Friday, April 25, 2008

Nobel Economics: The Sublime and the Ridiculous

This morning's CNBC Squawkbox program has featured three Nobel Economics laureates- Joseph Stiglitz (2001), Robert Engle (2003), Edmund Phelps (2006) and Robert Shiller, a Yale economics professor and author who has written about housing and financial markets.

I admit that it is interesting to see such an assemblage of economic talent in one place, and for that, I give CNBC credit. This part was sublime.

Of course, then they spoiled it by having their own resident senior economic idiot, Steve Liesman, share the air time with these other, professionally-trained economist PhDs.

Yes, that was the ridiculous part.

Generally speaking, Stiglitz, Engle and Phelps, along with Shiller, provided some simple, reasonable and insightful comments on various financial market topics.

For example, they noted that today's commodity price inflation is based upon real demand increases pitted against supply constraints, in the short run. Therefore, they cautioned against the folly of central bank rate increases to try to contain inflation. All agreed that this cure would simply kill the patient by throttling business growth.

Instead, they argued for allowing market signals to bring more supply onto the market, including the role of speculators. Rather than rail against those who, through derivatives, bet on commodity price increases, they note that these investors are taking risk with respect to a top in commodity prices, while providing added signaling power to suppliers of grains and energy commodities.

Their discussion of the housing market was rather more curious. To a person, especially including Shiller, they all argued for some form of Federal intervention, including Shiller's plea for some new governmental housing authority/lender of first resort.

Shiller contended that some nationalized mortgage bank needed to be created to lend and hold mortgages in a state of 'permanent workout,' was, I believe, the phrase he used, or something very near to that.

In effect, the Nobel economists, and Shiller, held that housing is so important to the US economy and its citizens that it is 'too important' to be left to markets. That private mortgage lenders engaged in overly-risky behaviors that have hurt us all.

Thus, in their considered opinion, we must now lodge all of this risk-assessment in a civil-service populated governmental entity.

Yeah. Right. And while we're at it, let's go find Russia's last seven year plan and try to emulate that, too.

But, to his credit, Stiglitz characterized the no-downpayment mortgages to poor people as essentially free options, because they were allowed to buy an asset with virtually no equity interest, betting on price appreciation. He noted that banks don't usually just give free equity options to financially shaky customers.

There aren't very many conservative economists, although some have won Nobel prizes. At least three of these economists- Stiglitz, Shiller and Engle- are pretty obviously liberals. Stiglitz served in Clinton's administration.

I think financial risk taking and mechanisms related to that is where economists part company with financial market theorists. For example, Steve Ross, currently at MIT, is both an economist and a finance professor. In an after-dinner speech at an MIT alumni function last year, he described the difference. There is one.

The assemblage of economic talent this morning on CNBC sort of self-organized into a stampede calling for more governmental oversight, regulation, pre-emptive action, etc., in the area of financial risk taking. I have to say, I think they all strayed on this topic pretty far from their actual area of expertises.

When viewer email questions were read aloud to be answered by the Nobel laureates, the first one involved who would be the best economic President among the current candidates.

On this point, you really saw politics and self-interest rear their ugly heads. Stiglitz and one of the other laureates quickly backed Obama. Arguments like his being 'new and open to new ideas,' and alleging that 'things are different now than in 1992, so Hillary won't be as appropriate' were the tone of their responses.

How disingenuous. Stiglitz worked for the Clintons, is a liberal Democrat, and probably sees the writing on the wall regarding Hillary's likely demise. If he's to snare another administration post, leading to more book sales down the road, what better way than to publicly provide Obama with his unsolicited endorsement on a nationally-watched, prominent business news program?

The most thought-provoking element of this morning's discussion amongst these economic literati, though, was the one about housing finance.

While I may disagree with Shiller's insistence on some ironclad uber-management of the function, in order to completely stamp out any sort of market 'failures' in the future, his arguments illustrate something important.

As my friend B has held for a decade, the eventual structure of the US financial services sector has seemed to be five or fewer gigantic utilities, along the lines of the current Citigroup, BofA, Chase and Wachovia. These firms, plus, perhaps, a few weaker investment banks added to them, have morphed into slowly growing, ponderous financial titans incapable of much growth.

B's idea was to eventually separate all of the truly core, insurable financial services activities, such as DDA accounts and transactions businesses- clearing, settlement, etc.- into government-insured, low-yielding utility-like entities.

Perhaps the ultimate solution for housing finance, along the lines of Shiller's suggestions, is to move residential home lending into a government-insured utility, too.

If housing is to be a major component of our economy, and we also wish to insulate borrowers against predation, interest-rate risk, and even asset value risk, perhaps we just need to remove the sector from the for-profit arena.

The last few decades saw significant private mortgage finance options grow to compete with Fannie and Freddie. Jumbo loans and low-doc, no-doc loans appeared, were offered and securitized. Now, it seems, the wisdom of that final step, and probably the earlier ones, was doubtful.

The effects of those mistakes, pulling housing prices down in the locales which also experienced such rampant appreciation, has soured many Americans on the idea of leaving this sector to private capital.

If, in their collective wisdom, citizens-cum-voters decide that they must punish private lenders, and themselves, indirectly, by prohibiting any more freewheeling privately-owned housing finance providers from behaving as they did in the prior housing cycle, so be it. In effect, Americans will have chosen to simply limit risk-taking in this sector, along with growth.

What the economists all failed to note, however, is the scream that would have arisen from liberals, had much of the private enterprise housing finance shut off credit to lower-income Americans. Charges of discrimination and redlining would have abounded.

Maybe, a la Shiller's solution, we'll just settle the argument once and for all by draining the profit-making incentive right out of housing finance, and returning it to its stodgier, less-risky roots in pre-1980s finance.

Some Recent Earnings Performances: Apple, Starbucks & Boeing Plus Microsoft On Yahoo Acquisition

Yesterday's Wall Street Journal contained articles on a host of interesting companies about which I have recently written. Nearby is a Yahoo-sourced two-year price chart of the various firms I'll mention in this post- Apple, Boeing, Starbucks and Microsoft- and the S&P500 Index.

For example, Apple, a company in which we currently hold long-dated call options, rose nicely following its earnings announcement.

Despite the many protestations of pundits as notable as Herb Greenberg that Apple and Steve Jobs just could not continue to surprise, they did. Even when analysts factored in Apple's expectations management, the firm still outperformed them.

This is one reason that our equity selection process is so strong- it ignores those observers and analysts who fail to appreciate actual historical performance of individual companies, opting instead to predict to the mean of all companies' typical performances.

Then we have Starbucks, whose sales have been affected by related economic softness. By going downmarket in the past few years, as I've written in prior posts, the firm exposed itself to the more price-elastic buying behaviors of less-wealthy customers. We're now seeing the results of that strategy.

Whereas financial firms purchase excess growth through asset risk, consumer goods companies like Starbucks purchase it through penetration of non-traditional segments whose buying behaviors are different than those of its core customer group.

So far, Howard Schultz' return to the coffee giant isn't going so well.

Boeing reported earnings on Wednesday, too, also announcing earnings above expectations. Consequently, its stock rose on the news by some 4.5%.

Does this mean Jim McNerney has finally straightened out problems at the airplane maker? Not by a long shot. Boeing is still counting on reversing the Air Force's decision to use Airbus planes to replace its fuel tankers, and the Dreamliner may yet suffer another setback.

Whereas Apple has gone from strength to strength for several years, as evidenced by the price chart above, Boeing has been struggling. I'd have to see a much longer period of sustained revenue growth and total return superiority before I'd believe that Boeing has solved its problems.
Then we have Microsoft. For a change, the Journal's article about the tech giant's CEO, Steve Ballmer, actually reflected well on him. Having its Yahoo acquisition offer outstanding for nearly three months, the software vendor, as represented by Ballmer, is expressing confidence that they can, if necessary, skip the Yahoo deal.
That's actually heartening to me. Not that I'm a Microsoft shareholder. It hasn't been in my equity portfolio for nearly a decade.
But Ballmer made some sense in that he has acknowledged his own firm's risk in integrating Yahoo. Citing internal reasons for not increasing Microsoft's bid for Yahoo, the CEO gave shareholders some reason for sanity in the looming hostile phase of the firm's quest for the ailing internet portal player.
As miserably as Microsoft has performed for years, it will probably only do worse as it attempts to do several new things: integrate a large acquisition, deal with various staffing exits and other related issues, and then have to actually make good on the promise that the Yahoo acquisition will somehow solve all of the firm's ills.
So, on balance, it's been a promising week for some large US companies. Not necessarily sufficient for me to invest in those I don't already own, but at least some signs of better management and perspectives among CEOs of Boeing and Microsoft.

Thursday, April 24, 2008

Wachovia's & Citigroup's Annual Meetings

My longtime friend and sometimes partner, B, sent me a copy of the American Banker's article yesterday on the annual meetings of Citigroup and Wachovia.

The article noted,

"The chiefs of Citigroup Inc. and Wachovia Corp. faced angry shareholders Tuesday as both companies held their annual meetings.
Though disgruntled shareholders are not a new phenomenon at annual meetings, both Citi and Wachovia held their powwows this year on the heels of reporting substantial first-quarter losses tied to the persisting credit crisis.

In New York, several shareholders called on Citigroup's entire board to resign, but all the directors were reelected, Citi said, with at least two-thirds majorities. In Charlotte several investors demanded that G. Kennedy Thompson step down as chairman, president, and chief executive."

I couldn't agree more with the shareholders calling for Citi's entire board to resign. And, given Wachovia's troubles from its Golden West acquisition, Ken Thompson should be leaving, as well.

If you need to see why there's only one weapon for shareholders, selling the stock of a company with which they are disappointed, consider the article's portrayal of Thompson's disgusting behavior,

"Mr. Thompson heard the first salvo early on as a critic approached the microphone before he could begin his presentation. Manuel Lopez, identifying himself as a shareholder, was the first of several to call on Mr. Thompson to resign. He accused management of either withholding facts or being "completely unaware" of Wachovia's financial condition, drawing strong applause from many of the 400 audience members.

Mr. Thompson took the criticism quietly before offering a mea culpa in his prepared remarks. "I'm not here to sugarcoat things, make excuses, or say that we are a victim of circumstances." Wachovia's revenue stream is sufficient to carry it through the economic crisis, he said, and he forecast long-term success. "Nothing is more important to me than restoring credibility" lost in the October 2006 purchase of the big Oakland, Calif., thrift company Golden West Financial Corp., he concluded."

As the nearby Yahoo-sourced one-year price chart for Citigroup, Wachovia and the S&P500 Index indicates, both banks lost more than 50% of their stock's value in that time period, while the index was marginally negative.

With results like these, you'd think Thompson would at least offer to return a few years' worth of deferred compensation, to show his firm's shareholders that he really 'felt their pain.'

That isn't going to happen, is it?

No. And this is why reforming CEO compensation to consist largely of lagged equity awards subject to consistently beating the S&P500's total return. Otherwise, CEOs like Thompson win big in good years, and do just 'pretty well' when their prior decisions boomerang, as his did with the Golden West acquisition.

You know that if one of his subordinates had been so boneheaded as to have done something so foolish, Thompson would have fired him.

Pandit's a little different, in that he lucked into his job so late in 2007 that he can't really be held accountable for much of anything yet.

If only his board were to resign, the new one could learn a lesson from both banks' recent difficulties, and redesign Pandit's compensation to go light on cash payments, and heavy on lagged, S&P-performance-related awards of Citi equity.

Well, at least you can't say commercial banking is as boring as it used to be.

Wednesday, April 23, 2008

Ford's 18 Months Under Mulally: Is This a Turnaround?

I first wrote about Alan Mulally's involvement with Ford, the company of which he became CEO in September, 2006, in posts here and here, in December of 2006 and July of last year.
Now, this morning's Wall Street Journal heralds Ford as its "..Recovery Advances; Earnings Improve."
But, turnaround?
According to the nearby Yahoo-sourced two-year price chart of Ford and the S&P500 Index, they were at about the same place when Mulally took over, on a percentage basis, from May of 2006. Now, the index is positive, with maybe a +5% return, while Ford is still negative, with what looks to be a return between -5% and -10%.
Granted, Ford has rebounded smartly from a -30% return only weeks ago, ending a precipitous slide begun last fall.
But, as I have asked in prior posts about 'turnarounds' at other firms, what will constitute a successful turnaround?
To me, net income performance, impressive as it has improved under Mulally, is not alone sufficient.
The pattern and magnitude of a firm's fundamental operating results create investor perceptions that underpin a firm's attainment of consistently superior returns for its shareholders.
Unless Ford is planning on really strong, consistent double-digit revenue growth in the years ahead, it's going to have to achieve any consistent total return performance mostly by productivity improvements.
It's clear that the Journal likes Mr. Mulally very much. All three articles about him provide unfailingly upbeat, flattering profiles. And my guess is they are not wrong.
Even this piece's details about Mulally's pushing to sell Jaguar and Land Rover, redesign the Ford Focus, and attack inventory problems all ring with the sense of a really good manager at work.
Still, call me sceptical. It's not just that Mulally must haul Ford back from the brink of bankruptcy or sale. He must, in my opinion, then lead the company to several years of unexpectedly good performance, either with new revenue and volume growth, or incredible productivity gains, in order to provide the basis for consistently superior total returns for shareholders.
Can Mulally accomplish this? Who knows? I'm a 'show me' kind of investor, and Ford has years to go before it can possibly, in my view, be accorded the title of a 'successful turnaround,' or 'recovery.'

Tuesday, April 22, 2008

United Technologies: A Different Type of Conglomerate Than GE

In last week's Wall Street Journal, the paper's minority owned writers compared GE's recent and longer term earnings performances to those of United Technologies.

As it happens, Friday's Journal featured the UT earnings report, trumpeting the headline "United Tech's Profit Jumps 22%."

Of all the conglomerates which once dominated the US corporate scene up until the 1980s, only GE and UT remain. Names like Textron, LTV, Gulf & Western, Westinghouse, and Litton are history. ITT is no longer the sprawling giant of Harold Geneen's day, while the more recently-created Tyco has also scaled back after its architect, Dennis Kozlowski, went to jail.

Since GE is relatively better-known, and less-covered, let's take a moment to acquaint ourselves with the 'other' Connecticut-based conglomerate.

UT's website lists its current divisions: Carrier, Hamilton Sunstrand, Otis (Elevator), Pratt & Whitney, Sikorsky, Fire & Security, and Power.

The company largely serves two major markets: buildings and aircraft. The bulk of its divisions, products and services focus on the needs of customers with these fixed assets.

Originally created by its legendary first CEO, Harry J. Gray (1971-87), UT has only existed as a conglomerate since the early 1970s, as we will subsequently learn, below. After Gray, Robert Daniell (1987-1994) became CEO, ceding that position to longtime employee George David (1994-2008), who leaves the company this year.

This article describes the history of Gray and United Technologies. Specifically, note the following passages,

"Harry Gray had been appointed president of the United Aircraft Corporation in 1971. United Aircraft was at that time one of the largest companies in the country and had a long history of manufacturing airplanes and helicopters for the American military. Gray was determined to diversify United Aircraft in order to diminish the company's reliance on defense contracts. Flourishing Essex International became his first acquisition. Under United Aircraft, soon to be renamed United Technologies....

Through the 1970s, Gray continued his program of growing and diversifying United Technologies through acquisitions.

Although Harry Gray's aggressive policy of growth through acquisitions had built United Technologies into one of the 20 largest industrial corporations in the United States, in the mid-1980s a number of Gray's riskier ventures turned sour. Indeed, net income dropped by about $600 million between 1985 and 1986. After a great deal of internal turmoil amongst UTC management, Gray stepped down as CEO of the troubled firm in 1986. Robert Daniell was appointed in his place. Daniell immediately undertook a major restructuring of UTC, streamlining the unwieldy company by selling off divisions that did not fit into United Technologies' main product lines. In 1988, as part of this reorganization, the wire manufacturing operations of Essex were spun off as an independent company, although the new enterprise continued to produce the wire for the automotive wire assemblies and electronic devices manufactured by United Technologies Automotive. Daniell's reorganization of UTC also included the dissolution of The Industrial Products Division, thus making United Technologies Automotive an independent business unit within UTC.

By the late 1980s, with the major building blocks of the restructuring in place, UTC began to look once again towards strategic expansion, although this time only businesses that would mesh with their major product lines would be considered."

So we see that the modern UT is built upon a collection of businesses with explicitly related technologies, not just a scattershot of various unrelated businesses.

The nearby price chart for UT and the S&P500 Index, from UT's inception to the present, tells and interesting story.

A longterm 'buy and hold' investor would have done well to invest with Harry Gray back in 1971. But the same investor could have bought the index and jumped in later, around the time of Gray's exit, in 1987. Or, again, in 1994, when the current CEO, George David, took over leadership of the industrial conglomerate. In fact, all of UT's superior performance, relative to the index, can be accounted for by just David's years as CEO. Despite progress during both Gray's and Daniell's tenures, the relative gains for shareholders by UT, relative to the S&P, always evaporated. The company has had a relatively steady track record of total return performance, implied by the price chart, assuming a constant dividend. But, still, it couldn't consistently outpace the index.

It's clear that Gray's diversifications ultimately caused trouble for the company and its shareholders. For example, as Robert Daniell began to lead UT, this article appeared, describing his first two years as CEO,

"At the start of 1987, United Technologies took a charge of almost $600 million against earnings to reduce the work force and sell unwanted operations, reflecting a change from the earlier acquisition-minded growth days to a management stressing cost savings and profit margins.

Mr. Daniell sold off 25 businesses and focused on three major areas: aerospace, auto products and building products, including Otis elevators and Carrier air-conditioners.

The strategy has paid off, with United Technologies reporting 1988 earnings of $659.1 million on revenues of $18.5 billion, both record figures for the company."

So, as long as twenty years ago, UT began to pull back from the sprawl created by Harry Gray's reign. It now epitomizes the notion of a large, multi-business company focused on common customers and technologies throughout its units.

The company's name seems to now aptly describe it.

Contrast this with GE's more sprawling, less-related businesses: appliances, aviation, consumer electronics, electrical products, consumer & business finance, healthcare, lighting, media, oil & gas, rail, security, and water.

Originated from Thomas Edison's electrical-related ventures in the late 1880s, GE was itself originally a much more focused conglomerate.

As this GE webpage explains,

"1876 was also the year that Thomas Alva Edison opened a laboratory in Menlo Park, New Jersey, where he could explore the possibilities of the dynamo and other electrical devices that he had seen in the Exposition. Out of that laboratory was to come perhaps the greatest invention of the age - a successful incandescent electric lamp.

By 1890, Edison established the Edison General Electric Company by bringing his various businesses together.

Several of Edison's early business offerings are still part of GE today, including lighting, transportation, industrial products, power transmission, and medical equipment. The first GE Appliances electric fans were produced at the Ft. Wayne electric works as early as the 1890s, while a full line of heating and cooking devices were developed in 1907. GE Aircraft Engines, the division's name only since 1987, actually began its story in 1917 when the U.S. government began its search for a company to develop the first airplane engine "booster" for the fledgling U.S. aviation industry. Thomas Edison's experiments with plastic filaments for light bulbs in 1893 led to the first GE Plastics department, created in 1930."

Thus, we see that some of the current, or just-exited businesses, grew from events or technologies unrelated Edison's original electricity-oriented businesses.

When adding GE to the prior price chart, since 1971, for UT and the S&P500 Index, we see that UT has outperformed its more-diversified and famous fellow conglomerate. By a fairly wide margin, since the y-axis is logarithmic.

And, as I noted in this recent post, this chart again illustrates that GE's performance under Welch, from the early 1980s to 2001, were distinctly and uniquely superior, relative to the market. From Welch's retirement onward, GE has declined, then flattened, relative to both the index and David's later years with UT.

All conglomerates are not alike. The most diversified, financially-oriented US conglomerates of forty-plus years ago are long gone. Of the two remaining entities of this type, it's clear that the more focused, less-diversified one, UT, has handily and steadily outperformed its more famous counterpart, GE.

Monday, April 21, 2008

GM's Management Realignment

GM's brand management realignment was reported in an issue of last week's Wall Street Journal.

According to the article, the company has organized its eight brands into four groups, for purposes of coordinating sales, marketing and advertising.

Cadillac, Hummer and Saab have been grouped into a 'premium channel' of brands for GM, with former Nissan executive Mark McNabb appointed to manage the group in North America.

Buick, Pontiac and GMC form another brand group. Saturn evidently remains as its own brand. The article didn't detail which vehicles form the fourth brand group in this reshuffling.

Mark LeNeve, GM's North American marketing chief, was quoted as saying,

"Think about (the channels) like a business,"

with channel executives gaining control of and responsibility for marketing and sales resources formerly in the hands of now-eliminated regional sales executives. These channel managers will also have "a role in product development."

I guess anything GM can do to sensibly cut needless expenses is a good thing, relatively speaking. And perhaps doing that with similar-brand marketing and sales expenses is the next best thing to culling actual models and brands in the shrinking firm.

Still, one is left wondering,

"So what?"

Isn't the real Achilles Heel at GM product development and technological innovation?

Much of GM's marketing and sales strategies in recent years has involved zero percent loans and other pricing gimmicks to offload production.

True product differentiation based on features or customer-specific marketing and segmentation doesn't seem to have been the order of the day.

If it were, would sales have sagged so much? It's one thing to not have pricing power versus competitors, but at least match their sales penetration and market share.

In GM's case, it's been years since they have held share with premium gross margins.

Will this new marketing organization make this better? Well, technically, no, since the entire marketing and sales structure expenses fall under the SG&A line, which affects net profit, but not gross margin.

I continue to believe that for GM, cost-cutting is still a short-run solution to a long-run problem that involves creativity, design innovation and getting those functions back in touch with customer needs and preferences. In that sense, this reorganization only offers the hope that the single-line reference to the new brand group channel chiefs' input into product development might make some difference in the years ahead.

Based on prior results at GM, I wouldn't hold my breath waiting for this to work.

Sunday, April 20, 2008

YouTube Video Clip of My Appearance on The O'Reilly Factor RE: GE, Iran & Immelt

In this recent post, I referred to my appearance on last Monday's Fox News program, The O'Reilly Factor.

After a week, someone has finally put the video of the O'Reilly segment in which I appear on YouTube.

For those readers who did not see it, but wish to, here it is.