Saturday, February 02, 2008

Reinventing Sales Management?

Last Monday's Wall Street Journal featured an article in the "Managing" column concerning Ram Charan's latest consulting-what would you call it- fad? scam?

According to the article's opening passage,

"Ram Charan is known for his platinum clients and his relentless schedule. The business professor-turned-management consultant says he's worked seven days a week for 30-plus years, advising executives at the likes of General Electric Co. and Verizon Communications Inc. on such topics as improving results and execution."

As a reference, I've pasted two Yahoo-sourced stock price charts for Verizon, GE and the S&P500 for the past 5 years, and beyond.

I don't know the timeframe in which Charan has advised the two firms. If it's within the last five years, they should get their money back.

As this chart clearly shos, neither firm has outperformed the S&P in total return over the period. GE barely mirrored the index, but still fell short. With dividends, maybe it was close for GE, but surely not sufficiently better to justfiy the excessive senior executive compensation the firm pays.

Verizon has barely earned a total return that is even 1/5 of that of the index.

This second chart shows a longer term of performance for GE, Verizon, and the index.

Again, not knowing when he worked with the two firms, if it were prior to five years ago, that isn't necessarily so impressive, either.

As far back as 2000, both firms began to fade, in performance terms.

With that as some empirical perspective on performance at two of the firms the Journal alleges Charan has 'helped,' let's move onto the interview. It opens with this passage,

"Recently, Mr. Charan turned his attention to sales, particularly from one business to another. He doesn't like what he sees. In "What the Customer Wants You to Know," published last year by Portfolio, he argues that companies need to "reinvent" the way they sell, to focus on their customers rather than product features. Mr. Charan talked to The Wall Street Journal about the problems with sales and how to fix them."

I think this would be news to most marketing professors in the better business schools around America. Sales management and process has been taught since I was in undergradate school, back in the late 1970s.

Beginning to quote Charan in the interview, the article relates,

"Mr. Charan: The sales function has traditionally been about execution. Most sales people are very good at connecting with the purchasing customer. They get training to know the product. And they beat the competition on price.

Now the world has changed. Copying a product became very quick. You now have competition on the Internet to beat down prices.

It has become very hard to differentiate yourself in the eyes of the customer, for business-to-business sales. So salespeople should not sell the product any more. They should find out what the customer needs, which will be a combination of products and services and thought leadership.
WSJ:Can you explain this new approach?

Mr. Charan: Salespeople need to work backwards from what the business need of the company is. Let's say I'm going to sell you this BlackBerry. I come to you and I say, "I've done some homework on your company. I think you're going to need 1,000 BlackBerrys. And in order to make your BlackBerrys fruitful, I'm going to need some information. How many users are in selling, how many in manufacturing, how many in research, how many in finance, how many on the road?"

With that information, I can design something that is useful to them. That information is proprietary. If you don't trust me, I will not get that information. Salespeople need to learn the business of the customer. They need to learn how to ask the right questions. They need to have analytic skills to diagnose a customer's business. They need to figure out who makes the decisions in a company."

Hasn't Charan, or, for that matter, the Journal's Phred Dvorak, ever heard of 'consultative selling?'

It's a little marketing and sales thing that's over 40 years old. IBM salesmen used it to sell the original 'big iron' mainframe System 360s and 370s.

Dvorak continues,

"WSJ:Don't most companies do this already?
Mr. Charan: No. They say how their products will reduce customers' costs. They don't touch on improvement of revenues, margins or brand image."

Honestly, I simply do not believe this. Just look at this post which I recently wrote about Tennant. This passage,

"As a result, the cleaned area would dry in about 30 minutes -- a pressing concern for institutions such as casinos that otherwise have to rope off cleaned areas for as long as 24 hours, Mr. Swenson says,"

clearly indicates that Tennant focused on improving their customers' revenues through value-added product features.

Finally, Dvorak closes his interview with Charan, having apparently sat there simply nodding his head and being totally accepting of Charan's contentions, with these questions and answers,

"WSJ:How does the sales force have to change?
Mr. Charan: The old salesperson: gregarious personality, very sociable. Plays golf. Goes to ballgames. Quick to link with people. Highly motivated. Long hours. Very perceptive in reading other people. The more successful ones know how to close the deal. It's still useful.
Going forward, the salesperson must build trust with the customers' people that's deeper than before and sustained over time. You cannot design a solution without information from the customer. And if the customer does not trust you, he or she will not give you information.

I would be very surprised if John Chambers, CEO of Cisco, thought his salespeople filled their order book just by taking customers to baseball games. Or Larry Ellison's. High-value, big-ticket institutional sales between companies have always been a consultative selling proposition.

WSJ:What else has to change?
Mr. Charan: In the old game, one person could do the selling. In the new game, you need a team from your company. The reason you need a team is the solution you're going to create is going to come from different parts of your company."

Again, large, complex, long sales cycle, big-ticket business-to-business sales have always employed extensive teams to win a customer's business.

It was hard for me to read this Journal piece with a straight face. Is Charan really so clueless that he is ignorant of better sales practicies in business stretching back decades? And was his interviewer, Dvorak, similarly ignorant?

How did this article make it into the Wall Street Journal's "Managing" column? It's just completely fallacious in its portrayal of the best practices of consultative selling in American corporations.

What is it with Charan? Can only he invent "new" concepts? So whatever strikes his fancy is new and worthy of a book or new fad, even if he's overlooked existing, long-used practices which happen to be exactly what he is preaching as "new?"

Friday, February 01, 2008

On Microsoft's Bid To Acquire Yahoo

How could I not write about the hottest topic of the day? Not most important, mind you. But most shocking and popular. I am referring, of course, to Microsoft's hostile tender offer of cash or stock for Yahoo.

Yahoo was worth, as of yesterday, pre-offer, some $25-27B. That's taking the 1.34B outstanding shares at the closing share price of $19.1. Microsoft offered a 60% premium, or $44.6B, worth about $31/share of Yahoo.

The software giant currently has about $19B in cash, making the all-cash version of the offer seem very feasible, as it carries no debt.

By this point, 1PM EST, some six hours after the announcement, every pundit on the planet has probably weighed in on this takeover.

Here's my sense of it.

First, like one of my techie friends who happens to hold Yahoo share, this is clearly a godsend for Yahoo shareholders. As the nearby, Yahoo (naturally)-sourced price chart reveals, it's been at least March of last year before the stock's price was, even for short periods, routinely above Microsoft's offer price. Jerry Yang's resumption of the CEO role last summer has cratered his firm's stock decisively since then.

As for Microsoft, I pity their shareholders. If they didn't have half of this offer in cash on their balance sheet already, would any bank lend them all of the money for this takeover bid? Could even Goldman float a bond issue to fund this for them at reasonable rates?

If anything, I think it reminds us, per my many posts on Microsoft, Gates and Balmer (see appropriate labels), that the company has been very sloppily managed in a financial sense.

How many shareholders, had the $19B been dividended back to them, would gladly give it back to own Yahoo? I'm guessing not many.

As the nearby, Yahoo-sourced five-year price chart of Google, Yahoo, Microsoft and the S&P500 illustrates, neither the acquirer, nor the target in this deal has performed particularly well lately. Microsoft has underperformed the index for the bulk of the period, getting a brief, recent bump. Yahoo did well for the first two years, then crested and has been sliding ever since early 2006.

From a longer perspective, the same chart looks like this. Google's rate of increase far surpasses either of the other two. Since 2000, Microsoft hasn't outperformed the index, and Yahoo has fallen precipitously, on a net basis, with a valley and gentle hill in between.

Clearly, neither Microsoft, nor it's target has been the subject of appreciative investors for their fundamental performances.

Here's my post from last May, when this idea was last in circulation. And a related piece from last week, focused on eBay, but touching, generally, on the concept at issue here. In the first post, I wrote, in part,

"First, doesn't one of the partners usually have to be successful already for this sort of combination to work?

Second, why would a merger of these two huge, lumbering companies create more than a more focused, nimbler marketing alliance agreement between the two? The latter would be far more likely to succeed, in my opinion. These two technology giants are already past their prime and too sluggish to have a high probability of combining in a manner that can yield a consistently superior total return performer. The companies are not similar in their product/markets, so there won't be much in the way of cost savings, yet they will spend considerable time and money attempting to mesh and reorganize post-merger. I suspect it is a recipe for disaster.

Third, Yahoo is, in my parlance, the 'used car of the internet.' This is going to be Bill's/Steve's new ride? Hardly an inspiring last act for the software titan. Can't they do better than a bumbling online-oriented hodgepodge of businesses mismanaged by ...?

Fourth, together, these two still probably won't catch Google. It's not about the's about the ideas. Neither has shown themselves capable of generating successful new ideas which have driven consistently superior total returns in the past five years. How will just mashing the two mediocre firms together change that?"

None of which, I believe, have changed in the intervening months. Except Yang, rather than Semel, is mismanaging Yahoo now. I concluded the post with,

"If this combination materializes, I will go on record predicting that it will not result in a firm that can regain a pattern of consistently superior total return performance. It will, over time, fail shareholders, relative to their option of simply buying the S&P index."

I still believe that, as well. Various pundits may extol Microsoft getting Yahoo cheaply. Or the back-end consolidation of their search engine and advertising businesses.

One bright pundit, Forbes' Dennis Kneale, opined, in a fashion similar to my partner, from this post, that Yahoo is a 'groups' type company, and Microsoft's Facebook investment might offer some value in relation to that. This post sheds some more light on the whole online 'community' business.

But even this begs the question of how all this value will be magically spun from the meger of these two aged, bloated tech titans?

Yes, it's a hot story today, alright. Very exciting for the tech, media and M&A crowds. Let's see how exciting it still is for Microsoft shareholders and/or Yahoo employees in, say, 15-24 months?

A Great Management Story: Tennant Co.

The Wall Street Journal spotlighted Tennant Co. in Monday's Marketplace Section. It's a heartening tale of Schumpeterian dynamics gone right, as well as good management and innovation.

As a cleaning equipment producer, the firm had long gone down the road of efficiency and cost-cutting. The article begins,

"Beset by cheap imports from overseas and facing a slowing U.S. economy in 2002, Tennant Co., a big name in the small market for industrial floor-cleaners, could have tightened its belt and sent more of its factory jobs overseas.

Instead, the Minneapolis company decided to place a big bet that it could outsmart its competitors with innovative products."

How Tennant did it is a pretty riveting story. Central to the tale is this incident,

"A key moment came in October 2002 when Chris Killingstad, then the recently installed head of North American operations, visited his first international trade show in the cleaning business, in Las Vegas. His main impression at the show was that "every machine looks like it's designed the same," recalls Mr. Killingstad, who became president and chief executive in 2005.

Mr. Killingstad returned to headquarters and helped push Tennant -- which makes vacuum cleaners, sweepers and scrubbers deployed in factories, schools, casinos and malls around the world and has 12% of the $5 billion world-wide market -- to boost research-and-development funding to fight back with better products."

Their bet on new features and, where necessary, technologies, worked well. Describing their two leading new products, the Journal article noted,

"The scrubber would tinker with the traditional cleaning method, which involves spraying water and cleansing chemicals onto the carpet, and then vacuuming it. Tennant's concept would inject water and cleaning fluid directly onto circular brushes under the machine. As a result, the cleaned area would dry in about 30 minutes -- a pressing concern for institutions such as casinos that otherwise have to rope off cleaned areas for as long as 24 hours, Mr. Swenson says.

ReadySpace, as the machine would be dubbed, was launched in 2004 and became the company's best-selling carpet-cleaning device.

Last fall, Tennant announced a product that used an electrical current to turn tap water into an industrial cleaner.

A top Tennant researcher who was in Japan about two years ago doing field-testing for a different product noticed a hospital there was using a technology that harnessed electricity to sanitize surfaces. The machines briefly split water into two flows: one an acid that kills some bacteria on a surface and the other an alkaline stream that removes grime and dirt.
Back in Minneapolis, the researcher developed a prototype using the technology. To help the opposing streams stay separate longer, prolonging their effects, he injected air bubbles."

As the nearby, Yahoo-sourced five-year price chart for Tennant and the S&P500 demonstrates, the company's efforts have paid off.
The past three years have been very impressive for Tennant's total return performance. And for four of the past five, the firm has outpaced the index's return.
Schumpeter's belief that innovation and constant forward movement in the quest to satisfy consumer preferences would pay off holds true in this case.
It's wonderful to read of the all-too rare case in which a firm engages in good, creative management and product development to maintain or increase their edge in a competitive product/market by adding more value, not merely reducing prices.

Thursday, January 31, 2008

More On Lampert and Sears

Yesterday's Wall Street Journal featured a Marketplace Section article on Eddie Lampert and Sears. It's one of many recent pieces documenting changes at the seriously ailing retailer. I wrote a few posts recently about the once-great retailer's difficulties, here and here.

The latest Sears CEO, Aylwin Lewis, has been discharged. And now, Lampert swears he's getting out of the 'hands on' management of the company. Apparently, according to the article, he has finally realized it's the only way he has a hope in hell of attracting someone qualified to continue the attempted turnaround.

Lampert characterized the as-yet-to-be-located Messiah as,

"... as a "mission-driven" leader who feels comfortable balancing multiple interests. "I want someone who will be able to deal well with complexity, who will be able to make decisions under conditions of uncertainty, and is someone people will want to step up and work for,"

and that,

"He pointedly says he's not looking to give up his chairman's title."

That sure sounds like fun, doesn't it? Does anyone believe someone that good wants to inherit this mess of potage? In the meantime, a logistics guy is running Sears. Great. Just what you want in an intensely merchandising-dependent business. An operations wonk.

The interview began with this passage,

"Speaking by phone from the company's Hoffman Estates, Ill., headquarters, Mr. Lampert bristled at critics who lost faith in Sears as its share price fell from $195 in April 2007 to about $104 now,"

suggesting Lampert is still in denial about the gigantic, intractable mess he has on his hands. A near 50% loss of shareholder's value, and he's bristling? That's rich!

Further along, Lampert defended the recent plan to break Sears up into independent business units thusly,

"Other large, complex businesses have successfully adopted the business-portfolio model. He compares Sears with Warren Buffett's Berkshire Hathaway Inc., in which managers are given a long leash to run businesses, and Mr. Buffett doesn't get involved in their day-to-day operations. He also says Sears can be rebuilt with a strong management culture, similar to General Electric Co., and Procter & Gamble Inc."

This is pretty amazing. Lampert is equating himself with Buffett as a successful manager of diverse, complex businesses within a single corporate entity. I agree there's a comparison, as I wrote here recently. But this isn't it. As the nearby, Yahoo-sourced price chart shows, Buffett's company only pulled ahead of the S&P500, for the past two years, four months ago.
Talk about having to time a stock!
Lampert's Sears has been in a stall since late 2006, and a swoon since last spring. It would seem that whatever 'management culture' it is to which Lampert refers will have to be imported, doesn't it?
It's a sad story. Lampert now retreating from his mandatory briefings by the minions who would fly to Greenwich every few weeks (Ed doesn't like to fly), but remaining chairman, looming over the shoulder of anyone brave enough to try to rescue Sears. And, as the recent Journal article noted, Lampert's through injecting more funds into the still-breathing carcass of the retailer.
What fun Lewis' replacement as CEO will have! Maybe as much fun as Lampert's fellow shareholders have had since he bought the company?

Wednesday, January 30, 2008

There's Risk...and Then There's Risk

The Societe Generale story has become almost a parody of banking one would expect to see in a typical Hollywood movie.

Jerome Kerviel, the trader with the inferiority complex, works his way up from the humble back office to a fairly unimportant trading desk. He proceeds to wreak havoc on his employer's financial condition by stealing passwords, dummying up trades, counterparty emails, and ledger information. Using his knowledge of risk management and accounting software, he juggles his books for over two years, completely hoodwinking the bank's management.

For me, one line amidst the several Wall Street Journal pieces on this evolving risk scandal rang absolutely true. It was the one concerning the French trader behaving decidedly un-Frenchly, skipping vacations and working overtime. A lot.

Back in my days at Chase Manhattan, officers were required to take two consecutive weeks of vacation for risk management purposes. We were told that, although our function was not even within distant earshot of any P&L responsibilities, we would adhere to the bank's regulations regarding vacation-taking.

It had been learned long before the arrival of us newly-hired corporate strategists that a two week break from making book entries was almost always sufficient to reveal any one-person fraud.

Funny how this well-known banking practice was simply overridden for Kerviel. One of banking's simplest and most time-honored ways of tripping up fraudulent bookkeeping was short-circuited without a peep.

And, then, we read that Kerviel would simply acknowledge suspect trades as 'mistakes,' make them right immediately. Then double back later that day and re-enter them. How many visits by the risk management or accounting folks would it have taken for SocGen's management to have suspected active and purposeful risk management evasion?

How many 'mistaken' trades per month, for a year, did the average trader experience?

Amidst all the talk of esoteric risks these days- CDOs, credit derivative swaps, and SIVs- here's a bank that got tripped up by the oldest scam of all. A simple fraudulent book-entry scheme that allowed the trader's position to balloon to many times his authorized limit.

It's probably going to take down the head of SocGen, and maybe two or three more senior officers. And it should.

I think it sustains my point from this recent post regarding bank consolidation. In it, I wrote,

"Kessler then writes,

"So who has the strong hand? As always, it's a capital game, whoever accumulates the most will be best positioned for what's next."

I disagree. Capital accumulation certainly matters, but I don't think it's a "most" sort of thing. If anything, Kessler misses the point that having so much- too much, actually- capital is precisely what has gotten many financial firms into trouble. They fail to diligently allocate it, and the result is what we see in recent months. Failed risk controls, sloppy capital allocations and wastes of funding. "

Large banks just seem to invite this sort of fraud and risk management failure. And what is the rumored reaction? That PNB wants to acquire the now-wounded SocGen.


Thoughts On The Current Economic & Financial Markets Situations- Part Two

I wrote about the current economic situation in yesterday's post here.

Today, I'd like to conclude with a review of the other major question of the day- wither our US financial markets? Are they headed for a prolonged downturn of several to many months, or a short 'correction' of just a few months? Is the Fed 'behind the curve' on easing, or wrecking longer-term economic fundamentals involving inflation and the value of the dollar? Are financial markets panicking, or correctly reacting to both economic and financial market news?

From my own academic economic training, study of the field as a business person since the late 1970s, and reading of and listening to various pundits, I believe that the Fed is now easing unnecessarily. As Brian Wesbury contended Monday morning on CNBC, the Fed's easing of late 2007 and, more recently, the ad hoc 75bp, are "baking in" serious inflation risks for our economy in the next few years.

Even this morning's GDP-related core inflation number was up, +2.7%. Only last year, Fed Chairman Bernanke stated that he was uncomfortable when inflation began to rise above +2%.

Some believe, and I agree with them, that our current troubles stem, in part, from Fed Chairman Greenspan's excessive easing in the post-9/11 era. This laid the foundation for the housing bubble and related mortgage problems now beleaguering some of our financial institutions. As such, Greenspan put us on a roller coaster of easy money, overreaction by the financial sector, asset value destruction, and, then, more calls for even lower interest rates to reflate the economy and provide "liquidity."

Here's something to consider. Only two years ago, in the wake of hurricane Katrina, the government pushed ethanol as a long-term solution to looming, oil-price-based inflation. Leaving aside the separate inflationary effects of this misguided move on the price of corn, and all of its downstream derivative food products, this would argue that we should be concerned about anything that excessively, and unnecessarily drives the dollar-price of oil up.

And guess what is the number one way to do that, in a controlled fashion? Cut the US interest rate, thus cheapening the value of the dollar. This causes the dollar-denominated price of oil to rise, thus, automatically importing more inflation into the US economy.

Every Fed easing in the last 8 months has effectively goosed inflation for all dollar-priced commodities.

On this basis alone, the recent easing, combined with what fixed income futures tell us are 'market expectations' of further easing, will almost certainly continue to exacerbate the US inflation rate in coming years.

This is partially to what Wesbury referred in his comment about things now looking a lot like the 1970s.

In truth, as Wesbury has pointed out in his on-air comments and Wall Street Journal editorials, most of our economy is sound, or at least only slowly-growing, not shrinking. This morning's initial 4Q2007 GDP number was +.6%.

Of course, this was immediately seized upon by the always-gloomy CNBC staff- Liesman and Haines, to name two- as weaker than the expected +1.5%.

But it's still positive. And as former Fed Vice-Chair Alan Blinder noted, it's going to be revised, probably, but not necessarily, upward.

And today's ADP employment number came in unexpectedly high- something like +130,000 jobs. Again, the primary determinant of recession, falling job numbers and aggregate incomes- is still missing.

Against this backdrop, why is the Fed cutting rates?

I think it is, sadly, unwise political accommodation by Bernanke & Co. to the Congress and Wall Street. Rather than stay the course against inflation, and at least attempt to honor the spirit of the great, late US Nobel Laureate economist Milton Friedman by moderating the rate of monetary base creation, the Fed seems to be more concerned with its public image.

In my opinion, they are a select few economists who are supposed to be intelligent, reasonably well-educated in their craft, accomplished, and deliberative. And sufficiently confident to be as insensitive as possible to the constant clamor of financial markets and the populace for easy money.

As I have written before in this blog, and various pundits have also contended, our current financial markets turmoil has had more to do with counterparty risk than liquidity. Therefore, easing rates affects market psychology more than it actually provides needed, otherwise-absent liquidity.

Of course, it also causes a loss of value among foreign holders of dollar-denominated assets, causing more pressure to replace the buck as the world's reserve currency. That's a change for which our economy and financial system are totally unprepared.

So, in addition to the mistaken fiscal stimulus package working its way through Congress, we are adding to our economic troubles by the Fed's needlessly, in my opinion, cutting interest rates.

As Wesbury noted recently on CNBC, we're all going to be feeling some pain in about 24 months, when inflation begins to crest.

How will we react, as a society, to, say, a +3-4% GDP growth rate with a 5% annual inflation rate? That's negative real growth. And an inflation rate higher than the one that led Nixon to institute wage and price controls almost 40 years ago.

Somehow, we seem to have lost our memory of the post-Carter era solution to excess government taxation and spending, high inflation and too-easy money. So we seem to be heading that way again. Inflation rates of the Reagan era, well below 2%, are now a distant memory. So, it seems, are the low tax rates.

The final conclusion, for purposes of this blog, is how all this would affect equities in the longer term. That's a no-brainer, isn't it? Rates of inflation above 4% and growth not much more? Equities will struggle, as a reflection of the struggling economy that they represent.

Tuesday, January 29, 2008

Thoughts On The Current Economic & Financial Markets Situations- Part One

Beginning with an article by Bill Wilby in last Wednesday's Wall Street Journal, entitled "The Dollar and the Market Mess," I've been reflecting broadly and seriously on the current combination of US economic and financial market situations.

More than any other time in my memory or study, the current situation is far from simple. And I believe, after a lot of thought, that part of this is attributable to a few recent technological factors.

Wilby began his article by quoting Keynes, who cited Lenin, that

"There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose."

That's food for thought right now, isn't it?

The core of Wilby's piece, for me, are these passages,

"Doesn't a failure to respond aggressively to the credit crisis by cutting rates too slowly risk a recession, or a Japan-like breakdown of the world's financial system? Unfortunately the recession risk is high, but not because of high interest rates (which are currently negative in real, after-tax terms). The recession risk is high because of a breakdown in the absurd system that developed for the packaging and underwriting of debt, and the excess liquidity that developed from the combination of that system and a highly stimulative monetary policy.

The Fed took a gamble on inflation to ward off what was perceived as a deflationary threat in 2001-02. The inflationary consequences of that gamble are now here, with the petrodollar monetary merry-go-round fueled by the weaker dollar. Those consequences will be much easier to deal with now, rather than later. Unlike Japan, where the capital-markets risk was concentrated in a handful of thinly capitalized large banks, the very growth of the credit-derivatives market that is the source of the current crisis in the U.S. has also resulted in a wide dispersion of risk in the financial system, and any recession will likely be mild and short.

While we might see a number of hedge funds and some isolated banks fail, the pool of distressed asset buyers waiting in the wings would result in a needed consolidation of the financial-services industry, without systemic failure. In the meantime, the systemic risk posed by the failure of one or more of these institutions is minimal compared to the moral hazard and longer-term inflation risks we incur from their bailout.

Sadly, the dimensions of the Fed's great dilemma would be much less acute had the Fed and Treasury officials not taken such a cavalier approach to the U.S. dollar over the past eight years. Our "strong dollar" (wink, wink) policy has never been articulated by either institution with any real conviction, and markets have rightly sensed that maintaining employment, growth and stock-market happiness has begun to take precedence over maintaining the value of money. In a world of fiat currencies, where trust is your most powerful policy tool, dollar strength is a far better indicator as to the appropriate stance of monetary policy than "core" inflation."

Wilby touches on one of the most important aspects of the current debacle. Does the loss of asset value among privately-monetized, housing-based financial instruments qualify as sufficiently deflationary for the US economy to merit the Fed's recent easing? And concomitant damage to the US dollar's global market value?

As a nice sort of bookend economics editorial, Brian Wesbury wrote "The Economy Is Fine (Really) in yesterday's Wall Street Journal. Among the more important statistics Wesbury cites are,

"It is most likely that this recent weakness is a payback for previous strength. Real GDP surged at a 4.9% annual rate in the third quarter, while retail sales jumped 1.1% in November. A one-month drop in retail sales is not unusual. In each of the past five years, retail sales have reported at least three negative months. These declines are part of the normal volatility of the data, caused by wild swings in oil prices, seasonal adjustments, or weather. Over-reacting is a mistake.

A year ago, most economic data looked much worse than they do today. Industrial production fell 1.1% during the six months ending February 2007, while new orders for durable goods fell 3.9% at an annual rate during the six months ending in November 2006. Real GDP grew just 0.6% in the first quarter of 2007 and retail sales fell in January and again in April. But the economy came back and roared in the middle of the year -- real GDP expanded 4.4% at an annual rate between April and September.

With housing so weak, the recent softness in production and durable goods orders is understandable. But housing is now a small share of GDP (4.5%). And it has fallen so much already that it is highly unlikely to drive the economy into recession all by itself. Exports are 12% of the economy, and are growing at a 13.6% rate. The boom in exports is overwhelming the loss from housing.

Personal income is up 6.1% during the year ending in November, while small-business income accelerated in October and November, during the height of the credit crisis. In fact, after subtracting income taxes, rent, mortgages, car leases and loans, debt service on credit cards and property taxes, incomes rose 3.9% faster than inflation in the year through September. Commercial paper issuance is rising again, as are mortgage applications."

So, in Wesbury's view, the current economic data do not scream "RECESSION!" Rather, what we seem to have is a ceaseless drumbeat of media focus on gloomsayers who keep assuring us that a recession is already here.

In this role, CNBC has taken, in my opinion, a leading role. Frequent guests and on-air staff parrot whatever negative views they can find. Steve Liesman and Mark Haines regularly wring their hands over the state of the economy. Jim Cramer is showcased confirming that we are surely in a recession.

In fact, just this morning, in an example of incredible irony, co-anchors and reporters on CNBC held a little on-air debate among themselves as to whether the media, specifically CNBC, could, by itself, lead the US public into a stronger belief that a recession is occurring, than data might otherwise indicate. Of course, most of the CNBC personalities dismissed this. But the mere fact that they were covering themselves covering the story speaks volumes.

One of the frequent visuals on the network since its publication is the recent BusinessWeek cover depicting a road and asking if we are on it to a recession. They love that on CNBC this week. Just love it.

I think that today's ubiquitous cable news media have, in fact, accelerated the spread of public opinion that the US may be in a recession.

Consider last night's comment by the woman on CNBC's "Fast Money" program. In just 10 seconds, during which I surfed by and heard this comment, she said, to paraphrase,

'I think we're in a recession right now. Well, not a recession like the definition. But you know what I mean- it's a lack of growth.'

When a major business entertainment (news, too, occasionally?) network has people using technical terms so casually, and deliberately incorrectly, what do you think is going to happen? Most people don't know that there is a very technical definition of a recession. Determined by the National Bureau of Economic Research to be "two consecutive quarters of negative real GDP growth."

Confusing the general populace by calling a slowing of positive economic growth a recession is bound to create havoc and panic. Congratulations to the media- it is.

Wesbury continues in his editorial,

"Yet many believe that a recession has already begun because credit markets have seized up. This pessimistic view argues that losses from the subprime arena are the tip of the iceberg. An economic downturn, combined with a weakened financial system, will result in a perfect storm for the multi-trillion dollar derivatives market. It is feared that cascading problems with inter-connected counterparty risk, swaps and excessive leverage will cause the entire "house of cards," otherwise known as the U.S. financial system, to collapse. At a minimum, they fear credit will contract, causing a major economic slowdown.

For many, this catastrophic outlook brings back memories of the Great Depression, when bank failures begot more bank failures, money was scarce, credit was impossible to obtain, and economic problems spread like wildfire.

This outlook is both perplexing and worrisome. Perplexing, because it is hard to see how a campfire of a problem can spread to burn down the entire forest. What Federal Reserve Chairman Ben Bernanke recently estimated as a $100 billion loss on subprime loans would represent only 0.1% of the $100 trillion in combined assets of all U.S. households and U.S. non-farm, non-financial corporations. Even if losses ballooned to $300 billion, it would represent less than 0.3% of total U.S. assets."

I think this is a very important few paragraphs. Who really believes that a loss of less than 1% of asset values in the US constitutes concern that we have severe monetary contraction?

Wesbury continues,

"Beneath every dollar of counterparty risk, and every swap, derivative, or leveraged loan, is a real economic asset. The only way credit troubles could spread to take down the entire system is if the economy completely fell apart. And that only happens when government policy goes wildly off track."

In the Great Depression, the Federal Reserve allowed the money supply to collapse by 25%, which caused a dangerous deflation. In turn, this deflation caused massive bank failures. The Smoot-Hawley Tariff Act of 1930, Herbert Hoover's tax hike passed in 1932, and then FDR's alphabet soup of new agencies, regulations and anticapitalist government activity provided the coup de grace. No wonder thousands of banks failed and unemployment ballooned to 20%.

But in the U.S. today, the Federal Reserve is extremely accommodative. Not only is the federal funds rate well below the trend in nominal GDP growth, but real interest rates are low and getting lower. In addition, gold prices have almost quadrupled during the past six years, while the consumer price index rose more than 4% last year."

Again, the comparison of current conditions to the Great Depression, as, for example Gary Shilling once again hinted at on CNBC this afternoon, is unwarranted.

These monetary conditions are not conducive to a collapse of credit markets and financial institutions. Any financial institution that goes under does so because of its own mistakes, not because money was too tight. Trade protectionism has not become a reality, and while tax hikes have been proposed, Congress has been unable to push one through.

The irony is almost too much to take. Yesterday everyone was worried about excessive consumer spending, a lack of saving, exploding debt levels, and federal budget deficits. Today, our government is doing just about everything in its power to help consumers borrow more at low rates, while it is running up the budget deficit to get people to spend more. This is the tyranny of the urgent in an election year and it's the development that investors should really worry about. It reads just like the 1970s.

Here, Wesbury makes a very good point. First, what Democrats decried only last year, they are now pushing through at light speed- deficit spending and a falling dollar. It truly does begin to make you worry that we may be on the brink of losing all the economic sanity of the Reagan and after years, in which inflation fell and real economic growth skyrocketed.

It was Democratic Congressional spend-and-tax policies that helped mire us in nearly a decade of what became stagflation.

The good news is that the U.S. financial system is not as fragile as many pundits suggest. Nor is the economy showing anything other than normal signs of stress. Assuming a 1.5% annualized growth rate in the fourth quarter, real GDP will have grown by 2.8% in the year ending in December 2007 and 3.2% in the second half during the height of the so-called credit crunch. Initial unemployment claims, a very consistent canary in the coal mine for recessions, are nowhere near a level of concern.

Because all debt rests on a foundation of real economic activity, and the real economy is still resilient, the current red alert about a crashing house of cards looks like another false alarm. Warren Buffett, Wilbur Ross and Bank of America are buying, and there is still $1.1 trillion in corporate cash on the books. The bench of potential buyers on the sidelines is deep and strong. Dow 15,000 looks much more likely than Dow 10,000. Keep the faith and stay invested. It's a wonderful buying opportunity."

Which brings me to my own conclusions about the current twin situations- our economy, and our recent financial markets turmoil.

On the economy, I am with Wesbury and Alan Reynolds. I don't believe we are in a recession now, nor are we likely to be technically in one anytime soon. However, I believe that many US citizens have been led to believe, and be scared that we are in a recession.

The current Federal government stimulus package is a huge mistake. Unfortunately, all of our political leaders have chosen to cover their collective asses, rather than simply sit tight and tell voters to get ready for the result of their collective economic misbehavior. To wit, people buying homes they couldn't afford, and, with their subsequent delinquencies and defaults, causing a ripple back up the supply chain to various other purveyors of goods and services. Yes, growth will slow. But it's not causing huge unemployment and a drop in GDP.

By caving into populist expectations, and a desire by a do-nothing Democratic Congress to be seen as doing something, the Federal government is probably doing exactly the wrong thing at the wrong time. Making the Bush tax cuts permanent would be much better for the economy's health, now and in the future, than sprinkling a few hundred dollars into millions of pockets, to be briefly spent and vanish into the much larger GDP.

Again, echoing Fox News' Neil Cavuto from last week, 'if this is what we do in a mild economic period, what will we do when we really have problems?'

Given the length of this post, I'll conclude with my thoughts on the financial markets turmoil tomorrow or the next day.

Monday, January 28, 2008

Kessler's Views On Banks

Andy Kessler wrote an editorial in Thursday's Wall Street Journal entitled, "What's Next for the Banks?" I must admit, as someone with experience in and observing the sector, I found his piece difficult to comprehend. By this, I don't mean its difficult to understand the text or ideas. Rather, it's difficult for me to understand why he wrote it, and why the Journal bothered to waste space publishing it.

Kessler, if memory serves me correctly, was a hedge fund manager turned venture capitalist. A bio of Kessler appears here, for what it's worth. Much is made of his beginning as a Bell Labs engineer and subsequent Wall Street sell-side analyst in the technology and communications sector- not banking.

The first half of Kessler's editorial sums of financial sector activity for the past half decade or so. He covers the expected landscape- CDOs, SIVs, subprime mortgages, etc. Nothing surprising there.

For instance, Kessler writes,

"First, no one, and I mean no one, is going to buy a package of loans without knowing what each and every one of them is, what the risk of default is, etc. Rating agencies can no longer be trusted. The good news is that the same computer technology used to create CDOs can easily be extended to offer this needed transparency, loan by loan. But the bad news for investment banks: The packaging game just won't be as profitable."

Well, duh! Thanks for that, Andy. I'd never have guessed that the failure of CDOs to even have a market anymore would imply that people may not buy them anymore without detailed knowledge of their constituent securities.

Kessler then writes,

"So who has the strong hand? As always, it's a capital game, whoever accumulates the most will be best positioned for what's next."

I disagree. Capital accumulation certainly matters, but I don't think it's a "most" sort of thing. If anything, Kessler misses the point that having so much- too much, actually- capital is precisely what has gotten many financial firms into trouble. They fail to diligently allocate it, and the result is what we see in recent months. Failed risk controls, sloppy capital allocations and wastes of funding.

After cursorily tossing off predictions of what will happen with banks, investment banks, private equity and hedge fund shops, Kessler then states,

"My view is that firms that successfully combine banking and investment banking will walk away with the prize, by being able to offer a full range of services to clients -- short-term loans against assets or receivables as well as bonds and equity for long-term projects, the kind of underwriting and trading that requires large amounts of capital. The inevitable consolidation that should have occurred after Glass-Steagall (the 1933 law that separated banks and investment banks) was repealed in 1999 had been on hold while everyone chased easy profits. But now the shakeout is here.

I can't be sure what Kessler means by "walk away with the prize." If he means that some institutions(s) will enjoy short-term share gains and profits, he may be right. If he means what I mean, though, i.e., earning consistently superior total returns for shareholders, then I think he's completely in error.

First, he misses the salient fact that Sandy Weill merged Citigroup and Travelers while forcing the rescission of Glass-Steagall. It's simply not true that "everyone chased easy profits." The era's penultimate combination failed.

Second, it failed because, as I noted above, attempting to manage too many assets at once typically leads to one, or both, of two mistakes. Either a firm pumps growth in its narrow business lines until they blow up from taking on too much risk. Or the firm spreads into many businesses, bringing cultural clashes and allocation conflicts that eventually make the firm entirely too difficult and complex to manage, a la Citigroup.

Kessler's next contention is,

Goldman Sachs will own a bank, maybe even Citigroup (Goldman's $85 billion market capitalization might be able to swallow Citi's $125 billion value) and strip it down to what it needs. JP Morgan should reunite the House of Morgan by merging with Morgan Stanley, and become a full-service powerhouse. But JP Morgan could buy Merrill or Lehman or Bear Stearns instead. Bank of America will merge with who's left. But don't count out others who have done well with capital. Fortress Investment Group, despite a rocky IPO a year ago, has a powerful real estate arm that could own loan origination and servicing and enough assets to buy its way into the banking or investment banking business. Same for the Blackstone Group."

What would Goldman possibly "need" from Citigroup? The former travels fast and hits hard. Commercial banks are ponderous and can't pay enough to truly attract, nor compete with, the best investment bank, hedge fund or private equity talent. Further, "buy(ing) its way into the banking or investment banking business," as he writes of Fortress or Blackstone, is exactly how firms lost billions. If all they can do is bring money to the party, they're likely to lose a fortune. Witness Merrill and Citigroup.

Further, in the wake of the past several years' financial stumbles, it's unlikely that regulators want or will tolerate even more concentration of risk assets among a few financial mega-utilities.

Additionally, there are fairly arcane rules governing the maximum market share of various deposits that a single bank may hold. Further concentration among the larger commercial banks is unlikely. Cross-business mergers will only give us another complicated financial titan, like Citigroup, which will promptly become confused by its own management agenda. Most commercial bankers simply aren't sufficiently smart to handle an institution like that. Most non-commercial financial wizards are smart enough to know better.

Kessler concludes,

"Capital flows a lot more fluidly around the globe these days. Expect consolidation to start now. The real winners on Wall Street will be the ones with huge stockpiles of capital who listen to the market, and who are fleet of foot enough to smell out and deploy their capital creating instruments that global growth companies need, rather than false profits from eating their own sausage."

I don't think so. See my comments above regarding further consolidation. Kessler states an oxymoron, "winners on Wall Street will be the ones....with huge stockpiles of capital who...are fleet of foot." That's more or less an empty set there. At this juncture, the smart set running Goldman, Fortress and Blackstone probably realize the cultural problems of buying anything large and meaningful. More likely, they'll simply watch and wait to use their existing capital to exploit opportunities for which they are well positioned.

In my opinion, Kessler sees a major sector reshuffling and consolidation that just isn't in the cards, for a multitude of reasons, some of which I have expressed. Such consolidation, if it does occur, is more likely fated to result in more large-scale losses and risk management failures.

Sunday, January 27, 2008

Cerberus & Chrysler: After The Buyout

Back in May, I wrote this piece concerning the then-imminent buyout of Chrysler from Daimler Benz by private equity shop Cerberus.

The topics were many, but I ended the post thusly,

"Then there was the editorial in the Journal extolling private equity for taking a risk on Chrysler, so taxpayers would not, once again, be forced to do so. I guess there is some sort of benefit to this, in an indirect way. But I still have the sinking feeling that Schumpeter would have preferred to see the number three Detroit auto company just close up shop with its current losses, rather than prolong the pain and bleeding.

The fact that the various deals mentioned in the Journal's article, mentioned above, reminds us that, in prior years, other very intelligent and experienced people entered into some ill-advised transactions. Not every sector-restructuring deal ends happily and profitably.

If I had to bet, I would bet that the Chrysler-Cerberus deal will not meet the latter's expectations for ultimate profit and disposition of the assets it is buying."

Now comes Friday's Wall Street Journal article entitled "Cerberus' Rocky Road." In it, the authors wrote,

"But now, the flagging fortunes of two of its biggest acquisitions -- Chrysler LLC and GMAC LLC -- and its sudden withdrawal from a $4 billion deal to acquire United Rentals Inc. have left open the question of whether the investment fund has stumbled.

Struggles at Chrysler also have raised questions about whether the firm should have invested in the car maker. Facing the prospect of a difficult 2008 for U.S. auto makers, Chrysler has retrenched. In November, the company announced it would cut 11,000 jobs on top of the 13,000 that had previously been planned and eliminated shifts at five plants.

Late last year, Chrysler's new chief executive told employees the car maker was "operationally" bankrupt. Mr. Neporent said Chrysler CEO Bob Nardelli was trying to rally them to action, perhaps with a poor choice of words.

Cerberus said Chrysler has ample liquidity and isn't only meeting but, in many cases, exceeding its financial targets. Mr. Neporent said the firm remains "extremely enthusiastic" and had anticipated the car maker's losses. He said it was too early to judge the success of the deal, and it will take years before one can judge their strategy.

Doubts about Cerberus's strategy have intensified in recent months as it has backed away from a string of deals."

I suppose it's too early to declare Cerberus' Chrysler purchase a failure. And with their cloak of private equity, nobody really knows just how close to, or far from, financial and operational performance plans the auto maker currently is.

Yet, with at least a slower-growing US economy ahead for the next six months to a year, and the scarcity of more capital, Cerberus might be on the hook for more losses than it expected. Plus, the idea of buying an auto maker which hasn't been a profitable leader for years, just because it was cheap, didn't seem all that compelling to me.

As the Journal article suggests, if Cerberus' other deals are looking worse than planned, perhaps Chrysler is, too. And then the firm backed out of its recent United Rentals buyout agreement. Could it be that current costs of capital are making some of the firm's most recent acquisitions hard to turnaround, as they are caught between a slowing economy, higher funding costs and less of a likelihood of spinning the units back out at higher prices than was once expected?