Friday, May 26, 2006

Frank Talk: Barney Frank's Scary Comments on CEO Compensation

Barney Frank, US Representative from Massachusetts, appeared on CNBC the other day to discuss his views on CEO compensation.

Being the extremely liberal Democrat that he is, it's difficult to enumerate all of the nonsense that he spouted in a ten minute interview. However, a few examples serve to illustrate what we are in for if the Democrats regain the House later this year.

Bob Nardelli's pay package as CEO of Home Depot touched off this past week's firestorm over CEO compensation. The company's stock has struggled recently, after plunging during Nardelli's early years as CEO. If I recall correctly, he joined Home Depot some five years ago, when it became clear he would not be replacing Jack Welch as CEO of General Electric.

Frank is so ill-informed regarding performance metrics that he voiced the opinion that perhaps CEOs should be compensated on the basis of 'net revenues or market share.' Apparently his staff is as clueless as Frank is, because neither measure of corporate performance makes sense. Market share is notoriously difficult to calculate effectively, since it can vary by market segment, and makes no sense whatsoever for a multi-product company. Paying a CEO for increasing revenues is simply idiocy. If you think we've seen fraud recently, you haven't seen anything yet if Frank's suggestion becomes law.

What I found most interesting, however, was his diametrically opposing view to mine of what realistic options are available to minority shareholders of public companies. Frank expounded on the lack of "shareholder democracy" implicit in the advice that shareholders who don't like the performance or CEO pay policies of a company sell their shares. I remain unable to understand this.

Why do so many people, Frank included, believe that any minority shareholder with as little as one share of stock, should have the right to set corporate policies? The ability to easily and inexpensively sell your stock when you don't like what a company is doing is a benefit of our capitalist system in the US, not a weakness. In addition, it is not as if most shareholders founded the company, then lost control. No, they typically buy into a company whose prospects they deem attractive. But they know going in that they do not control anything.

Perhaps the most fear-inspiring comments from Frank were about the need for federal government interference in the affairs of publicly-traded companies in the US. He seems to feel that their "rights" need protecting, because selling shares in a company with whose policies a shareholder disagrees is viewed by the Congressman as "undemocratic." Nevermind that liquidity in most publicly-traded shares is more than adequate to allow a shareholder to exit an unwanted stock.

It seems that Frank, along many other critics, have the mistaken notion that minority shareholders control the policies of corporations in which they own shares. In reality, in our system, minority shareholders get the benefit of the performance of companies whose shares they hold. And they may vote on candidates for the board of directors. But that's it. They don't own controlling interests, and most of them did not found the company. They know the limitations of their position going into the stock purchase. And, most importantly, there are many other companies whose stock they may buy if they become disenchanted with the shares they own.

How much worse it would be if there were no liquid, inexpensive markets in which to simply sell unwanted positions and be rid of corporate situations with which one disagrees.

From his comments the other day on CNBC, my sense is that if Frank ever becomes chairman of the House committee on which he serves (I believe it is Finance), Sarbanes-Oxley will become the lesser of our worries regarding unwanted Federal intrusion into private enterprise.

Enron, Worldcom, et al: Innovation vs. Total Prevention of White-Collar Crime

I suppose I have to write something about the biggest business news story on the planet yesterday- the convictions of Jeff Skilling and Ken Lay for their Enron crimes.

Here's what I find noteworthy on this "morning after."

Watching Sharon Watkins appear on CNBC this morning, I found myself wondering what the cost to our economy will be, in terms of future dynamism and creative growth, from Sarbanes-Oxley?

Several commentators yesterday solemnly intoned how the Enron verdicts provided the matching "bookend" to the decade of greed and excess that was the 1990s. Then, some other pundits, in response to questions from the talking (air)heads on CNBC's afternoon programs about "is this finally the end of corporate wrongdoing and scandals?" noted that all periods of explosive economic activity and growth beget some excesses. Excesses which are typically found, later, to be illegal.

What concerns me is this. Do we know, empirically, that the illegal "excesses" of the 1990s were above-average in the damage they caused? Can anyone really legislate a priori the total proscription of illegal behavior?

Doesn't it really boil down to the ethical values of the CEOs in charge of public companies? Sharon Watkins spoke about being a "whistleblower" with real passion and angst. I've never worked in a company which commited fraud while I was there. But I can attest to the general climate of which Watkins spoke. She told of being pulled aside by Andy Fastow, Enron's CFO, and told to keep her nose out of accounting business that was not her job. She thereupon transferred to another division. Charlie Gasparino then chastised Watkins by asking something like, 'shouldn't you have really done more, gone public, instead of transferring at that point?'

How presumptuous and pompous of Gasparino to be so judgmental. Anyone who's put serious time in with a large company knows that it is far harder to explicitly and vocally tack away from the corporate course and risk dismissal and loss of income, than it is to just find another place to hang out and do something for a paycheck. Nobody who is not independently wealthy, and does not actually commit a crime, deserves to be questioned and judged like Gasparino and a few of his colleagues did with Sharon Watkins this morning on CNBC. I hate to put it this way, but watching her this morning, it was hard not to compare CNBC's treatment of her to a rape victim being asked if she didn't conspire in the crime.

Drawing these themes together, I simply wonder if we are not making Enron, Worldcom, et al, into mountains of larger size than they actually were. Are we sure that, given the business activity and benefits of the 1990s, the consequent damage done by these corporate frauds is historically "excessive?" Their faults were, at bottom, unethical CEOs and sleepy boards. Now, several CEOs will be in jail for a very long time. If this doesn't give pause to sitting CEOs, will Sarbanes-Oxley? Which, as we all know, was not in existence when the crimes for which Ebbers, Skilling and Lay have been convicted were commited.

Our dynamic economy creates explosive, creative growth. Sometimes, things get out of hand. Nobody can stop white-collar crime before it even gets started. Even whistleblowers like Sharon Watkins are sceptically treated after the fact. It's just not philosophically compatible with our American system to presume people guilty of unethical or criminal behavior before the fact. We punish when we find the crime- not before it's commited. And who among us believes you can somehow legislate a person to have better ethics than they already have as they become a CEO?

Let's hope the effect of Sarbanes-Oxley is not to starve our better new ventures of capital in the public markets. Let's hope it doesn't drive creative enterprise into private equity forever, damping publicly-accessible returns for the average American investor. And, most of all, let's hope Sarbanes-Oxley doesn't have a long term dampening effect upon American entrepreneurship, creativity, and economic value creation. Because if it does, we've just handed the rest of the world our heretofore economic leadership on a silver platter.

Actual Volatility in Equity Markets

I saw an interesting exchange the other day on CNBC. Dylan Ratigan was cross-examining some poor analyst or CEO in connection with avian flu worries and pharma or food stocks. I really don't recall which it was.

What I do recall, however, was Ratigan's comment that flustered his poor guest. It was something very close to this, "....c'mon, the stock moved 6% in one day! Stocks don't usually do that!...what's going on there?"

Well, actually, yes, I think they do "do that," Dylan. Maybe you need to watch individual stock volatilities more often, to stay in touch with how wild the equity markets have become lately.

For example, I have a portfolio of twenty-one equities. Looking at yesterday's results, one rose over 4%, and another over 5%. Neither had particularly significant news that day. Another stock was within a hair of a 4% gain.

I've seen 6% daily moves, too. Recently. Especially with the large market moves of the past few weeks. I don't keep daily change records, but my point is this. Daily price volatility can actually be pretty large now. Remember Microsoft's loss of 11% of its value in just one day, for reporting higher-than-expected expenses?

I find it rather ironic that an anchor for a business entertainment network, CNBC, which stressed daily reporting, if not hourly reporting, would be so insensitive to the realities of daily stock price volatility in this environment.

Thursday, May 25, 2006

Toyota's & GM's Texas Plants

Wednesday's Wall Street Journal featured an article comparing the Texas production plants of GM and Toyota. The overall conclusion was that, although GM's facility is its most "efficient" one, it is still running behind Toyota's newer one.

I have a couple of observations.

The first one involves barriers to entry. If you don't already see auto production and marketing as a low barrier-to-entry business, and, thus, a business tending toward commoditization, this piece ought to be your wake-up call.

It reminds me of a business in which I was engaged to troubleshoot at Chase Manhattan Bank years ago. The master trust and custody business was primarily an IT activity. It involved electronic record-keeping of pension funds and the associated assets, as well as handling the interfaces for trustees (the companies with the pension plans) with their designated asset managers (the money management funds actually managing the pension assets). What we found back in the 1980s was that any bank could, if it so chose, invest sufficiently to develop a newer, more feature-laden system, and begin to take share from existing providers with older, more antiquated capabilities. At the time, Bankers Trust was doing just that, and taking share from the weaker players in the marketplace.

This awareness informed us, the corporate planning strategic troubleshooters for the bank, that the pension trust and custody business was going to have some natural limits to ROI, due to the need for ongoing investment. Thus, any value-adding edge we hoped to create and sustain was going to have to be from growth. Margins were always going to be under pressure due to significant ongoing systems developments and upgrades.

The WSJ piece on the auto plants reminded me of this. If all it took to best GM's best plant was a slightly more forward-looking perspective by Toyota, then GM investors crowing about this week's temporary stock price reprieve should take a really good look at this story about the Texas facilities.

Legacy issues are fact. I've written about this in connection with technology companies last fall. Now, we see it in something as mundane as auto production.

A related topic mentioned in the article is how the writers chose to treat the "productivity" of the two plants. For my views, see this post, and this one as well.

In one paragraph, they discuss the labor hours per vehicle at the GM plant. Later, they note that, when actual labor rates, meaning unionized wages and substantial GM overhead, are applied, Toyota's newer plant wins, hands down.

My question is, why even bother with hours/vehicle? That's "efficiency," not "productivity." Productivity implies value, and even adding labor costs doesn't totally reflect the "productivity" in terms of value-added to the vehicle, and its salability. For arguments' sake, let's agree that the GM vehicles in question are very salable, for now.

My overall impression is that the article provides a rather useful anecdote as to just how much continuing trouble GM has on its hands. Like it or not, being the one-time share leader in a business that benefits from at least one entrant's continuing drive for improvements- in product, production processes, etc- can cause existing market leaders to simply crumple from inertia.

So, for what it's worth.....that GM stock price rise this week? Well, I don't hold the stock to begin with. If I did, after reading this WSJ piece, I'd be thinking profit taking. There are plenty of better opportunities for less-risky investment gains than GM right now.

But maybe that's just me....

Wednesday, May 24, 2006

More Confusion from the WSJ: Creativity vs. Management

Yesterday's Wall Street Journal was a motherlode of interesting articles on which to comment.

The first is Lee Gomes' follow up to the Gates-Otellini op-ed letter in the Journal last week. That letter was their "reply" to comments by Journal technology reviewer Walt Mossberg's comments on the relative merits and status of Apple's "closed" design system vs. WinTel's "open" system. I wrote some thoughts about the Gatellini letter here.

Gomes stated that he would "like to play the peacemaker in a debate kicking around in these pages over the past few weeks." He then goes on to describe the prior written pieces, and their positions.

I don't like to seem to be harsh on any one person, but I have to say, this is the second article in a row from Gomes, whom I usually enjoy reading, that simply contains shallow thinking.

Consider the title of his piece yesterday, "Above All Else, Rivals of Apple Mostly Need Some Design Mojo."

Really? Indeed! How wonderfully simple to fix. Just call a few industrial designers, and Microsoft is back on track to consistently superior return performance for the rest of this decade. Same for intel, eh?

I don't think so. No, it runs far deeper. Like product strategy, choice of arenas in which to compete, and corporate sizes so large as to insulate the senior executives from a meaningful appreciation of the amount of value destruction that continued mediocrity will cause.

I found Gomes' last paragraph to be the most telling evidence of his misunderstanding of what has been going on in this situation. He writes,

"Apple has worked hard in recent years to adopt some of the business-process efficiencies that the Wintel companies have long taken for granted. Its rivals, then, ought to be able to make themselves a little more creative."

Again, it's not that simple. I have undertaken proprietary research on the occurences and sources of consistently superior total return performance among large-cap companies. My findings have shown that innovation and creativity are the most unique, important attribute of such companies. Whereas expense and process management are fairly easy to hire and implement, true innovation and creative product development, which drive consistently superior revenue growth, appear to be the rare talents.

Therefore, it's not going to be very easy for Microsoft and Intel, at their size, and with their bloated bureaucracies, to simply "make themselves a little more creative." Not when Chairman Bill is the self-ordained "chief software architect" of his software empire. As I have written prior to this, if Microsoft is to break historic patterns, it probably has to seed entirely new companies. For more on this, see my piece on new style corporate governance.

To close, I remain disappointed that the WSJ continues to pump out such shallow and badly-conceived ideas about business strategy. I doubt it would have taken more than a few phone calls to business colleagues for Lee Gomes to be disabused of his notion that, just like process efficiency improvements, creativity can be easily hired or "managed" on demand.

It cannot. And that, dear readers, is why Steve Jobs' Apple is running (profitably) loose among product/markets no other PC software or hardware providers can even begin to consider. He has a natural flair and appreciation for design and usage that Bill Gates has never displayed. And in the current environment, that now matters.

Carly Fiorina, H-P & Corporate Governance

Alan Murray of the Wall Street Journal wrote an excellent piece this morning about H-P's recent performance, and how it relates to the firm's ex-CEO.

In further comments on CNBC this morning, as Alan usually does to follow-up on his weekly column, he aptly fended off inquiries from the guest-host, Herb Greenberg, regarding the wisdom of the Compaq-H-P merger. What Alan pointed out is that, while sales may not have increased by more than simple addition because of the merger, expenses clearly fell from scale economies.

My ears perked at this, because it dovetails with my own research. In slower-growth companies, ROI matters a lot for achieving consistently superior total returns. And a big part of that comes from expense base management, since, by definition in a slower-growth company, it won't be coming from revenue growth.

Alan further pointed out that the board members backed the merger, but not, ultimately, Carly's personal and professional management style.

I again perked at this. What Alan Murray is really saying, without naming it, is that H-P's board did the unheralded right thing of dumping a problematic CEO and replacing her with one who focused on what they felt was critical for H-P at this time. That's a rare thing, despite the recent years of lackluster total returns at H-P.

So, for once, we have actually witnessed some effective "corporate governance" by a board that took action to benefit shareholders, without some scandal forcing them to do it. Maybe the system can work- it just takes the right board.

Maria Bartiromo's Fed Appointment Reversed

It's official. In testimony before a Senate committee earlier this week, Ben Bernanke retracted his remarks to Maria Bartiromo, upon specific questioning of the incident by Senator (former perfect game hurler) Jim Bunning of Kentucky.

In a rather muted moment, Bernanke muttered that he had a lapse of judgment concerning speaking to the CNBC talking head about his and the Fed's true intentions with respect to rate hikes.

Thank goodness! Sanity prevails, and Maria's not un unofficial member of the Open Market Committee after all.

Monday, May 22, 2006

Some Common Sense About Interest Rates & Current Market Conditions

Rick Santelli, CNBC's Chicago reporter on the commodities and options markets there, has been in its New Jersey studios recently. What a breath of fresh air! I swear, this guy should be anchored there all the time.

I periodically castigate the network for focusing on the "action" on the floor of the NYSE, when the real decisions regarding equities are made in institutional money management offices across the country and globe. However, with fixed income, it's slightly different.

Bonds, particularly Treasuries, are a mathematical play. Pure and simple. In fact, one business partner of mine, my friend Bob, has opined that equities are the wild west, where any valuation can happen, without a clear cause. Fixed income, on the other hand, which is where Bob spent much of his productive career, are all math, and very understandable.

Santelli does a really wonderful job explaining the market forces at work while the camera shows the trading pits of Chicago in the background. Unlike, say, Bob Pisani, who looks up at some market stats board on the floor of the NYSE, then makes up his own story about why "the market" is doing something, Santelli calmly explains how the math of interest rates and inflation are pushing bond prices around, and affecting the term structure of the yield curve.

Thus, his remarks over the past few days have been calming, albeit delivered from a desk on CNBC's New Jersey set. He essentially said that a rise in rates from 5% to 5 1/2% was hardly enough to justify all the carnage recently seen as a result of inflation expectations. I think he is right. His calm explanation of the recent moves, and probably long term affects, seemed very reasoned and sensible.

Later that same day, CNBC had Gail Dudak, one-time frequent guest of the late Lou Rukeyser, on as an equity markets commentator. She made a number of clear and reasonable points as well. In particular, when asked if we are now seeing the beginning of a bear market, she said, "no." She likened these past few weeks to last Spring and October, when there were temporary market drops due to unfounded worries over various economic problems. I recall October's roiled markets clearly, as they came as a partial result of Katrina's then-uncertain effect on the US economy.

Overall, these two people, Santelli and Dudak, provided with clear, reasoned and believable analysis. Admittedly, it reinforced my own beliefs, but they had different perspectives, which was important.

I think that, once again, we are witnessing a market which is in the throes of misinterpretation of economic data by a lot of inept seat-warmers in the money management sector.

What An Analyst Does

Today's Wall Street Journal features a section on "star" equity analysts.

As I read the first page of the section, seeking to understand the bases on which analysts were evaluated, I learned the following. Analysts are apparently judged on their ability to produce a best "buy" or "sell" recommendation, in terms of total return.

At first glance, this might seem appropriate. But it seems to me to run counter to what I have been led to believe analysts are supposed to do.

First, measuring an analyst on their one best recommendation seems akin to awarding a batting title in baseball to the hitter with the single longest home run. It doesn't count the other recommendations, or the average performance of all recommendations, etc. Or adjust the best recommendation for some sort of riskiness of the analyst's worst recommendation. How anyone is supposed to make use of such information stymies me. Which one, of many recommendations, should I have followed from each analyst?

Wouldn't it make more sense to reward the analyst with the best overall average return on recommendations? But, wait....that would make the analyst sort of like a portfolio manager, wouldn't it?

So, maybe the notion of rewarding analysts for something investment managers are paid to do is rather awkward.

My understanding, from years in the financial services industry, was that analysts were supposed to be uniquely able to understand specific companies in depth. And that the hallmark of this was to have the least error in predicting things like earnings, or earnings per share, for companies the analysts covered. What happened to this criterion? Has it just vanished, as we admit analysts are really just junior money managers?

Of course, there's the question of how one would weight a single best recommendation from an analyst. At the same time the WSJ features articles which counsel risk management for individual and institutional portfolios, they devote an entire section to lauding analysts who made a single "best" equity buy/sell call.

Confusing, isn't it? How our largest daily business newspaper, the Wall Street Journal, can be so schizophrenic with respect to what it seems to value as good financial advice to its readers.

Sunday, May 21, 2006

What About The Mediocre Companies?

My friend S, a consultant, was discussing corporate performance with me recently. While debating the recent fortunes of tech companies such as Google, Intel, and Microsoft, she challenged me to articulate what I would to fix what ails the last one. I had opined that Microsoft is, essentially, finished as a company capable of generating consistently superior returns, in part, as I have written recently, because of its chairman's excessive wealth. By the way, according to S, my estimate of Gates' net worth may have been light by as much as 50% or so. He apparently was worth some $50B as recently as 6 months ago, not the $25B I thought.

In any case, I said that the first, and, for a while, only thing I would do at Microsoft would be to essentially execute the threatened anti-trust remedy of the Netscape case- split the company into three: an applications software company, an operating systems company, and an internet-related company.

I'd like to explore my friend's next major remark. She assailed me, in a friendly way, for essentially ignoring the existence of less-than-consistently-superior return-generating companies, as if they should all perish. As a consultant, I believe her tendencies and motivations lean toward fixing mediocre companies, rather than simply tossing in the towel on them. It's a laudable goal, and no doubt a profitable one for the consulting sector.

However, I approach these issues as, I believe, most of my readers do- a passive investor. Mind you, I do opine on situations which I believe can be rescued. I say whether or not I believe a company can be put back on a path to consistently superior returns, or not. For example, GM, Intel, Dell and Microsoft- almost certainly not. HP and AMD- quite possibly.

But, what is a passive investor to do now? What does a passive investor desire now?

The obvious answer to these questions is that a passive investor desires to earn total returns which exceed the market average. S/he wants, ideally, consistently superior returns, on some risk-adjusted basis. Therefore, owning the stocks of mediocre firms is probably not high on such an investor's list of things to do.

Furthermore, the investor does not have to "settle" for shares of a mediocre, below-average-return company. Because of inexpensively-marketed, passively-managed index funds from complexes such as Vanguard, an investor may easily and cheaply buy an index which represents the S&P500, or virtually any sector. There are many ways an investor may take positions in companies through these vehicles, with expectations of returns that benefit from diversification, without ever needing to actively select a single company, much less voluntarily buy a lackluster one.

However, an investor may wish to attempt to outperform the market with part of her/his funds. It so happens that my large-cap investment strategy is based upon proprietary research which has shown that the best way to increase the odds of owning consistently superior total return-generating companies is to select those who have already been doing so. Then hold them a little longer, to reap the benefits of their continuing ability to surprise other investors with their consistently superior fundamental performance. That's why I have no interest in mediocre companies.

Mediocre companies have shareholders, and employees, and produce things. They exist in our economy, and no doubt provide valuable products and services, without which you and I would probably have lives which are different as a result. These opinions of my friend S are all true.

However, that doesn't mean you, or I, should want to own stock in these mediocre purveyors of economic necessities. But someone does. And, frankly, unless they decide to take a loss, these owners may not be able to sell their shares. Of course, it's easy to see that, should they believe they have better return expectations with some other investment, they should sell. But people are not always rational about these things, by any means. For more evidence of this, just Google "behavioral finance" and sample some of the literature from this field.

So, what happens to them- the underperforming, mediocre companies? There are several possible outcomes for these companies.

For some, their stock price declines, as a result of their increasing ineptitude, until it is so low that someone actively buys up a lot of it, believing that they can modestly improve the firm, and reap the attendant total returns. An example of this in the market now is Kirk Kerkorian's long-running bet on GM's return from near-death to just "pretty sick." Eddie Lampert has gone one better at Sears, buying a controling interest in the firm, and betting on wringing some excess returns out of it, one way or another.

However, both of these are active solutions unavailable to the typical investor- even most institutional ones.

Another path for a mediocre firm is for the CEO and senior management to take the firm private, using private equity backing, in order to reap the rewards of significant restructuring away from prying eyes and quarterly demands of the investing public. In these cases, the inside management takes advantage of their better knowledge of possible outcomes for the firm, and buys it cheaply, relative to potential returns, from a lesser-informed group of shareholders. However, this removes the firm from the public markets, so, again, a passive investor won't be seeing this option until later, after the anticipated turnaround.

This leaves mediocre firms who attempt turnarounds on their own. Firms whose stock price has sunk so low that, with a modicum of better-than-average performance, their share prices may spurt up in surprised response to the unexpected results. However, by definition, this is essentially betting on aberrant behavior. It requires a lot of in-depth analysis of just the "right" opportunities. It is an exlicit timing play. The investor has to get it just right, and that usually means taking significant risks.

I actually explored these situations in my proprietary research, as one type of strategy to pursue in the equity markets. My findings were, essentially, that the likelihood of turnarounds, among all possible situations of declining performance, multiplied by the average resultant total return, provided an unfavorable expected return. It simply is not a statistically viable approach for those on the "outside" of such situations, having no special knowledge of the ensuing turnaround.

Finally, let's consider why one invests in equities. Ideally, you are in equities for their growth potential. That means valuing them for their future growth, rather than fixed-income-like steadiness of cashflows. Thus, discounted cash flow valuations are inappropriate for equities which are bought and held for, well, the potential that equities uniquely offer. This being the case, and, again, my research has supported this analytically, one would not want to buy the equities of mediocre, low-growth, or low-earnings-growth firms. It just makes no sense, when there are plenty of better alternatives out there.

So, in the final analysis, this is my reply to my friend S, as to why I ignore mediocre companies, or those formerly superior companies now lapsing into their dotage. I ignore them because, relative to currently consistently superior total return firms with the fundamental performances to sustain those returns, the mediocre companies are simply not attractive for providing the passive investor with consistently market-beating total returns.

I know someone will continue to hold the equity of mediocre companies. Some may be turned around. Others may be acquired, merged, or simply stripped and closed. But for passive investors, getting involved in mediocre firms is a high risk, low return proposition. I don't see that changing anytime soon.