Saturday, September 24, 2011

It's Not About Jobs- It's About Dreams, Businesses & Careers

As someone who left corporate life in 1996 to adapt what I'd learned concerning corporate strategy and performance into quantitative consulting products and an equity management process, I'm familiar with the concept of building a business.

Thus it strikes me as foolish and naive to hear federal politicians of both parties ceaselessly natter on about "jobs," as if that's all people want. Some sort of economic unit of income delivery.

That's not what people want.

The people who inadvertently create jobs want to monetize their dreams. They have what they believe to be either unique, or uniquely competitive business concepts, the successful implementation of which they believe will bring them fulfillment, satisfaction and wealth.

Some of those people who start businesses, as they in fact succeed, may create employment for others. It's likely been this way for homo sapiens since we hunted mastodons while living in caves hundreds of thousands of years, and longer, ago. There were, in each group, probably one or two superior hunters with whom others hoped to join, in order to get a share of the food he would lead them to and kill. Perhaps a loose confederation of a superior tracker and the best spear-thrower of the group.

Call them chiefs, kings, what have you, human social groups have probably always had, in the hunter-gatherer era before settled communities, rainmakers. Those who organized and led the efforts to secure food.

Today, we buy food, water, shelter and clothing. Those basics about which I learned in a simple 7th grade economics unit taught in Social Studies by, I believe, the current secretary of Transportation, Ray LaHood. So rather than join other humans in hunting game or gathering edible plants, we hope to earn sufficient income to buy those goods and services which we once procured directly by our own efforts.

Most people want more than a job. A job suggests a temporal source of money which necessarily results in reduced spending and a large sense of uncertainty about which of your life's aspirations will be attainable. Even those who labor at manual tasks ideally seek situations which make their own sense of economic and financial vulnerability to forces outside their control somewhat less.

I think what those who don't create businesses want is to be useful and valuable to, employed by someone with a passion for building their successful business. So that they can look forward to some security in their ability to rely on the income they earn in that business.

They want careers, not jobs. But both business creators and their employees ultimately desire, though it's hard to attain, long term involvement in a business which brings them income security based on the continued success of their efforts in creating value in the enterprise.

If you've ever worked for a large company, as I have- AT&T, Chase Manhattan Bank and Andersen Consulting (now Accenture), you know that, in the post-1970s era of downsizing and LBOs, you were only as secure as your connection to your upper management, if then. More likely, as happened to me at all three companies, large-scale reorganizations could affect your job, and, thus, your career,

In the era of my late father's corporate career, working for a large firm typically meant security, as things moved slowly. Not so in the era that followed. The era for those of us in the middle and late boomer cohort.

My experience after corporate life, in a smaller consultancy (Oliver Wyman & Co.), working as a consultant to a wealthy would-be hedge fund operator, and in association with various hedge fund and private investment partnerships, provided the expected trade-offs of anonymity with direct risks of interpersonal quirks and individual unreliability. A most personal form of counterparty risk, if you will.

Working in small organizations, with or for entrepreneurs, affords no less risk than working in a large firm- simply a different sort. You know the person who will dismiss you for purely personal reasons, or in a direct contravention of agreements. Your partner loses his financial backer, whimsically decides to pursue other businesses and exit the effort on which he's asked you to work, or simply comes up missing with promised capital, as my last partner did. Or, as in the case of the last consulting firm for which I worked, decides your success on agreed-upon objectives are now too expensive, and reneges on original employment terms.

My point is, earning income is never as simple as just having a "job" for anyone with a college degree and hopes of more than mindless manual labor. Every employment or business creation effort involves risks. You hope you wisely manage those risks, but they never just vanish.

To fix a nation's hopes on public spending to employ road and building construction workers misses the point of returning our nation to a situation in which educated people can imagine, construct and manage their careers.

The sort of personal income streams creation that will return America to the type of society it had in recent decades will only be achieved by the ability of those who want to create businesses to do so, and perhaps employ others in their impassioned drive to build those enterprises.

Those will be careers, not just jobs seen by politicians as temporary or unenumerated income production units.

The involvement of humans in US society to earn income transcends simply putting in a day's work for a current paycheck. And, thus, transcends seeing such effort as just a job.

That is why temporary measures, including more federal borrowing to build roads and schools (a/k/a Stimulus II) and/or suspension of payroll taxes, won't deliver what people want. Those measure might create temporary jobs, but they won't provide opportunities for the business creation and expansion which provides careers.

To do that, government needs to lower taxes, reduce cumbersome regulation, and provide a more certain, reliable climate in which more businesses may be formed, and existing ones expanded. That comes from real demand from the private sector for what those businesses provide, not the faux-demand of temporary government fiscal policies.

Friday, September 23, 2011

About Meg Whitman As HP's New CEO

We've all heard and read more than we probably wanted to since yesterday morning concerning HP's firing of 11-month old CEO Leo Apotheker, in favor of board member and former eBay CEO and failed California gubernatorial candidate Meg Whitman.

So I'm not going to opine on HP's board, valuation, or checkered history of so many CEOs in so few years.

Here's what struck me this morning.

How frustrating must it be for the millions of unemployed, formerly middle- and/or senior-managers in America who can't get replies to inquiries, or interviews, or jobs, because those hiring consider them unqualified or insufficiently qualified.

Now they see Meg Whitman, who has never run a hardware or software company, simply given the job of CEO of a large one which does both.

It must be very galling to be seeking a job in some function in which you have experience, perhaps even in an industry you know, and get nowhere, only to see Whitman asked to take a lushly-compensated job for which even pundits on the business cable networks this morning assert she has no serious credentials to qualify.

Talk about luck and serendipity.

As my first boss, at AT&T, John Tyson, used to tell me about the manyfrustrating situations he encountered in his job at the company,

'Sometimes I don't know whether to laugh, or cry. I laugh, because it hurts less.'

US Equities Finally Crack

Well, I didn't have long to wait to see my expectations for US equities, expressed in this post on Wednesday, to come true. I closed that post with these passages,

"The longer they insist things will be fine, in the face of Greek riots and continuing deterioration in the Euromarkets, the more one is led to conclude Bass is right.

So why is the US S&P500 Index holding its value? Perhaps a temporary triumph of hope over good sense."

In my opinion, in addition to the facts mentioned in that post, the Fed added an officially downbeat US economic outlook in its recent statement.

Thus, "good sense," in my opinion, returned to US equity markets this week in the form of  back-to-back S&P500 declines of -2.9% and -3.2% on Wednesday and Thursday, or a decline from 1202.09 to 1129.56.

Yes, as of 10:10AM, when I'm writing this post, the S&P is at 1127. But the index's return for September is currently -7.5%. Its worst month since May of last year.

I don't like a falling S&P any more than anyone else, but let's face it. It's reasonable.

It's not reasonable to see a continually-rising S&P500 in the face of real economic and financial problems around the globe. And the inability of central banks to really affect any solutions this time around.

It's not so much that they are out of ammunition. It's more like the curtain hiding the Wizard in Oz has been drawn back, and we see the reality of his limitations.

Sensible investors realize that global money printing and/or bond issuances, which amount to the same thing, won't fix real debt and spending problems in all major countries.

We're likely in for another bout of global recession and corresponding softening of equity prices.

For how long? Who knows. But I'm actually more comfortable with equity markets that acknowledge real global economic issues than with one that is, to quote a former Fed chairman, irrationally exuberant.

The Sensible Industrial Conglomerate: UT's Bid for Goodrich

I find the recent news that United Technologies is buying Goodrich to be yet another example of how much better-managed UT is than GE. And how UT chooses a large acquisition that serves common customers and/or provides additional products to complement existing lines at the company.

In contrast, GE's last really large purchase was RCA, years ago under Jack Welch. The firm got rid of most of RCA, but kept NBC. But, after decades of disappointing performance and management distractions, current CEO Immelt finally threw in the towel and undid Welch's deal.

The other quasi-sizable deal done by Welch, buying investment bank Kidder Peabody, also blew up from a trading desk scandal. It didn't fit with the rest of GE Capital, other than, well, they both involved finance.

To see how these different approaches to conglomeration are expressed as performance, the first chart is of the past five years of prices for UT, GE and the S&P500 Index.

UT has clearly outperformed the diversified conglomerate, GE.

Looking back further, to 1970, before UT's restructuring, the two were rather similar in performance for almost 20 years. By the mid-1990s, UT's performance, which has been fairly consistent for 40 years, became even more consistent. In contrast, GE experienced more explosive short term growth due to GE Capital and some apparently generous accounting treatment of several units, which came under closer scrutiny after Welch departed. GE's performance fell significantly right away under Immelt, Welch's successor, then really disintegrated in 2008 due to GE Capital's precarious financial condition.

Diversified conglomerates went out of style, for good economic reasons, before Welch left GE. But UT's brand of related conglomeration which focuses on specific customer groups, technologies and/or products, continues to perform consistently well, when well-implemented.

Goodrich looks like another piece which will fit well into UT's operations.

Thursday, September 22, 2011

Regarding The Tyco Split

In Tuesday's post concerning Netflix and its apparent preparation for a split into two companies, I neglected to mention the companion disintegration story of the day: Tyco.

Long associated with the excesses of its senior management and CEO, Dennis Koslowski, Tyco was restructured in the wake of his departure. Now, the remaining businesses under the Tyco umbrella are splitting yet again.

It strikes me as odd that the general sentiment greeting Tyco's announcement was positive, calling some pundits to compare it to Irene Rosenfeld's dismantling of the Kraft conglomerate she just mashed together only a few years ago.

Why is it that those two are good de-conglomerations, but Netflix's more clear-cut separation of businesses isn't?

Furthermore, not to miss an opportunity to drive this point home yet again, how can investors embrace such unbundling of needless conglomeration, yet fail to push GE's CEO Jeff Immelt to finally split that firm into its natural, individual constituent parts? And save investors the pricey headquarters functions which include Immelt's own lavish compensation package?

GM, China & Technology

I found the recent article in the Wall Street Journal discussing GM's China business to raise some interesting questions.

Unsurprisingly, GM management feels constrained by Chinese rules which demand technology sharing in exchange for investing for substantial growth.

Fortunately, one theme of the article is the risk both Ford and GM take if they expand, only to find themselves in an over-supplied market. Which would not be too hard to imagine, as every auto maker views China as the last great untapped market. I'd say it's more likely that there will be too many producers, driving prices and margins down.

But on the technology topic, there's something that puzzles me. Most vehicles are more assemblages of supplier components than they are totally manufactured by the company whose name is on the car. Thus, much of the technology in a modern car may be purchased off the shelf from existing vendors.

I suppose there are some proprietary transmission, engine and perhaps high-end electronics. But what can't be bought from suppliers can be bought, disassembled and reverse engineered.

The article mentions GM closely guarding its Volt technologies, which I found to be laughable. Nobody buys the thing in the US without hefty government subsidies. I have trouble believing China will have a ready-to-use, adapted power grid to handle the Volt.

To some extent, I think that companies wishing to do business in a country become embroiled in situations much like those of extractive industries. When you are bound to a location, the host country can pretty much demand whatever they like, even change terms, and the companies being victimized have to constantly reassess their decision to operate in that country.

It seems that GM and Ford will continue to experience this dilemma for the foreseeable future, with ongoing risk for their investment and whatever truly proprietary technology they offer.

Wednesday, September 21, 2011

Europe's Continuing Debt Crisis

You have to love the determination of the various official players involved in the European debt crisis to proclaim loudly and often that:

1. There won't be any defaults.
2. The Euro is just fine.
3. The crisis is manageable and containable.
4. There's no reason to worry about sovereign European debt.

The prospective solutions from a wide variety of players, including US Treasury secretary Geithner and even former TARP chief, now PIMCO global equities chief, Neel Kashkari, all stress smooth, controlled resolution of the many-faceted European debt crisis.

Meanwhile, you have more riots in Greece. No progress on the privatization of any of the national Greek businesses which, a Wall Street Journal editorial notes, would necessarily lead to lost public sector jobs and corresponding control over those votes. A downgrading of Italian sovereign debt. Continued concerns over French banks and their ability to fund themselves in the money markets.

Oh, and then a cut by the EU in its forecast GDP growth rate.

Personally, I found Kyle Bass' recent comments on CNBC to be the most believable and extensive by any single person. I closed that piece with these observations, as a result of Bass' remarks,

"First, there will be European country defaults. Second, there will be corresponding private sector bank insolvencies. Third, a lot of money will be lost by holders of securities issued by the defaulting countries and bankrupt banks. Fifth, the effect on the US will involve both capital losses and overall economic trade reductions. Sixth, after all this, the global financial and economic systems will then have to pick up and move along, losses absorbed, and work with the resulting situations. "

At present, officials like Geithner and various EU, ECB, French and Greek senior officials keep whistling past the graveyard of defaults in Greece and Spain and likely insolvencies in various European banks.

The longer they insist things will be fine, in the face of Greek riots and continuing deterioration in the Euromarkets, the more one is led to conclude Bass is right.

So why is the US S&P500 Index holding its value? Perhaps a temporary triumph of hope over good sense.

Daniel Yergin Explodes The Myth of Peak Oil

In support of his new book, The Quest, Pulitzer prize-winning author and oil expert Daniel Yergin wrote an essay in last weekend's edition of the Wall Street Journal. Of particular interest to laymen like me was his explanation of the origin and folly of the concept that has come to be known as "peak oil" production.

While his essay is quite lengthy (it was the weekend Journal's 'Big Essay,' thus running for the first two pages of section C), I've excerpted just what Yergin wrote about "peak oil" and its originator, Marion King Hubbert:

"Since the beginning of the 21st century, a fear has come to pervade the prospects for oil, fueling anxieties about the stability of global energy supplies. It has been stoked by rising prices and growing demand,
This is actually the fifth time in modern history that we've seen widespread fear that the world was running out of oil.

This specter goes by the name of "peak oil."

Its advocates argue that the world is fast approaching (or has already reached) a point of maximum oil output. They warn that "an unprecedented crisis is just over the horizon." The result, it is said, will be "chaos," to say nothing of "war, starvation, economic recession, possibly even the extinction of homo sapiens."

The date of the predicted peak has moved over the years. It was once supposed to arrive by Thanksgiving 2005. Then the "unbridgeable supply demand gap" was expected "after 2007." Then it was to arrive in 2011. Now "there is a significant risk of a peak before 2020."

But there is another way to visualize the future availability of oil: as a "plateau."

In this view, the world has decades of further growth in production before flattening out into a plateau—perhaps sometime around midcentury—at which time a more gradual decline will begin. And that decline may well come not from a scarcity of resources but from greater efficiency, which will slacken global demand.

Those sounding the alarm over oil argue that about half the world's oil resources already have been produced and that the point of decline is nearing. "It's quite a simple theory and one that any beer-drinker understands," said the geologist Colin Campbell, one of the leaders of the movement. "The glass starts full and ends empty, and the faster you drink it, the quicker it's gone."

This is actually the fifth time in modern history that we've seen widespread fear that the world was running out of oil. The first was in the 1880s, when production was concentrated in Pennsylvania and it was said that no oil would be found west of the Mississippi. Then oil was found in Texas and Oklahoma. Similar fears emerged after the two world wars. And in the 1970s, it was said that the world was going to fall off the "oil mountain." But since 1978, world oil output has increased by 30%.

Just in the years 2007 to 2009, for every barrel of oil produced in the world, 1.6 barrels of new reserves were added. And other developments—from more efficient cars and advances in batteries, to shale gas and wind power—have provided reasons for greater confidence in our energy resiliency. Yet the fear of peak oil maintains its powerful grip.

The idea owes its inspiration, and indeed its articulation, to a geologist who, though long since passed from the scene, continues to shape the debate, M. King Hubbert. Indeed, his name is inextricably linked to that perspective—immortalized in "Hubbert's Peak."

Marion King Hubbert was one of the most eminent—and controversial—earth scientists of his time. Born on a ranch in San Saba, Texas in 1903, he did his university education, including his Ph.D., at the University of Chicago. One of his fundamental objectives was to move geology from what he called its "natural history phase" into its "physical science phase," firmly based in physics, chemistry and, in particular, rigorous mathematics.

In the 1930s, while teaching at Columbia University, Hubbert became active in a movement called Technocracy and served as its educational director. Holding politicians and economists responsible for the debacle of the Great Depression, Technocracy promoted the idea that democracy was a sham and that scientists and engineers should take overthe reins of government and impose rationality on the economy. "I had a boxseat at the Depression," Hubbert later said. "We had manpower and raw materials. Yet we shut the country down."

Technocracy envisioned a no-growth society and the elimination of the price system, to be replaced by the wise administration of the Technocrats. Hubbert believed that a "pecuniary" system, guided by the "hieroglyphics" of economists, was the road to ruin.

In the late 1940s, Hubbert heard another geologist say that 500 years of oil supply remained in the ground. This couldn't possibly be true, he thought. He started doing his own analysis. In 1956, he unveiled the theory that would forever be linked to his name. He declared that U.S. oil production would hit its peak somewhere between 1965 and 1970.

His prediction was controversial, but when U.S. oil production hit its high point in 1970 and began to decline, soon followed by the shock of the 1973 embargo, Hubbert appeared more than vindicated. He was a prophet. He became famous—and so did Hubbert's Peak.

Hubbert was very pessimistic about future supply. He warned that the era of oil would be only a brief blip in mankind's history. In 1978, he predicted that children born in 1965 would see all of the world's oil used up in their lifetimes. Humanity, he said, was about to embark upon "a period of non-growth."

Hubbert used a statistical approach to project the kind of decline curve that one might encounter in some—but not all—oil fields, and he assumed that the U.S. was one giant oil field. His followers have adopted the same approach to assess global supplies.

Hubbert's original projection for U.S. production was bold and, at least superficially, accurate. His modern-day adherents insist that U.S. output has "continued to follow Hubbert's curve with only minor deviations."

But it all comes down to how one defines "minor." Hubbert got the date exactly right, but his projection on supply was far off. He greatly underestimated the amount of oil that would be found—and produced— in the U.S.

By 2010, U.S. oil production was 3½ times higher than Hubbert had estimated: 5.5 million barrels per day versus Hubbert's 1971 estimate of no more than 1.5 million barrels per day. Hardly a "minor deviation."

"Hubbert was imaginative and innovative," recalled Peter Rose, who was Hubbert's boss at the U.S. Geological Survey. But he had "no concept of technological change, economics or how new resource plays evolve. It was a very static view of the world." Hubbert also assumed that there could be an accurate estimate of ultimately recoverable resources, when in fact it is a constantly moving target.

Hubbert insisted that price didn't matter. Economics—the forces of supply and demand—were, he maintained, irrelevant to the finite physical cache of oil in the earth. But why would price—with all the messages that it sends to people about allocating resources and developing new technologies—apply in so many other realms but not in oil and gas production? Activity goes up when prices go up; activity goes down when prices go down. Higher prices stimulate innovation and encourage people to figure out ingenious new ways to increase supply.

The idea of "proved reserves" of oil isn't just a physical concept, accounting for a fixed amount in the "storehouse." It's also an economic concept: how much can be recovered at prevailing prices. And it's a technological concept, because advances in technology take resources that were not physically accessible and turn them into recoverable reserves.

In the oil and gas industry, technologies are constantly being developed to find new resources and to produce more—and more efficiently—from existing fields. In a typical oil field, only about 35% to 40% of the oil in place is produced using traditional methods.

As proof for peak oil, its advocates argue that the discovery rate for new oil fields is declining. But this obscures a crucial point: Most of the world's supply is the result not of discoveries but of additions and extensions in existing fields.

When a field is first discovered, little is known about it, and initial estimates are conservative. As the field is developed, more wells are drilled, and with better knowledge, proven reserves very often increase substantially. A study by the U.S. Geological Survey found that 86 percent of oil reserves in the U.S. were the result not of what was estimated at the time of discovery but of revisions and additions from further development.

Estimates for the total global stock of oil keep growing. The world has produced about one trillion barrels of oil since the start of the industry in the 19th century. Currently, it is thought that there are at least five trillion barrels of petroleum resources in the ground, of which 1.4 trillion are deemed technically and economically accessible enough to count as reserves (proved and probable).

Based on current and prospective plans, it appears that the world's production capacity for "oil and related liquids" (in industry jargon) should grow from about 92 million barrels per day in 2010 to over 110 million by 2030. That is an increase of about 20%.

A major reason for continuing growth in petroleum supplies is that oil previously regarded as inaccessible or uneconomical is now part of the mix, such as the "presalt" resources off the coast of Brazil, the vast oil sands of Canada, and the oil locked in shale and other rocks in the U.S.

Things don't stand still in the energy industry. With the passage of time, unconventional sources of oil, in all their variety, become a familiar part of the world's petroleum supply. They help to explain why the plateau continues to recede into the horizon—and why, on a global view, Hubbert's Peak is still not in sight."

I had no idea this was how Hubbert developed the notion of "peak oil." It flies directly in the face Julian Simons' contention, sustained by real world examples, that rising prices and declining volumes of a key natural resource spur new supply. Reading Yergin's extensive description of the background and application of the concept, it's easy to see why it's indefensible.

Tuesday, September 20, 2011

The Panic Over Netflix

I'm frankly a bit surprised at the panic and anger following Netflix's recent pricing changes. Here's the email Netflix CEO Reed Hastings sent to customers the other day:

"Dear (Customer name)-

I messed up. I owe you an explanation.

It is clear from the feedback over the past two months that many members felt we lacked respect and humility in the way we announced the separation of DVD and streaming and the price changes. That was certainly not our intent, and I offer my sincere apology. Let me explain what we are doing.

For the past five years, my greatest fear at Netflix has been that we wouldn't make the leap from success in DVDs to success in streaming. Most companies that are great at something – like AOL dialup or Borders bookstores – do not become great at new things people want (streaming for us). So we moved quickly into streaming, but I should have personally given you a full explanation of why we are splitting the services and thereby increasing prices. It wouldn’t have changed the price increase, but it would have been the right thing to do.

So here is what we are doing and why.

Many members love our DVD service, as I do, because nearly every movie ever made is published on DVD. DVD is a great option for those who want the huge and comprehensive selection of movies.

I also love our streaming service because it is integrated into my TV, and I can watch anytime I want. The benefits of our streaming service are really quite different from the benefits of DVD by mail. We need to focus on rapid improvement as streaming technology and the market evolves, without maintaining compatibility with our DVD by mail service.

So we realized that streaming and DVD by mail are really becoming two different businesses, with very different cost structures, that need to be marketed differently, and we need to let each grow and operate independently.

It’s hard to write this after over 10 years of mailing DVDs with pride, but we think it is necessary: In a few weeks, we will rename our DVD by mail service to “Qwikster”. We chose the name Qwikster because it refers to quick delivery. We will keep the name “Netflix” for streaming.

Qwikster will be the same website and DVD service that everyone is used to. It is just a new name, and DVD members will go to to access their DVD queues and choose movies. One improvement we will make at launch is to add a video games upgrade option, similar to our upgrade option for Blu-ray, for those who want to rent Wii, PS3 and Xbox 360 games. Members have been asking for video games for many years, but now that DVD by mail has its own team, we are finally getting it done. Other improvements will follow. A negative of the renaming and separation is that the and websites will not be integrated.

There are no pricing changes (we’re done with that!). If you subscribe to both services you will have two entries on your credit card statement, one for Qwikster and one for Netflix. The total will be the same as your current charges. We will let you know in a few weeks when the website is up and ready.

For me the Netflix red envelope has always been a source of joy. The new envelope is still that lovely red, but now it will have a Qwikster logo. I know that logo will grow on me over time, but still, it is hard. I imagine it will be similar for many of you.

I want to acknowledge and thank you for sticking with us, and to apologize again to those members, both current and former, who felt we treated them thoughtlessly.

Both the Qwikster and Netflix teams will work hard to regain your trust. We know it will not be overnight. Actions speak louder than words. But words help people to understand actions.

Respectfully yours,

-Reed Hastings, Co-Founder and CEO, Netflix
p.s. I have a slightly longer explanation along with a video posted on our blog, where you can also post comments."
Punditry has come down on both sides of this issue. CNBC's Herb Greenberg renewed his customary energetic attack on the company, once more reminding one and all of the firm's balance sheet's store of unexpensed acquisition costs. And Greenberg asserts that providers like Netflix will become commodities, thus ruining the firm's business model.
Others, however, side with Netflix for sensibly now splitting two very different businesses. As well as prepare customers for the eventual arrival of bandwidth pricing, which will affect how they use online media.
As for me, I'm rather sick of the whining by pundits (like Greenberg) and customers who are shocked- SHOCKED!- that prices for the physical disc side of Netflix's business have risen.
They remind me of the people who are outraged that Social Security- correctly called a Ponzi scheme by Rick Perry- won't deliver on all of its phony, never-was-possible benefit promises.
In the case of Netflix, pricing was what it was while it was. Initially, they gave away metered online usage according to your pricing plan. Then it became unlimited, which of course encouraged migration to streaming.
But the streaming business has always had a distinctly smaller inventory of video to view. I don't know about other customers, but I viewed the two services- streaming and discs- as two separate vendors, anyway, because of the availability issue.
So it makes a lot of sense to me that Hastings & Co. have finally announced a formal split of what have been two different-looking businesses for at least a year.
Meanwhile, thanks to Tivo and Netflix streaming, I only need to have one disc available now. Much of my video consumption on Netflix is satisfied by selecting videos on the website for Tivo to access for my subsequent viewing on a television screen. My children preferred to view streaming material directly on their laptops.
My use of discs is for special material that is typically arcane, classic and/or no longer very popular, and, thus, not among the limited streaming inventory.
Hopefully, Hastings will go all the way and spin the two businesses- Qwikster and Netflix- into two separate public companies. The segmentation, costs and overall business dynamics are so different as to make that entirely sensible.
As for the anger some customers are experiencing? Get over it. Say goodbye to a business model that simply isn't viable at older price levels anymore.
As for the effect on Netflix's equity price, that's not entirely surprising, either. Thus the benefit of splitting the businesses, with either some sort of transfer price from one unit to the other for content, or a priori shared purchase of said content. In time, the two units should have dramatically different values and growth rates.

Will the streaming business recoup the recent equity price decline? I have no idea. Investor reactions will determine that. If not, then I can confidently predict that the equity representing that business won't be in my portfolio.
Regardless, those who've had Netflix in their portfolios for some time, as my selection process has, enjoyed substantial gains, and if they rebalanced consistently, this recent slide won't be the end of the world. It hasn't even had a drastic effect on my portfolios which include Netflix, as other firms, such as Apple, have continued to gain value, offsetting Netflix's stock price drubbing.

After all, no equity grows in value forever. Not even Apple.

Delta Desks Pose Banking Risks

I don't categorically exclude any particular sector from my quantitatively-based equity selection process. Rather, I let the specific performance of each company either qualify or disqualify the entity.

That said, over the past 20+ years I've operated the portfolio selection process, to my knowledge, only one investment bank- Goldman Sachs- and no more than two or three commercial banks, briefly, have managed to merit inclusion.

My experience with Chase Manhattan Bank in the 1980s provides me with an understanding of what occurs inside these large financial institutions which tends to exclude them from my process' portfolios. It's a combination of size, diversity and asymmetric payoffs to traders and managers while limiting their risks.

Consider this recent Wall Street Journal article concerning UBS' recent admission of $2.3B in losses by their so-called rogue trader.

Delta Desks Emerge as Mine Fields

A Key Revenue Source for Banks Has Been at the Center of Two Recent Scandals.
By Carrick Mollenkamp

The scandal at UBS AG is casting a harsh spotlight on a corner of the financial world—so-called Delta trading—that Wall Street has been counting on to boost revenue in the wake of a financial crisis.

Kweku Adoboli, the UBS trader formally accused Friday of fraud in UBS's $2 billlion loss, worked on UBS's "Delta One" desk in London. Delta trading—the name is derived from the fourth letter of the Greek alphabet—is a gauge of risk exposure for bets made on the movements securities such as stocks and securities.

The transactions generally involve two parts. First, a client would request a "derivative" trade, effectively a bet on the direction of a group of stocks or other securities. When the bank executes the trade, it actually acquires the securities in question.

In the second part of the trade, the bank creates a mirror of the derivative to mitigate the risk.

The "delta" is a measure of how the value of the derivatives would change compared with the underlying stock or other asset. Delta has become a term to indicate that a bank can customize a security for a client and then closely replicate it on the banks books.

At UBS, Mr. Abodoli's Delta One desk specialized in exchanged-traded funds and other securities positions, according to people familiar with the situation. On Friday, Mr. Abodoli was charged on three counts: two counts of false accounting and one count of fraud. He didn't enter a plea during a court hearing.

Delta trading has gained momentum in a markets environment in which the mortgage-bond trading business is on the skids and global regulations require banks to set aside expensive capital for loans.

Wall Street is counting on trading large volumes of stocks and derivatives to bolster revenue.

There is nothing inherently improper about such Delta trading. And many large financial institutions employ this strategy, including Société Générale SA, BNP Paribas SA and Goldman Sachs Group Inc. in Europe and Goldman and Morgan Stanley in the U.S., according to a J.P. Morgan Chase & Co. report.

The trading requires state-of-the-art technology systems and can produce as much as $1 billion in annual revenue at top banks, J.P. Morgan said, which noted, "Delta One products in one area of growth in our view, with strong growth in client volumes, resilient margins and untapped potential in emerging markets."

But it earlier gained notoriety in 2008, when French bank Société Générale said that Jérôme Kerviel had worked on a Delta One desk while trying to hide $7.2 billion in losses in another rogue trading scandal. Last year, Mr. Kerviel was sentenced to three years in prison.

I recently wrote this post placing these 'delta desk' type trades and losses in a larger perspective.

Except, perhaps, for Goldman Sachs, which has a reputation, and performance record, for better risk management than its competitors, extensive and deep participation in these delta trades in a proprietary fashion by large financial institutions seem to create their own pattern of volatile earnings or, more specifically, large losses.

Now, of course, these firms are supposed to be sunsetting their proprietary trading activities. Which makes them less loss-prone, but, also, prone to lower growth rates, as well.

However, reading a companion Journal article (to the above piece) detailing UBS' efforts to improve, overhaul and generally tackle risk management since 2007, and how it has failed, gives me little hope that firms of that ilk will ever get this right.

Years ago, I actually knew and played squash with Barry Finer, the guy who was the risk manager on the desk where Joe Jett ran his trading scam at GE's Kidder Peabody unit. I subsequently compared notes with colleagues at then-independent consulting firm Oliver, Wyman & Co., who had been hired by GE to do a post-loss review of what had happened.

We all agreed that Finer had done his job, but essentially been ignored in the typical fashion that occurs in so many large financial institutions. Until line/desk risk managers and the risk management function is better-compensated, insulated from desk managers, and reports directly to a CEO, with penalties for failure commensurate with compensation, these unpleasant trading loss surprises will continue to be a periodic staple of large investment and commercial banks.

Monday, September 19, 2011

Regarding Goldman's Global Alpha Fund

I read the article in Friday's Wall Street Journal concerning the closing of Goldman Sachs' Global Alpha fund with great interest.

Coming as it did on the heels of the UBS so-called rogue trader loss, and this related, recent post, it brought to mind, once more, Michael Lewis' books about publicly-owned investment banks.

The story is rather eye-opening. Begun with Cliff Asness at the helm in 1997, he bolted to form his now-famous AQR hedge fund the next year. No mention of where Global Alpha existed, organizationally, in relation to GSAM, the firm's formal asset management arm. But the Journal piece states that Global Alpha ran $12B in 2007, lost 23% of that "in August 2007 and was down 40% for all of 2007."

According to the Journal article, the fund lost 12% so far this year, and had fallen to just $1B in size. So Goldman has shuttered it.

Global Alpha's last manager, Katinka Domotorffy, is leaving the firm. No doubt with tens of millions of dollars of her own, soon to set up shop managing her own funds and those of a few select friends or colleagues. Perhaps as a consultant, in order to avoid the intrusive new hedge fund rules which have driven Carl Icahn from the business.

I can't help but muse about Goldman's experience with Global Alpha and, perhaps, other funds. I'm sure they charge premium fees. I doubt they allowed much of a hold-back period on incentive fees, or refunded any fees as they closed Global Alpha.

Along with proprietary trading, which former CEO John Whitehead thought a bad idea, so, too, has asset management apparently proven to be an expensive new business- for Goldman's clients.

Even at just an average size of $5B, Global Alpha was probably earning at least $100MM annually in management fees, and who knows how much more by executing the fund's trades on Goldman's own desks? Then there are the incentive fees in the good years, which for the year in which it earned 30+%, translates into another 6% of assets, or $300MM in additional revenues. The fund doesn't take a share of losses, so this asymmetric payoff, along with redemption lockups, can quickly result in sizable income for Goldman.

Add in the fund manager's probable large cuts for not leaving to join folks like Asness in the true private hedge fund business, and you have Global Alpha becoming a gigantic funnel for client assets being transferred to Goldman fund managers, bit by bit.

Heads, both parties win, tails, the client loses and, eventually, departs.

From Goldman's perspective, it's even richer than brokerage or proprietary trading, because there's a nice fixed fee, regardless of the client's losses. Yes, over time the fund can tank, as Global Alpha eventually did. But the problem is firewalled to just that fund.

If Goldman was able to manage an average of $5B for almost 15 years in Global Alpha, I'm sure it was a very lucrative venture for the firm and the fund's managers, regardless of how much the fund's investors ultimately lost before redeeming.

This is a theme on which Michael Lewis touched in The Big Short. Something most people can't quite comprehend.

When fund assets reach such large sizes that fixed fees alone provide adequate revenues, in a very few years, the firm and the fund's managers can become sufficiently wealthy from their cuts that they simply don't have to care so much as they may have initially what happens to their investors' money.

Today's Journal profiles celebrated fund manager John Paulson in the midst of a tough year. His funds have apparently struggled so far in 2011, posting losses. Paulson's funds are reported to have attracted something like $10B in new money in recent years, which doubled the amount of outside funds under management.

But the article also mentions that, as a result of his very public success betting against mortgage-backed bonds during 2005-08, Paulson personally took home $5B in pre-tax earnings in 2010.

Read that again. $5B last year.

Even if Paulson invested and lost half of that in his own funds, he still kept at least a billion after tax.

How can you reasonably expect him to manage investor funds the same way now as he did before 2005? Sure, he's no doubt competitive and values his reputation. But, like Julian Robertson, who got sloppy with risk management at the end of his Tiger Fund's run, Paulson no longer is staking his ability to make a living on how his funds perform.

At 2 & 20, with even just $20B in outside money, Paulson's complex is earning $400MM in annual fixed fees, regardless of performance. If you allow for extravagant expenses, the group is probably bringing at least $300MM to its compensation pool.

How many businesses do you know of which provide such life-altering compensation in just one or two years, regardless of how customers fare?

I'm not saying it's unfair, or requires regulation. I'm saying investors should beware of jumping into mega-sized, successful hedge funds, expecting a continuation of past performance.

One needn't invest with Bernie Madoff, nor any Ponzie scheme, to experience disappointing results from a hedge fund. Size (of funds) does matter, and investors who ignore that do so at their peril.