Saturday, July 28, 2007

On Diversification, Conglomerates, and Consistently Superior Returns

I wrote this recent post reviewing a NewYork Times piece on GE and its CEO, Jeff Immelt. As I reflected on it, this passage from the Times piece struck me as all wrong (the italics are from the Times article, the quote preceding it my text),

"Immelt, according to Schwartz, argues for keeping GE intact as follows,

"In defending their stance, Mr. Immelt and other current executives don’t fall back on Mr. Welch’s no-surrender, last-man-standing rhetoric. Instead, they make a more subtle argument against breaking up the company: Not only does being a conglomerate help G.E. ride out the inevitable ups and downs of the economic cycle, it also creates those elusive synergies that most other companies only talk about." "

This is simply wrong in today's capital markets. It may have been true forty years ago, as I wrote here and here. But no longer. As I wrote in that second linked post,

"Simply put, corporate diversification for cash flow smoothing has been a discredited management approach for creating consistently superior total returns for some time. My own proprietary research, which drives my equity portfolio selection of consistently superior large-cap companies, confirms this. Back some thirty or forty years ago, when trading equities was expensive and information and innovation were in shorter supply, it may have made sense for investors to hold shares of conglomerates. And, in the day, they existed- Gulf&Western, ITT, and Litton, to name just a few. But they are gone now. ITT still exists, but in nothing like the shape it had under Harold Geneen."

And, in the later post about another recent Times article fawning over Immelt and GE, I stated,

"Thus, Immelt has actually broken the pattern of GE leadership through the ages by essentially changing virtually nothing. The firm has adapted to past eras, that is true. And this era is one of the continued de-conglomeration of American business. His sarcastic shots about Google to the contrary, Immelt's firm is too diversified to provide consistently superior returns to shareholders, because it's taxing them to feed an overgrown bureaucracy presided over by....none other than Chairman Jeff the First.

What Immelt fails to understand, in suggesting Google can't continue growing in its natural niches, is that every business undergoes a Schumpeterian life- and death- cycle. My guess is, Immelt is going to preside over GE's death.

Third, regarding Immelt's observation about investors "going through cycled where they don't like conglomerates" is a bit disingenuous.

The era of growing, permanent corporate conglomerates is over, thanks to very efficient, large and deeply liquid capital markets. Markets so liquid that private equity firms can borrow to buy ailing business units of conglomerates, fix them, and spin them back out to the public. The only apparently consistently profitable "conglomerates" these days appear to be the large, multi-operating-unit private equity shops. But they don't seem to want to hold their businesses- just increase their value and flip them back to the public."

So, in actually, Immelt isn't running GE in order to give shareholders the best chance of enjoying consistently superior (to the market, or S&P500) returns, no matter when they own the stock. Instead, he's pursuing some hoary, forty-plus-year-old goal of 'earnings smoothing' via 'diversification.'

I don't think I've seen a single diversified conglomerate among my consistently-superior, high-growth portfolio selections. Ever.

Conglomerates, as I wrote in the reposted passages above, are holdovers from a bygone era. Managing according to the theory that there is value in diversifying to "ride out the inevitable ups and downs of the economic cycle" is simply being backward in this more financially modern era of liquidity, low/negligible trading costs, and easier risk management via derivatives.

What is surprising to me is that nobody in the business press seems to call the few remaining conglomerates, especially GE, on this issue. GE has become a quasi-index, closed-ended fund, with a big management fee discount from its componet values. There is simply no way Immelt, as GE's CEO, is entitled the many tens of millions of dollars he is paid annually to essentially manage an index fund.

I would expect better coverage of this egregious waste of value in one of the nation's largest newspapers.

Thursday, July 26, 2007

Some Late July Thoughts on Equity Markets

As I read the headlines of this week's business and financial news, and see the equity market averages see-sawing, one thing comes to mind.

It's summer.

Despite our advanced society and technological prowess, seasons matter. And in this season, many of the heavier-weight investors and traders are away for weeks during these prime two summer months.

Equity trading volumes are lighter. Analysis can be less insightful than even its typical mediocre level.

So, when events occur which move markets, the real reactions, those that count, may be weeks in the offing. Or never really materialize, as many deputy investment managers and traders simply keep the seats of their managers warm for a few weeks.

This week's housing-related news is a case in point. Sub-prime mortgages are simply not likely to bring the entire economy down. They were overdone, and badly done. By some mediocre, unwise lenders. Those originators and buyers will likely feel some pain.

Yes, it will cascade a bit to home-related companies, such as those engaged in furnishing homes.

However, it's unlikely to affect global economic growth very much. And large US companies are currently reaping the benefits of being well-positioned for primary construction and economic growth in many other countries, particularly in Southeast Asia and China.

On the whole, like last quarter, corporate earnings are coming in above analysts' expectations.

So, we will probably see equity price volatility continue to be high, as expectations are surprised. But the overall global trend for the next six to twelve months continues to look good.

At times such as these, I am happy that my equity strategy focuses on buying and holding, rather than frequent trading. Volatility is something that I watch my portfolio absorb, but into and through which I rarely trade.

Wednesday, July 25, 2007

GE in the NY Times- Again

My business partner sent me last weekend's recent New York Times devotional to GE and Jeff Immelt, entitled, "Is GE Too Big for its Own Good?" penned, this time, by Nelson Schwartz. Last month, I wrote this piece about another Times writer's love paean to GE and its failed CEO.
For the record, nearby is a Yahoo-sourced, five-year price chart comparing the S&P500 and GE. Even with its modest recent price improvement, GE still badly trails the index for the last five years.

Far from the adulation his predecessor, Jack Welch, earned when he retired, Schwartz had this to say about Neutron Jack's legacy at GE,

"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.

A cooler, humbler and more reserved chief executive than Mr. Welch, Mr. Immelt readily acknowledges that the last several years have not been easy."

So, now it's Saint Jeff who is trying to rehab the broken GE he apparently inherited.

At least Schwartz acknowledged Immelt's lackluster performance over the last six years as GE CEO, in this passage,

"Even so, the clock is ticking. 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."

Ironically, Schwartz even hints at one of the explanations behind GE's mediocrity, when he writes,

"Whereas Mr. Welch took over a company vulnerable to foreign competition and hamstrung by a bloated work force (and cut so many jobs that he earned the unwelcome sobriquet Neutron Jack), 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."

The right answer is that GE is too big. A smaller firm that actually focused senior management on operational issues in its businesses would be far more nimble and quickly growing. GE is suffering the curse of diversified conglomerates- they are difficult to grow and nearly impossible to operate so as to generate consistently superior total returns.

It is Immelt's fault and responsibility for allowing this situation to continue far after global business and competitive conditions have rendered GE's size a detriment, rather than a benefit. For instance, by way of comparison, Schwartz notes,

"Even worse, shares of its archrival and Connecticut neighbor United Technologies have nearly doubled over the same period."

Not surprisingly, Welch has his own views on these topics, as Schwartz reports in his piece,

"Mr. Welch vehemently disputes the notion that Mr. Immelt has been forced to clean up a financial mess, and he is equally adamant in his critique of calls to break up the company.“It would be a tragedy of enormous proportions,” he says. “When you start talking like that, it’s surrender.”"

Yes, I rather think Jack would be up in arms when accused of leaving a mess to his successor. Regardless of what Welch may have or have not done, he certainly pulled the right levers to make investors and analysts believe he ran a consistently superior-performing company, even if he didn't. GE was, for most of Welch's tenure, inconsistently superior in its performance. In retrospect, revered, but difficult to have faith in before the fact.

On the matter of breaking up GE, Welch seems to just be misty-eyed and egotistical. It's way past time for GE to be split into its more economically-manageable pieces. Immelt, according to Schwartz, argues for keeping GE intact as follows,

"In defending their stance, Mr. Immelt and other current executives don’t fall back on Mr. Welch’s no-surrender, last-man-standing rhetoric. Instead, they make a more subtle argument against breaking up the company: Not only does being a conglomerate help G.E. ride out the inevitable ups and downs of the economic cycle, it also creates those elusive synergies that most other companies only talk about."

The trouble is, riding out 'the inevitable ups an downs of the economic cycle' merely gets you mediocrity for shareholder returns. Which is what Immelt has delivered, in spades. Consistent superiority requires some guts, some intelligent foresight, planning and execution. Not just covering all your bets and saying you 'rode out the cycle.'

As my partner intimated, throughout the piece, Schwartz seems to treat Immelt as if he is some sort of business wise man. He writes,

"G.E.’s raw scale and visibility, and the regal status accorded to past holders of the top job, put Mr. Immelt into a very exclusive club. He’s only the 12th man to hold the position since Thomas Edison founded G.E. Indeed, it can be lonely at the top, but Mr. Immelt has sought advice from Warren Buffett, the renowned investor and chief executive of Berkshire Hathaway. He says he also regularly dines with fellow C.E.O.’s like Kenneth Chenault of American Express, Samuel Palmisano of I.B.M. and William Weldon of Johnson & Johnson. Unlike Mr. Buffett, though, Mr. Immelt isn’t a hero to investors these days."

Frankly, I don't think all that much of Buffett, Chenault or Palmisano. Neither has run a consistently superior company for any considerable period of time. Perhaps a few brief shining moments, but nothing stellar for the longer term. Immelt is, if anything, even worse.

Although Schwartz, paints Immelt as a more outwardly-focused CEO than Welch, via this passage,

"While Mr. Welch was obsessed with internal productivity gains, Mr. Immelt is more focused on sales and marketing, says one former associate."

GE's growth rate would make you wonder why. Once again, Immelt seems to be more about smoke, mirrors and image, than delivering consistently superior performances.

And, once again, the "People's Daily" gives Jeff a pass. At this point, I have to believe it's just to mollify the CEO of a major advertiser. And "green" CEO. It's hard to take these puff pieces seriously, when they lionize Immelt and GE for intentions and effort, but skip over simply evaluating GE under Immelt as a failure for shareholders. For six, long years.

Tuesday, July 24, 2007

More Blind CEO Devotion: An Interview with Ford's Mulally

Yesterday's Wall Street Journal carried an interview with Ford's new(ish) CEO, Alan Mulally.

I cannot help but feel that this is one of those "happy talk" sessions, where the interviewer fawns over the CEO, tossing softballs and avoiding embarrassing questions.

The Journal interviewer largely focused on the process by which Mulally became acquainted with Ford, upon his arrival, and how he had managed since then. Scrupulously avoided were realities such as: Ford's dismal recent and forecasted profit performance; Ford's insufficient size to compete with giant Toyota in the years ahead; the reality that realizing Ford has the wrong mix of cars during a time of high gasoline prices has nothing to do with quickly creating the right mix.

Mulally seems like a sincere, hard-working, dedicated guy who may have jumped into a lethal fire. Despite his apparent success in rescuing Boeing a few years ago, he didn't get the top job. That being the case, he jumped at Bill Ford's offer of the Ford CEO position.

No matter how well Mullaly builds his executive team, or learns about auto production and marketing, he is still CEO of an ailing, smallish producer of largely commodity products. His five "tips" for "taking on a new company in an unfamiliar industry" read, in part, as follows:

1. Deal with reality, and restructure accordingly.
2. Talk to everybody.....
3. Fine-tune the business plan every week- not once a year.
4. Get all the players at the table.
5. Encourage subordinates to disclose problems.

Honestly, I don't think we need Mulally to know these things. But, what's missing is number 0:

"Admit when you simply do not have a winning hand, and need to seek a merger, or dissolution, rather than simply exhaust assets in a futile attempt to survive."

I don't think Mulally is being totally candid- with Ford, or the Journal. He said he spoke to dealers at length, asking them what they thought. Trouble is, for every major auto maker, but especially ailing titans GM and Ford, the dealership network is killing them. Consolidation is required, but not really an option, due to existing laws in most states.

Further, Mulally is silent on just how much time investors will give a company which plans to lose money for the next two years, has racked up large losses recently, and faces further uncertainties and difficulties in its competitive, regulatory and customer arenas.

As I have written previously, Ford, partly due to its family's concern with the company that bears its name, has roused itself several times before to affect a self-rescue. This time, however, I believe it has waited too long, become too small, and run the odds of success to a new, potentially fatal low point.

Maybe Mulally can dress Ford up for a merger or sale to another auto maker. I seriously doubt, given his glib responses in the Journal interview, and his focus on process, rather than results, that Ford will ever, independently, earn consistently superior total returns for shareholders over several years.

Monday, July 23, 2007

On "Management by Data"

Today's Wall Street Journal contained an article by Scott Thurm entitled, "Now, It's Business By Data, but Numbers Still Can't Tell Future."

As I began to read the piece, I was hopeful that it would herald a general trend toward more competent, aware, and quantitatively-sensitive management by more senior executives in US large-cap companies.

Mr. Thurm writes, in part,

"The success of enterprises as diverse as Harrah's Entertainment, Google, Capital One Financial and the Oakland A's has inspired case studies, books and consultants promising to help executives outpace rivals by collecting more information and analyzing it better.

There is much to be said for the approach. Guided by Chief Executive Gary Loveman, a former Harvard Business School professor, Harrah's rethought customer incentives, adjusted slot-machine payouts, and poured money into hiring and retaining top-notch employees. Its shares are up more than fourfold in the past decade and the company has agreed to a $17 billion buyout by private-equity firms.

Google has outdistanced Yahoo, Microsoft and others by tweaking both its Internet-search algorithm to provide better and faster results, and its formula that determines what ads are displayed alongside search results. This virtuous circle draws both more Web surfers and more advertisers.

In many cases, analyzing data would be an improvement over prior management techniques, which Stanford business professor Robert Sutton derides as "faith, fear, superstition and mindless imitation." Mr. Sutton is co-author of "Hard Facts, Dangerous Half-Truths & Total Nonsense," one of several recent tributes to the data-driven enterprise."

So far, so good. Then, Mr. Thurm states,

"Running a complex enterprise can't be reduced to a spreadsheet, however. Even the most detailed statistical analysis has limitations, as Mr. Sutton acknowledges.

For one, conditions may change, rendering the analysis misleading....

The tension between the short term and the long term is familiar to managers. Other research suggests that quality-focused approaches may reduce defects, but hamper innovation.

That helps explain why companies seem invulnerable one minute and aimless the next. For a decade, Dell captured an increasing share of sales and profits in the PC industry by mastering supply-chain logistics. But Dell couldn't diversify its business, making it vulnerable once Hewlett-Packard matched its expertise.

The real trick, then, is to combine these skills, gaining advantage by analyzing today's problems while looking creatively for tomorrow's opportunities."

At this juncture, I became pretty disappointed with Mr. Thurm's article. After initially acknowledging the value of data-driven management, whether it be marketing, operations, competitive, or environmental data, he rather quickly began to give reasons why it's not enough.

Of course it's insufficient to just analyze data and manage in light of it. What Mr. Thurm, and most other business writers, continue to fail to acknowledge is Schumpeter's original observations concerning the fragility and impermanence of any company's dominance of dynamic, attractive markets.

I will further add, from my proprietary research, that diversification generally spells mediocrity.

Thus, the fundamental reality that is so frequently missed, including in Mr. Thurm's article, is that even the best management of a great business is fated to earn consistently superior returns for a limited time period. I've argued elsewhere as to why my preferred metric is consistently superior total returns, so I won't repeat them.

Suffice to say, it's simply unrealistic to expect any one firm to use one, or more, management approaches to sustain its consistently superior return performance. That takes a mix of good management, plus innovation. Historically, firms simply do not continue such performance even for a decade.

Success typically creates its own competitive reaction, if not environmental and legal/regulatory ones.

Thus, Dell's weakness was not failing to diversify, but simply succeeding so well for so long. To have done less would have brought another consistently-superior performance-ending scenario into being.

Despite Mr. Thurm's contention that "the trick" is to balance current management and future opportunities, it's not a trick at all. It simply exists so rarely, if at all, as to be practically impossible.

Thus, the point of his article becomes more about noting another management fad, rather than a serious, philosophical revelation that even the best managerial schemes cannot forestall Schumpeter's fundamental observation: that businesses exist in shifting sands of competitive and environmental contexts which prevent them from enjoying consistently superior performances without innovation. And to which I would add, few successful firms innovate sufficiently radically to move them beyond the developing trap of their current, consistently superior performances, while successfully adapting to the new innovations to continue their current performances.

It's nice to read about how some firms have successfully used data to manage themselves in ways which earn consistently superior returns. It's dispiriting to read yet another business column which suggests that companies can achieve perennially consistently superior return performance, if only they would combine the right mix of managerial tonics.

That's just not how business has worked, nor, due to the nature of humans operating them, are ever likely to work in the future.