Friday, October 05, 2007

Growth, Risk Management, & Attendant Excesses in Financial Service Firms: The Merrill Lynch Case

As I read yesterday's Wall Street Journal, it occurred to me how Merrill Lynch's recent firings, sub-prime experience, and diversification are a textbook example of why large financial service firms almost never provide consistently superior total returns for shareholders.

In case you missed the piece, or other news stories about it, Merrill fired its global head of fixed income, his deputy, the co-head of fixed income for the Americas, and the former co-head of institutional securities. According to the article, an unnamed analyst estimated that Merrill will be writing off nearly $4B in losses from its sub-prime mortgage holdings.

While other firms, such as Bear Stearns and UBS, have also ejected senior executives, I want to examine the Merrill situation in more detail, because of its size and business scope.

Mr Kim, Merrill's recently-fired co-head of institutional securities, had led the team and area which bought First Franklin Corporation, a subprime mortgage originator, for $1.3B.

A dissenting executive, Jeff Kronthal, was fired as the team bought the sub-prime firm.

Once purchased, of course, First Franklin became a machine with which this fixed income team churned out lots of CDOs, becoming the #1 underwriter of the instruments since 2004.

According to the Journal article, the former global head of fixed income, Mr. Semerci,

"and Mr. Kim were known for putting a greater priority on expanding market share than on risk controls."

And there you have the crux of the phenomenon.

At diversified financial service firms, managers compete for promotions, compensation and control. In order to win these, they must out-grow their peers.

So they take excessive risks in the mid-cycle of a business, riding high growth and turning it into more explosive, riskier growth.

Sometimes, this approach works and the executives involved rise to lead the firm. If not, they still get compensated well, and the firm takes the hit to its balance sheet when the risk catches up with the earnings.

When I was at Chase Manhattan Bank in the early 1990s, the Real Estate division pushed for high, risky growth via construction lending in Manhattan. Eventually, that bubble burst, leaving the bank to take several hundred million dollars in writedowns in 1990. Meanwhile, the executives who made the loans, often found, upon later auditing, to be improperly documented, if documented at all, received large bonuses for making loan origination quotas.

In a large, diversified financial services firm, this drama plays continuously. That is why some element of a diversified financial conglomerate like BofA, Citi, Chase, Merrill,, seems to explode in fantastic losses every few years.

So long as these giants incent managers to get ahead by growing their businesses, which, in financial services, must, to sustain growth over time, lead to riskier business, this will be a permanent feature of the sector.

That's why my equity selections process never identifies a non-acquisitive diversified financial conglomerate as an investment. Sans acquisitions, which prop up revenue growth artificially for a time, these giants are continually prone to the sort of losses being recorded at Chase, Citi, Merrill, Bear Stearns, and UBS this year.

Merrill can axe three highly-ranked fixed income executives, but that won't stop this from happening to the firm again. The story is as old as Lehman's original fist fight in the partner's board room that saw Lew Glucksman, the firm's one-time trading titan, oust Pete Petersen, who went on to co-found the now-famous private equity BlackStone Group.

Glucksman went on to binge on trading and, subsequently, trading losses, in the next few years, leading the firm to fall into the lap of American Express.

Only the faces will change. The culture and internal climate of any diversified financial services firm will guarantee repetitions of the recent Merrill experience for years to come.

When financial service firms rely on one, or, at most, a very few businesses to fuel their value creation, and manage risk accordingly, only then will they avoid these recurring risk-management failures.

In short, it's risk management that brings down large, diversified financial service firms every time. More than anemic growth, excessive growth in one or two businesses inevitably leads to excessive risks, which are typically hidden from the credit and audit functions, as well as senior management. After all, the executives are playing with the firm's money, so it's a win/win or lose/win proposition for them. Either way, their firm takes any losses.

The days of smallish Wall Street partnerships in which risks were well-understood, acknowledged, and managed, because the partners owned the risk, are long gone now. Instead, diversified financial mega-firms such as Merrill and BofA own many business units, in which managers play a risky game to advance their careers.

Thus, the entire complexion of financial service businesses, markets, and the risks inherent in them, have changed irrevocably, as a function of the sector's current organization. That's why you can expect something like the current Merrill writedowns and firings every few years at one or more diversified financial giants.

Thursday, October 04, 2007

Vindication: The Wall Street Journal Officially Buries "Wal-Mart Era"

Yesterday's Wall Street Journal featured a prominent, front page piece entitled, "Wal-Mart Era Wanes Amid Big Shifts in Retail."

As such, I'm going to declare yet another of my predictions vindicated. I wrote pieces on this blog, here, and here, as long ago as September of 2005, when I began writing this blog.

Among the quotes from my earlier posts are these from April of this year,

"Friday's Wall Street Journal ran a piece in their Money & Investing section on what ails Wal-Mart, and how to fix it. Trouble is, they mostly asked a group of money managers. Why they think those guys would have a lock on such knowledge is beyond me.

In my opinion, most of them are barking up the wrong tree. Wal-Mart isn't 'coming back' as they knew it. It's big, sluggish, and hard to manage with its saturated markets.

Rather, Wal-Mart is likely at a crossroads. If it desires to regain consistently superior total return performance via growth, then it needs to do a better job identifying those markets which will sustain its traditional, logistics-dependent strategy for dominating the low end of retail merchandising. Whether this means staying or leaving Japan, I don't know. But Wal-Mart's management should.

My own view is that it's unlikely that Wal-Mart will regain its former consistently superior outperformance record. Its size, need to be in multiple countries and exposed to radically varying cultures and logistics environments probably presents the firm's management with too many challenges to overcome simultaneously.

But, since I'm neither a broker, nor a current investor in Wal-Mart, I don't have a stake in convincing others to either buy, or sell the firm's stock based upon expectations. I'm just writing what I have observed, from both my proprietary research, track record of portfolio selections, and the recent media coverage of Wal-Mart's performance."

And these sentiments, from September, 2005,

"Back when I was earning my degrees in Marketing, there was a theory which was taught that went by the name of “the wheel of retailing.” It essentially observed that every so often, a new, low-cost retailer will arise that rips through the existing sector structure like a hot knife through butter, growing at the expense of outmoded, expensive older giants.

That said, the Wal-Mart saga since the 1980s is both remarkable, yet not surprising. What the company did is not all that new. It upended several existing chains of general merchandisers who had grown inefficient, insensitive to consumer needs and wants, and basically moribund. How it did it was with the latest version of what the lowest entrants on the wheel of retailing always use- low-cost supply of large volumes of goods. It looks glitzier now, with integrated IT functions shared among vendors. But if you go back to the architect of Sears’ great transformation, you will find that Robert Wood, the creator of that transformation, learned his supply skills as quartermaster on the Panama Canal, one of the more challenging logistical projects of that era.

What is puzzling me is why there is all this attention paid to the mid-late life growth pangs of a retail success. Retailers who began life at the bottom always try to extend growth, once they saturate the market with stores, by moving up-market. And they nearly always fail in doing so.So will Wal-Mart. The company appeared briefly as a selection in the large-cap equity portfolio I manage. That was back in the 90s. But it hasn’t performed in a consistently superior fashion in over a decade."

I'm quite proud of the fact that I called the demise of the "Wal-Mart era" two years ago. It's sort of sad that as fine a business newspaper as the Wall Street Journal both missed the boat for this long and, even now, in their comprehensive article yesterday, can't come up with a reporter who is familiar with the 'wheel of retailing' concept. Or Schumpeterian dyanmics. Because both figure in this story.

The 'wheel of retailing' is an old, but still valid, marketing concept which observes that, over time, low-end retailers eventually attempt to move upmarket, making way for new entrants, while tending to stall in their new product/markets. This is Wal-Mart, to a "T." Schumpeterian dynamics explains, additionally, why, over time, Wal-Mart sowed the seeds of its own competition, as well as became a target for regulatory and social activist forces, sapping its energy and tarnishing its reputation.

As it is, the article thoroughly documents Wal-Mart's troubles amidst shifting consumer values which place style and convenience above price. Further, having dominated their product/market spaces for so long, they became the target at which to shoot. Consequentially, the article mentions that many competitors, such as the drugstore chains, Walgreens and CVS, simply redefine their offerings to avoid head-to-head competition with the retailing giant. Krogers does the same in food, offering semi- and fully-cooked meals to differentiate itself from Wal-Mart's grocery stores. Tesco, the British food retailer, is about to enter the Western US market with a portfolio of store types, taking on Wal-Mart in this large product/market.

The Yahoo-sourced price chart in this post demonstrates, compares Wal-Mart's performance since the early 1970s with the S&P500. It's clear that, except for a brief 2-3 year period in the late 1990s, Wal-Mart's market performance has been stalled since 1992, i.e., for 15 years!

That's an awfully long time to be waiting for a turnaround, isn't it? That's why I called the company dead as a consistently superior total return performer. The Wall Street Journal article echoes my own research findings and observations about the retailer- it's simply grown too large and stable to respond with alacrity anymore to changes in consumer tastes. Further, with such a large, inertial sales volume, significant growth is no longer easy. Wal-Mart's ventures abroad have disappointed, suggesting their management style is not transferring well or easily to China, Europe, et. al.

As the chart above shows, if you had bought Wal-Mart stock over 30 years ago, and simply held, you'd still have outperformed the S&P for the period by a stunning margin. But you'd have to have sat and watched it tread water for this entire decade. Simply put, Wal-Mart's best days are behind it in terms of consistently superior shareholder return performance.

And you read it here first. Two years ago.

Wednesday, October 03, 2007

Chuck Prince's Nine Lives

I'm beginning to think Citigroup CEO Chuck Prince is some sort of shape-change artist out of Harry Potter, who is, in reality, a cat. A nine-lived cat, to be precise.

How many mistakes can a CEO make and still keep his job? Perhaps due to Prince's example, GE CEO Jeff Immelt figures he has lots of time left to continue to mismanage his firm.

But, back to Citigroup. Having taken the helm from Sandy Weill in 2003, after the latter's excesses of merger-mania, Prince has presided over a performance that underruns the S&P for the timeframe.

As observed in the nearby Yahoo-sourced chart of stock prices for Citigroup and the S&P500 Index for the last five years, Prince has led the banking firm to a clear underperformance during his tenure.
Despite the company's major shareholder, Saudi Prince Alaweed bin Talal, commenting,

"No financial institution is immune from the financial turmoil in global markets....It's a hiccup in our journey to reach normalization at Citibank,"
Prince never seems to do more than 'normalize' mediocrity. As the two-year price chart nearby shows, even before this summer's fixed income markets crises, which have led to Citigroup posting third-quarter earnings that are 60% below last year's similar quarter, Citi was already lagging the index, suffering a plunging stock price since early this year.

As I wrote in these posts, here and here, in May and January of this year, Prince has been mismanaging Citigroup for quite some time. It has nothing to do with the market troubles of this summer.

Here's what continues to confound me. Prince would probably not suffer performance like his own in a lieutenant for as long as his board has suffered his own mediocre performance, without firing them.

Why is Prince still CEO? As I have written in prior posts, he's out of his depth trying to run the overly-diversified Citigroup. And financial service firms so diversified almost never manage to post consistently superior total returns.

As I wrote in my last (linked) post,

"Ideally, Citi needs to be split up into more easily led and managed, standalone units which may more nimbly respond to market and competitive forces in their particular financial service sectors. As a financial supertanker, Citi has proven unmanageable in a manner that performs consistently better than the markt for its owners. Can it really do worse as a number of smaller, more responsive entities?"

And Prince should go- break up, or not. He is simply overmatched by the firm's and market's complexity. It would be nice if the Saudi Prince considered other shareholders, and voted to boot the American Prince.

Tuesday, October 02, 2007

American Century Investments & Lance Armstrong

This past weekend's edition of the Wall Street Journal featured an article on the recent management turmoil at American Century Investments. I last wrote a post about the firm here, in February of 2006, when I noticed that Lance Armstrong had formed a relationship with the firm.

As I mused in that post, it seemed odd that Armstrong would represent a service like mutual fund management, which is so prone to changes in fortunes.

And, as it happens, that's exactly what is occurring at American Century now. According to the Journal article, it has a number of poorly performing funds which have had management shake ups.

Meanwhile, the article tells us, the founding family of American Century, the Stowers, have moved on to endowing a medical research institution nearby to help cure the cancers with which both elder Stowers have diagnosed.

Between the family's focus on the medical institute, and Kansas City's declining attraction for many of the investment firm's managers, the talent drain began recently, seeing 20 or more managers and senior executives leave the firm. Some complained that the benefit to the institute of a rise in the price of American Century shares had eclipsed their use as long term incentive compensation for fund managers at the firm.

As for Armstrong, his own foundation receives more money from American Century when the investment firm's results exceed a certain threshold. The former cyclist is quoted as saying that he thinks people "want to be involved with a company that's put themselves out there on such a human level."

Personally, I think the average retail investor simply wants better returns. Institutional investors, which are a new focus of the investment management firm, are even more focused on returns, and less on social issues.

One of American Century's funds, Ultra, seems to be moving in the right direction this year, with its performance back up to 15%. However, it seems to me that the entire episode of wholesale management changeover, and a drop in returns of many of the firm's funds, until recently, demonstrate how risky it may be for someone of Armstrong's ilk to tie his fortunes to such a financial services vendor.

Monday, October 01, 2007

Home Depot Again: Stories from the Front Lines

This weekend, I had the pleasure of seeing old friends who are the parents of one of my daughter's friends. Having moved about an hour away, several years ago, my visits with Jon and his wife are now, though less frequent, longer and more involved.

Jon has had success in startup ventures in the past, and is currently busy with another one. An engineer by training, he fills a number of roles in the venture, including that of supply officer for the firm's various hardware, testing and building materials needs.

This was news to me. Jon related how he has become a regular at the Home Depot located within a few miles of his firm's offices in Northern New Jersey. Typically not that observant of details at stores, such as Home Depot, so Jon says, he has noticed a number of things this summer that corroborate my many posts describing the building supply chain's woes.

For example, he cited the many times he wanders the aisles, while knots of orange-aproned employees are busy talking among themselves, leaving him to fend for himself.

The aisles, he says, are far from presentable. I think he described them as cluttered and messy, when the shelves weren't empty.

But the best story he told involved product mix changes. Specifically, a ban saw.

His group does lots of research and experimentation, so they need power tools for building things on their test benches. Jon had recently bought a ban saw. Within a few weeks, they'd worn the blade out, and he returned to Home Depot for replacement blades.

No luck. It seems that the supply chain had switched product lines, and now markets, as Jon puts it, a decidedly cheaper ban saw.

Well, he was there for blades, not another saw, right? So, no problem.

Ooops! Home Depot told him they don't carry legacy parts for the old saws- meaning spare blades. None. Nada. Zippo.

So they sell him a fairly expensive power tool one month, only to drop support of the consumable blades the next month. No offers to search other stores, or order the blades, or even provide contact with the manufacturer.

My friend was both displeased, as well as bewildered as to how a major chain such as Home Depot could engage in such dysfunctional and unsupportive behavior.

At least when Apple dropped the price of its iPhones, the old ones still worked. In this case, Home Depot simply drops support for their customers who are foolish enough to buy a fairly expensive tool which requires spare parts support.

The nearby Yahoo-sourced chart displays prices for Home Depot, Lowes, and the S&P500 Index, for the past two years. While HD and LOW have moved very similarly over the period, there's no mistaking that HD has diverged very sharply from the index in 2007.

Lowes seems to have popped up a bit more from its recent bottom, coincident with the summer mortgage-based woes, than has Home Depot. Looking more closely, Lowes was back to a positive return when the housing finance crunch hit, whereas Home Depot was in the red. Then it appears that market forces hit Lowes, as well, from which it rebounded a bit better than Home Depot.

What really struck me, of course, was that my friend could instantly detect serious failings in Home Depot, from his perspective as a customer. It echoed what I have seen in the performance data for Home Depot for at least the past year.

I have a feeling that the firm's troubles now run deeper than simply an arrogant, overpaid, now-departed CEO. And that it may be a while before Home Depot is back on track, both with consumers, as well as investors.