Risk Week: Bear Stearns, Jim Cayne & Warren Spector

Last weekend's Wall Street Journal edition carried a rather detailed article on the people and actions that led brokerage firm Bear Stearns to its current, sub-prime mortgage fueled debacle. A debacle that has now claimed one casualty, board member and head of stock and bond trading, Warren Spector. And may yet claim another, Chairman James Cayne, contrary to his rather boastful statement that he intends to remain until 2011.

Basically, Cayne and Spector screwed up and lost significant amounts of shareholder value, owing to their failure to properly oversee risk management among Bear's positions in various esoteric debt instruments.

Bear Stearns deserves to be in trouble. From just the cursory details in the Journal piece, you can see Spector's rise as a fast gun trader. The type of swaggering trader who demands ever more lush and powerful packages, in order not to bolt to a larger firm, like Goldman, or some hedge fund. In his case, Spector happened to share an interest with the current Chairman. They both play bridge, and Spector was a phenom as a youth. Cayne recognized his name.

As my partner mentioned at lunch today, wasps like Cayne, at Wall Street firms like Bear, are more clubby and parochial than people might imagine. Having passed muster as a bridge maven, it appears that Cayne essentially gave Spector a pass on any more supervision.

Thus, Spector was given a board seat at Bear at age 30. Shortly thereafter, apparently after elbowing a rival off the path upward, the command of Bear's equity and fixed income trading functions. Last year, Spector was paid some $33MM by Bear.

It's important to note how such large compensation packages affect the behavior of management at such a firm. Neither Cayne, nor Spector, was going to go homeless if whatever their equity interest in the firm became worthless. Even the lack of many more years of such compensation isn't exactly becoming poor.

So, if anyone thinks that financial consequences would ever figure in supplying some sense of risk awareness and prudence to either Cayne or Spector, think again. Folks at that level are motivated more by power and prestige than by money. The former are provided by others, as a function of staying in power, while the latter becomes a non-motivator pretty quickly at those sums.

Thus, we find both Cayne and Spector, laughably, attending a bridge tournament during a key week in July, when the fortunes of their firm were souring. You cannot make this stuff up.

It's debatable whether Spector, or anyone else, can do much about Bear's position. Let me make some conjectures.

First, the problems stem from rather exotic debt instruments which are not always traded. See this post , from yesterday, for some more details on how this works. Perhaps some forms of credit derivatives are also involved.

How do you price instruments which are either seldom traded, individually tailored, over the counter, and/or based upon exotics? Well, without much confidence is the answer.

As a one-time partner of mine, B, who built a well-known Street mortgage business, used to tell me,

"A model can tell me what something was worth yesterday, or may be worth tomorrow. But the only way I know what it is worth today is to take a piece and offer it, and see what the bid is."

Just so. And very scary, since if the bid is much lower than the carried value by the firm, the difference in value must be marked down.

Now, if these instruments were hedged, with credible counterparties, then one reasons that the damage would be contained, right? For limiting upside profit, a downside loss could be minimized.

What do you want to bet very few of Bear's positions were hedged? Because, after all, limiting profits limits bonus pools and, therefore bonuses. And who wants that? The firm pays out bonuses from those profits. It never allocates the losses to the traders.

With such a handsome asymmetric payoff matrix, why would the traders or their managers hedge much of the risk? Besides, the models probably assumed they could simply sell problem instruments when needed, per my earlier post.

So, it's not hard to imagine Bear having held, unknown to the senior managers who didn't really want to, or know how to, ask many piercing questions, that, in mutual funds and/or on proprietary trading desks, there has been substantial, unhedged exposure to some thinly-traded, esoteric debt.

That Cayne would so callously and dangerously declare the current debt markets to be the 'worst in 20 years,' is a measure of the depth of Bear's desperation and situation. By attempting to make the system and market the problem, he hopes to deflect observers from the truth- that Bear got into this mess on its own.

Fortunately, quite a few pundits, and Ben Bernanke, have vocally disagreed with Cayne's view, since his over the top comments in last week's conference call.

As Herb Greenberg, of Marketwatch, noted, this is one case where the retail investor dodged the bullet, because the class of instrument which has disintegrated is too complex and inaccessible for most of them. The institutions which have been brought down or damaged- mortgage companies, fund managers, brokerages- all knew what they were doing.

Typically, every decade has its financial debacle. It usually features young, inexperienced traders and risk managers who believe they have everything under control. More senior managers, with prior experience during financial market meltdowns or major problems, are typically further from detailed knowledge of the risk management and positions, and better insulated, financially, from damage, should the firm go under.

Bear's senior executives, Cayne and Spector, deserve to lose their jobs. Bear, as a firm, probably deserves to be bought or acquired by a better firm. In the final analysis, the company finally seems to have run afoul of its buccaneering attitude and less-than-adequate risk management, losing

As the nearby, Yahoo-sourced chart displays, Bear has lost considerable value this year. More than two-thirds of its returns for the prior two years.

Management like this deserves to be replaced. But in a firm with a culture like Bear's, that may not be sufficient. The whole firm may need to go down.

Rupert Murdoch's Big Opportunity

If you need to see the size of the opportunity that now awaits Rupert Murdoch and his new acquisition, the Wall Street Journal, look no further than this afternoon's Fed meeting watch on CNBC.

Here we are, amidst a turbulent credit market that is spooking the equity markets. There's a tension between bailing out institutions that made bad decisions in credit markets, and holding the lid on inflation.

So, who does CNBC have on their Fed watch segment? John Rutledge? Larry Kudlow? Mike Holland? Any of the former Fed Governors who appear from time to time?

No.

They have the Marx Brothers of finance- Jim(my) Cramer, Steve Leisman, and Ron Insana.

Cramer is, as I wrote here recently, an unabashed shill for his trading desk friends on the Street. Leisman is the networks uncredentialed, nonsensical, self-impressed 'senior economics reporter.' He is regularly bested by their Chicago on-air correspondent, the excitable but wise Rick Santelli.

Finally, we have Ron Insana. A former CNBC correspondent and anchor of no particular talent who managed to lose at least one prime-time afternoon slot due to his lack of presence and knowledge. Now, we are told, he is a guest commentator, and managing partner of Insana Capital Partners.

Oh. How impressive.

Does anybody else but CNBC know this guy at all?

So, for one of the most anticipated Fed meetings in memory, we have three clowns moderated by the earnest, but underappreciated Erin Burnett. More farce than analysis or sense.

For Murdoch, constructing a network to put CNBC out of business should be like shooting fish in a barrel.

Recruit the better anchors away- Kernen, Quick, and Burnett. Use the Wall Street Journal to fuel content. And add distinguished guest commentators, making sure they are available for breaking news events, like today.

Simple enough. And it should help send GE's stock further down under Immelt's lackluster stewardship, as even the media group loses yet another opportunity.

Risk Week: When Is A Market Not A Market?

As I devote this week's posts to the topics of risk, and risk management, I want to discuss the question,

"When is a market not a market?"


There are two fundamental assumptions which, when they fail, effectively turn a market into something that is not a market- and does not function like a market. Those two assumptions are: that buyers and sellers always exist for each other, and that pricing is continuous.


These failed in 1987, according to a then-friend of mine who was a very successful asset manager at a major firm. They failed three times in early 1987, on the way up, when the market was peaking, and fills took place at prices higher than those thought to be the execution price. As he wryly noted, nobody complained at that time.

Then, in October of that year, they failed again, this time on the way down. Way down.

People traded, not knowing for days what the actual price at which they sold was. And prices didn't move in small increments, as specialists deserted their functions.


Prices skipped downward, discontinuously.


Further, in panics, markets fail in terms of liquidity. There are not buyers and sellers present to 'make' the market. Again, specialists in equities step back. And in debt markets, bids simply vanish.


The whiz kids of today don't recall LTCM in 1998, much less the crash of 1987. They do not realize that, in a crisis, a panic, the "market," as we conceive of it, vanishes.

Bids fail to materialize. Prices do not move continuously, especially for esoteric, non-listed instruments.

This is, in my opinion, key. So much of the trouble invariably begins with thinly-traded instruments and/or derivatives thereof. One-off CMOs, CDOs, their derivatives, derivatives based upon some proprietary index.

It seems that many trading desks, risk managers, and hedge fund managers either were unaware of, or forgot these phenomena. When markets stop being markets, and become something else, all hell has effectively broken loose in the OTC market where so many esoterics trade, as well as in the more thinly traded listed instruments.

Happy to book profits on originating, distributing and/or trading these esoterics, Wall Street firms suddenly realize how risky they can be at times of lessened liquidity.

In my opinion, this is where a number of interacting phenomena combine to cause major problems.

Few traders remain traders into their forties. Thus, most on a desk at any given time may have no more than ten years' experience. Risk managers are likely similar. Promotions for both tend to lead them off the floor, into senior management, or into other firms, perhaps at hedge funds.

Thus, with each new crisis, the frontline troops are largely untested, and the experienced managers are slower to see the new problem unfold, and are often unfamiliar with the details of the source of the latest debacle. Thus, when all is well on the way 'up,' managers don't think to ask or check that a desk trading mortgage CDOs is in a position to be passively hedged, in the event of a meltdown, so that losses are minimized without the need to trade through non-market periods in which bids vanish or skip around.

Besides, hedging limits profits. Who wants that? It puts a lid on bonuses, doesn't it?

Fuggggetaboutit!

And there you have your new financial instrument crisis. The new whiz kid traders, risk and fund managers think they have it all controlled via quantitative programs. But they fail to account for the inability to even trade a portfolio during the time when asset values are plummeting, if there is a recent market value at all.

And this is, in my opinion, how and why we repeat these types of instrument-based financial market failures every decade. It simply doesn't pay for the adults to bother building in safeguards because, as the Wall Street Journal noted in an article lately, bonuses are short term, but the risks held in portfolio are longer term.

When individuals are paid upwards of $3-4MM annually, the loss of net worth due to the decline of their firm's stock's value is a lot less painful than most people realize. Coming atop a cushion of tens of millions of past compensation, it simply isn't a sufficient incentive to curb current excesses- ever.

Chrysler & Bob Nardelli

I would be remiss if I did not comment on today's announcement that Home Depot's ex-CEO, Bob Nardelli, has been named CEO of Chrysler, now a holding of Cerebrus, the private equity group.

There really isn't all that much to say about the move. Oh, there are the obvious aspects.

Having drawn the ire of many shareholders through his overpaid failure to earn respectable returns at Home Depot, being CEO for a small group of private owners removes that problem this time.

But looking more deeply, one wonders why Cerebrus would choose a cost-cutter to save a firm whose major problem is developing, building and selling cars people will actually pay list to buy. Plus, they've given the sack to at least one Chrysler executive, and a former Cerebrus advisor on automotive units.

Since I don't believe Cerebrus made a good deal buying Chrysler to begin with, putting Nardelli in charge simply adds to my scepticism about this situation.

Many people, including some pundits, believe that, as the Wall Street Journal cited today, Ford's Alan Mullaly and, now, Chrysler's Nardelli will, together, bring a radical new perspective to union negotiations, and magically eliminate the two firms' cost disadvantages relative to firms like Toyota.

Let's just say, I remain to be convinced that; a) this will happen, and b) it will matter in the long run.

Risk Week: Jim Cramer Shills for Hedge Funds

In view of the salient events of the last few weeks in the credit markets, and their overwhelming effects on the equity markets, I'm making this week's posts all about risk.

Yes, it's "risk week." I will be writing posts about various aspects of the recent activities in the debt and equity markets, and risk, and its management.

To begin my posts, I want to discuss Jim Cramer's outrageous comments last week on CNBC while speaking one afternoon (Thursday?) with Erin Burnett.

He set himself up as a sort of God of the markets, claiming various Wall Street trading desk personnel were beseeching him to tell Ben Bernanke how bad the credit situation is. Cramer alleged that these traders told him,

'You're the only one they'll listen to. You can get through to them....'


Nice try, Jim. But you're just a shill for your trading desk and hedge fund friends. They are using you the same way you used to use CNBC and The Wall Street Journal when you managed a hedge fund, as you have admitted.

What is going on now is not a general credit market meltdown. And in no way is it remotely as bad as Bear Stearns Chairman, Jim Cayne, alleged, saying it is the worst credit market in 20 years.

All that is happening is that some investment banks and hedge funds have made poor risk management and investment decisions. They hold more sub-prime mortgage paper than is prudent, if holding any at all is, at this point. These institutions would love to have the market bail them out. Rather than admit they have made costly mistakes, they would prefer that others believe, instead, that the credit markets are in crisis.

Thus, as Cramer was shilling the other day, Ben Bernanke must cut rates. Damn inflation, let's rescue some overpaid, underperforming traders and fund managers!

There is no crisis. What there is, is a case of some greedy, opportunistic, short-sighted managers at some firms being caught with heavy losses on bad investments.

It pains me to see CNBC allow Cramer to openly shill for his friends, and other industry insiders. At least this morning, several commentators directly contradicted Cramer, though not naming him specifically. They simply reiterated my position, that this is not a credit market crisis, it's a problem for some firms.

What most people fail to grasp is that these traders and fund managers will do anything to escape the losses they now face for injudicious decisions. If crying "fire" in a market, and getting others to stampede and believe the market is in crisis, so be it. So long as it leads to the Fed cutting rates, pushing debt prices up, then these traders and hedge fund managers will be relieved of some of their losses. And can rapidly dump their trash onto the market before others catch on.

The truth is, credit market problems primarily lie with a sub-species of the collateralized mortgage obligations market. Not corporate debt, or Treasuries. Not equities. It's a weakness confined to those players who knowingly bought sub-prime mortgages, or sub-prime-based paper, knowing the greater risk these mortgages bore.

I don't think it merits a general hand-wringing over the credit, or equity markets. And it certainly does not merit Jim Cramer anointing himself God of the market, and imploring Ben Bernanke to quit doing his job as Fed Chairman, and just loosen the monetary spigots to bail out some overpaid Wall Street traders, fund and risk managers.

Tomorrow: when a market is not a market, and why that surprised this generation's risk management whiz kids on Wall Street.

On Marketing

Wednesday's Wall Street Journal contained a review of the book "The Marketing Mavens," by Noel Capon. Mr. Capon, it is noted, is a professor at the Columbia Business School.

If this is the extent of new marketing discoveries at Columbia, they are in trouble.

According to the review, Capon led a team on a four year study

"to examine companies across 25 industries, interviewing 57 executives from an array of concerns."

The book alleges to provide "the lessons of the long-term winners." Nowhere, though, does the review cite what constituted "winners" according to Capon.

Before I reveal Capon's list of five "imperatives," let me recite another list.

Back in 1976, over thirty years ago, in a marketing course I took from Dr. David Lambert at Saint Louis University, he taught us the five bases for successful segmentation of markets:

1. Segments must have differing behavior, in order to have the behavior exploited through segmentation

2. The segments must be identifiable.
3. The segments must be specifically reachable, or targetable.
4. The segments must be of sufficient size to merit segmentation.
5. The segments must be such that serving them uniquely is profitable.

Now to Mr. Capon's imperatives, as reported in the book review in the Journal:

1. "picking markets that matter"
2. "pick the market segments where they can deliver the best product"
3. "securing a 'differential advantage' over competitors"
4. "adjust systems to better serve customers"
5. "measuring what matters"

Maybe it's just me, but I'm not just unimpressed with Capon's list. I find it, at best, derivative of the basic truths about market segmentation that I was taught, as an undergraduate, thirty years ago.

Capon's first imperative echoes Lambert's fourth basis of segmentation. His second, which closely resembles his third, is really just a no-brainer about business in general, and product development/management in general. There's no direct relation between the segmentation bases and Capon's fourth or fifth imperatives.

Having the rare combination of undergraduate and graduate degrees in marketing, I've probably sat through more hours of marketing instruction, by very capable professors, than most business graduates, and anybody I have personally yet met. For me, the most basic facet of marketing is segmentation.

Segmentation, as exploited by the University of Pennsylvania's pioneering, and the nation's first, marketing department, under genius Wroe Alderson, is a direct application of the microeconomic theory of segmenting buyers according to their price inelasticity behaviors. Observing the opportunity to discriminate, profitably, on price, and then provide other bases (product features, delivery, or promotional messages) on which to justify the price differences, is marketing's true core operational mission.

Of course, as Stanton wrote in his classic introductory marketing text, seen from a larger perspective, marketing is dedicated to satisfying consumer needs, over the long term, profitably.

Identifying and satisfying those needs leads, obviously, to segmentation, and, thus, the five bases.

When I reflect on that verity, Capon's work seems superfluous. So much neo-marketing fluff.

At root, marketing, even explicitly and appropriately consumer/customer-centric marketing, begins with segmentation. From this, all other marketing practices and knowledge flows.

To even attempt to speak of marketing fundamentals, and skirt the centrality of segmentation, is, I believe, to mark oneself as sadly, fatally misinformed.

Beyond his somewhat off-the-mark ideas on marketing, Capon, according to the article, chooses some examples that ought to raise eyebrows. Among them are Charles Schwab, Pfizer, and Target. The review doesn't provide details as to when in their life cycles Capon chose to study each company, but the first two are most assuredly not 'winners' on the basis of consistently superior total returns.

I personally respect and laud Target's marketing savvy, but that hasn't made it a consistently superior total return performer, yet, either.

What I conclude from the review of Mr. Capon's book is yet another academic conducting a dubiously-designed study, in order to publish a book and cash in on the resultant consulting business he hopes will follow.

I'm skipping this book. You should, too, now that you know Dave Lambert's five bases of successful market segmentation.

CNBC's Erroneous Focus on "The Trade"

As the equity index volatility of the past few weeks continues, it makes the prospect of buying or selling equities fraught with concern that the market price is not truly reflective of long term factors.

Rather, the price at which one might sell an equity could be heavily influenced by temporary forces or misconceptions.

As such, it's caused me to reflect on something I see quite a bit these days on the cable business news network, CNBC. It seems that every day, some of the anchors and/or on-air staff will bark at a guest,

'so, if that's true, what's the trade?'

Or a correspondent will breathlessly describe some equity's price movement in terms of 'the trade' between it and something else.

This is a mistake. It's not about the trade. Here's why.

Unless you know what someone already holds in their portfolio, describing 'the trade' is a meaningless term. It is a mistaken focus on 'the trade,' rather than relative buying or selling opportunities.

For example, suppose you and I each hold a single equity. I hold a technology-oriented company's stock, while you hold the stock of a durable good manufacturer.

We are sitting together, watching CNBC, when a reporter announces a significant rise in the price of oil. The on-air anchor then turns to a guest and excitedly asks,

"so, what's the trade here, Ron?"

Well, Ron can't know what's in either of our portfolios. So Ron can only say, univocally for all viewers, something like,

"I can't say what 'trade' to make, Dylan, because I don't know each viewer's portfolio composition. However, given the reporter's news, I would say that this makes energy stocks more attractive, relative to other things consumers might buy. So several sectors may now be less attractive, such as consumer discretionary items, luxuries, durables, etc. However, I don't think it will affect business technology spending."

But "Ron" never actually says something like that. Instead, there will be some platitude about selling this and buying that.

It's just typical business cable "news" network entertainment nonsense.

Last week, I believe, I saw a really excellent few seconds of commentary from CNBC's morning guest host, Liz Ann Sonders, Chief Investment Strategist for Charles Schwab & Co. She basically made light of the current equities volatility, and called attention to the real investment needs and objectives of Schwab's retail base of customers. Sonders noted that, for the average retail investor, or any investor with a long time horizon, this recent spate of market turbulence and volatility are no basis to "trade" anything.

Rather, she argued for simply continuing with existing investment strategies, and ignoring temporary, emotionally-based pricing dislocations and hysteria-based volatility.

I think this is very wise. Volatility is no reason for trading, per se, for most investors. Perhaps for those investment bank and hedge fund trading desks for whom this is their business. But not longer-term investors.

Temporary valuations driven by fears involving sub-prime mortgages, counterparty risks in credit derivatives, and overall debt liquidity, are hardly the stuff on which to base long term investment approaches. These influences on equity prices will be volatile and uncertain during their duration.

Certainly, these factors cannot be the basis for someone in the business media to solemnly announce 'the trade' which is now compelling. At best, their exhortations are simply silly. At worst, they can cause real damage for the unwise, who are not well-advised or knowledgeable as to what, if anything, they should remove from their portfolio, in order to buy the hyped equity.

For investors, trading is simply the means by which our strategies are implemented. We trade when our investment processes indicate to own less of some equities, and more of others. We don't trade simply for the sake of trading.

We invest.

Microsoft's Latest Attempt at Resurrection: Craig Mundie's Mandate

A very recent Wall Street Journal article focused on Craig Mundie, the man who is being touted as 'Bill Gates' replacement.' Mundie is the new chief of strategy and research at Microsoft.

I wrote several posts, here, here and here, among others, about Microsoft's dilemma, and a potential solution. The last of the three, and its predecessor a few days earlier in November, 2005, contain the seeds of my ultimate recommendation and prophesy for Microsoft.

Simply put, as good a guy as Mundie probably is, he can't and won't personally, single-handedly overcome:

- the wooden-headed, arrogant and wealthy Steve Ballmer's insensitivity to Microsoft's shareholders

- the vast, entrenched, far-flung bureaucracy and operational mindset at Microsoft, which has been built over two decades of prior success

- a company so large that it simply will never be able to match the speed and innovation of smaller startups in any area in which Microsoft chooses to try to 'lead' from a technological base

- the apparent trusim that technology firms, as technology firms, simply do not have successful second acts. Ever.

As I read the Journal article, I was struck by how very much like the old AT&T, at which I plied my trade in the 1970s and '80s, Microsoft now is. So large that the same solutions are developed in isolation, multiple times throughout the firm. A single leader is annointed to fix the problem and shake things up, but without sufficient authority.

Time and again in the article, Mundie exhorted some or other staffer to go see another, kindred group, meet with the senior executive of some similar activity, or build stronger ties to produce groups.

The trouble is, it matters to people who gets credit for solutions. Mundie seems oblivious to how the groups in power will respond to being presented with 'solutions' by smaller research units from far away locations. The integration of the various ideas and solutions will not be seamless, if it happens at all.

So long as Microsoft tries to use its existing structure to be something it hasn't been before, it will fail. As I wrote nearly two years ago, what Microsoft needs to do is think and behave like a venture capitalist, and spin out various smaller entities to work on the areas in which it wishes to lead. By retaining a stake in the firms, seats on their boards, Microsoft, the parent, will share in the innovation-based value that these startups will create. In time, these startups could become the next Googles, etc.

But so long as senior Microsoft executives respond to Mundie's efforts with comments like Tom Gibbons, VP for various non-computer software efforts,

"I need to think of this as a completely new effort,"

in response to Mundie's stimuli involving mulicore processors, I think Microsoft is doomed to remain a large, hulking, mediocre giant whose best days of consistently superior total return performance are way, way behind it.

One talented, even motivated executive like Craig Mundie just cannot overwhelm the weight of factors arrayed against him at Microsoft, no matter how correct Mundie's insights and actions are.

Bancroft Family Reveals True Whorish Capitlistic Values

Today's Wall Street Journal, and CNBC, reported on the final stages of the Bancroft family's sale of Dow Jones to Rupert Murdoch's News Corporation.

What is delicious irony, of course, is that, after all the Bancroft crowing and public fretting about 'editorial independence,' the deal's closing is now dependent upon them extracting a sort of modern "greenmail" from Murdoch.

To wit, some of the Bancrofts are demanding reimbursement for legal and advisory fees connected with the entire negotiation process. This, they argue, is in lieu of a simply higher price for their weightier, on a voting basis, and, thus, more valuable shares.

As my partner noted to me, in an email containing the initial inklings of this on Friday, it demonstrates that, in the end, the Bancrofts are shameless capitalistic whores, just as many decry Rupert Murdoch to be. It wasn't simply a matter of protecting the Journal's editorial sanctity that would lead to the deal's closing.

Oh no. That was just a first step. The real action comes now that the family is seeking to extract the maximum price they believe Murdoch will tolerate paying for their publicly-listed, but, ultimately, family-controlled company.

I posted on this topic at the time of Murdoch's bid, here, back in May. Then, the Bancroft family enlisted various greybeards, such as Peter Kahn, a former Journal executive, to publicly fend off Murdoch. In the ensuing months. they've looked high and low for other alternatives. However, as I wrote then, the truth is, print-only companies are simply too small, in an economically efficient sense, to survive in today's media world.

Murdoch is the best fit for the Dow Jones Corporation media assets. Others share his vision for how to use them, but only Murdoch actually has the goods. As for retaining a stake in the entity, as one interloper suggested, the family members who want to participate in future growth of the brand under Murdoch can simply by News Corp stock.

But the real story now is how the Bancrofts are making use of the two-class stock they created when Dow Jones went public, to extract maximum gains only for themselves. Personally, I have no pity for the non-family shareholders. Despite what some, like CNBC's guest host this morning, Ron Insana, may say about family shareholders not being entitled to their gains because they simply "inherited" the shares, other shareholders bought the stock knowing full well that they could not vote a controlling interest, even as a united class.

Thus, they knew that they always faced the prospect of the Bancrofts screwing them in order to cut a better deal for their controlling shares. And that is exactly what is happening now.

By demanding that the advisory fees they incurred during the sales process be paid by Murdoch, some Bancrofts are, in effect, receiving higher prices for their shares than other owners are. We used to call this "greenmail," back in the 1980s, when people like Carl Icahn accepted higher prices directly from management in order to repurchase his shares of a takeover target.

Now, however, the Bancrofts are using the tactic in reverse. In order to takeover Dow Jones, Murdoch must pay greenmail.

No doubt, if we were to search back through the sainted editorial pages of the WSJ back in the 1980s, we'd find sanctimonious pieces by the Journal staff decrying the practice of paying greenmail, or otherwise treating shareholders of the same company differentially.

All of which goes to show, in the end, it's all about capitalism, capital, and the money. No shame in that. Things generally go better when we are honest about our motives and keep financial activity in its realm, and charity or "public interest" elsewhere.

Obviously, in the end, the Bancrofts believe this, and are no different than the man who runs the company to which they are selling theirs.

Microsoft's Xbox 360 Dilemma

The Wall Street Journal ran an interesting piece earlier this month, sourced from breakingviews.com.

Essentially, the article contended that Microsoft's latest troubles with its gaming unit's product should spell the end for the product group. At least under Microsoft's aegis.

I could not agree more, and have written as much last spring (2006). In this post, I suggested the following,

"My friend S, a consultant, was discussing corporate performance with me recently. While debating the recent fortunes of tech companies such as Google, Intel, and Microsoft, she challenged me to articulate what I would to fix what ails the last one. I had opined that Microsoft is, essentially, finished as a company capable of generating consistently superior returns, in part, as I have written recently, because of its chairman's excessive wealth. By the way, according to S, my estimate of Gates' net worth may have been light by as much as 50% or so. He apparently was worth some $50B as recently as 6 months ago, not the $25B I thought.

In any case, I said that the first, and, for a while, only thing I would do at Microsoft would be to essentially execute the threatened anti-trust remedy of the Netscape case- split the company into three: an applications software company, an operating systems company, and an internet-related company."

The recent Journal article also advocates spinning off Microsoft's gaming unit. It notes that the Xbox group accounts for only 10% of the company's revenues, yet has become a drain on profits, as sales of the gaming consoles have failed to meet expectations.

As I have written before, having too much financial cushion, and a complicated internal capital allocation process, tends to make units of conglomerates like Microsoft less competitive in the marketplace. They aren't as committed to "do or die" innovation and product success, because, regardless of the group's performance, they will still get paid.

Trouble is, the online gaming business is now a bare-knuckles, innovative slugfest among Nintendo, Sony and Microsoft. There's no room for a half-hearted entrant to dominate the sector.

Between the recent Xbox recall, and its already-slow sales start, I would agree that it is time for the software giant to cut this entity loose to sink or swim on its own.

It isn't doing shareholders much good, and CEO Ballmer still has his hands full with the other two major divisions- applications software and operating systems. Neither of which is yet on track to return Microsoft to its glory days of consistently superior total return performances.

On Diversification, Conglomerates, and Consistently Superior Returns

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Some Late July Thoughts on Equity Markets

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

It's summer.

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

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

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

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

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

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

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

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

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

GE in the NY Times- Again

My business partner sent me last weekend's recent New York Times devotional to GE and Jeff Immelt, entitled, "Is GE Too Big for its Own Good?" penned, this time, by Nelson Schwartz. Last month, I wrote this piece about another Times writer's love paean to GE and its failed CEO.

For the record, nearby is a Yahoo-sourced, five-year price chart comparing the S&P500 and GE. Even with its modest recent price improvement, GE still badly trails the index for the last five years.

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

"Toxic mud wasn’t the only mess Mr. Immelt had to clean up when he took the reins from the legendary Mr. Welch in 2001. Along with dealing with a struggling reinsurance unit that forced G.E. to take billions in write-offs, a power turbine business poised to collapse and an overvalued stock, Mr. Immelt had the misfortune to move into the corner office just four days before the Sept. 11 terrorist attacks altered the political landscape and the outlook for core G.E. franchises like jet engines and aircraft leasing.

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

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

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

"Even so, the clock is ticking. There is growing pressure on Mr. Immelt to do something — anything — to get G.E.’s stock moving after six years of stagnation. Despite a 15 percent rally over the last two months, G.E. shares are still down 30 percent from their Welch-era peak. And in April, the analyst Jeffrey T. Sprague of Citigroup Investment Research stunned Wall Street by calling for a breakup of the company, urging Mr. Immelt to sell off NBC Universal, as well as the consumer finance and real estate units."

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

"Whereas Mr. Welch took over a company vulnerable to foreign competition and hamstrung by a bloated work force (and cut so many jobs that he earned the unwelcome sobriquet Neutron Jack), Mr. Immelt took over a giant that had been successful but wasn’t growing as fast as smaller, more agile companies — and which had a number of financial and operational time bombs in its portfolio."

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

On "Management by Data"

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

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

Mr. Thurm writes, in part,

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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