Thursday, April 20, 2006
Actually, it matters very much. As I first realized ten years ago, when I wrote a paper on the detailed relationships between these terms, their misuse has been the source of much bad thinking and writing in business publications.
This past Thursday, the Wall Street Journal featured its "SmartMoney Stock Screen" on page D3. The subtitle of the boxed piece was, "Efficiency Experts." It discussed how to use and interpret ROE for a company, alternately describing it as "managerial effectiveness," and "how efficiently its managers are using the plants, equipment and other resources...."
Well, it can't be both. So which is it?
I prefer to call ROE a "total factor productivity" measure. It can be deconstructed into labor productivity (Value Added/# Employees), operating efficiency (Net Income/Value Added), and Capital Intensity (# Employees/Equity). The benefit of this decomposition is to provide a view of the resources typically used by any business: people, capital, and expense dollars. Using value added removes the distorting effects of revenue attributed to a business that was, in fact, merely passed through as a purchase from a vendor.
Thus, ROE, or ROI, for that matter, as it was also mentioned in the WSJ article, may be interpreted as both total factor productivity measures, as well as simple equity or capital employed productivity measures.
I have found that efficiency typically refers to inputs. As such, what most economists and business writers call "efficiency," and measure with dollars/input unit, I find more sensibly called "volume efficiency" and measured with units/input unit. How a firm efficiently produces a product or service may be understood irrespective of the market-provided value of that product or service. I find this leads to clearer appreciation of the production efficiency issues typically under consideration when discussing "efficiency."
For labor productivity, I prefer value added divided by the number of employees, as this does provide a valuation measure for an input. The same is true for operating efficiency, which measures the productivity of expense dollars in producing a dollar of net income.
After much thinking and wrestling with the terms I found at hand in 1996, it became clear that more terms were needed, not fewer.
And certainly not a perspective that equates "efficiency" and "effectiveness." Good Lord! Can you get any fuzzier than that?
By the way, as is this deliberate, or, more sadly, unrecognized obfuscation was not sufficient, the writer, Jack Hough, concluded with the comforting sentence, "As always, please remember that stock screens produce research lists, not buy lists." What the heck does that mean? I just wasted my time reading his piece, only to find he really doesn't believe anything he just wrote? That he wants to publish his "research," but for God's sake, don't use it to actually, you know, buy a stock! Just mull it over, and talk about it at your next weekend dinner party.
No wonder the public is better-served by just buying managed funds, rather than individual stocks. With "help" like this, can you blame them?
Wednesday, April 19, 2006
I ran into Bob two days ago at the squash club. Bob is a retired retail executive and consultant. He's worked for many major retailers, as well as consulted them and others. Plus he's older than me, which I like, because he remembers things of which I am not even aware.
When I queried him about "the wheel of retailing," retailers moving upmarket, and Wal-Mart, he was guarded in his remarks. Essentially, he feels that a retailer may, if they move very slowly, creep upmarket. But he was much less optimistic about doing so in a consistently profitable manner.
As I expected, he dwelt on the omnipresent risks in such a strategy of losing one's original market segment, especially when the move is on economic dimensions, rather than on, say, pure style or even product niche. He nodded vigorously when I suggested that maybe Les Wexner's Limited was a better example of how to reach new customer segments, via added brands, rather than repositioning your current one.
So, after that discussion, and from even the past two days' news concerning Wal-Mart's fears regarding inventory management, gasoline prices, and sales growth, I still feel comfortable with my comments in September of last year. I do not believe Wal-Mart will be able to successfully reposition itself by moving upmarket and perform with consistent profitability and consistently superior returns for shareholders.
That's my expectation, and I'm sticking to it.
First, the entire topic has taken on a kind of Randian quality now. Witness yesterday's, and today's, prominent pieces in the Wall Street Journal focusing on Dr. William McGuire, CEO of the very successful UnitedHealth Group. Dr. McGuire is one of the few large-cap CEOs to have actually earned his considerable compensation, by consistently creating superior shareholder returns during his tenure. However, by yesterday afternoon, he was already giving an interview on CNBC, pointing out that he had recommended to his board that he and other senior executives have now earned 'enough,' and need no more options grants.
Does this not remind you of "Atlas Shrugged," wherein the masses enjoy the fruits of an inventive few, but demand to control how those value-creators are compensated? The WSJ article pinpointed the concern that, while many pay rising health care costs, the publicly-held UNG has chosen to pay, from its shareholders' pockets, very large amounts of compensation to Dr. McGuire for creating stunningly large amounts of shareholder value.
The nerve!!!!! That private individuals, in their role as common shareholders, should decide how to spend their own money! Can you imagine? Why, it smacks of....of..... capitalism!
It has crossed my mind frequently in the past few days that the obvious solution for this is going to be a marriage of successful companies and private equity. What if the masses, through political and regulatory intimidation, excessively constrain compensation for those who successfully perform the very difficult task of consistently earning superior total returns for large company shareholders? Would this not be an ideal situation for private equity owners to take such a firm out of public hands, compensate the CEO appropriately, and enjoy the subsequent shareholder returns split among fewer owners? Out of the public spotlight?
Ironically, the net result, taken to the extreme, could be fewer well-run firms left among public companies, thus denying "the masses" the opportunity to profit, as small shareholders in well-run large-cap firms. I do not think that is a healthy development for American capital markets, nor its economy in general. It strike me instead as a short-sighted, bone-headed move to encumber otherwise-competitive US corporations.
Why didn't the WSJ, in conjunction with some compensation 'experts,' instead spotlight the most over-compensated CEOs in the US, relative to the shareholder wealth they have created for the past 5-10 years? That is the real problem. Boards of underperforming companies which continue to pay their CEOs as if they are creating value, when they are not. But except for Alan Murray, in his column in today's WSJ, and in his appearance on CNBC, nobody else seems to really be focusing on this part of the problem.
Sadly, I'm afraid that Ayn Rand would be smiling at all this and nodding her head in understanding.
Tuesday, April 18, 2006
According to just the price charts alone, the company's stock has risen some 300% in the past five years, and has a current market value of $67.4 billion. By my reckoning, the company's market value was in the neighborhood of $20B five years ago, to account for the total return in the interim. Thus, it appears that Dr. McGuire led the firm to increase shareholder wealth by roughly a factor of 48 times the value of the options granted to him for said performance.
Not a bad deal for the shareholders, actually.
On CNBC this morning, they asserted that various UNG investors who had been interviewed held a range of opinions. Some, like me, felt McGuire had earned his compensation, and were happy to have had the opportunity to pay him for the performance. Others were outraged.
What was of more interest, though, was some of what the 'executive compensation' expert, invited on the program for this segment, had to report. Among founder-led firms, such as Dell and Microsoft, there is no single policy. Gates gets no stock, nor options. Michael Dell, on the other hand, receives options from his board.
I think this alone is very insightful. There simply is no "right" answer. But everyone agreed that the board was responsible and accountable for the compensation situation. The "expert" then went on to babble about more disclosure of options granted, rescinded, etc. It sounded like maybe the SEC has something afoot here.
Taking all this together, plus my earlier posts, I think the situation boils down to this.
1. Boards have created this mess by having retired CEOs, most of whom were probably overcompensated in their time, continue the tradition of overpaying the CEOs of the firms on whose boards they sit for similarly mediocre performance, i.e., it is a learned trait.
2. CEOs who consistently create superior returns for their shareholders deserve extraordinary compensation for their extraordinary performance.
3. CEOs who do not consistently create superior returns deserve modest fixed compensation. Their bonus compensation should definitely depend upon the superior shareholder returns they cause to occur. No superior returns, no wealthy CEOs.
4. Change takes time. Americans aren't particularly good at being patient. But, if one would give market forces a chance, and not rush to legislation, this "problem" of CEO (over)compensation should be self-correcting in not too long a time. I have suggested how this might happen here.
It reminds me of the mess that our politicians have created with Federal election campaign finance "reform." The more they have tinkered with it, the worse the problem has become. Had they simply opted for full disclosure of campaign financing to begin with, the whole matter would probably have been self-correcting there, too.
Sometimes, you have to let markets, even "information" markets, take a little time to work. But they do. Rushing them usually creates unintended consequences of significant proportions.
When I read the two posts together, they portray me as perhaps a bit schizophrenic in my assessment of the company's fortunes. Back in September, I classified Wal-Mart as an aging and no-longer consistently superior performing retail giant which will probably not regain its luster. I noted that it has not been in my equity portfolio selections for many years. Yesterday, I referred to it as having usually outperformed the S&P during the last 25 years.
Some clarification is in order.
My proprietary research unearthed performance benchmarks which, when applied to large-cap companies, increased the probabilities that a given firm could outperform the S&P's total return consistently over a period of multiple years. The benchmarks differ for low-growth and high-growth firms. However, firms that would adhere to their respective operating benchmarks would have statistically significant increases in the likelihood that investors would reward such performance with consistently superior total returns, in the form of stock price increases.
When these insights are applied to the selection of equity portfolios, some adjustments must be made. A CEO may, or may not, adhere to my benchmarks, and still enjoy some periods of superior total returns. Further, whether or not the firm meets my investment criteria, it may still do better than the S&P over various periods.
However, as an investor, I need to use better quality criteria for portfolio construction than I would advise a CEO to use for actually running his company. This is because the CEO has some control, or at least influence, over his firm's operating characteristics and performance. Thus, the level of certainty of achieving the recommended operating benchmarks is probably higher for the CEO than for me as an investor. I don't have any control over the assets I own, whereas the CEO has control, via business strategies and resource allocation.
So a company, such as Wal-Mart, may, ex post, have outperformed the S&P for some years, yet still not, ex ante, have displayed investment quality performances that would have merited its inclusion in my equity portfolios.
Thus, as a business strategist and observer, I observe that Wal-Mart has created shareholder value at a superior rate, relative to the S&P, for most of the past 25 years. As a disciplined equity investor, however, I observe that the company's evolving performance characterisitics over the same time period did not warrant risking investment in the firm, relative to other opportunities in the S&P500, in order to construct portfolios which had significant likelihoods of consistently outperforming the same index.
I still doubt that Wal-Mart's new thrust to move upmarket with its retail brand will succeed. By "succeed," I mean consistently create superior total returns for shareholders over the next 5-10 years. The company may eventually move its brand franchise up the "wheel of retailing," but I believe the time and cost will not, in the end, have been warranted, relative to other strategic opportunities available to the firm. I wrote of these in my earlier piece.
This is not to say that I think it cannot occasionally realize better total returns than the S&P in the next few years. However, my guess is that its fundamental performance will continue to keep it out of my equity portfolios. Its current strategy is, in my opinion, unlikely to provide the performance consistencies which I have found to be the hallmarks of desirable investment opportunities among large-cap companies in the S&P500.
This is one of the conundrums of using the same shareholder return performance measure from inside a company, as opposed to an investor's perspective. The CEO may achieve above-average, though statistically unlikely, total return performances for a while, thus rewarding shareholders. But the chances of that occurring consistently may be so low as to make owning those shares too risky, from a disciplined investment process perspective. The CEO will have succeeded, and done well for some shareholders at certain times. But that does not mean, ex ante, it was an attractive stock to own.
Monday, April 17, 2006
On Friday, CNBC aired various reruns to fill time, as the markets were closed for the Good Friday holiday. One of these is their old standby, David Faber's program about Wal-Mart.
I have seen some of this piece before, as it is by now at least a year old. However, the portion which I viewed Friday left me awestruck. A former chairman of the firm, whose name I do not recall, related in an interview that the senior management of Wal-Mart "...wakes up everyday worrying about how the company is going to survive and continue to grow...." Seldom have I seen such a visceral statement of an attitude which must be present in a firm which has a chance at attaining consistently superior total returns for its shareholders.
The Faber piece also featured video clips of Wal-Mart's intensive focus on employee (yes, I know, "associate") training and the sharing of best practices. These people are nothing if not commited to learning from their mistakes, as well as their successes. When asked about some recent public gaffes, CEO Lee Scott freely admitted that, even in Wal-Mart, some managers are going to be "knuckle heads," and he could not control that. However, it was clear that the firm assiduously tries to minimize its mistakes, both in hiring and managing, as it moves forward in time.This discipline shows in the company's performance history. While, like Ford, Wal-Mart has had periods of underperformance, over 25 years, they have pretty consistently outperformed the S&P500 index. For the past 5 years, they have only begun to experience a performance decline about 12 months ago.
Of course, no company can control all the variables which affect its success. In Wal-Mart's case, it appears that two things happened to cause this failure to continue its attainment of consistently superior total returns.
One has been, evidently, the ever-present "wheel of retailing" phenomenon, in which customers move up the retail ladder to more expensive, more service-intensive and better assortment-offering chains. In the middle of last year, as the business media began to grudgingly admit that maybe the US was in the midst of a continued low-inflation, solid expansion, concern began to arise that perhaps Wal-Mart's target market was leaving it behind and moving upscale.
The second challenge Wal-Mart has begun to face is, quite simply, the penalty for large-scale success in the US. Like IBM, CDC, Xerox, and Microsoft before it, to name but a few, Wal-Mart has drawn the ire of various consumer and governmental organizations. "Follow the money," as it were.
Nevertheless, it was refreshing to see interviews with former and current senior officers of a company that "gets it." That they can never become complacent, resting on their laurels. That they continue to manage and execute with discipline. Whether Wal-Mart's planned move upmarket into more fashionable goods will succeed (and I have argued here that it is unlikely to do so) or not, I give them credit for being hungry and concerned all the time. It's a trait a few other large US companies, such as Ford, GM and Time Warner, would do well to emulate.
Sunday, April 16, 2006
In another article from the WSJ pages of recent weeks, I read with great interest, and admiration, how Mark Hurd, late of NCR, now CEO at HP, is revamping the sales force.
What was of particular interest to me is the depth of focus Hurd is reported to have given to an issue that, allegedly, Carly Fiorina acknowledged, and failed to solve, on her multi-year watch at the helm of the ailing tech firm. Kudos to Hurd for quickly assessing the situation, diagnosing the problem, and, most importantly, ramming home changes in the sales organization to both trim unproductive middle-layers, and realign the function with the way HP markets to its customers.
This is the kind of CEO performance which, when effective, can be worth whatever price the shareholders pay for it. While I do not own HP, I genuinely hope Hurd successfully restores it to a high-revenue growth path, with consistently superior total returns following not far behind.
It gives me great satisfaction to see a company have the courage to oust an ineffective CEO, hire a new one, and have done a good job recruiting a new CEO who will actually fix the company's problems, rather than merely enjoy his lucrative new compensation package.