Friday, May 25, 2007

Business Media & Schumpeterian Dynamics

Today's "Financial Insight" column on the back page of the Wall Street Journal's Money & Investing section discussed Dell's recent foray back into retail, via Wal-Mart.

Essentially, the computer maker has deigned to sell some desktop units through the giant discount chain. Notably absent, however, are its notebook products. I wrote this post last fall, discussing how mistaken I believe Dell's strategy is in this respect.

At the end of the short piece, the authors wrote,

Dell has tried this strategy before, and it failed. In 1993, it began selling PCs at Sam's Clubs, a division of Wal-Mart. One year later, it pulled out. The reason: "This is a no- or low-return business," said Michael Dell. "We like to be in businesses where we can make money, and we know how to do that in the direct business. He must be hoping history doesn't repeat itself"

Guys, it never does.

What puzzles me is why much ink is even spent on this sort of Dell action anymore. History assuredly won't 'repeat' itself, in the larger sense, in that Dell is history. Its phenomenal total return and sales growth run is history. It has become just another datapoint sustaining Joseph Schumpeter's keen observations, early in the last century, on the nature of the rise and fall of businesses in a technologically-based, fast-moving capitalistic economy.

Home Depot is essentially the same. It, too, is now a market-saturating, mature company. The salad days of rapid, profitable growth and consistently-superior total returns are over.

Why can't the people in the business media see this? Companies are born, some develop strongly, they mature, then they age and go gently into that good night.

From an industrial structure point of view, aging sectors tend to consolidate, in order to preserve some vestiges of profit margin, amidst slowing or declining sales volumes and revenues. Very rarely, if ever, do leaders in a non-cyclical sector rise again, without drastically changing their business focus.

Dell and Home Depot are now, hopefully, just interesting, Schumpeterian footnotes in business history. I wish I could write that we won't hear a lot about them anymore, but that's probably not true. Because business writers and reporters don't seem to know all that much about business theory and reality over time. At bottom, business "news" and reporting seems to be more about entertainment than providing useful insights and information.

Thursday, May 24, 2007

Burberry's New CEO and New Focus

Today's Wall Street Journal featured an article on Burberry's new CEO, Angela Ahrendts, and her retrenchment strategy at the famous brand's company.

I think Ms. Ahrendts is a very bright and decisive CEO. Her corporate pedigree suggests she's ideal for the job.

What really puzzles me, however, is that her predecessor was unable to effect the same strategy, even though it is more than 50 years old.

According to the article, when

"Walking through the Burberry showroom here after becoming chief executive last July, Angela Ahrendts looked at the wealth of apparel and accessories and thought, she recalls, "Way too much stuff."

....On her third day as CEO at Burberry Group PLC, Ms. Ahrendts asked Burberry Chief Financial Officer Stacey Cartwright for a report on what each product contributed to the business. Its findings: 80% of Burberry's sales came from 20% of its wares."

This simple, yet magnificently effective analytical approach was pioneered by Russell Ackoff in the 1950s among America's steel mills.

My manager and mentor at Chase Manhattan Bank, Gerry Weiss, used to say,

"There are hundreds of business aphorisms which we all know. The question is, which three or four apply in this particular instance?"

Few CEOs, it appears, know enough of the business strategy playbook to be able to shift gears and handle different situations, well, differently. So many seem, in effect to be one-trick ponies. Perhaps growth, or cost-cutting, or simply 'steady as she goes.'

Thus, Ms. Ahrendt's predecessor, Rose Marie Bravo, pursued rapid growth at Burberry's, although it eventually plateaued after almost a decade.

What I think this suggests is that boards of directors need to be more sensitive to how a CEO continues to perform over time. Initial successes are fine, and should be compensated. But that does not guarantee an endless honeymoon.

The reality of business seems to be that most CEOs cannot easily transition between environments, such as turnarounds, cost-cutting, or growth.

So at Burberry's, as Ms. Ahrendt reins in the product line, improving profitability, it will probably be worth watching in a few years to see how she does re-igniting profitable growth, when the pruning is finished.

Wednesday, May 23, 2007

On Derivative For Risk Management: Richard Bookstaber's Views

Last Friday's Wall Street Journal featured a long article which constituted, more or less, a review of Richard Bookstaber's new book, "A Demon of Our Own Design: Markets, Hedge Funds and the Perils of Financial Innovation."

The review sketches out Bookstaber's informed opinion that the dynamic use of various financial innovations, specifically derivatives, has contributed greatly to market meltdowns- the 1987 crash and 1998 LTCM, to name two.

Later that day, I saw a corresponding interview with Bookstaber, by the hapless Maria Bartiromo, on CNBC. Bookstaber reiterated most of the points covered in the Journal article. His response to her question concerning why Ben Bernanke would express confidence in derivatives as helping to spread risk more manageably throughout financial institutions, as evidenced by reduced market volatility, while Bookstaber is sounding a warning regarding the potential for increased, dysfunctional volatility, was quite interesting.

Bookstaber said, in effect,

"Yes, it's quiet right now, and things are working. But once they don't, watch out! That's when all hell will break loose."

Without a doubt, he's right, as is Bernanke. I discussed this with my current, and a former business partner at lunch that day. I hadn't yet heard Bookstaber's interview, but the same point was implied in the Journal piece.

The key to understanding the situation is to examine whether derivatives are used statically to guard against an unexpected, sudden market meltdown, or are planned to be used to offset a sudden and unexpected market meltdown. If you are using derivatives for the latter purposes, then, per Bernanke's view, they are beneficial. If, however, you are expecting to use derivatives dynamically amidst a market crisis, then Bookstaber's warning is correct, and, if anything, and understatement.

My partners and I all agreed, from twenty years of observing modern financial market meltdowns and crises, that the one thing of which you can absolutely be sure during a market crisis is that you cannot be certain of being able to trade any position.

Thus, there is a major difference between, say, using derivatives, such as options, as outlined in this prior post about Nassim Taleb's book, The Black Swan, and employing them in mind-numbingly complex combinations which are only underpinned by probabilistic distributional expectations, rather than straightforward, certain relationships. The use of call options to gain exposure to equity price appreciation, while removing the corresponding full exposure of price depreciation, is an example of the former. LTCM's complicated straddles and linked, cross-instrument and -market bets is an example of the latter.

When multiple derivative positions involving different instruments and markets are employed, many more assumptions regarding underlying distributions of occurrences of various price movements, and the probabilistic bets taken thereon, are often made than are realized.

Personally, I think this relates in some sense to the quality of talent going into financial engineering disciplines. Too often, less attention than necessary is paid to assumed underlying price distributions and various probabilistic assumptions on which, ultimately, so much of the value of presumed portfolio 'insurance' rests.

So, in this respect, I believe Bookstaber is right. Getting overly complicated in the use of derivatives invites failure of an investment strategy in the midst of a market meltdown that precludes any certain ability to dynamically reposition a portfolio.

Thus, as we consider options implementation of my basic equity portfolio strategy, I am mindful that it would be a static one, rather than an options approach that assumed any ability to trade in the midst of the type of rapidly-moving, unexpected market conditions. The key to successfully using derivatives is to allow them to function just by being in place, rather than hoping that a string of them move as predicted, according to 'typical' market conditions, or, if not, that they can be traded during such a market maelstrom to try to repair the damage of any incorrect assumptions.

Tuesday, May 22, 2007

Jeff's GE: Discounted Closed End Fund

Exactly one week ago, my partner and I attended a talk given by MIT Franco Modigliani Professor of Finance and Economics, Stephen Ross. I wrote about it here.

One of Professor Ross' topics was the anomaly of closed-ended funds selling at discounts to their net asset value. Specifically, approximately 7.5% for financial funds. I wrote that Ross discovered,

It turns out that simply quantifying and modeling the effects of management fees on the value of income and asset value to a closed-end fund-holder explained the difference between the market price and NAV of such funds.

What, you may ask, does this have to do with Jeff Immelt's GE? Plenty.

Today's Wall Street Journal carries a short article on page C14, by the paper's guest columnist, the online website Usually, these pieces are pithy, regurgitating what's already been in current discussion in the business media.

This morning, however, it raises the question of what GE's plastics division sale says about the rest of the conglomerate's valuation. To quote from the article,

"GE's vaunted premium to the sum of its parts, as estimated by analysts, has pretty much disappeared. Moreover, the plastics sale suggests many of GE's assets may have more value than investors and analysts are giving the company credit for in their models.....Companies that trade at a discount to their parts are prime targets for activist investors. Mr. Immelt should consider spinning off businesses such as GE Money and NBC Universal, before uppity investors dictate a more-Draconian corporate strategy for him."

I couldn't have said it much better, although I wrote it first. Here. Last August. Only it's not about spinning units off, but simply breaking the whole company into its constituent, standalone, unrelated businesses.

You see, Jeff Immelt is, in reality, simply an overpaid closed-ended fund manager. GE's shares are, well, shares of a closed-ended fund. The fund has invested in, actually acquired, a collection of unrelated businesses- finance, power systems, plastics (now gone), entertainment, etc.

As Stephen Ross illustrated, closed-ended funds trade at a discount due to management fees. In financial funds, those fees are typically one percent of assets, plus some expenses. You may ask why closed-ended funds exist. I did. Perhaps they are holdovers from the days when brokerage fees were high, liquidity was in shorter supply, as was information, and the best way for many investors to diversify was to buy a diversified fund.

None of those conditions are true today. That's why GE is an anachronism, as currently structured. It has no current reason for being.

To drive this home, let me relate what I heard yesterday morning on CNBC, Jeff's private (GE-owned) network. While discussing the plastics unit sale, he took the opportunity to once more attempt to fend off calls for splitting up GE. In particular, he argued that NBC/Universal was now turning around, and that they had a great slate of network programming and films on the way.

This was just hilarious. Jeff Immelt, corporate titan, is also a seasoned entertainment exec, with a sure eye for the next big hits on both the small and large screens of the world.

If you believe that, I have a bridge in Brooklyn to sell you.

As I contended in this recent post, Immelt is actually the only GE CEO in modern times not to have put his own stamp on the company. In this post, I explained why that doesn't matter to Immelt. He's already received a stupendous payday for nearly six years of abject failure.

Now, putting together today's Journal piece with Professor Ross' findings on closed-ended funds, it's much easier to see why GE should be dismantled into its standalone pieces, exchanging one share of GE for shares in each of its units. The discounted value as a whole conglomerate won't go away. But the plastics unit sale will now signal to the private equity crowd that there's money to be made simply by gaining control of the firm and releasing unrealized value in a breakup.

This should be a most interesting year for GE and the private equity funds.

Monday, May 21, 2007

Foreign Stock Brokers

Saturday's Wall Street Journal's Money & Investing section greeted me with an article that I had to start twice to be sure I was reading it right. Suffice to say, it lent more credence to my business partner's belief that the Journal's expansion to a weekend edition has seriously diluted the quality of its columns in that edition.

A guy named Jeff D. Opdyke wrote this piece, extolling the virtues of investing in overseas individual equities using foreign brokers.

According to Opdyke, many "bigger and more important markets" now include: Hong Kong, Auckland, and Cairo. Other markets one may ostensibly access from these include Shanghai, Shenzhen, UAE, Oman, Morocco and Turkey.

Apparently, liquidity and market manipulation are no longer considered risks in these outposts of capitalism. Forget about mutual funds that invest in foreign equities. Or the foreign exposure to be gained by investing in US global large-cap companies.

Further on in the piece, Opdyke warns of various risks, like one-day, 15% drops in the Thailand market due to government currency restraints, foreign exchange value risks, and unexpected closing of outfits like the Beirut exchange for days.

Honestly, I cannot understand who this article helped. Anyone with sufficient money to be able to, as Opdyke writes, "lose a chunk of it if their investments fall apart several time zones away while they are asleep," probably already uses a foreign country mutual fund. Those people would tend to understand these undiversifiable risks. That is why you pay professionals to enter markets like these.

Those who can't afford that, probably shouldn't know any more which helps them to hurt themselves. Frankly, the average retail investor in the US who already uses a broker is being sufficiently badly-served. Why compound the pain by introducing them to the same scourge in overseas markets?

I don't know anyone who still uses, voluntarily, a full-price, full-service retail broker. Between mutual funds and discount, execution-oriented brokers, the role of the stock broker in America is finally diminishing. Information is plentiful and cheap, if not free, while transactions costs are low and self-trading technology is excellent and likewise inexpensive.

When the service-oriented brokerage model is finally near extinction in the US, why is this Journal writer hyping its use in markets that are of far less quality and reliability than the American equities markets that already can deliver so much loss and pain to the average retail investor? This strikes me as, at best, irresponsible journalism and, at worst, reckless in inviting investors to lose even more money on specious investments beyond the reach of recovery for American investors.