The problem there, and the outlooks are now moving toward - at best - a bottoming in late '08 not early this year as was true not to long ago, is that the lag timing of housing downturns keeps getting under-estimated. There is no more sticky market than housing so it takes a long time for prices to adjust down. Similarly it takes a long while to permit and start construction so the current employment levels haven't been as impacted as expected because a lot of work is still going on. Finally consumers used their houses as ATM's but with the re-pricing of home equity that's coming to an end.

 

Part of the problem is that the high-frequency data updates thruout the month so at any point in time some will be missing and in process. Hence some "missing" entries. Here we have YoY% changes in som key data, oftentimes a smoothed 3MoMA to dampen things a little bit. For Consumption indicators we have monthly real consumption (PCER), real retail sales and auto sales. For future consumption we have wage and job growth - wages drawn from average real weekly earning data. And New Home sales. And for the business outlook we have industrial production and durable goods orders ex-aircraft.

Take a look at the chart - that's not a set of numbers that makes me feel sanguine just on the base economy - more sanguinary. And that's before we factor in the various deeper and more hidden issues mentioned above.  One thing to notice about last year that shows up clearly is the clear upkick created by lower oil prices on last year's consumption. Last Spring's expectations of lower spending, lower growth and increased inflation risks were pretty well grounded until we got a huge drop in oil prices. That "tax" is going to be working the other way now. Well real consumption recovered but is showing a downtrend while real retail sales falterred a bit in June after a slight uptick in May but both are consistent with the trend (shown) downward. Meanwhile Auto sales (on the r.h. scale) took a huge drop last year but are still showing negative growth - despite the chances for better YoY comparisons. Longer-term indicators aren't particularly strong either. Employment growth seems to have, at best, floored off at about 1.5% which doesn't increase demand while real wages, after showing a strong uptick - and the first in this "recovery" - are showing a much stronger downtrend. In other words there are not indicators of sustained consumer demand, let alone growth in demand.

Shifting to the business side of the house take a  look at the accompanying chart. For comparisons PCER is left as is New Home sales (partly because residential construction is the "other" major driver of investment spending and has been so crucial this cycle). The other two key indicators are Industrial Production and durable good orders ex-Aircraft. And I have to say those definitely don't look well. Take a look and see what you think. Orders have shown a fairly steady downtrend. It doesn't look as if the much ballyhooed recovery in business spending is underway, or at least to the extent it might be, with much strength. But it's industrial production that shows this the most clearly and most recently, since the June data came out last week. In fact after a very slight May uptick which in now way disturbed the fairly steep downtrend it tipped back down again in June.

Taken all together then one would have to say that an outlook for Q2 GDP growth of 3.5% is pretty optimistic. And an outlook for the last two quarters that results in 3% or better growth for the year seems highly unlikely. Paul Kasriel of Northern Trust has suggested, as have others, that we might see an uptick in business spending in Q2 as inventories are re-built but that the 2nd Half outlook is not particularly good. Calculated Risk put up an interesting post a while back (discussed in our prior post on GDP components and outlooks) that used the available two quarters of consumption data to make guestimates. For the first two months of Q2 personal consumption spending rose at a rate of about 1.7% annualy. That means that the factors supposed to get us over the hump will have to have big upticks.

As they say - may you live in interesting times. Oh, I forgot. We ARE living in interesting times. Sorry

Aholes, Shirkers and Performance: a Draft People Principles Policy

Several posts here have explored the relationship between enterprise performance and the human environment. The argument is that the better people are treated the better they will perform for the company by taking care of customers and its' interests. Now my biases in this case are shaped by both my management experience and my earliest working experience at Fedex who's motto was/is "People, Service, Profit". And they backed it up - the three policy manuals around which the company governed itself were the People, Service and Profit manuals. Compensation and promotability were determined by effectiveness in people management and they've found since their beginnings that people are the key to service which is their whole reason for existence (& pricing and profit : ).

That said, at the same time, people are definitely not all perfect. In fact my experience has been that out of any ten person team normally assembled you're lucky to get one star solid performer, three decent ones and a lot of folks who'd like to be more than they work or are capable of. And further everybody's in denial about this from both sides - both bad bosses and bad employees. With all due respect to HR's due processes they aren't taken very seriously in general.

But, I'm more convinced than ever that good HR is a mandantory strategic performance requirement and excellent HR is a competitive differentiator.

UPDATE (8/1): Seth Godin has two interesting post on toxicities among bosses and employees that are short, sweet and to the point. To which I'd add, my point here, toxic behavior is not rational (this is a family blog so scruples prevent putting it more strongly). 

Bob Sutton over at his blog has covered his new book "The No Asshole Rule" and triggered an avalanched of heartfelt outpourings on bad treatment. Some of the stories of aholes run amok and bad people policy are....what ? Startling, heartrending, make you shake your head ? Well my triggerring was to start wondering about the rationality of these choices and on several lines of inquiry I'd argue that we can make a very strong case (see the three prior posts cited below for different perspectives on total enterprise performance and people management). Let me put that more directly and strongly.

  1. Bad people policy makes no rational sense and damages corporate performance in the short- and long-runs.
  2. Bad people policy has a measurable impact on both enterprise value and internal efficiency and effectiveness. It is NOT judgemental though judgement as to consequences is required.
  3. In other words the costs and benefits of strategic investment in investing in people can be thought of in the same way as we do other strategic choices.
In other words we've all known for a long-time that we don't like working in bad environments and our collective tribal knowledge is that it's bad for us, for the company and for the stock. But we've also generally talked about these issues in 'soft' terms. I would argue that's mis-guided when the problem is properly framed and thought thru.

So how to bridge the gap between delusions and realities ? Well, it's not entirely clear that I've got an answer but being on a plane and in that wonderful state of sleep-deprivation, crampedness and caffeine over-dosing where sometimes the gods speak to you what they suggested was this little manifesto. It's based on the principle of running a company for adults. See what you think:

Six Principles of People Management (draft manifesto): 

  1. You are an adult, worthy of respect, who has every right to be treated as such and so expect.
  2. But we also expect you to be and act as an adult who takes responsiblity for their actions and deals with the good and bad  times equally well.
  3. You are entitle to a fair day's pay for an honest day's work
  4. We expect you, in fair exchange, to put the organizations long-term best interests first in your priorities but not to the unbalanced exclusion of others in your life.
    • The virtuous circle of priorities is Customer (take care of them), Organization (which results in satisfaction and value) and You (so the Organization will take care of you).
  5. We will walk this walk together - not just talk about it while we walk to the bank and you walk to the door.
  6. Good work done well is worth doing and it's fun (or least satisfying). We intend to do good and do well and have fun as best we can manage.

Taken all together the organization will perform better in the short- and long-runs. Which implies the pie (Pi as in profits) will be bigger for all of us even if somebody's slice changes relative size.

 The prior posts that make the case are:

and Bob's blog is here and one of my favorite posts dead on this is "Waste of Talent" .

 

Weekly Reader 22Jul07: Weekend Listings Cont'd

 Here's a double re-fresh with articles/columns/blog on Investment & Markets, the Economy and Businesses of particular interest. This time around we've created a general purpose category of specially interesting links on CEO Libraries, the Breaking Up of GE and future earnings outlook from S&P.

Bon Appetit' ! 

General & Special

C.E.O. Libraries Reveal Keys to Success : Perhaps that is why — more than their sex lives or bank accounts — chief executives keep their libraries private. Few Nike colleagues, for example, ever saw the personal library of the founder, Phil Knight, a room behind his formal office. To enter, one had to remove one’s shoes and bow: the ceilings were low, the space intimate, the degree of reverence demanded for these volumes on Asian history, art and poetry greater than any the self-effacing Mr. Knight, who is no longer chief executive, demanded for himself. Could it be possible to read Phil Knight’s books in the order in which Mr. Knight read them — like following a recipe — and gain the mojo to see a future global entertainment company in something as modest as a sneaker? The great gourmand of libraries, the writer Jorge Luis Borges, analyzed the quest for knowledge that causes people to accumulate books: “There must exist a book which is the formula and perfect compendium of all the rest.”  Personal libraries have always been a biopsy of power. The empire-loving Elizabeth I surrounded herself with the Roman historians, many of whom she translated, and kept one book under lock and key in her bedroom, in a French translation she alone of her court could read: Machiavelli’s treatise on how to overthrow republics, “The Prince.” Churchill retreated to his library to heal his wounds after being voted out of power in 1945 — and after reading for six years came back to power. Poetry speaks to many C.E.O.’s. “I used to tell my senior staff to get me poets as managers,” says Sidney Harman, founder of Harman Industries, a $3 billion producer of sound systems for luxury cars, theaters and airports. Mr. Harman maintains a library in each of his three homes, in Washington, Los Angeles and Aspen, Colo. “Poets are our original systems thinkers,” he said. “They look at our most complex environments and they reduce the complexity to something they begin to understand.”  He never could find a poet who was willing to be a manager. So Mr. Harman became his own de facto poet, quoting from his volumes of Shakespeare, Tennyson, and the poetry he found in Arthur Miller’s “Death of a Salesman” and Camus’s “Stranger” to help him define the dignity of working life — a poetry he made real in his worker-friendly factories.

Is G.E. Too Big for Its Own Good? : Toxic mud wasn’t the only mess Mr. Immelt had to clean up when he took the reins from the legendary Mr. Welch in 2001. Along with dealing with a struggling reinsurance unit that forced G.E. to take billions in write-offs, a power turbine business poised to collapse and an overvalued stock, Mr. Immelt had the misfortune to move into the corner office just four days before the Sept. 11 terrorist attacks altered the political landscape and the outlook for core G.E. franchises like jet engines and aircraft leasing. There is growing pressure on Mr. Immelt to do something — anything — to get G.E.’s stock moving after six years of stagnation. Despite a 15 percent rally over the last two months, G.E. shares are still down 30 percent from their Welch-era peak. And in April, the analyst Jeffrey T. Sprague of Citigroup Investment Research stunned Wall Street by calling for a breakup of the company, urging Mr. Immelt to sell off NBC Universal, as well as the consumer finance and real estate units. Whereas Mr. Welch took over a company vulnerable to foreign competition and hamstrung by a bloated work force , Mr. Immelt took over a giant that had been successful but wasn’t growing as fast as smaller, more agile companies — and which had a number of financial and operational time bombs in its portfolio.  “Five years ago, we had troubled franchises and no liquidity,” Mr. Immelt says. “Think about being in the aircraft leasing and aircraft engine business on September 12.”

To reinvigorate the corporate behemoth that is G.E., Mr. Immelt has made more than $75 billion worth of acquisitions in sectors like energy, aviation, water treatment and health care while selling off the division where he and Mr. Welch both began their careers, GE Plastics, for $11.6 billion in May. The result, says Mr. Immelt, “is that the company in every way is different than it was in 2001.”

Earnings: Where's the Growth?: With corporate profit gains slowing, S&P doesn't see much upside potential from current levels for stocks this yearFrom Standard & Poor's Equity ResearchThe second quarter 2007 earnings season got off to a rough start last week, with Home Depot (HD), D.R. Horton (DHI), Ryland Group (RYL), and Sears Holdings (SHLD) among the companies revealing that housing-related weakness appears to be having a continuing damaging effect on consumer spending and the consumer discretionary sector. Meanwhile, Standard & Poor's Ratings Services (an entity that operates independently of S&P Equity Research) downgraded some 500 subprime classes of debt totaling $6.4 billion in rated securities, dampening any hope of a swift end to housing and mortgage-related weakness. The discussion on the fundamental profit environment during S&P's Investment Policy Committee meetings continues to revolve around an expected lack of real earnings progress in 2007. S&P analysts estimate the S&P 500 index will post only 5% profit growth in the second quarter, a continued deceleration from the 8% increase posted in the first quarter of 2007. It is not only the relatively low prospects for earnings growth that are of concern, but rather the components of growth itself. S&P estimates that favorable foreign currency translation will contribute about 2% or 3% to quarterly earnings growth this year, with stock buybacks adding another 1% to 2%. Meanwhile, simple inflation is contributing 2% to 3%. When overall earnings growth is 14%, as it was for all of 2006, favorable foreign currency translation and stock buybacks are merely nice kickers to the earnings story. But now, with earnings growth expected to be only 7% in 2007, these former boosters are accounting for much of the total.

Investment & Markets

Debt Market Is Squeezing Private Equity : After two years of rapid-fire deal making, private equity firms are finding it harder to get the job done. Some 15 to 20 debt offerings — analysts’ estimates vary — have been modified or postponed as anxious investors have demanded better terms for high-yield loans and bonds, the lifeblood of the leveraged buyout. Private equity firms have had to raise interest rates and sweeten the repayment — or risk having to withdraw the offerings entirely. This week, the sale of loans meant to finance the buyouts of the Chrysler Group and the European retailers Alliance Boots and Maxeda have been sweetened or postponed. Bond sales have not fared much better: about $3.65 billion in offerings have been postponed since June 26, according to data from KDP. If conditions do not improve, private equity firms and their bankers may face an even uglier situation. Some $235 billion in loans are waiting to be sold, nearly all for leveraged buyouts, according to Standard & Poor’s Leveraged Commentary and Data.

Nearly all major debt offerings that were expected to take place next month have been pushed back In short order, one of the friendliest environments that private equity firms have seen in years has quickly grown hostile. Once they could command extraordinarily lenient terms from investors, making the debt used to fuel leveraged buyouts quite cheap. So-called covenant-lite loans, which have few restrictions on repayment, blossomed, as did pay-in-kind toggles, bonds that could be repaid by issuing more debt. Now, analysts say, investors have shunned that easy debt, forcing buyout firms to pay more to get their deals done.

The troubles in the loan market have followed similar struggles to sell high-yield bonds. Over the last month, companies like U.S. Foodservice, a major provider of food to restaurants and school cafeterias, and ServiceMaster International, a lawn care and pest control services provider, have had to cancel bond offerings totaling almost $2 billion.Buyout firms are not the only ones suffering from the growing wave of caution sweeping through the markets. An increasingly popular practice among banks has been to assume part of the equity of these deals in what is known as an equity bridge. The tighter credit markets may not choke off deal making. But, analysts say, private equity must be willing to pay a higher price.

Dollar diversification, Stephen Jen reveals all

Well what do you know? All sorts of people, governments and institutions have been blamed for dollar weakness. But contrary to popular presumption, says Stephen Jen, Morgan Stanley’s global head of currency research, More…

Well what do you know? All sorts of people, governments and institutions have been blamed for dollar weakness. But contrary to popular presumption, says Stephen Jen, Morgan Stanley’s global head of currency research, US real money managers are the biggest dollar diversifiers, not the Asian central banks.

Controlling about $20,700bn in assets - four times the size of the total global official foreign reserves - US real money managers have been diversifying aggressively out of the US since 2003, says Jen. And if you buy his line that ‘currency diversification equals currency weakness’, this explains why the dollar has shown a gradual downtrend since then - and why it is so weak now.

Energy Shock: Sector's Shares Still a Bargain

Here's an energy shock you might not have considered: Many energy stocks are still cheap.

It might not seem possible after the sector's multiyear run. But it's true because investors all along have been pricing these stocks as if the surge in energy prices was temporary, and not a permanent shift in the landscape of the industry. Investors also have been wary of hot sectors after getting burned by the dot-com bubble.

 

Economy

Northern Trust Daily Commentary (July 20, 2007 )

  • How Do You Say "Rube Goldberg" in Chinese? (***)
  • More Evidence of Spillover from Housing to Consumer Sector

Northern Trust Week in Review

Passing the torch: After relying mainly on consumers to provide the push since its inception back in 2001, the economic expansion is finally getting a helping hand from the business sector. Just in time, too, since data describing consumer activity has become mixed of late. Retail sales took a header in June, even as many chains reported better same-store sales than the Street expected. And consumer sentiment in the first half of this month rose to its highest level since January while motor vehicle sales sunk to a multi-month low. But there's no doubt where business spending is going. Virtually every statistic describing the business side of the economy is now flashing green.

No help for gas buyers -- or oil investors: Rising oil prices and increased refinery costs mean gas prices will keep going up. Yet record profits mean little to investors, since companies don't have a good place to reinvest the cash.

Gasoline prices are likely to continue rising, and it's not just because crude oil prices have risen above $75 a barrel.

Oil refineries, which usually buy their oil at a price below that headline price, have seen their discounts virtually disappear. So the price they pay for oil is up twice -- once because the headline price of oil is higher and a second time because their discounts have just about vanished. You can bet that those two price increases will be passed along to anyone filling up at the gas pump.

Big Rise Seen in Demand for Energy It started with a simple question by Samuel W. Bodman, the energy secretary: What does the future hold for supplies of oil and natural gas? After nearly two years, Mr. Raymond has finally delivered his answer: Because the world’s population is growing and living standards are rising worldwide, energy consumption globally is expected to rise by more than 50 percent over the next 25 years. But finding supplies to match that growth is going to be increasingly tough and will require huge new investments in coming decades.

Fed’s Moskow: Potential Growth Has Slowed :

Chicago Fed President Michael Moskow added to the evidence Fed officials are less optimistic about the economy’s long-run growth rate. “We at the Chicago Fed think potential GDP growth is lower than it was five years ago, and currently is somewhat below 3%,” Mr. Moskow said in a speech to be delivered today to the Global Interdependence Center at the Federal Reserve Bank of Philadelphia. Potential growth reflects both growth in the work force and output per worker (that is, productivity). Lower potential means a given growth rate is more likely to test the economy’s productive capacity and fuel inflation.

A missed opportunity ... : China is growing incredibly fast.   No doubt net exports are contributing significantly to China's current growth.    But net exports are equally clearly not the only reason for China's current growth.  If net exports contributed 3% -- that is just a guess, but one consistent with the data from q1 -- to China's 12% growth in q2, China would have grown by a very respectable 9% even if its trade surplus didn't grow.  That is the missed opportunity.   This is a time when the global economy should be adjusting. If the global economy doesn't adjust now, when will it adjust?

The irony is that right now, China is at a stage in its domestic economic cycle where it doesn't need the stimulus from net exports, while the US does.  Yet with the dollar at a multi-year low -- and with the RMB still effectively pegged to the dollar -- China ends up getting a stimulus from the external side precisely when it doesn't need external stimulus.   Right now, China's authorities want less growth, not more.  China's premier famously called China's current pattern of growth unstable, unbalanced, uncoordinated, and unsustainable ...

The new risk from China: deflation
Wildly rapid growth has made China the world's fourth-largest economy. But burdened with industrial overcapacity and corruption, it's in danger of a Japan-sized bust.
Could China, the driver of global inflation in commodities such as crude oil and iron ore, be looking at domestic deflation in 2006? Deflation effectively took Japan out of the global economy for more than a decade, slowing global growth and increasing global economic volatility. Serious deflation in China has the potential to be a lot more dangerous. At its least damaging, it would flood the world's markets with even cheaper Chinese goods. At the worst it could stall the Chinese economy, a major driver of global growth, and even send the country into one of its traditional periods of instability.

·        Time running out on China's boom

·        China: Tons of money, wanton waste

·        Why China can't slow down

Lombard Street Research - Red-hot China out of control

Thursday’s announcement of an 11.9% real GDP gain in Q2 from the year before, after 11.1% in Q1, looks like an honest number (for a change): the nominal GDP increase was 16.4% and the difference is reasonably close to the inflation rate. But the key issue remains trade. China’s trade surplus is exploding. Its current level of $25 billion a month is a $300 billion annual rate — with non-trade items added in, the current surplus in Q2 was in the region of a $350 billion annual rate. Not bad, considering it was $240 billion in 2006, $160 billion in 2005, and minor until 2004. This explosion shows no sign of letting up, as the growth of exports far exceeds that of imports, and is now working off a much higher base.

China has settled into a pattern of nearly-30% exports growth, versus imports rising 20% or less. But its exports are now running at $1.2 trillion, about the same as Germany’s (as is GDP — Thursday’s boast in the People’s Daily) less than two years after overtaking Britain and France. These exports are also a massive 40% of GDP, extremely unusual for such a huge country, which should have a much larger relative internal market than medium-sizers like Germany, etc. (This statistic alone indicates the degree of distorted mercantilism in Chinese policy.) When 40% of GDP grows at nearly 30%, the growth contribution is nearly 12%. When the 30% that is imports grows at 20%, the growth deduction is 6%. The difference, the net export contribution, is 5-6 percentage points. In a country with a 10% growth trend that only leaves 4-5% for domestic demand if GDP is to grow at trend. But income growth is in line with GDP. So for domestic demand to grow only 4-5%, versus income at 10%, the savings rate has to go up. But it is already a totally unprecedented 50% of GDP! Fundamental disequilibrium indeed!

 

Business

Accounting for good people: Surprising as it might seem, the Big Four accountancy firms have lots to teach other companies about managing talented people. BEING interesting can be overrated. Accountants became suddenly intriguing in 2002 with the spectacular collapse of Arthur Andersen, because of its involvement in the scandals surrounding the fall of Enron. This added unwanted colour to a grey profession. Since then the surviving titans of accountancy—Deloitte Touche Tohmatsu, Ernst & Young, KPMG and PricewaterhouseCoopers (PwC), also known as the Big Four—have mostly retreated back into the shadows of public awareness. But interesting they remain, above all for the way they manage their people. It is not just that they collectively employ some 500,000 people around the world. Many companies are as big as they are. Unlike most, however, the Big Four really mean it when they say that people are their biggest assets. Their product is their employees' knowledge and their distribution channels are the relationships between their staff and clients. More than most they must worry about how to attract and retain the brightest workers.

The meaning of EADS : In some ways the story of EADS has been a one-off. No firm has ever been so bitterly fought over by two governments. No company has ever been saddled with such a daft management structure in consequence. No corporate saga has ever demonstrated quite so conclusively that politics and business don't mix. But the tale illustrates a general point too: that even the maddest manifestations of economic nationalism give way in the end to the pressure of globalisation.  What has changed is not the politicians, but the aerospace business. In ten years Boeing has gone from an introspective protégé of America's Department of Defence to a global civil aviation giant. It has outsourced production to contractors in America and found international firms, notably in Japan and Italy, to join in as risk-sharing partners, making much of its successful new 787. Boeing has taken the lead in developing new technology to make big aircraft more efficient, more economical and more eco-friendly. Airbus, meanwhile, has fallen on hard times with delays to its flagship A380 and to the launch of its rival to the new best-selling Boeing long-haul jet. Work shared between France and Germany led to a lack of co-ordination and delays on the A380 that have cost billions. And the rise of the euro against the dollar has made much of its production uncompetitive. Most of Airbus's costs are in euros, but aircraft are priced in dollars.

Ford's Volvo Dilemma

If Ford really wants to sell Volvo, as press reports in New York and London suggested last weekend, it must be in deep trouble. But at least there might be some willing buyers for its Swedish subsidiary. There don't seem to be many car manufacturers eager to take on the two Ford properties already up for grabs: British icons Jaguar and Land Rover. Depending on how all this shakes out, it could have major implications for European car making. …Ford has denied the reports that it is trying to sell Volvo, but the reasoning behind the speculation -- that Ford is pressured by its hemorrhaging finances -- is sound enough that the rumors refuse to die. Last year Ford lost $12.7 billion. In December it arranged the financing for its $23.4 billion restructuring plan. …Volvo, with its brand values of safety and general worthiness, has proved itself a success. Sales are accelerating as it replaces its model lineup. The company has also become an integral part of many other Ford products, providing components for the Taurus and Sable in North America….If the Volvo reports do prove true, it would clearly look bad for Ford. The company releases quarterly results next Thursday. With that in mind, Mr. Newton says, the rumors may indicate that Ford's U.S. operations are sliding even further than before, forcing CEO Alan Mulally to consider selling Volvo.

 

PluggedIn: Vista's growing pains leave room for XP:  David Daoud ran into trouble when he started using Vista, the new version of Windows that Microsoft Corp. (Nasdaq:MSFT - news) and PC makers have spent millions of dollars advertising since it came out six months ago. He said it short-circuited key software programs he counts on: Quicken for balancing his checkbook, Lotus Notes e-mail and a networking program that connects his home to the office. His Sony camcorder also doesn't communicate with the PC properly.Such problems are part of the normal growing pains that come with every major upgrade to the Windows operating system. To ease those pains, some consumers are seeking out machines equipped with the more compatible Windows XP. That's prompted some PC makers and retailers to give the older operating system more room in their product lines. Hewlett-Packard Co. (NYSE:HPQ - DELL - 0992.HK) and Toshiba Corp. (6502.T) also offer similarly equipped machines. Microsoft has done its best to get Vista off to a strong start, making it compatible with more than 2 million different types of hardware. The effort seems to be paying off. The company late on Thursday reported quarterly revenue of $13.4 billion, up 13 percent from last year, citing help from strong Vista sales. Microsoft says most people using Vista are pleased with it and that nearly all software and hardware is compatible. Still, some companies have been slow to respond to Microsoft's call for upgrades. Consumers have taken note.

Business Sales Lift Microsoft's Net as Consumer Units Struggle:  Microsoft Corp.'s latest financial results and an upbeat forecast signal how sales to businesses are helping mitigate growing pains in the company's high-profile but money-losing consumer businesses.

The software giant disclosed strong sales and profits for its fiscal fourth quarter ended June 30 and slightly increased its forecast for the year ending June 2008. Company executives said that renewals of Microsoft's long-term contracts with its largest business customers are a sign of stronger growth in the current fiscal year. Overall, sales of Microsoft's core Windows operating system and Office software helped offset costs associated with greater-than-expected defects in its Xbox 360 videogame consoles. Earlier this month Microsoft said it would take a $1.05 billion to $1.15 billion pretax charge to extend warranties on the Xbox. Net income rose 7.3% in the latest quarter, including a charge of eight cents per share for covering the Xbox 360 costs.

The results show how Microsoft's traditional core business -- selling software to businesses -- continues to subsidize promising but difficult consumer plays, including its videogames and online efforts. Those investments are closely watched in part because they center on battles with high-profile companies like Google Inc. and Sony Corp., but they continue to siphon off money Microsoft makes from its core businesses. Fortunately for Microsoft, most of those divisions continue to perform well -- though Microsoft's server division, which sells software used for large corporate computers, underperformed some analysts' projections for the quarter. Meanwhile, sales of Microsoft's Office 2007 suite of programs increased 20% in the quarter over the previous year to contribute $600 million to revenue.

 

Google Pays Price for Spending to Spur Growth

Text Box: •  What's New: Google's profit was less than expectations for the second quarter because of staff expenses and other costs.  •  Backdrop: The aggressive spending was related to faster hiring and an accounting change.  •  Reaction: With revenue-growth rates slowing, Google's spending caught some analysts off guard.Google Inc. showed the price for its heavy spending to keep up with breakneck growth.

The Mountain View, Calif., Internet giant's second-quarter profit fell short of expectations as staff expenses and other costs weighed on the bottom line. Expenses have rarely been a major concern for investors amid surges in Google's sales. But with revenue-growth rates now slowing, the company's aggressive spending caught some analysts off guard.

Google posted a 58% increase in revenue to $3.87 billion, driven by strength in its core Web-search and online-advertising business

SAP Stock Price, Profit Rebound On New Products

Investors are slowly regaining confidence in SAP AG, as the German business-software giant woos customers to new products and improves profitability. SAP's stock price had dropped sharply in the 12 months through April, as it missed sales targets and struggled to persuade big companies to switch to its new generation of software. But the share price has bounced back, and the company got another boost yesterday when it reported strong second-quarter earnings 

·        SAP, Oracle Move to New Battlefields

Caterpillar's Net Falls 21% On Soft Construction Market: Caterpillar Inc.'s second-quarter profit fell 21%, due to lower sales of truck engines and continued weakness in the North American construction market.

However, the Peoria, Ill., heavy-equipment manufacturer reported a 7.1% increase in sales, as demand continued for equipment used in mining and non-residential construction. Revenue was also boosted by continued strength in overseas sales, which made up for weakness in North America.

Caterpillar also forecast continued weakness in North America in the second half of the year, but added that lower sales there should be more than offset by higher sales in other parts of the world.

July 21, 2007

Weekly Reader 21Jul07: Interesting Links

Below are links to interesting and useful columns and posts that cover Investment & the Markets, the Economy and Business. Key articles are marked (**).

No surprise after this last week but a dominant theme, now moving beyond the talking heads at MSNBC, is the re-pricing of risk beyond sub-prime into other structured debt. Which in turn is causing both the Buyout and Buyback market drivers to come under pressure. As for the Economy the higher-frequency data is not supporting the headline optimism with increased signs that Housing has a long way to go while the Consumer comes under increasing pressure. Supplemented by rapidly rising oil prices and gasoline prices.

Meanwhile Businesses are coming under increasing pressure for performance - as they should of course. I particularly reccomend the interview with Jeffrey Pfeiffer on "What Were They Thinking" about bad choices made for ill-considered reasons. And the column on "Storm-proofing a Business" which compares and contrasts Totyota's long-term gradualism in building a resilient enterprise by design with Detroit's accumulation of problems by avoidence and inadvertence.

Investment & Markets

Chanos of Kynikos Says `Contagion' Spreading in Mortgage Market July 18 (Bloomberg) -- Paul McCulley, managing director at Pacific Investment Management Co., and James Chanos, president of Kynikos Associates Ltd., talk with Bloomberg's Brian Sullivan about the impact of the subprime mortgage market on the U.S. economy, investing in mortgage-backed securities and the outlook for Federal Reserve monetary policy.

"Right now things are starting to come unglued"

That's a quote from Charles Gradante of hedge-fund consultant Hennessee Group.

The only question is how far this thing is going to spread -- to other funds, to underwriters and ratings agencies, to investment banks special charges. You know, how *CONTAINED this is.

JPMorgan's Dimon Sees `A Little Freeze' in Lending for LBOs

 JPMorgan Chase & Co. Chief Executive Officer Jamie Dimon said demand for leveraged buyout debt is drying up and banks may be left holding more loans that they can't sell. JPMorgan, the third-largest U.S. bank, is among lenders that have been saddled with at least $11 billion of high-yield bonds and loans they haven't been able to readily sell, data compiled by Bear Stearns Cos. analysts show. Investors have balked at the increasing amounts of debt being taken on for LBOs. In most deals, investment banks promise to provide loans to the buyer. They then seek other lenders to take pieces of the loans and find buyers for bonds. When buyers vanish, the banks must either buy the bonds themselves or provide a bridge loan to the borrower, tying up capital that would otherwise be used to finance more deals. The banks typically parcel out portions of bridge loans to reduce their risk. Lenders have committed to about $100 billion of high-yield bond or bridge financings and $200 billion of loans, according to Dimon.

Bain Capital's Latest Fund Builds In Rainy-Day Factor

Bain Capital, in a concession to uncertainty about the health of the deal-making environment, is raising $15 billion for its latest private-equity fund, but it will keep a large chunk of that on the sidelines to ease the pressure such megafunds feel to become fully invested as quickly as possible (WSJ)

WSJ:Two Bear Funds Nearly Worthless, Investors Told -Sources

Weeks after the meltdown of two prominent Bear Stearns Cos. (BSC) hedge funds that bet heavily on the market for risky home loans, the brokerage has told the funds' investors that the portfolios' assets are almost worthless, according to people familiar with the matter.. (WSJ)

Banks May Sweeten Terms Of Loans for Chrysler Deal

… bankers marketed a $10 billion loan for Chrysler's auto business at 3.75 percentage points above the London Interbank Offered Rate, compared to the 3.25 percentage points discussed when the road show kicked off about three weeks ago, Standard & Poor's said. (WSJ)

How cheap debt overinflates stocks(**)

Today's availability of easy money distorts calculations that are used to determine whether stocks are overvalued or undervalued and makes the markets hard to read.

For bears, being right still hurts

Yes, the bears have it right: Despite yesterday's drop, the stock market has been soaring for months on a flood of debt. But being right hasn't stopped bears from taking a beating.

KKR, Blackstone IPOs Risk Their Style

KKR and Blackstone have strayed from their own precepts about how to run companies better as they rush to go public. It will be harder to stick by maverick decisions amid public ownership.

Subprime Uncertainty Fans Out

Bear’s Funds Are Essentially Worthelss: The revelations marked another anxious day for subprime investors. As a market index that tracks the performance of subprime bonds hit new lows, signs emerged that the pain experienced by Bear's hedge-fund investors is being felt by investors around the world.

RGE Coverage of the Signs of Stress in Credit Markets

 The RGE Monitor regularly covers a variety of issues in credit markets and credit derivatives. Here is below the bi-weekly RGE Monitor note that was sent today to our subscribers where we discuss the latest developments and stresses in credit markets.

Economy

Economic Forecast: Second Quarter Rebound, Third Quarter Relapse, Fourth Quarter Rate Cut?

From Northern Trust and the always insightful Paul Kasriel and his team. Well worth reading.

Bernanke: growth more subdued this year

Federal Reserve Chairman Ben Bernanke told Congress Wednesday that the economy has emerged from its anemic spell, but overall growth for the year will be lower than expected. Inflation remains the chief concern, he said.

Delivering a midyear Fed economic report to Capitol Hill, Bernanke struck a somewhat cautious tone. He suggested that the economy appears likely to expand "at a moderate pace" over the second half.

Still, the Fed chief told the House Financial Services Committee that growth this year will be a bit slower than the Fed projected in February. Growth should strengthen a bit next year, he said. The inflation forecast, however, wasn't changed. It calls for prices other than food and energy to edge lower.

 

Housing Starts and Completions for June

The Census Bureau reports on housing Permits, Starts and Completions. Seasonally adjusted permits decreased sharply:

Privately-owned housing units authorized by building permits in June were at a seasonally adjusted annual rate of 1,406,000. This is 7.5 percent below the revised May rate of 1,520,000 and is 25.2 percent below the revised June 2006 estimate of 1,879,000.

Starts increased slightly:

Privately-owned housing starts in June were at a seasonally adjusted annual rate of 1,467,000. This is 2.3 percent above the revised May estimate of 1,434,000, but is 19.4 percent below the revised June 2006 rate of 1,819,000.

And Completions declined:

Privately-owned housing completions in June were at a seasonally adjusted annual rate of 1,470,000. This is 6.0 percent below the revised May estimate of 1,564,000 and is 28.2 percent below the revised June 2006 rate of 2,047,000.

As expected, Completions have followed Starts "off the cliff". Completions are now at the level of starts.

Home Builders See Bleak Future

For more than 20 years, the National Association of Home Builders has been asking its members how they perceive the pace of single-family home sales and expectations for the next six months and what kind of traffic they’re seeing in unsold homes.

Gas Prices Hit Discretionary Spending

More households say they’re cutting back on discretionary spending due to higher gasoline prices, a new survey shows.

Small Firms’ Data Indicate Persistent Inflation

Both the consumer price index and the personal consumption expenditures index have offered indications that inflation is moderating, taking some pressure off the Fed. However, the National Federation of Independent Businesses says the picture may not be as rosy as it appears, as small firms are still raising prices.

The oil squeeze has just begun

Think the market is already tight? It's going to get tighter over the next five years under pressure from both the supply and demand ends. Here's why

Business

 

Ten Questions with Jeffrey Pfeffer(**)

(An interview with Jeff Pfeiffer) based on his latest book:What Were They Thinking?: Unconventional Wisdom About Management.

  1. Question: Why do companies do stupid things?

Answer: First, they ignore feedback effects. There has recently been a lot of interest, and apparent surprise, that programmers in India now cost a lot and their wages have been rising rapidly. Did people forget supply and demand? If everyone moves work to India, what did companies think would happen? Or, to take another example, when companies cut their retirement benefits, and people can not afford to retire, guess what, they won’t.

Second, companies often ignore the interdependence or connections between actions in one part and those in another. So, even as some departments are trying to cut the costs of benefits, others are worried about recruiting and retaining enough qualified people. Maybe the parts should work together.

Third, many companies presume that incentives are the answer to everything, and have a very mechanistic model of human behavior. That is also incorrect.

Icebergs Ahead: Designing a Risk-Proofed Company

Businesses, too, face life-threatening risks. And like physical structures, they can be designed to be rigid or flexible, vulnerable or adaptable, brittle or resilient. To see how these differences play out in terms of business models, consider the designs of two of today's most prominent businesses: Toyota and Ford.

Toyota is generally regarded as the world's best-managed automobile manufacturer. Its enormous financial and marketplace success -- and its ability to thrive even as its industry and the worldwide economy undergo repeated shifts and shocks -- stem not merely from the company's well-earned reputation for producing fine vehicles. They also derive from a series of smart business design decisions that, in combination, have made the company more durable, flexible, and risk-proof.As a result of Toyota's choices, its business design is architecturally sound. When we compare it, point by point, with that of a major U.S. competitor, Ford, we see why Toyota is prepared to survive the strategic shocks and shifts that are constantly occurring in the auto industry.

 

The Decline of Detroit

Meanwhile, the news from the market is ominous for both sides. June's recorded sales show that Detroit's once "Big Three" automakers collectively accounted for barely half the U.S. total market, a new low. Their share of the market seems likely to sink below half in July.

Honda to Sell New Brand of Car Developed With Chinese Partner

TOKYO -- Honda Motor Co. said it will start selling cars with its Chinese partner under a new brand in 2010, becoming the first foreign car maker to develop an original brand in China and highlighting the growing efforts by Chinese auto companies to gain more access to resources of foreign companies.

Retail Value - 'Lampert Premium' = Sears's Stock?

Investors in Sears Holdings Corp. got a reminder of the retailer's precarious state last week.

Shares had climbed sharply earlier this year on the belief that the company's chairman, Edward S. Lampert, could turn the retailer into a Berkshire Hathaway-like investment vehicle. But the stock price tumbled 10% after the retailer warned that profit this quarter would be half that of a year ago.

Sort of Evil

Bless Ed Markey, the House telecom subcommittee chairman, but it didn't enter his head unaided to hold up an iPhone at a hearing last week and -- like the ape in the movie "2001" -- ponder why he shouldn't use it with any wireless network he wants rather than just AT&T's. He was inspired by an alien epiphany (though he did not throw the iPhone in the air). Under brain stimulation from Jupiter, the movie ape noticed that a bone could be used to club a fellow ape. Under brain stimulation from the Google lobby, Mr. Markey noticed a club with which to bash the wireless industry into changing its business model and adopting one that better suits Google.

 

Yahoo seeks 'plan' as profits dip

 The new chief executive of Yahoo has said he is working on a "strategic plan" for the firm after reporting a sixth quarterly profit fall.

July 20, 2007

Real SP500: Thinking About Strategy & Outlook

We've been talking a lot about both the SP500 per se and it's relationship to other markets and sector breakdowns as well as having just finished a 3-part extended discussion of the Liquidity, Buyout and Bayback financially-driven market. And this is looking like a pretty jittery week for the US Markets. Since our perspective here tries to combine shorter-term technical and longer-term fundamental & economics perspectives in a context of digging into the real enterprise performance it might be helpful to look at long-term returns. And, courtsey of multiple sources, to especially inflation-adjusted returns.

An very interesting tool you can always consult is Political Calculations blog for the S&P real-return calculator - which runs all the way back to the late 1800s on a monthly basis: The S&P 500 at Your Fingertips . Some time ago (2003/2004) I made the observation that with a likely low and slow "recovery" this was, first off, going to be a picker's paradise. In other words careful decision making about both timing and fundamentals was and is important. The other observation was that with traditional assets classes showing low real returns AND show much liquidity being thrown off and turned into more liquidity (the essential point of the 3-parter) not only were alternative assets going to be the medium of choice but that a lot of creativity was going to be result in some interesting new investment products. Little did I realize just how creative things would be - nor how poorly grounded in basic operating performance.

So take a look at the following charts and consider that the implications are both for personal investing and, more especially, for capital allocation and economic outlooks. By that I mean if capital isn't getting a return because we're in a low-growth environment we need to re-think some of our most fundamental strategic guidelines. And not just in investing either ! 

Here's the real return on the SP500 from 1970 (courtesy of CrossingWallStreet via TheKirkReport) As we suspected the '70s were good to noone (thank you George C.). And the 80s and 90s were by-and-large good for everyone. Notice that the '00s have basically reverted to a long-term mean trend. Which actually should be pretty encouraging, at least if economic prospects were better (btw the most recent Fed testimony is that they've adjusted down the long-term speed-limit of the economy to below 3% because of slowing population growth and lower productivity trends.)

Now looking at the period from '00-now though one has to wonder a bit because it looks like all we've down is barely reach back to where we were. And there's the rub, as they say. What is the long-term outlook ? 

Before we tak a deeper dive on more recent inflation-adjusted returns let's take an even longer-term perspective (courtesy of Arthur Laffer vis BigPicture ).

 

This chart provides us with an even longer time-frame back to 1960. With that as a baseline the lost decade of negative returns is thrown into starker relief. Fascinatingly (at least to me) it wasn't until about 1994 that the markets got back to level ground - just before the onset of the investment-driven boom led to the bubble and crash. The good news is that we appear to have retained the gains of the 90s and are trending higher in this perspective.

So, the question is where do we all think we're going from here ? The world's going thru some massive structural changes with the significant re-entry of China and India on the world economic stage for the first time since the 1830s. Meanwhile Europe and the US seem to be struggling with finding the Next Big Thing that will drive us forward. And Latin America and Africa seem to have their own severe problems. While we're pondering that question - and I'm certainly open to suggestions and comments - let me add in a a little table based on our friend at PoliticalCalculations:

 

 

 

July 18, 2007

Market Drivers 3 (Buybacks):Investment, Hiring, Nah...Bonus, Bonus, Bonus !

 This started out to be a straight-forward post on the shift from an economically driven market environment to a financially driven one. It's important - and is widely recognized if not diagnosed and analyzed - that "liquidity" is behind a lot of what's been going on. It's turned into a three part set looking at the markets & the economics of liquidity (here ) and on the role of credit and leverage (here). The third leg of the stool that's pumping lots of cash into stocks AND pulling large/huge amounts of stock off the market is corporate buybacks using all that excess case from profits that aren't going into capital spending or hiring. Or dividends for that matter (personally I'd rather get the money back and decide for myself). Just to put it all in perspective, and maybe confirm that indeed things are a little unusual, take a look at the Fed data on "net equity issuance". It looks to me as if it started the '90s in neutral, grew slightly negatively until '98 (from stock options at technology firms ?) and turned back toward neutral. And then started sharply downward in '04 just about the same time the LBO buyout was coindicidently turning sharply upward.

Actually it's not a coincidence at all and is both driven by some of the same forces and being driven directly by the buyout boom. The theory of the latter is that going private improves the effectiveness of capital structure by increasing debt held and getting better returns thru leverage. Company executives prefer to reserve their powder for long-term contingencies so you have two views of the world. But with highly conservative investment plans, no accelerated hiring and no capex there was and is a lot of cash being thrown off that has to go someplace.

And on top of that as the amounts of firepower accessible to the LBO community exponentiated public company execs came under the same pressures to re-factor their capital structure as if they'd been taken private. That is, add lots of debt to the balance sheet and pay out the free cash in dividends or buybacks. Oh yeah, we should mention that shareholder and executive interests aren't entirely congruent here - buybacks keep stock prices up and bonuses are paid on stock prices. And it's actually gotten to the point where pubco's are borrowing to pay dividends and make buybacks. In other words, and this could potentially be really important, they are re-leveraging their balance sheets at what increasingly looks like the best the economy is going to be; i.e. when revenues, profits and cash flow have nowhere to go but down.

There's a whole seperate discussion here about whether paying execs to keep stock prices up in the short-term is good for the long-term (which we've also analyzed in the case of HD). And whether or not a better incentive structure wouldn't be to set the strategic goals and metrics thereof and pay for hitting those benchmarks. What a fascinating idea...we'll have to pursue its sometime. 

Meanwhile we can ask whether re-leveraging the balance sheets to keep stock prices up at the expense of investment or hiring is a good thing. And what the downstream consequences, especially when that leverage is being put on at the best of the economy.From Irwin Kellner on Marketwatch we get this little gem of a pointed observation:

"... last year, companies put most of their surplus cash (of which they had plenty, thanks to the surge in profits and the surfeit of liquidity) into dividends and stock buybacks. As a matter of fact, last year was the first year ever that the blue chip firms spent more money on buying back their stock than on capital spending."

An interesting point indeed. Consider what it's saying - the best strategic option we can find is to  buyback our stock because we don't see anyway to put it to work growing the company. And if we buyback our stock we get control rather than paying it out in dividends so you can re-deploy it to other industries, or even other assets that you think might do better. The chart puts a lot of that in perspective. Lots of debt went onto balance sheets in the 90's but it was used to buy a lot of equipment (and seperately to hire a lot of people. The late 90s was the first time both real wages and net new job creation had turned up in over a decade). All in all good for everybody. Now corporations have lots of "savings" but aren't putting it into re-building or growing the capital stock.

Oddly enough the punditrocracy has been reporting on this story since at least '04, and I think '03, and always concluding with the notion that lots of funds are available for investment. Which will then of course either keep the economy growing or even accelerate it. Judging from the chart we're just seeing basic replacement spending. NOT investment for new growth.

So, whether you're an employee, an investor, a stakeholder or one of the buyout and/or other investment folks you have to ask yourself is this what you want ? Consider my "textbook" case of Home Depot. After getting nicely compensated by pushing up earnings at the expense of the long-term health of the company but "upsetting" nearly everybody the board finally pushed Nardelli out after an activist hedge fund came to town as the new sheriff. In an earlier post we suggested six major strategic initiatives that HD needed to pursue to survive the housing downturn, stabilize the company and return to organic, long-term growth and profitability. ALL of those strategies - which are inter-dependent, require serious investment. Yet HD just announced a major buyback and dividends. Will their cash flow cover all three requirements - re-development, dividends (to payback the Hedgies) and buybacks ? An interesting question indeed.

Or consider Cerberus' in-process acquisition of Chrysler. What kind of investment funding will be required to recover that situation ? Where's it coming from ? And what kind of operating performance will be required from Chrysler in the short- and long-runs ? Even in the short-run serious additional funds will be required. And how many other companies, public, private or in the deal-stream, can this same sort of inquiry be made. I'd think it might be all of them.

These are really beginning to look like interesting times indeed, aren't they ? 

It stikes me that enterprise performance is going to be an increasingly critical requirement for mere survival. But we'll see. 

Update(20Jul07):

Share Buyback Boom:A look at why stock buybacks have been soaring, with CNBCs Scott Cohn. Apparantly my timing on topic is better than my market timing as coverage of this issue is picking up. Have to say this short little blurb doesn't have room for much depth but also have to say the sense of the comments is opposite of my conclusions.

Markets Drivers 2 (Buyouts): the Carry to Cash Economy

One interesting "benefit", as we shift from a cash & carry economy to a carry and (created) cash financial one, is that globalized markets allow many folks to borrow in low-rate markets (Japan) and put those assets to work in higher-rate ones (US, but anywhere actually). The Japanese Central Bank is thinking, after nearly two decades, of raising rates but they've got a lot of room to manuver. Meanwhile the European Central Bank and the Bank of England ARE raising rates as their respective economies recover. That's not helping the dollar any but in the meantime there's a lot of cheap money around.

Where it gets even more interesting is that that cheap money can be used to grow even more money - that's why liquidity is such a fluid and fungible concept. Not is it entirely clear that I'm entirely clear on the mechanics of all this. And from the last few weeks of sturm und drang in the structured debt markets associated with the sub-prime implosion it's not entirely clear that the rocket scientists involved thought everything through first themselves.

But, basically, it works like this. A Hedge fund or Private Equity group raises capital from investors, including for example some of the folks who have all that slosh at hand (notice China buying into Blackstone ?). Then the LBO guys take whatever equity they raise and make an offer on some company at increasingly high valuations. More fun yet they often (always) leverage up that equity at another large multiple. 10 or higher ? So a $1B equity fund is $10B of buying power. To make it even more fund, I mean fun, there are structured, securitized debt derivatives in various flavor and forms. The process for constructing securitized and "structured" debt instruments is shown courtesy of our friends at the WSJ but captures the basic proces pretty well for all the various derivates built on all the various assets.

That money the banks loaded, I meant loaned - just one darn Freudian typo after the other today, to the LBO guys gets turned into another asset, a virtual one this time. Then the investment banks pool a bunch of these new virtual assets together and re-slice them into pieces with various levels of risk and return. These slices, or tranches, are re-sold to say the Hedge funds as high-grade debt instruments with lower risk according to the models being used. Note - mathematical models not actual markets - it's a critically important distinction.

But the end result of the that is the Hedge funds who have been raising their own equity pools and also leveraging up now can leverage the leverage by buying up these structured derivatives. Thereby further increasing the pool of funds - liquity creating liquidity creating liquidity and providing more fuel to the fire of more money chasing few good real assets.

Oh, btw, there are a couple more interesting things here. First, the buyouts take stock off the market. A lot of it. All those earnings and profits and free cash flow have to go somewhere so more and more investible funds are chasing fewer and fewer stocks (or other assets). Second, the whole thing depends on the underlying "Thing" (property, house, business) actually performaing as advertised.

That's what's happened to Bear-Sterns. Well actually two things. First, the sub-prime implosion made the real payment flow look a lot less certain and much more risky so the value of the core assets went down.  And secondly, the value of those assets were based on math models built on statistical estimates of the risks and performance relationships. Guess what - each new instrument is unique and priced by a model based on the assumtion that nothing will change from history. That's how statistical modeling works. Whoops.

By the way my favorite financial columnist has a fascinating illustration of all this which is well worth your time to watch. I guarantee it'll help make all this rocket science stick in your mind.

Confidence is just an emotion, but a loss of it can cause the bond market to rumble. The recent case of a Bear Stearns hedge fund forced to liquidate billions is an example, MSN Money’s Jim Jubak says.
And the article that goes with the video plus a couple more that are also well worth your time (including the embedded videos) can be found here:

Let me repeat that - markets price assets because a lot of people have different views and debate and arbitrate them. That means, necessairly, that there has to be a common set of characteristics. It's why there are standard commodity contracts for example - Cargill got started in part to create standard markets based on defined standard agricultural products. To this day the culture views reserved grain barge slots not as ways to move grain to market but as speculative hedges that can be liquidated by re-selling the capacity and dumping the grain :).

Meanwhile another little chart captures the consequences of all that leverage building on leverage in terms of the rapid, one is tempted to call it exponential, growth in the buyout market. 

And another little historical note. The great German mathematician Gauss - the "Prince of Mathematicians", invented linear regression analysis to correct sampling errors in survey data and ESTIMATE what the real data was and improve the representation of the real world. Mathematical models with parameters based on statistical analysis aren't they underlying reality. They are a representation of it and much farther detached - after all Gauss was looking at real earth. The derivatives rocket scientists are looking at theories based on history and assumming it won't change and selling that as reality.

A set of assumptions we're in the process of testing !

July 17, 2007

Market Drivers: Liquidity, Liquidity(Buyouts) and Buyouts (Buybacks)

The last post on market performance looked briefly at the SP500, compared it to various other markets (Europe, Japan, Emerging, Asia, Tech and Small-Cap) and dove into various sectors performances (Real Estate, Gold, Energy/Oil Services, and Utilities). A finished up with a slightly deeper dive on real estate (commercial vs. homebuilders) to see where things have been and where they might be going. One key argument was that in a market with low long-term returns it was critically important to be picky. Picky in terms of timing & trends, picky in terms of market and sector differentials and, most very especially, anomalies that generate value-capture opportunities. And finally, given all that, to understand what the sources of the anomalies were as well as their technical characeristics.

I also threated to take a deeper dive on the S&P as the representative proxy for much of what's driving all these markets collectively - to wit, Liquidities, Buyouts (which are driven by liquidity in turn) and Buybacks. So here let's take a look at the S&P, dive a little farther into this liquidity thing and its' consequences (with the thought that we need to take a seperate dive on that sometime) and ask how market performance is being driven by the balances between fundamentals and internal technicals.

SP500 Performance 

If we look back to last year to now and think about expectations and outlooks you may recall that the consensus was for a summer dip followed by a fall gain with the end-of-quarter drop along about Oct. as the institutions adjusted their holdings and performances. That was based on the notion that the economy was slowing, inflation was going to pick up, rates were likely to rise and earnings would be flattening. Well we got, from somewhere, a huge drop in oil prices which boosted or sustained consumer spending. As a result the economy held up reasonably well and profits and earnings were good, though not as good as they had been. BtW - profits and earnings aren't necessarily the same thing but that's another topic to be tabled. And with oil down a major driver for inflation was controlled and the Fed, having reached a neutral stance, put further rate increases on hold. Which also btw is about as sound a monetary policy as we've managed in the last six decades. A Goldilocks market for a Goldilocks economy in other words.

If we take a closer look we did indeed get the summer dipsy-doodle drop from 1300 to 1250 but since then we've roared back to around 1525, at least until this last couple of weeks, barring the Feb/Mar Shanghai Surprise when it looked like the bursting of the Chinese bubble (still to come btw) would take all the other world markets with it. Once we discovered that Shanghai was a miniscule portion of the world's capitalization we not only recovered but plowed thru the prior highs around 1450. Recently, at least to me, it looked as if we were topping out at the aforementioned 1525 but in the last couple of weeks broke thru the resistance line quite nicely. At least for those of you looking for continued uptrends, as opposed to those of us looking at fundamentals and economic performance. In other words the market is up 20% since the beginning of last year and the bottom last July. Half, 10%, of that gain is since it looked like a top was being reached last fall. And from the Shanghai bottom to now we're up 15%, 5% of that or so within the last couple of weeks !

Now a couple of other things. First, word on the street - at least as filterred thru CNBC/MSNBC - is that there's a lot of short sellers scrambling to cover with a fairly large pool of funds. Over the next 6-8 weeks that puts some legs, albeit skinny and shaky ones, behind continued moves up. So if you'll take a much closer look at the chart above you'll notice that we had a trading range evovling very nicely with three tops (& resistance) and bottoms (& resistance of course). But last weeks sharp and sudden rally burst thru that. So here we are having climbed the known wall of worry and burst into the upland sunlight of new vistas - or something like that. That means as earnings roll in, some more economic news trickles by and, especially, the repricing of risk in the credit markets beyond sub-prime rolls on it will be fascinating to see if we keep that sunny space or not... 

Slosh, Slosh, Where's All that Money From ? 

Like I said in the prior post - wheee......e ! Taking a closer look what's going on ? Well for one thing earnings have continued to go up very nicely as a result of corporate profits being at a post-WW2 high as a % of GDP. Bear in mind if corporate cash flow is going into earnings and buybacks it's not going into investment or hiring. Which means lower demand now and in the future. The other thing that's going on is, as everybody has acknolwedged and been saying for a while now, there's a lot of money looking for a home and not finding many good places for it. Liquidity - cash, funds and borrowings X leverage - has several key sources.

  1. With an anemic recovery there's little demand for investable funds at the same time businesses are throwing off a lot of cash flow since it's no going to equipment or people. That explains the conundrum of why long-term rates were and are so low btw.
  2. With the trade balances a lot of US funds are going abroad (primarily to Asia and Japan) to pay for imports. They then have the option of letting it into their economies and creating their own unstainable booms, letting it bleed into the consumer sector and driving up inflation or watching their currencies appreciate dramatically. That would mean lower export growth and, a major socio-economic risk - especially for China were job growth IS social stability and the alternative to a revolution. The alternative is to absorb it into reserves and use those reserves to buy US assets, which is what they're doing. It makes a nice co-dependency - we consumer and pay them with funds they re-loan to us so we can keep buying stuff and so on around the circle. One wonders, doesn't one ?
  3. The petro-exporters (Saudia Arabia, Russia, especially as Mexico, Iran and Venezuala are spending it on domestic social programs) have the same re-cycling problem and have adopted and adapted their versions of similar responses.

July 16, 2007

Whee....Markets and Relative Performance

It's been a pretty wild ride in the markets recently. To tell the truth it's not clear to me that this is entirely based on a firm grasp of fundamentals but then reasonable, or other, folks can disagree about markets, at least in the short-term. As Keynes pointed out though, "markets can stay solvent and wrong a lot longer than you can stay right and bet against them". (Paraphrasing and unfortunately so given my take on the economy).

Right now I'm pretty convinced that this has been a momentum driven market, that is one driven by its' own internals, at least so far this year. And like all feedback loops you have to watch for reversals. Underlying the technical and momentum character of this market is a pretty profound change from an economic (profits and earnings) foundation to a financial foundation. In fact what I think has driven a lot of this market is Liquidity, Liquidity(Buyouts) and Buyouts (Buybacks). A follow-on post will try to dissect the SP500 and explain a little better what that crypticism is meant to mean. Right now it is what it is and instead of standing in front of it let's take a look at what's been going on.
 

If you think the teeny little chart is a suggestion to click on it for a better review that's entirely true. When you do you'll see the SP500 (taken for itself and as a general indictor proxy) has been on a real tear, rising from 1300 to 1550 or so. Which is not what most of us expected. In fact, starting last summer, has really been its' best performance in quite a while. A key to remember is what the expectations for inflation, oil and GDP were before the sudden decline in oil prices put a bump in consumer spending and took a lot of the up-pressure off inflation and interest rates. Certainly earnings have done well driven by the share of Profits though multiples haven't done as well. In a couple of prior posts we looked at actual PEs vs. Grahm-Dodd valuation-based PEs (GDPE) for the market and for individual companies. Over time they tend to converage on realistic valuations of performance but in shorter periods there tends to be a lot of volatility. In this case earnings have grown well but PEs are staying pretty compressed. Meanwhile the MACD tecnical indicator has stayed positive, fairly large though not acclerating. Like I said perhaps a liquidy-based and momentum-based market but with a touch or more of anxiety given the valuations.

We can compare the SP500 to some other domestic and foreign markets to get an idea of relative performance as well. Here's a fun chart that compares Europe (IEV), Emerging Markets (EEM), Japan (EWJ) and Asia x-Jpn (EPP) to the S&P, small-cap R2000 (RUT) and Nasdaq indices using ETF funds as proxies for their respective markets where possible. Lots of things could be noticed but several are important here. Notice that this time last year things were pretty synchronous with some differentials. Since then Japan hasn't shown a lot of relative progress but Europe and the Emerging markets are on a real...real tear. As is Asia. So perhaps the first thing to note is that there are substantial differents in relative performance. In other words it realy pays to notice anomalies in different markets. The world is indeed changing drastically.

The other thing to note that's almost as important is that despite large, and occaisionally acclerating, relative performance all the markets are moving together on the same trends, patterns and turning points. For example the Shanghai Surprise caught everybody this last Mar. The old theory that diversification across markets and assets classes to improve returns and lower risk doesn't hold up when all the markets are marching to the same drummer. That's a strong sign of a liquidity driven market where funds are looking for returns and will flow where they can do best.

Perhaps another key lesson is that as certain markets (EM, Asia (China), etc.) are accelerating away if that's due to liquidity and we're in a momentum driven market then some of that's speculative feedback. How much though in light of the strong economic performances of Europe, China and the EM's ? The latter in particular seem to have made an enormous structural breakthru to a firmer institutional footing instead of alternating between populist and military dictators. 

Another place to look for anomalies in relative performance and value is between sectors in a market. In fact given a relatively flat, non-job-creating economy, and major indices that have only with this recent (since Fall anyway) run gotten above their levels in 2001 this market has been about picking things rather than riding trends. The accompanying chart compares commerical real estate (IYR), oil services (OIH), major oil (XLE), utilities (IDU) and gold (IAU) to the S&P. And indeed intersting pockets show up. Gold was doing well early last year but has since settled in a trading range as inflation fears have dampened down. Oil dropped with the decline in benchmark prices and started rising again last Fall with the return of increases and has been an accelerating upmove post-Shanghai as oil prices have re-accelerated. Commercial real estate did well all last year as it appeared that housing was going down but real estate would roll over; as it looks like the "contagion" will spread (& also with an on-coming over-supply in hotels and possibly in office supply do building and what's in the pipeline) though it's been on a downtrend.

Utilities (IDU) showed a steady uptrend partly due to consolidations by strategic buyers but also buyouts by the LBO firms (the TXU deal comes to mind though it's less clear how the financing on that will go from here). Taken all together one sees more volatitliy between sectors, a greater opportunity to find pockets of value and opportunity and the re-inforcement of several of our earlier arguments about liquidities and buybacks driving the market. Perhaps the cardinal lesson though is that it really pays to understand the fundamental trends driving a particular market in both intermediate- and long-term timeframes, e.g. today's reports that supply-demand imbalances will grow significantly over the next several years as oil demand outstrips available production, and technical and player activity and forces in the short-run. If one believes for example that those imbalances will persist for a long time then energy-related investments will continue to be as much an "anomalous" opportunity as technology was in the 90s.

On the other hand we can reinforce the requirement to take a careful look at the fundamentals of a sector (and the firms in it) by thinkng about real estate. Comparing Homebuilders to Commercial Real Estate is a perfect example. Over the last few years with multi-generational low interest rates we saw a huge bubble in housing which began deflating, or at least topping, in '05 even though huge amounts of ARM and sub-prime mortgages were generated throughout '06 and prices continued to rise somewhat. And all the talk last summer and thru the fall was that the bottom had been reached. As a result Homebuilders recovered thru the beginning of this year until the realty (reality) that we may be, at best, about a 1/3 or a 1/4 into the adjustment process. Recently even comercial has shown a downturn.

If that doesn't reinforce the dig into the real value equation I'm not sure what will. Unfortunately this is more a "do as I say" argument since this particular valuation anomaly escaped me until it was clear that it'd be priced away and the bubble was bursting. Yet, in hindsight, economic and financial fundamentls make it obvious.

The question then becomes twofold:

  1. What are the other anomalies around, if any ?

  2. And what are the fundamental and technical forces driving them in what timeframes ?

If you think you've found a well-grounded anomaly that the broader markets haven't found, the classic Grahm-Dodd strategy (and Warren Buffett and Peter Lynch as well), then the trick is to find a way to take advantage of it. Isn't it ?

July 14, 2007

Aaargh, Captain Ye Best Take Care of the Crew

Earlier, back when we were focused on what makes a company tick rather than all these sidetrips into understanding the economic environment, we took at look at the heretical notion of treating people as strategic assets (People & Performance:Assets or Fungible Commodities ? ). There we made the following argument and asked the key question:

Have you ever stopped to wonder why everyone who works for an effective startup is excited and works long hours at 120% efforts levels. Sure, some of it is the wealth prospects and some of it's the challenge. But a lot of it's the fundamental satisfaction we all get from doing good work that is worth doing and makes a difference.

The real question is why don't we manage our organizations to maximize total performance by managing people as assets ?

We came to that critical concern by looking at Home Depot's performance under Bob Nardelli and the continuing challenges they face in improving morale and customer service - which are critical to maintaining and improving performance for them. Particularly in view of the rolling and roiling housing market and their earnings performance (more later - I promise). The critical challenge, or question, is this: how should you run a company to get the best long-term performance and value ? And then how should you treat your employees ?

All organizations and social groups need to work thru these challenges - and they all do one way or another. One of the most interesting historical answers to that challenge was found by 17th century pirates (hat tip EconomistsView ).

But before sailing away let's take that up a level - how should you organize any social group to maximize it's long-term performance and find the best balance between group goals, cohesion and individual requirements and desires ? And how do you structure the governance or management system ? Stop and think about that for a minute. The Boy Scouts have an answer, so does your local beer-league softball team and LA street gangs appear to have evolved a highly successful recruiting, training and leadership development capability, judging by their mere survival and prosperity. Let alone their sustained prosperity. They even appear to have solved one of the most difficult problems for autocratic governments - finding a way to ensure the transfer of power and successions without destroying the 'society'. Unfortunately. Of course their turnover is pretty high at all levels.

The "Pirates Code" iscussed by James Surowiecki in a New Yorker article on "The Pirates Code" , reporting in turn on a paper  by Peter Leeson, an economist at George Mason University, and “The Republic of Pirates,” a new book by Colin Woodard. To borrow from the column:

...pirate ships limited the power of captains and guaranteed crew members a say in the ship’s affairs. The surprising thing is that, even with this untraditional power structure, pirates were, in Leeson’s words, among “the most sophisticated and successful criminal organizations in history.”

...Nor were they held together primarily by violence; while pirates did conscript some crew members, many volunteered. More strikingly, pirate ships were governed by what amounted to simple constitutions that, in greater or lesser detail, laid out the rights and duties of crewmen, rules for the handling of disputes, and incentive and insurance payments to insure that crewmen would act bravely in battle.

But rules alone did not suffice. Pirates also needed to limit the risk that their leaders would put individual interests ahead of the interests of the ship. Most economists today would call this problem “self-dealing”; Leeson uses the term “captain predation.” Some pirates had turned to buccaneering after fleeing naval and merchant vessels, where the captain was essentially a dictator—“his Authority is over all that are in his Possession,” as one contemporary account had it. Royal Navy and merchant captains guaranteed themselves full rations while their men went hungry, beat crew members at their whim, and treated dissent as mutinous. So pirates were familiar with the perils of autocracy.

As a result, Leeson argues, pirate ships developed models that in many ways anticipated those of later Western democracies. First, pirates adopted a system of divided and limited power. Captains had total authority during battle, when debate and disagreement were likely to be both inefficient and dangerous. Outside of battle, the quartermaster, not the captain, was in charge—responsible for food rations, discipline, and the allocation of plunder. On most ships, the distribution of booty was set down in writing, and it was relatively equal; pirate captains often received only twice as many shares as crewmen. (Woodward writes that Privateer captains typically received fourteen times as much loot as crewmen.) The most powerful check on captains and quartermasters was that they did not hold their positions by natural right or blood or success in combat; the crew elected them and could depose them. And when questions arose about the rules that governed behavior on board, interpretation was left not to the captain but to a jury of crewmen.

 Let's pause for a minute or so and think about what we've just read.....the official ships were organized as strict hierarchies, backed by the police power of the state, and captains and officers putting the interests of themselves ahead of the welfare of the crew, and flagrant abuses, were not unusual. In fact if you skim the paper they were fairly common and a major reason for naval and commercial crew to become pirates. By putting their own interests ahead of the welfare of the crew, preying as it were on them, the captain and officers were damaging the long-run welfare of the ship and it's owners.

Now, that's not necessarily an argument for a democratic organization nor even a lack of hierarchy. It IS an argument for every member of that hierarchy to act with an appropriate balance between their own interests and the interests of the organization. And similarly instead of "they pretend to pay us and we pretend to work" (a historical quote describing accurately the characteristics of the Soviet incentive system) we need for employees to give us a fair day's work for a fair day's pay.

The only way for that to happen is if, first, what they are asked to do is felt to be fair in terms of effort vs. reward, if they similarly see others being rewarded appropriately to their contributions and if the "officers" aren't treating the organization predatorily. In other words if employees feel that the system is legitimate in two senses. First rewards are fair and justified. And second the distribution of authority and rewards is fair in the sense of going to people who earn them. The more legitimate an organization the more efficient it will be in the short-run and the more effective and resilient it will be in the long-run.

Let's take this into the real world a bit. Whether you're an employee, a manager or executive, an investor or an owner which type of organization do you think will do better over the long run ? If, for example you're one of the LBO firms looking to buyout an under-performing firm how much of an asset or liability is the relative performance of their human systems ? 

If someone had translated the deteroriation in observable employee morale at Home Depot into the perceptible deteroriation in service two years prior to Nardelli's departure then....well I'll leave the rest of the question to you to frame. But think about this - how's the place you work ? Shop ? Invest in ? Hmmm....

July 12, 2007

Headline vs Sub-text: Where's the "Financing" Indeed ?

Well the market finished the week in rip-roaring fashion. We’ll take that question up in a bit but part of the reason for the performance was supposed to be the Retail Store Sales numbers from Th. – the day of the startling jump – the Retail Sales data from Fr. So, I’d like to do a little compare and contrast between some different perspectives. WSJ headlines and reporting from Th., compared to Northern Trust’s Weekly Commentary to a slightly older assessment of Consumer spending by Calculated Risk and the implications for the Q2 Consumption (PCE) and GDP outlooks. I might also point to the last entry on the various components of GDP and the expectations that Q2 will be benign based on the likely outcome for the components.

As a commentator pointed out – “where’s the financing going to come from ?”. Exactly. And bearing in mind that it's Consumption (PCE) that's the major component of GDP - in other words if PCE doesn't hit 2.5-3.0% YoY then it's not likely GDP will.

Retailers Post Modest Gains,
But Department Stores Are Weak

By JAMES COVERT
July 12, 2007 1:29 p.m.

NEW YORK -- Retailers rang up modest sales gains for June, confirming that shoppers are hunting for bargains amid a weak housing market that's expected to persist in the coming months.

….

For June, retailers reported a 2.4% increase in sales at stores open at least a year -- or same-store sales, a closely watched measure of industry performance -- according to an index of 50 major chains compiled by the International Council of Shopping Centers.

That's at the high end of the New York trade group's forecast, and comes despite a calendar quirk that shifted some Memorial Day-related sales into May this year. Still, it's short of the year-ago 3% gain, said Chief Economist Michael Niemira. The results confirm a collective pace this year that's stuck in the 2% to 2.5% range -- well below the 3.6% increase logged for all of 2006, he says.

….

Wal-Mart, Bentonville, Ark., posted a 2.4% increase, topping its forecast for sales to be flat to up 2%. The company's namesake stores reported a 1.6% gain, while Sam's Club posted a 6.9% jump excluding fuel sales. Wal-Mart touted strong sales of flat-screen TVs and computers, boosted by remodeled electronics departments and improved products including a new, exclusive computer line from Dell Inc.

Still, Wal-Mart admitted sales of apparel and home-related goods were weak, and that its grocery aisles continue to be the busiest. In a written statement, Wal-Mart said gasoline prices have become its shoppers' "chief concern." But brisk food sales are an indication that shoppers are feeling the pinch of higher prices for meat, bread and milk, and flocking to Wal-Mart and Sam's Clubs for bargains, says Britt Beemer, president of America's Research Group, Charleston, S.C.

Wal-Mart expects its July same-store sales to rise 1% to 2% and backed its forecast for second-quarter earnings of 75 cents to 79 cents a share.

Interesting, because it was WMT’s surprising performance which was supposed to be a major trigger – yet when you parse it doesn’t appear all that good and also appears to be based on “brisk food sales”. As theBigPicture points out that’s got a lot to do with food and energy inflation and not real sales increases. Now turning to Northern Trust economics team in their weekly commentary we quote:

“Nominal retail sales declined by 0.9% in June after rising 1.5% in May. For the second quarter, nominal retail sales increased 5.0% vs. 6.3% in the first quarter. Assuming that the CPI for retail goods is flat in June, probably too optimistic and assumption, then price-adjusted retail sales in the second quarter will have contracted at an annual rate of 4.9% vs. their first-quarter annualized growth of 2.5%. Moreover, the quarterly averaging arithmetic sets third-quarter price-adjusted retail sales on a course of approximately 2% contraction at an annual rate….”

 

Later they continue:

“Annualized growth in second-quarter real personal consumption expenditures is likely to come in at less than 1-1/2% vs. first-quarter growth of 4.2%. One has to be in a state of denial not to acknowledge that the tentacles of the housing recession are beginning to strangle the consumer.” (emphasis added)

 

Finally, one of my other favorite insightful sources (Calculated Risk – highly recommended for economic and housing/real estate related insight. This is the place where you can housing data and the economic implications parsed like no other. The place where the sub-prime was analyzed presciently beginning last summer despite what the MSM media and the markets had to say, to the point where both now consult CR as a key source) has an interesting post on using monthly PCE data for two-month periods to guesstimate total quarter PCE. The chart below doesn’t look very sanguine, more sanguinary. Take a good look and decide for yourself, unless it's an unusual quarter where the 3rd month has a huge upside surprise (in complete contradiction to the Retail Sales data), if you'd expect Q2 PCE to hit 3.0%.

 

It looks more to me like 1.5% is generous. Which means, given a headline consensus of 2.5% GDP growth that the other components will have to generate some very unusual upsides indeed. Of course the world is full of suprises. 

UPDATE (7/14/07 12:24): Barry Ritholz extends his summary and survey of the state of retailing and the consumer with a very nice piece this morning. Good stuff.

July 09, 2007

Headlines, Schmedlines: Real Changes In GDP and Components

 It's been fascinating to read the headlines over the last few weeks in the mainstream business press and try to interpret the tealeaves in terms of what's really going on beneath the headlines. Under time pressure all too often we simply skim the headlines and move on to making our daily bread. Well the reporters have the same pressures so it's hard to look at trends and dig into them. But, as our old buddy Ben Graham argued, it pays to look beneath the surface to try and figure out the structures and deep currents 'cause those are what really drive the environment we have to survive in. In other words is the headline really telling me what's going on that I need to know ?

As an example let's consider some of those headlines (shortened) and some summaries:

  1. "Economy Slows But May Hold Seeds of Growth", WSJ 4/28. (Consumer spending held up and business may be recovering)
  2. "Economy Is Clawing Back...", WSJ 5/10. (Expect 2.2% GDP growth in Q2 and 2.6% rest of year)
  3. "As Sleepy Sectors Stir, Economy May Wake-up Without Consumers", WSJ, 5/21. (Inventory re-building after drop in Q1, growth in business Capex spending, and Trade)
  4. "Economy is Picking Up Speed", WSJ, 6/2. (Employment and manufacturing {industrial production} growth is robust)
  5. "Slow Growth May Presage Pickup", WSJ, 6/1. (Major problem in Q1 was inventory drawdown and production slowdowns. Look for re-build)
  6. "Strong Jobs Signal Gaining Steam", WSJ, 7/7. (Looking for 3+% in Q2 and 2-2.5% or better for 2nd half growth)

The chart at the right (feel free to clickon for a bigger picture) is taken from the first article and shows the contribution of the major components to the growth in GDP. Now, here's an interesting thing. The preliminary Q1 rate was 1.3% at an annual rate, which is the data used to create the chart. The revised and final numbers are actually more like 0.6%, again at an annual rate. Or putting that another way, try dividing by four and you get  a QtQ growth rate of 0.15% ! That's pretty flat. Actually the original estimate was nothing to write home about and the benchmarks are worth keeping in mind. The general rule of thumb is that the speed limit of the economy is about 3.3-3.5%/year, the sum of productivity growth and labor force growth. There's some evidence the speed limit is lowering as productivity growth slows but the bottomline is that at anything below 3% we aren't keeping our head above water (defined as more jobs, investment, profits, earnings and opportunities). To my mind that makes putting a reality check on liklihood and reasonableness a pretty interesting exercise.

 Which also makes the chart  below on QtQ growth in GDP, Consumption and Investment particularly interesting. Worth your while to click on it and see where the big changes are and look across the trends.

One of the reasons I prefer YoY change charts is they show you trends, turning points and relationships whereas this way you have to "eyeball" the changes. But in this case, just to stay on point, we've stuck we QtQ numbers and NOT annualized them. Nonetheless you can see GDP and Consumption showing a steady trend with the occaisional gyration, being bolsterred by Investment (lumping business and residential together here). In the last couple of quarters though you can see overall GDP growth being pulled down by declines in Investment, as it turns out primarily Residential Investment. That makes the questions of exactly where we're at in the housing downturn very interesting, doesn't it ? And the question of whether Consumer spending will hold up as well about as interesting too.

If you check out the predceeding articles the expectation is that Inventory re-building (Industrial Production), Capex and Trade (among other things) will make Q2 pretty robust and that Consumption will not slow much. In fact the last set of headlines is that we seem to have gotten thru the softpatch with few scratches and, while the rest of the year and even next, won't be robust - defined as exceeding the middle of the fairway 3.3% speed limit or even reaching 3%, it won't be "too bad". Trust me, an outlook for 2.6% growth for '07 and 2.8% for '08 assumming Goldilocks stays in the house is still not the world we'd like to be in. It certainly beats the R-word though.

Let's take one more look at the components of Q1 GDP growth and see what contributed what. In the prior economics post, "So, Dearie, What Time IS It, Anyway ?" we laid out the YoY% change in GDP, etc. using our standard approach. Now that was done with the preliminary estimates and showed a rate of about 2.1% (still very...very low) instead of the revised rate of 1.9% annual growth that was actually achieved, but the structure, timing, and patterns didn't change much. Though Investment really did, and continues to fall off a cliff, with Residential Investment declineing 16.3% instead of the original 16.7%. :) !

The accompanying chart breaks down the YoY changes by major components of Consumpton (Durables, Non-durables, Services), Investment (Capex, Residential, Inventory), Trade and Gov't spending. Each bar shows the YoY change in $B, with the top label showing the YoY% change in that piece and the bottom number showing the % contribution of the component to the total change in GDP. It would be the number most comparable to the WSJ chart shown first.

So, for example, services grew $154B, or about 3.5%, but contributed 72% of the GDP gain. Conversely Residential Investment dropped $101B, or about 16.3%, and contributed a -41% to GDP. Inventories didn't help either. It'd be worth your while to look back at the headlines and what's argued to be the turn-around factors and compare it to the relative magnitudes and ask - are those arguments reasonable ?

So what this chart is both telling us and asking us look out for might be several things:

  1. Consumer spending needs to hold up (how's Retail and Auto Sales doing, monthly consumer spending, etc. ?)
  2. The housing bust needs to either slowdown or at least not get to much worse (so how's the spring season going, what're the earnings outlooks on the home builders, how far are we thru the sub-prime mess and what about ARM resets ?)
  3. Need some inventory re-building to at least neutralize a significant it not major impact
  4. And it'd be nice if business spending grew a little bit too. (Ignoring for all the moments the question of why in the world businesses would increase investment if they don't think demand will increase. Just which end is the cart on, by-the-way ?)
  5. And while we're at it it'd also be nice if trade and government spending were positive contributors as well.
Preliminary Q2 numbers will be out this month but as we've seen those can swing pretty widely. In the meantime we need to be looking at the higher frequencey information on sales, consumer spending, employment and so forth. But that'll be for another entry. 

BUT....when you're watching those headlines flicker by you might keep this little checklist in mind. I sure hope so.

UPDATE: Nouriel Roubini has an excellent analysis of H1 performance, the outlook for H2 and the key factors at play - especially consumption - that's consistent with but more standardized. Worth your time: Prospects for US growth for the rest of 2007 depend on the resilience of private consumption that is now under stress