Friday, March 03, 2006


It was amazing to see the market's reaction earlier this week to comments from the CFO of Google regarding its future growth. Mr. Reyes acknowledged that the firm will need to find additional sources of revenue growth, and the stock fell 14% in intra-day, ending up down something like 7% at the market's close.

Obviously, this news was a big negative surprise for many investors. But how shocking can it really be to learn that a firm which has launched so many "free" services just this year believes it needs to find new sources of organic revenue growth?

I confess to still not fully understanding the profitability dynamics of Google. Fortunately, my own investment selection approach requires several years of actual performance in order to qualify as a candidate for inclusion into my portfolio. But generally speaking, I don't buy (or sell) what I can't understand. There are several reasons for this, one of which is best illustrated by the following story.

In the late '90s, I co-managed a venture with a hedge fund group. My role was the management of a static long-short version of my current equity strategy. In this capacity, I did marketing and sales work, including appearing with my colleagues at some hedge fund conferences.

On one of these sales trips, we had the occasion to dine with some Californians, among whom was a trustee and member of the investment committee of one of the state's better-known universities. At this time, Julian Robertson's Tiger Fund group had just gone out of business. Not being privy to the details of that group's fall, I opined that perhaps, like Long Term Capital, they had relied on historic correlations among various hedged instruments, and not adequately understood what would happen if their assumptions proved faulty. Upon hearing this, the university trustee exclaimed that that was exactly what had transpired. He then regaled us for some time with his story of hearing Robertson explain what had happened, as the university had invested in the Tiger fund. Essentially, the fund had hired some hot managers to do some hedging which, according to our acquaintance, Robertson himself had said he did not fully understand. The results are now well-known. That particular group made some horrendous bets which became "unhedged" and caused appalling losses which led to the liquidation of the Tiger funds. Apparently, Robertson lost it all by acquiesing to some managers whose approach he did not, in fact, comprehend.

Back to Google. From what I have read for several years, I still cannot fully understand what the revenue engine is for this firm. Can that many people be clicking on ads while using their search engine? Then there is that occasional story about click-fraud in connection with the websites using Google for their advertising.

In any case, Google's recent spread of activities into digitizing books, starting email and chat services, and global mapmaking, suggest to me, as I have written earlier, that they perceive their brand to be somewhat perishable, not to mention their current search engine advantage. Thus, it is not at all surprising to me that their CFO would admit that Google needs new sources of revenue to continue growing.

It makes me wonder how much of the investor interest in Google is purely momentum buying and holding, and how much represents fully-informed shareholders.

Hurricanes & False Positives

So now we are treated to video tapes of President Bush and his advisors being warned that Katrina was, in the "gut" of FEMA's then-head, 'the big one.'

It's all very well and good to judge in hindsight. I was driving yesterday and heard a news report on a local liberal classical music station that New Orleans Mayor Ray Nagin 'had a sinking feeling' when he heard of, or watched, the videotape. Nice dramatic touch- it's clearly his style. Find a scapegoat and pile on, while hoping everyone will forget your own culpability.

In reality, though, the situation was not nearly so clear prior to Katrina's landfall.

Let's remind ourselves of the two risks which exist in every hurricane situation. They are familiar to any data analyst. I am speaking of Type 1 and Type 2 error.

Type 1 error is that against which statisticians are trained to guard. It is the risk of rejecting an hypothesis which cannot, in fact, be confidently rejected. Most statistical tools focus on the rejection of hypotheses at some "confidence level." In this case, it is the risk of rejecting the premise, "Katrina is the ultimate lethal hurricane," or something similar, when, in fact, the premise is found later to be true.

Type 2 error is the risk of accepting a false hypothesis.

If Katrina had been judged, before it made landfall, to be as deadly as it ultimately was, then the correct decision would have been to order massive evacuations. If it turned out to be rather small instead, then authorities would have made a Type 2 error. They would have accepted the premise, "Katrina is the ultimate lethal hurricane," when, in fact, it was not. Don't think that great ridicule and anger would not have been unleashed on all authorities, beginning with President Bush, in that event. Ray Nagin would have been screaming, '...they told me to evactuate. it's not my fault that people died, were injured, and property was looted in the rush out of town.....'

As it now stands, authorities believed they should wait until they were more sure of the hurricane's strength than, evidently, the date and time of the recently-released videotape. They minimized Type 2 error, accepting a false premise, in favor of not needlessly disrupting a major city for a non-lethal hurricane. Either way, the administration was going to be criticized.

It's convenient, in the aftermath, for the mayor of New Orleans, and anyone else with a liberal-leaning agenda, to declare that the Federal authorities "knew" all along how deadly Katrina would be. But that's just not true, and it's an oversimplification of what most people understand is an always-difficult decision- if and when to evacuate a large population center in advance of a hurricane, attempting to balance the probable costs in lives and property of evacuation with those of staying put.

Tuesday, February 28, 2006

Taking a "Haircut"

As I waited at my barber's this morning, the result of a half hour's difference in our understanding of my appointment time, I had the occasion to skim through the most recent issue of Fortune Magazine. Most "haircuts," in the financial sense, cost you money. This morning, since I do not typically read Fortune, I got a free bonus- the theme for this piece.

This issue, the first in March, contained the magazine's "most admired companies." Naturally, I was surprised to see Jeff Immelt's face on the cover. When I think of companies I admire, my thoughts turn to those rare gems which can consistently outperform the S&P500 for several years- often up to five. When I read of a current survey, I assume the performance in question must be recent.

GE is not one of these companies. Go check its return versus the index on one of the free finance sites, such as Yahoo. It isn't even close. Not for the past 12 months. Not for 2 years. Not for 5 years. No contest- the race goes to the index.

I read a few more passages from the article, and noticed IBM was also touted. The phrase "turnaround" caught my eye.

So I checked IBM's return over the last five years versus the S&P500 Index. Care to guess whether this well-known information processing hardware, software and services titan did any better than GE?

IBM also failed to best the index over 1, 2 and 5 years in terms of total return. So much for a "turnaround."

Why would a business magazine such as Fortune waste so much ink and effort on "admired" losers? Is this what we have come to regard as business success in America? Maybe I'm the one who is out of step. I just can't see glorifying companies, and their managements, for underperforming an index you can buy for no more than two-tenths of a cent on the dollar from Vanguard.

My research and continuing portfolio management demonstrate that it's a rare, and "admirable" characteristic just for a company to consistently outperform the S&P500 over several years. As an investor, I could not care less what else the company does for the time I hold their stock, or how widely admired it is for other reasons, so long as they beat the index.

Did I mention that I don't subscribe to Fortune? Does it surprise you that this morning's quick read through their latest issue makes me feel I've made a wise decision?

Sunday, February 26, 2006

Orwellian "Free" Trade and U.S. Port Operations

This week's Congressional hysteria over the imminent deal to allow a United Arab Emirates-owned company manage several large US port operations is a blow to American attempts to promote global free trade.

From what I have read and seen so far, there is no security issue whatsoever with the change in ownership of a company which currently manages several large US port operations, from a British to an Arab conglomerate. US port security is managed by Customs and the Coast Guard, not operational management of a port. This was clearly stated when CNBC interviewed the chairman of the firm which operates the port of Houston last week.

So what we actually have is some of our country's 535 legislators up in arms because an agreed-upon vetting process does not give them final say. Did I mention the Wall Street Journal's comment regarding campaign contributions to some key New York-area senators and representatives by local cargo-handling interests? There is probably a good reason for the vetting process being handled by the Executive branch. You can be pretty sure that if Congressional members are involved, influence-peddling won't be far behind.

Most damaging in this affair, though, is its effect upon the efforts of the US to influence freer trade on a global basis. Thanks to our typically short-sighted members of Congress, such as Senators Clinton, Menendez and Schumer, and Representative King, countries such as China now have an example to which to point in the US, when they refuse to open their own economies to more global competition. Another significant, perhaps lesser issue, is the damage these same legislators are causing by failing to understand that, as it now stands, their opposition looks like ethnic bigotry targeted at Arabs, rather than a legitimate US security concern. It isn't a question of US management versus foreigners, but "these" foreigners.

Hopefully, President Bush will stick to his guns on this issue, and, after a second vetting of the deal, it will be cleared and closed. Otherwise, we risk damage to both the cause of free trade, and our image in the Arab world.

Reforming Health Insurance: Cream Skimming vs. Responsibility

The Wall Street Journal carried an article last week featuring a South African life insurer which offers the equivalent of "frequent flyer" points to customers who engage in healthy activities. Without reprinting the entire piece here, suffice to say, the insurer rewards various activities, such as exercise, checkups, and other activities shown to be related to better health, with points which may be redeemed for various things, such as inexpensive stays at resorts, etc.

This insurer is now entering the US market with its programs. As might be expected, the company is being accused of "cream skimming," both in its home country, and in this one. Essentially, sceptics believe that this insurer seeks to hold costs down by insuring only the healthiest individuals, thus avoiding expensive claims which would depress profits.

This brings me to the point of this post. The salient issue of this situation is, quite simply, responsibility. Who is responsible for poor health? For disease? And, thus, who should pay for the condition?

What is wrong with incenting people to behave in healthier ways? Nothing. Merely incenting me to exercise more, not become obese, etc, is good for me, and the insurer.

Clearly, the key question is something more along the lines of the following example. Suppose a child is born with a serious disease which cannot be "cured." The child will be ill, and nonproductive, in the sense of being capable of living as a self-sustaining individual. Who is "responsible," who should pay for that outcome? If an insurer chooses not to underwrite that child, or the adult with the child, is that "wrong?"

It seems to me that the general notion that "cream skimming" is bad always revolves around this question. Whether it involves private (Catholic) education, driving, or health, the real issue is how to distribute the real cost of high risk in society.

It seems to me that perhaps there is a better approach than the binary "all or none." Perhaps each person, or family, should be insured by society, i.e., government, at an agreed-upon level of "benefit," or claims, reflecting the probabilities that they will incur specific uncontrollable diseases. In addition to that, one may purchase, as available, private insurance. This at least acknowledges the reality of the occurrence of such diseases, and offers a minimal level of support for same.

There are, of course, a host of complications. How do we define these diseases? Which ones qualify? Does DNA testing mean there will be no effective private underwriting of such additional risk? Does it even go so far as to suggest that society may withhold coverage from individuals with unacceptably high probabilities, as predicted by DNA samples, of producing children with these diseases or conditions?

These are serious moral and economic questions for any society. How we choose to allocate our resources, in a world of competing national economies, is not a trivial question or topic.

Thus, the question with which this note opened, that of "cream skimming," is a much deeper one than it may initially appear. How we view the answer to this question suggests how we view answers to the deeper related questions of responsibility for situations which may be, for now, uncontrollable. It seems to me that exploring the answers to these questions is a good thing. Simply demonizing those who offer products and services from one vantage point is not.

Lance Armstrong's Troubling Endorsement

Last week I noticed an ad in the Wall Street Journal for a mutual fund complex, American Century Investments.

What was unusual, if I am not mistaken, is that the ad featured an endorsement by Lance Armstrong. A picture of the cycling great was the background for the text, which compared Lance's focus on winning to the presumed need of customers everywhere to focus on their financial performance.

If this is, indeed, an explicit endorsement by Armstrong, I confess to being dismayed.

First, who cares what a bicyclist thinks of a mutual fund complex? Armstrong is rather noted for employing a coterie of handlers to deal with the many complicated details of his operating empire. Why would anyone think he knows about equity or debt fund management?

Second, this is the first time I can recall seeing Armstrong endorse a non-athletic product which he, presumably, has not used. Or is not a tangible good. Isn't this insanely risky on his part?

It's one thing to oversee the design and production of, say, a bicycle, or an accessory, or whatever else Armstrong endores. Perhaps a car, I think? But the ongoing managment of a mutual fund complex?

Wow. Talk about financial risk!

Does this imply Armstrong's desperation, or naviete? And what of the perceived value of his endorsement, now that he's peddling money management to the masses?

I liked it better when he just rode his bicycle.

Inverted Curves

A very hot topic in financial circles for the past month has been the inversion of the Treasury yield curve. Currently, it is in a condition such that longer-term yields are lower than current yieleds.

At various times in the past, and I mean long past, such as up to 20 years ago, this has been coincident with the onset of recessions.

So, as you might imagine, quite a few financial media types are all over this story, to sell more ads and newspapers.

Here's a headline, though, to pour cold water on the hot topic. When asked about this, directly, during his recent Congressional testimony. He succinctly and directly replied that the inverted curve does not now portend economic recession.

How much clearer can you get? The chief monetary expert in the country, who has made it his research focus, does not believe that current conditions sustain the hypothesis that an inverted curve always portends recession.

This notwithstanding, the journalistic airheads on CNBC keep ranting about the inverted curve. All month long they have ignored Bernanke's comments, and sensationalized a host of minor analysts.

For the record, times have changed. I have found, in my own equity research, that the markets are qualitatively different now than prior to 1985 or so. It's easy to forget how scarce and expensive fundamental and technical information was in those days, compared to today. Computers were slower, less capable, not "online," and much more expensive. There is a sort of "one way" arrow of information effects over time. My own equity approach was less consistently successful in the era before the inexpensive and ubiquitous availability of performance data.

It pays to focus on credible sources, and ignore the lesser lights. I think Bernanke is viewing global economic expansion, and seeing the current yield curve inversion as evidence that the mediocre 70% of market participants are not processing market information correctly.