AOL & Google Joint Venture

This week's announcement of Google's venture with Time Warner's AOL unit seems almost anticlimactic. The major news about the venture, I suppose, is that Microsoft lost out on the defensive move.

It seems to me that anything Google really needs accomplished will be done on its own, with full control. For some time now, the mating dance by Yahoo, Microsoft and Google around AOL was seen as mostly to keep the latter's customer base out of one of the others' grasp. Just in case it turns out to be useful for something.

Watching Dick Parsons juggle his succession lineup and attempt to fend off Carl Icahn in the midst of this venture is amusing, when it's not sad. I owned AOL at the time of its merger with Time Warner. Then, as now, I thought the latter's board did a profound disservice to its shareholders by accepting AOL's offer, and not spurning it. It is hard to believe that a marquee name investment bank would not have found adequate grounds to reject the offer, protect the board's exposure on the "fiduciary duty" basis, and provide sufficient doubt of the longer-term value of merging with a temporarily-highly valued suitor like AOL.

Perhaps, more than anything else, this deal demonstrated, once again, that "synergies" are rarely realized post-merger, and that simpler business structures are frequently more consistently superior in generating market-beating total returns for their owners.

I don't envy the managers at AOL. Being the "partner" of a celebrity company like Google, and nearly publicly disowned by its management, can hardly be an appealing career opportunity.

CNBC's Squawkbox: Investing As Entertainment

Is it not ironic that within two weeks of the NYSE voting to merge with Archipelago and move decisively away from its open-outcry market method, and the regulatory problems it has experienced with its specialists, CNBC revamped its early morning business program, Squawkbox, moving part of its coverage to a set located inside the exchange?

If this doesn’t demonstrate the networks treatment of investing as primarily entertainment, what could?

The NYSE move to electronic trading, in order to minimize the egregious regulatory infractions of it’s specialist members, including front-running its customers when order filling, makes the trading floor an even less important place in the investing process then it already has been for some time. With the rise of managed funds, 401K plans, etc, institutional management has been the driving force in the market for quite some time. The trading floor is for order execution, but is not, in itself, the locus of investment decision-making that moves the markets.

Thus, CNBC seems to be moving to cover the sizzle, but not the actual “meat” of the capital markets. If you needed to understand what is going on in the markets, you can monitor any number of real-time ticker and index data feeds. Actually seeing the trading floor and filling of orders is superfluous.

However, if you simply want to portray an entertaining drama of market forces at work, I suppose having a program set located within earshot of the trading floor frenzy does that.

Pepsi’s China Potato Farming

The Wall Street Journal carried a feature article this morning discussing PepsiCo’s efforts at growing its own potatos in China for the local production of Lay’s potato chips.

What struck me were the last two paragraphs. After describing the agony PepsiCo has gone through to produce enough potatos in China to drive Lays’ market share to 40%, the piece noted that Wal-Mart (in China) complained about shortages of Lays on its shelves. The article finishes with these lines,

“….The chip-production goal has been increased again to meet rising demand. Mr. Shi’s shoulders slumped.

“We’re under a lot of pressure from the sales guys,” he said. “It’s growing too fast.”

This reinforces my thesis that the best way to buy successful growth companies is to buy those who have already demonstrated successful growth. That is because sustained profitable growth is so hard to achieve.

Isn’t it interesting that a world-class company like PepsiCo, with so many resources available, has to struggle, as the article depicts, just to introduce and grow the Lays potato chip brand in the world’s most populous country? You would think this would be child’s play. But evidently it is not.

PepsiCo has only attained a cumulative 20% total return for the past five years. By comparison, the S&P500 is slightly under a 0% return for the same period. That means that PepsiCo has had an average out-performance of only 4% over the S&P for the last 5 years. Clearly, it is by no means currently successful at turning whatever top-line revenue growth it has into consistently-superior total returns.

However, my portfolio strategy has selected a host of companies over the years which have consistently performed much better than PepsiCo. Thus, my preference for owning companies that have actually demonstrated consistently-superior performance over time, rather than those who one would believe should be able to do so. And the wisdom of my strategy’s approach is evident in the portfolio’s consistently superior returns over time.

“Good To Great” or “Consistently Superior” ?

Much of my work for the last decade has involved measuring the performance of publicly-held U.S. corporations. There is really only one body of work of which I am aware that sounds remotely similar to mine. The Wall Street Journal has made a few references recently to that body of work, by Jim Collins in his book, “Good to Great,” published in 2001. I decided to acquire a copy and read it myself. Amazon was very helpful in providing me with an inexpensive copy, with no benefit to Collins in the process.

What I found upon reading Collins’ methodology was an odd mixture of quantitative and qualitative bases of analyses. There are a variety of problems with his methods, which I will address both here and in subsequent posts.

To start with, Collins uses cumulative returns over long periods of time to judge a company as “good” and/or “great.”

However, my own research on large U.S. publicly-held companies reveals that among companies which outperform the S&P 500 average total return over a period of years, firms which consistently outperform the S&P index, on average, create shareholder wealth at a much higher rate than companies which earn most of their total returns with a few years of outstanding performance.

This is a very non-trivial issue. If, as CEO, your decisions are guided by the desire to “maximize the present value of the firm”, how do you choose when to maximize that value, which in turn maximizes shareholder wealth? Will the decisions you make enrich some shareholders at the expense of others because they own your company’s stock at different points in time?

It is highly likely that a consistently-superior firm’s great wealth creation is a reward for not forcing investors to be market-timers. Collins completely misses this distinction in his work. Since it is the first screen by which he typifies companies, it therefore compromises the entire remainder of his findings and body of work as described in the book.

I must admit, I was rather shocked that such slipshod and simplistic quantitative definitions of “good” and “great” performances would exist in a book so seemingly well-regarded in the business community. Perhaps it is yet another case of the broad class of mediocre managers and leaders being unable to distinguish “great” work when they see it.

As I read more of Collins’ book, I will post additional comments on the differences in approach and findings between his work and my own.

GM- The Truth At Last?

I checked my blog posts to see when I first wrote about the GM situation. On October 18th, I first wrote of my expectation that GM is now in what will come to be seen as its death throes. With the title "Speaking Truth to Power," I questioned why so many media and brokerage analysts failed to seriously question GM's future viability, in the face of so much evidence of its travails.

Yesterday's downgrade of the company's debt by Standard & Poors may now give these parties the "cover" they seek to express their true feelings. According to today's Wall Street Journal story on the subject, S&P's rating of GM now places it in a category in which 5.7% of whose companies typically default within a year. So, now we have at least one quantitative estimate of GM's viability over the next twelve months. Since GM is involved with the Delphi situation, I stand by my belief, expressed many weeks ago, that the former will be merged, acquired, or in bankruptcy at the end of two years from now.

It is noteworthy that S&P, perhaps a more "neutral" analyst than many brokerages, is quite clearly concerned about the revenue and market-share dilemmas facing GM, rather than the company's self-diagnosed cost-control challenges.

What I now wonder is how much value in investors' portfolios has been destroyed by GM's roughly -19% return from October 18th until yesterday's closing price? How do the sell-side analysts defend their silence then, given this recent loss in GM's value? I don't track how many downgrades were issued, or when, by various analysts since mid-October. What I do know is that the media and analytic climate two months ago was one of relative silence in the face of what seemed pretty obviously the beginning of the end for GM.

Desiderata

Go placidly amid the noise and haste,and remember what peace there may be in silence.

(Max Ehrmann, Desiderata, Copyright 1952)

I thought of this poem the other day while watching an end-of-day report on trading in the stock market on CNBC. It captures very nicely my style of investment amidst the daily frenzy of the equity markets.

Most portfolio managers trade more frequently than I do. My twice-yearly trading allows my positions to quietly run their course, often amassing substantial returns while others would “rebalance” away profits. This half-year has been no different in that regard, with energy issues earning double-digit returns.

I have, however, come to terms with the steady drumbeat of sell-side analysts and media pundits, such as Jim Cramer. Daily volatility is now something I expect, as it represents other investors and traders entering and exiting the market on any particular day. These daily price fluctuations assure smooth and liquid trading on the two days per year I will trade. With few exceptions, the actual movement of the market over a few hours on any given day is not that large.

So I now “go placidly”, holding my positions patiently while observing the daily frenzy. No matter how volatile the daily price moves, the monthly volatility is less affected. And so are even longer-term moves of prices and indices. My portfolio may experience some volatility due to short-term market exuberance, but in the longer-term, the superiority of the portfolio’s selections typically reappears. The key is to not succumb to daily or weekly concerns due to traders’ constantly-shifting valuations, but maintaining the discipline of my investment process.

GM: The Agony Continues- Part 4

General Motor’s CEO Rick Waggoner’s op-ed piece in the Wall Street Journal Tuesday morning contained an interesting little bit of monetary policy information which almost escaped my attention, and may have eluded yours as well.

"… This ignores the fact that American auto makers and other traditional manufacturing companies created a social contract with government and labor that raised America's standard of living and provided much of the economic growth of the 20th century. American manufacturers were once held up as good corporate citizens for providing these benefits. Today, we are maligned for our poor judgment in "giving away" such benefits 40 years ago…."

Waggoner is saying that GM and other large US corporations privately monetized future promised benefits as a form of currency to lubricate and drive US economic growth. He implies that they promised wealth in order to drive more consumption on the part of the workers. He seems to be arguing that making false promises which accelerated US growth in prior decades is defensible on the basis of the end, namely, falsely promising undeliverable benefits.

Is this amazing, or what?

First, Waggoner effectively admits that corporate America has been privately creating money by issuing dubious pension promises. As if GM hasn’t had enough difficulty just being a consistently-good investment for its shareholders, it apparently dabbled in monetary policy, too.

Then, with unmitigated gall, Waggoner goes on to suggest that making pension promises which have turned out to be unaffordable was justified, because it caused workers to feel wealthier, spend a lot more money, and drive economic growth.

Maybe Rick Waggoner would be better off not speaking or writing anymore, and trying to find a merger partner for his wreck of a company, while it still has some cachet with a few buyers in some of its customer segments.

GM: The Agony Continues- Part 3

General Motor’s CEO Rick Waggoner’s op-ed piece in the Wall Street Journal this morning is a pathetic paean to socialistic corporate policy.

Waggoner first makes a dismissive nod to the need for producing vehicles which people actually want to buy, rather than stuffing GM products with various features that still fail to address the overall demand of the driving public. The extent of his solution is found in this passage, “We will step up our performance in this regard.”

Wow. And all this time, it was so easy. Just write that you will ‘step up …performance,’ and you have it covered. No details as to how your entire heretofore ineffective creative design staffs will change overnight. Or how these people, or perhaps their replacements, will quickly produce newly-interpreted solutions for the vehicle-buying public. No, just tweak a few knobs down in the design department and you are back in the black!

But the really sad part of Waggoner’s article is the roughly one-third of it which wraps his company in the American flag. This tactic sent me to Bartlett’s for this line:

“Patriotism is the last refuge of a scoundrel,” is attributed to Boswell in his Life of Johnson.

According to Waggoner, while GM freely entered into its pension agreements with its workers and their unions, they did it because “….(American manufacturers) were once held up as good corporate citizens for providing these benefits.” He goes on to say that these same companies are now “maligned for our poor judgement in ‘giving away’ such benefits 40 years ago.”

What Mr. Waggoner fails to realize, as apparently did his predecessors, is that his and their fiduciary duty is to GM’s shareowners, not to a faceless holder of opinions about whether a company is a “good corporate citizen.” He takes the easy way out, pleading that GM’s prior and current managements must bend to the will of public opinion regarding their status as corporate citizens.

Never mind their option to make their own case to these same opinion-holders regarding the long-term financial inviability of the agreements GM freely made. Instead, Waggoner effectively blames the social environment of the last 40 years for his company’s plight. I would opine that, if anything, this displays how inept the GM management has been for years at correctly assessing its own costs of business, and putting its shareholders first.

If this kind of scapegoating and avoidance of responsibility is how Waggoner plans to lead GM, I continue to predict that he will have a short tenure.

Productivity Wrongly-Defined

...since we are dealing with an organic process, analysis of what happens in any particular part of it-say, in an individual concern or industry- may indeed clarify details of mechanism but is inconclusive beyond that. Every piece of business strategy acquires its true significance only against the background of that process and within the situation created by it. It must be seen in its role in the perennial gale of creative destruction; it cannot be understood irrespective of it or, in fact, on the hypothesis that there is a perennial lull.

Joseph A. Schumpeter
Capitalism, Socialism and Democracy, 1942

This morning on CNBC, the Squawkbox crew debated recently-revised “productivity” data for the US economy. I use quotes because I have my doubts that the popular use of the term promotes clarity of thinking, as I hope to demonstrate in this piece.

Steve Liesman spent a considerable amount of time discussing how the improved physical output of a machine would improve productivity of its worker, and also profitability of the firm using it. If only life were that simple.

As my old boss and mentor, Gerry Weiss, SVP of Corporate Planning & Development at the old Chase Manhattan Bank used to say, producing another poorly-selling Cadillac Cimarron more efficiently adds little, if any value to the US economy.

Simply put, there is a major difference between efficiency and productivity. I find most classically-trained economists make this mistake, Schumpeter’s passage notwithstanding. To understand the difference, we need to understand the “background,” as Schumpeter stated in his 1942 book.

Liesman made a common mistake in assuming that whatever that machine was producing could be sold at a market-clearing price, thus improving overall profitability and margins. However, this isn’t correct. Productivity didn’t improve from that machine’s added output- efficiency did. We only know about the physical output of the machine per unit of time or other resources- workers, maintenance expense, etc.

We know nothing about the sale price of the product into which the machine’s output goes, nor the price elasticity of the product, the demand for it at various prices, etc. These elements affect what I call the product’s, or sub-component’s “resource value productivity.” This would be the value-added to the firm of that component or product divided by the particular resource, in this case, a more efficient machine.

Confusing efficiency of output with the ability to create more value-added per unit of resource shows a lack of understanding of how economics is morphed in a company into marketing.

For example, what if the management of the firm in question has mis-estimated demand, and the newly-efficient machine is producing unwanted product? Think this is rare? Look at GM, Ford, Merck, or even a Hollywood movie studio. If GM more efficiently produces an SUV that will sit on a dealer’s lot, to be sold at deep discount, was there any productivity gain? Or was an unwanted, little-valued product made more efficiently?

It strikes me as odd that reporters on a leading business program can be so well-versed in economic theory, but miss the major difference that an advanced, consumer-driven market economy has over a production-driven economy. That difference is the need for producers in the former to get product development and price-points right, in order to sell highly-valued merchandise and services to a demanding and selective market. Once you grasp this, you immediately can grasp how production efficiencies are not at all the same thing as resource (value) productivity.

Schumpeter’s observations about the perennial gale of creative destruction makes this so. Too bad so many business people and economists recall the two-word phrase, but not the author’s deeper analysis of its implications.

Over-Compensated American Senior Management as a Source of Competitive Disadvantage

Carl Icahn gave an interview to David Faber of CNBC late last week. Many of Icahn’s remarks were self-serving and postured to support his current involvement in pressuring AOL regarding its current asset divestitures and strategy. He makes no secret of wanting Dick Parsons out. For what it’s worth, I think he is right about that.

However, what really made me sit up and take notice was Icahn’s pointed comment regarding the modern large-cap American CEO. He feels that, on average, and as a group, they are seriously disadvantaging US business relative to foreign businesses. This is a fascinating viewpoint. It echoes my own research, writing and feelings, some of which are found elsewhere on this blog.

Icahn specifically voiced concern that today’s CEOs are so over-compensated that they simply do not pay sufficient attention to maximizing ongoing shareholder wealth. In this, I totally agree ( see my recent post regarding pay-for-performance for large-cap CEOs). He feels that if this trend continues, American business will lose its competitive edge and, over time, fall victim to hungrier, more attentive foreign competitors.

With GM, Ford, UAL, Merck and TimeWarner as examples, it’s hard to argue with him. It is possible that Ricardian economics is responsible for the leadership in steel, airlines and autos going overseas.

But couldn’t these firms have accomplished what Intel has around the world, and remained competitive via global facilities and globally-sourced talent? My suspicion is that Icahn is onto something here. As superior innovative talent in other countries becomes more globally accessible and able to be leveraged, it may signal another round of American industrial restructuring to come on the order of that which we saw in the 1980s and early ‘90s.

“Purpose Brands” ?

Tuesday’s Wall Street Journal featured a piece in the second section’s “Manager’s Journal” that can only be described as remedial marketing.

The piece, entitled, “It’s the Purpose Brand, Stupid,” advances the apparently-novel notion that products (and services) should be focused on customer needs.

Really? Do tell!

What struck me as I glanced at this piece is how low the Journal’s staff must be aiming to waste space on this type of pablum. And, thus, how uneducated the staff must feel their average reading audience is.

But there’s more shocking news. The piece is an exerpt of the authors’ upcoming article in the Harvard Business Review. One of the co-authors is a member of that college’s business school faculty.

The notion of developing products to satisfy customer needs is literally as old as marketing itself, and covered in an introductory marketing course at the undergraduate level. Why this would need to be re-stated as a special topic in the world’s leading business daily makes a sad statement about the state of mediocrity among business executives in general.

Perhaps this is because the MBA as an educational program is insufficient to impart the necessary knowledge in depth to lead and manage businesses effectively. With less than 24 months duration, and the last 6 of those typically wasted on job search, the educational program may be too short to really imbue its students with effective managerial tools. In my opinion, it seems to have become more of a financial- and other functional tradecraft certification, and much less of a management degree.

If this were not true, would an article such as the one mentioned in the beginning of this post be appearing in the leading business daily paper, as well as a well-known business monthly magazine?

Southwest Airlines: A Case for “Right Sized” Airlines ?

This weeks’ Wall Street Journal article about Southwest Airlines’ move into a new hub in Denver brought me back to some insights about the airline sector from a few years ago.

There seems to be an irreconcilable conflict in many sectors between a company’s growth objectives, its profitability, and the real constraints to satisfying both of these. It is especially obvious with airlines.

As a business with large fixed capital assets and varying customer demand levels, both in unit volumes and revenues, airlines have always been management challenges. Factoring in the relevant economic attributes of the typical airline- low barriers to entry, relatively high capital requirements, unionized labor, lack of control over the system in which it operates, tendency towards costly evolution to multiple plane types, underlying derived demand for travel- suggests that there are probably very real limits to profitable growth.

In Southwest Air’s case, when I read about the airline changing its operating model to accommodate growth, I expect financial doom to be in the offing. The stock is down over the last five years as it is, and even under-performs the S&P500 during that period.

Similar to the “wheel of retailing,” about which I have written in an earlier post, budget airlines beg for trouble when they depart from their original low-cost, no-frills, or limited-geographical service model. It does seem that historically financially successful airlines were regional carriers who had identified a fairly self-contained segment of fliers whom they could serve at lower costs than larger airlines could do so. So long as such airlines expanded within a region that provided high load factors while the airline grew service points and passenger volume, there was no problem.

What seems to sound the death knell for these regional carriers is their eventual desire for passenger and revenue growth which requires them to outgrow their original, self-contained market segment of travelers. Just because an airline wishes to profitably continue its growth does not mean it should, or will, happen. Thus, Southwest’s dilemma.

It is pushing for growth while its total returns over the last five years are already penalizing its shareholders.

Hard as it may be to accept, many companies simply run out of profitable market segments in which to grow, and then their days of consistently superior returns are over. Airline total return performances seem to reinforce this conclusion with stunning regularity. So much for learning by example, or even from their own mistakes.

US Financial Super-Utilities

Both Chase and Citibank have become massive, mediocre financial super-utilities in the past decade. But neither one has out-performed the S&P500 over the past 5 years. Chase’s last merger, with the combined Midwest banking conglomerate, FirstChicago-BancOne, hasn’t and won’t change that.

Ironically, my old boss, and SVP of Corporate Planning and Development of the “old” Chase Manhattan, Gerry Weiss, predicted back in 1986 that eventually the major money center banks of Manhattan would merge into one or two giant mediocre financial services companies. He was eerily prescient.

What Gerry saw from his unique vantage point was how difficult it was to effectively manage such a wide range of types of businesses at these banks, in conjunction with the lack of adequate managerial talent. Financial services has never attracted good managers.

Traders, deal-makers, and financial products innovators, yes. Consistently-effective managers, no.

My original research at Oliver Wyman & Company, now Mercer’s financial services consulting unit, confirmed this. Money center banks and large investment bank/brokerages never enjoyed consistent superiority in their shareholder wealth creation. They were out-peformed by single-line firms in credit card lending, mortgage banking, private banking, asset mgt, etc.

Empirical research of over a decade of company performances confirmed my old friend and boss’ hunch, and added a new finding. Not only were and are these financial leviathans simply too complex for the executives that are typically drawn up through their ranks to successfully manage. By being so broadly diversified, and large, they are sure to experience every major financial calamity which befalls the sector- be it real estate lending, sub-prime credit, risky proprietary trading, or, as in the Enron case, over-zealous complex financial products marketing which apparently crossed the line from finance to abetting financial fraud. The result is that consistent total returns prove to be an elusive goal, as these huge financial behemoths are beset with every market excess which occurs in the industry.

That is no doubt why these companies are rarely, if ever selected by my portfolio strategy. Revisiting my original sector research, and Chase’s and Citigroup’s recent performances, is a comforting reminder that my strategy’s bias in favor consistently superior performance is based on sound empirical research. Size for its own sake is of no value when you want to out-perform the market, despite what analysts may believe.

Chase: Remembering “Vision Quest”

A reference this weekend to an American Indian “vision quest” brought to mind a long-ago corporate monstrosity, Chase Manhattan Bank’s own “vision quest” project of the early ‘90s. The effort was, I believe, ascribed to then-CEO Tom Labreque. I recall that a friend told me, after I had moved on to other work, that the bank actually inscribed the resultant values from the “vision quest” project onto a panel on the wall of the bank’s then-headquarters downtown at Chase Plaza.

I suppose an indication of how useless the resulting “vision” was is that Chase was acquired by Chemical bank within just a few years of the company-wide project’s conclusion. As I recall, it was that, or have Michael Price, then a hot mutual fund manager, force the bank’s senior management to dismember the firm in order to wring more value from it. Either way, Labreque's hand was forced, and he lost control of the bank he had labored so hard to finally "lead."

Today, Chase is a combination of Manufacturers Hanover, Chemical, and JP Morgan with Chase. The only significant US banks on the island of Manhattan that didn’t merge into it were Bankers Trust, which was snapped up by Deutsche bank after its ill-fated derivatives moves later in the decade, and Citibank.

Maybe the lesson here is that clueless white senior managers shouldn’t try “vision quest” –ing on their own, or with conventional management consultants.

Perhaps if Chase had actually retained an American Indian consulting group, complete with hallucinogenic substances, their efforts would have met with more success. It's arguable that the results of such a "vision quest" could have led to any worse results than those which followed from the erstatz process the bank actually employed.

AT&T: Meet the New Firm, Same as the Old Firm

I read the Wall Street Journal’s page one piece this morning about Ed Whitacre’s new strategy for the “old” Southwestern Bell Corp, now reborn as the “new” AT&T. To be honest, it left me with a very eerie feeling of déjà vu. Yes, Yogi, déjà vu “all over again.”

You see, I worked for the “old” AT&T. The one prior to the spinoff and deregulatory shuffles of the mid-late 1980s. Sadly, Whitacre’s vision is just about exactly the same one that Charlie Brown, AT&T’s then-CEO, had more than twenty years ago. Once again, smaller, nimbler, more experienced competitors have already staked out turf and begun operating in the areas that the new AT&T is still planning to conquer.

It is inexplicably bizarre that one corporate name should be retrieved to brand yet another headlong lunge into a new, complex technological battle of precisely the same type that destroyed its first incarnation. When I arrived at AT&T in 1979, it was rapidly girding for a deregulated operating environment. And immenses riches were planned to flow into the corporate coffers from dominating voice, data, text and video communications. We had nascent private quasi-internet projects, like ACS, as well as new multi-media digital processing products. What we didn’t have was credibility in designing and marketing the new products and services, much less sufficient customer behavior information to drive their design and integration.

I don’t see much difference this time around. Once again, the guys with the AT&T logo are claiming that they will swamp existing competitors with multimedia services, delivered in unrivaled volumes and combinations, and with technological superiority. Forgive me for being cynical, but I not only saw this movie already- I was actually cast in it. Believe me, when you are inside a behemoth like this, bent on implementing its market-conquering view, no amount of realistic advice will change anything.

Can one firm, one corporate name, endure a second trip to the ash heap of corporate history? Maybe, like large killer hurricanes, corporate names from spectacular disasters should be retired, never to be used again. I think the “old” AT&T deserves at least that much respect.

GM: The Agony Continues

Amazingly, this morning’s announcements by Rick Waggoner, CEO of General Motors, all focused on cost reductions and/or layoffs. Not a word about its salient challenge- getting customers to buy more GM products at prices which cover all costs, including a return to capital.

The original research which drives my large-cap equity portfolio strategy has shown that turnarounds such as this one are fraught with risk, and, thus, rarely return a company to a path of consistently-superior total returns. Even if expense levels are cut, the ability to regain healthy revenue growth rates seems to be a very rare phenomenon. In short, shareholders will continue to wish they had simply bought the S&P500 index for the long term, rather than continue to hold GM stock.

I knew for sure that GM is still in trouble when Waggoner attributed this newly-announced initiative to “our smartest people.” Translation: ‘Look out! The best minds who have assisted me in bungling the management of this former market-leader over the past few years have conspired to bring you another page from the same book.’

Don’t hold your breath for the return to health of this industrial wreck. At best, Waggoner will perhaps engineer a merger of equally-unhealthy auto makers before GM runs out of time and money.

Counterparty Risk Is Now In Prime Time

I feel like I’m watching a real-life version of the movie Cassablanca play out in front of me this week, as if Claude Raines said, “I am shocked, SHOCKED that there is underfunding for pension liabilities going on among US large-cap industrial firms!”

The notion of counterparty risk, usually found in financial enterprises, has recently become much more widely understood, albeit under a different name. GM’s pension liabilities, for example, are now realized to be at risk of being unpaid, as its debt yield exceeds that of at least one South American country. The reason it’s finally a hot topic, as evidenced by CNBC’s week-long focus on “lie now, pay later,” is that a major industrial firm is now judged to be an unreliable counterparty in the pension arena.

Truth be told, this is not really news. The topic was very au courant in the early ‘80s, when I was fresh out of graduate school. During the roaring inflation of that era, and subsequently, FASB introduced the first changes in pension liability accounting, to begin to accurately portray these unfunded obligations.

But before concluding that GM and its ilk are lying, cheating and despicable pension thieves, let’s revisit what actually occurs in an employment situation.

Imagine someone offers to hire you for $100,000 per year of compensation, but they will only pay you $80,000 in cash. For the remaining $20,000, they promise you that they will pay the cumulative amount at a time in the not-so-near future. No escrow account, promissory note, bond, or anything like that. Just a written promise. So, in effect, you have bought, or in financial parlance, “gone long,” your employer’s counterparty risk- the risk that they might not actually be able to deliver on their financial promise.

This is typical behavior of employees in the US. Thanks to the federal government’s expansive pension benefit legislation, what individuals would ordinarily consider too risky is judged safe because of governmental policy. But the truth is that because of governmental meddling, people take far more risks, as well as leave of their senses, when agreeing to accept unsecured future payment promises from companies whose legal resources are so vast as to nullify any possible means an individual realistically has to make said company satisfy its pension obligations.

I find it ironic and sad that, thanks to governmental interference, yet another area of compensation has been mucked up. Rather than mandate a company cash contribution into individual retirement accounts, our government allows companies to run the private equivalent of the Social Security mess- undivided, massive pools of pension funds which are unequal to the claims against them.

In all probability, Congress probably thought it was “protecting” workers from their own naivete in managing their pension savings. But do you really think most individuals would have done this bad a job on their own? Winding up with their entire pension held hostage to the probable bankruptcy of a once-large manufacturer, GM?

Who can afford much more of this kind of “protection” by our federal government?

GM: Step Up and Step Down ?

At this point, besides Kirk Kerkorian, who do you think actually wants to, and does, own GM stock?

Some wags refer to GM as a company ‘run for the benefit of its retirees’ health care expenses.’ Perhaps so. According to information mentioned on CNBC yesterday morning, a significant portion of the stock is owned by employees and retirees. So maybe it’s justice that the firm seems to now exist to pay their medical expenses.

Seriously, who in their right mind would hold or buy this stock now? Does anybody really feel it is a comparatively attractive equity play? GM’s situation has gotten me to muse about why people still hold a stock like this. And that, once issued, someone has to own the shares. How odd. You could have all this equity out there in one company being used in a gigantic game of pass the financial trash.

And what about the board endorsing Rick Waggoner in his role of presiding over the slide toward bankruptcy of what was once the world’s largest automotive enterprise? Are they sticking with the devil they know, simply because a new CEO would take even more time to sort this mess out? Or because, embarrassedly, nobody else would take the job now?

I saw an interview with one portfolio manager who actually holds a lot of GM stock. When asked by CNBC interviewers what he hoped would happen, he kept saying he expected the board to “step up” to the task. This was echoed by a corporate governance pundit as well. When pressed, neither would elaborate.

Do they really mean that Waggoner should “step down?”

Successful Second Acts

Last night, my friend Dr. Larry and I were discussing the day’s equity market activity. As he was bemoaning his lackluster Home Depot position, I opined that the company had once, long ago, been among my consistently superior portfolio selections, but that it hadn’t returned to being in that group in many years. He asked if very many large-caps ever could produce a successful “act two.” I’ve been musing about that this morning. Actually, the question has flitted in and out of my mind for a decade. Are there explainable successful second acts among large-cap companies and, if so, are there common characteristics among them?

After reviewing my portfolio strategy’s selections over the past fifteen years, a pattern does become clear. Companies that sell discrete items or services that are not considered “technology” may regain the characteristics of consistent superiority, i.e., consistently above-average revenue growth and total returns. Retailers, white goods manufacturers, apparel makers, pharmaceutical companies, financial services companies and other producers of discrete products and services are examples of this. Software makers are not.

If you think about “technology” companies, many of them, by their very nature, will only have at most one significant period of consistently superior performance. Various generations of computing platforms, such as mainframes, minicomputers, and, yes, even personal computers, seem destined to experience only one explosive period of superiority. After that, either growth rates fall with saturation, or the investment community learns to expect appropriate performance from the maturing firm, and returns no longer out-perform the market.

Software is even more prone to obsolescence. It creates the “installed base” or “legacy” problem, even as it provides a convenient price/performance target for the next generation of solutions to exceed. I first became acquainted with the installed base issue while at AT&T. While electro-mechanical telephones did not have software legacy issues, the time and expenses involved in servicing its vast installed base of older telephone equipment caused AT&T to carry a burden for years. Due to regulatory constraints, the firm was unable to recapture competitive profits on the expensive older base. Yet, early termination of the equipment would have thrown huge numbers of existing customers into the market at a time in which AT&T’s market share was slipping, causing its cashflow to shrink just as it had to fund new digital communications products.

For a firm like Microsoft, the legacy challenge is perhaps even more daunting. The firm must provide reasonable portability between generations of its products for its customers, even as it attempts to remain competitive with new entrants on performance and price/performance bases. This probably accounts for much of Microsoft’s slowing new product introduction rate, as well as the lack of significant new “killer applications”. Worse still, eventually moving to a web-based access model competitively priced to rival new entrants such as Google is likely to force it to devalue its own core products without additional new sources of revenue.

But let’s return to the initial focus of this piece. Actually, retailers like Home Depot, Wal-Mart, Kohls and Bed, Bath and Beyond have a greater probability to return as consistently superior portfolio selections in my strategy, after falling out of the group, than many other companies. This is because they satisfy frequently recurring customer needs, yet they don’t have to design or manufacture their products. As end-distributors, they simply need to continually offer the best choices of relevant products, and be well-managed. This is not to say it will happen all that often. Dysfunctional cultures and myopic management are still the rule among most US large-cap corporations. However, since consistently-superior revenue growth is the single hardest business phenomenon to create, these companies have the advantage of serving recurring needs of fairly large sized customer bases.

As I observe this week’s continuing business media fascination with Microsoft, it baffles me that they can’t grasp the fundamental nature of technology companies. The latter compete to solve specific customer needs with a (typically) proprietary or unique technical solution. The solution requires substantial resources dedicated to a particular methods, technologies and capabilities. When another company eclipses their solution, why would any intelligent person think that the once-successful vendor should be able to simply technologically leap-frog new competitors to reclaim its past pre-eminent position?

After the Peak: Microsoft Part 2

To see an example of how Bill Gates should be approaching his second act, consider his sometime-nemesis, Steve Jobs.

Jobs has demonstrated a talent for successfully implementing two, perhaps three, business visions. However, to do so, he started Pixar separately from Apple. He didn’t attempt to create it as a division of the latter. Rather, Pixar is about entertainment technology. Who knows how warped its development may have been, were it to have been birthed within a personal computer maker. It seems to be in the nature of human behavior, especially for leaders of previously successful enterprises, that these people seldom lead those organizations to long-term domination of a product/market across technological divides.

It’s interesting to consider that Job’s, and Apple’s, latest and greatest invention, the iPod line, occurred after Pixar. Perhaps Jobs appreciated the needs and solutions for personal entertainment better after having created and successfully run an entertainment-related company. The iPods are a far better concept and implementation than the Apple Newton was in its day.

However, contrast Jobs and Apple with Gates and Microsoft. The former created a radically new business by starting from scratch. The latter are attempting to recover from several product/market defeats with a biased, existing culture. Even Ray Ozzie, Microsoft’s new visionary team member, is on at least his third organization. To him, it’s a new culture and environment, so he isn’t limited by Lotus or Groove Networks.

However, Bill Gates is still at Microsoft. Despite Ozzie, whatever Microsoft does to compete with Google will look a lot like, well, how Microsoft would do online/internet services.

For an example of how wrong this can go, consider this. In my youth, when I joined AT&T, I met veterans from the company’s first large-scale digital PBX development team. They described how Bell Labs product developers had originally provided access to computer software on the product via four-digit numerical access codes. While everyone else in the world was using computers via full keyboards, these guys were going to give their users access via numeric touchpads on a telephone. It was simply the world they knew.

I think Gates will have much more success by simply putting Ray Ozzie in charge of a new company, funded by Gates/Microsoft, to pursue the latter’s latest visions. It will bear none of the cultural burden and ponderous size of Microsoft, both of which are sure to be handicaps in the race to compete with Google, Yahoo, et.al. You can’t really believe that Microsoft’s employees feel totally free to change direction with Gates’ personality still in resident. That’s not to say Microsoft can’t develop online service versions of their current product portfolio. But at this point, who cares? Nobody else is competing in those now-commoditized and basic niches anyway.

Mind you, I don't think this takes away any credit whatsoever for what Bill Gates did with Microsoft. He performed a very successful wealth-creation job. Nobody should discount that. It's just that now, Microsoft's time is over- like GM's, IBM's, AOL's, etc. These companies have already seen their most creative, consistently-superior wealth-creating days. They are now simply large, slower-growth, mediocre remnants from once-hot product/markets.

When I began these two latest posts, I was focusing on Bill Gates and his belated attempts to not just change the direction of his supertanker that is Microsoft, but actually rebuild it in the water en route. What I have concluded, surprisingly, is that the really great role model for radical corporate change is Steve Jobs. He had the courage to found an entirely new company (two, actually, if you count Next) in order to implement part of his digital vision. And probably used that to pollinate Apple with ideas that led to the iPod line and iTunes.