Berkeley's Haas School's Dubious Move Into "Socially Responsible" Investing

This Tuesday's Wall Street Journal contained an article detailing the University of California, Berkeley's Haas Business School's new program to teach its MBA students about asset management. This will be done via a new, "socially responsible: fund, the $250,000 of initial capital for which was donated by Charlie and Doris Michaels. Mr. Michaels is a Haas alumnus and currently president of Sierra Global Management, to be managed by Haas students.

From the interview with Kellie McElhaney, the faculty member who is director of the Center for Responsible Business at the Haas School, we learn that the intent of the program is to teach MBA and MFE (Masters of Financial Engineering) matriculants about investing.

Just on this information alone, I have grave concerns about the direction Haas is taking business education.

In January, I wrote this post, commenting on an article in the Wall Street Journal regarding the very theme of this new Haas program, "socially responsible investing." It wasn't very pretty. Not at all.

I will cite just three passages from the Journal piece by Jon Entine, a fellow at the American Enterprise Institute, which I also cited in the January post,

"The social investing community also suffers from the hubris that it can separate the good guys from the bad guys. The Times report mentioned that half of the children attending a high school in South Africa suffer from asthma and other respiratory disorders that the Gates Foundation is committed to eradicating. It noted that a nearby refinery that spews out pollutants is owned in part by a foundation-held company, BP. Outrages like this would not happen, the Times suggested, if only the foundation would use socially responsible rating services of firms like the Calvert Group in Bethesda, Md. So much for investigative reporting. Calvert not only invests in BP, it praises the company as an environmental leader. For the record, Calvert added Enron to its approved list in March 2001, just as its ethical house of cards was collapsing, and also owned HealthSouth, ImClone and other ethically-challenged firms.

The dark secret of "social investing" is that it is neither art nor science: It's image and impulse. It reflects perceptions, not performance. Years ago I did a report on the Body Shop, the U.K.-based cosmetic company whose founder, Anita Roddick, was hailed as the Mother Teresa of Capitalism. In the early 1990s, the Body Shop was the world's most popular "socially responsible" investment. It was touted for its natural products, charity, fair trading and integrity. I discovered that Ms. Roddick had stolen the name, concept, product line and even its brochures from the San Francisco-based Body Shop that started seven years before she opened her copycat version. Ms. Roddick fabricated her history; she gave almost no money to charity over the company's first 11 years, and has given meagerly since. The Body Shop's products were made mostly from water and cheap petrochemicals; it had a record of exploiting poor Third World producers; and its franchise system was riddled with mismanagement, which eventually resulted in the company paying more than $500 million to buy out dissidents and diffuse fraud suits. My report sent the company's stock down by more than $600 million -- causing great anguish to social investors -- and contributed to a 10-year tailspin that resulted in its being sold.

It should come as no surprise that a recent Wharton study calculated that funds that layer on ideological screens often perform worse than the general market by about 31 basis points a year, a huge discrepancy. Domini Social Equity Index, considered the gold standard of social index funds, rates a lackluster C- in Business Week's latest ratings. Calvert's Social Index Fund has lost 1.82% since its inception in 2000, ranking it in the bottom 15% of all funds. Now Bill and Melinda Gates are being asked to turn over investment for billions of dollars to these same social researchers?"

Well, at least the kids in the new Haas program don't have such a high hurdle to clear, in order to beat the average "socially responsible" fund's returns.

Seriously, though, Entine's piece suggests that the Haas program is, to be blunt, folly. The very credentialing process by which firms are judged to be "socially responsible" looks to be pure art, and easily fooled, at that.

So how are 10 MBA and MBE students going to outwit the fraudsters who, for a living, fool professional investors on this dimension?

Then there's the "MBE" matriculants.

As I contended in my recent video post, here, the 'financial engineering' degree represents yet another step in the continuing degradation of the MBA into a purely narrow, technical degree, now far removed from the certification of general business management knowledge and capability for which it used to stand.

As Wilbur Ross hilariously commented, cited in this post, from one of his appearances on CNBC this summer,

'When someone mentions two words, financial engineering, you know it's really an attempt to underprice risk.'

Great. Now we have burgeoning degree programs designed explicitly to teach new wunderkinds how to parse, conceal and pass along mis-priced risk.

Haven't we just learned what systemic folly this is in the past two and a half months?

However, perhaps the most chilling part of the Journal article, for me, was these two passages,

"Will this experience give students the skills they need to land jobs with funds that have a social-responsibility focus?

Absolutely. It will give them a competitive advantage over students with just course work on social responsibility or just investment experience. There have been a lot more SRI funds created in recent years, and I see an increasing number of job opportunities out there. What I have yet to see are the traditional investment houses posting jobs for professionals with SRI experience. But I hope I will be able to send more knowledgeable students into the traditional Wall Street firms where they can raise social-responsibility issues from inside the companies.

Does this take corporate social responsibility to a new level in academia?

It definitely will because we'll have data. It may be negative, positive or inconclusive, but there will be data. We in corporate social responsibility are still really in the throes of proving ourselves to other academicians, and the only way we can do that is through research and data."

Reading these two passages, I don't whether to laugh, or cry.

With Entine's piece as background, the 'spread' of this disease to major institutional portfolio managers is likely to depress already-mediocre average returns, for which fund owners pay good money.

To further state that this program will 'prove' anything to anyone is laughable.

Rather than take even $1MM, ten students, dubious criteria for "socially responsibility," and actually buy and/or sell short various equities, wouldn't it be more useful to task these students to rigorous, refereed papers of the sort financial academics write, to attempt to refute research hypotheses concerning "socially responsible" investing and the performance thereof?

With only $100,000 apiece, these students won't impress anyone in the industry with their performance. Believe me, I know. It takes about $25MM before anyone pays serious attention to an investment track record.

However, financial theory is routinely advanced through the use of rigorous theory development, implementation via backtesting, and analysis of the results. Each of ten students formulating different "socially responsibility"-related hypotheses, then testing them over long periods using market data would produce more, and more convincing results, in my opinion, than the Haas' new, tiny investment laboratory.

Credit Markets: Is Evolution a One-Way Process?

A recent piece in 'breakingviews.com,' a feature on the back page of the Money & Investing section of the Wall Street Journal, touched on an interesting point.

The notional headline concerned whether investment banks/brokers may be bought by, or merge with, commercial banks. The contention is that banks have certain regulatory and accounting features which happen to allow them to weather the current sub-prime mortgage-sourced credit markets turmoil.

For instance, banks may borrow at the Fed's discount window for liquidity purposes, to avoid selling prime assets to raise cash. Brokers may not do this.

Banks may use their discretion in valuing questionable assets by placing them in an 'investment' account, thereby avoiding the need to mark them to current market value. Brokers must carry all of these types of assets at the best current market value they can deduce, regardless of the loss to the brokerage firm that such valuation may entail.

The column simply addressed the potential for mergers of banks and brokers. Perhaps brokers are merger fodder for commercial banks.

But a larger issue struck me in this piece. Maybe credit markets went too far in their evolution to total market pricing of credit and debt.

Commercial banks seem, after all, to have a few advantages that were unapparent in a consistently up-market.

Could it be that, rather than a uni-directional march toward market pricing and underwriting, credit markets are, in reality, about to swing between extremes? Moving from all-bank balance sheet valuation and warehousing, to heavily market-priced and securitized, and now back toward the original pole of bank-sourced and distributed credit instruments?

It's not something I've read anyone else hypothesizing. Even I just assumed that banks had pretty much become a mere origination platform for credit.

Now, with this latest credit market debacle, the first since really heavily asset securitization of mortgages and corporate loans have kicked in, we are learning that there are market conditions under which non-banks may not be viable for very long, if they originate and/or hold volatile fixed income assets.

It's an interesting phenomenon. Who would have guessed that there was life in the old commercial bank model, yet?

Back in my days at Chase Manhattan, our group's boss, Corporate Planning & Development SVP Gerry Weiss, attempted a number of efforts calculated to move Chase into some sort of arrangement with a US investment bank, in order to, as he put it, so to speak,

'get their management in charge of our assets, with the advantages of our regulatory structure.'

Therefore, it's ironic to me that something like this might happen. Sure, Sandy Weill agglomerated a bunch of different piece parts to form the now-unwieldy Citi bank. But Salomon and Smith Barney are now almost lost inside of it. And the bankers remained in power, as the investment banks they took over had been weakened by various events.

Now, it would be possible to see a Chase or BofA take Bear Stearns, for example.

An interesting development in the quest for a viable, efficient, profitable organizational structure with which to transact fixed income businesses.

GE's Immelt To Be Next (Democratic) President's Secretary of Commerce

Last week's Friday Wall Street Journal carried a page-one article extolling GE CEO Jeff Immelt's tackling of global warming with his firm's "ecoimagination" program. A program so important, it even has its own manager- Lorraine Bolsinger.

I won't go into details- you can find the article and read it. But suffice to say, Immelt's got a lot of unhappy power generation customers on his hands. Mostly coal-fired utilities and such.

Even within GE, many are angry at him for pushing to make ecological footprints of the company's businesses on a par with growth and profits.

Let me be just a wee bit cynical here, and suggest what is really going on.

Could Immelt be showcasing himself to be the next (Democratic) President's: Secretary of EPA, Commerce, or (gasp) Treasury?

Perhaps realizing he's already ruined GE in terms of long run growth prospects and lackluster under-performance during his current CEO tenure, he will go green. He can complain that "big business" just does not "get it."

Wouldn't a John Edwards or Hillary Clinton eat that up? Good cover, just like Bob Rubin was for Bill Clinton. A bona fide corporate chieftain joins the eco-camp and demands that business come to heel under the newly-green hobnail boot of the Federal government.


Thereby becoming highly useful cabinet material for a green Democratic President. Or even a moderate Republican.

By pretending to grapple with ecological issues at GE, involving customers, the EPA, talking about carbon caps and trading, etc., he actually benefits from failure to make much headway. He can cite his futile efforts as having given him depth and breadth of experience in the politics of corporate pollution and eco-business, while aspiring to go into 'public service,' where, thanks to his travails at GE, he will now realize the real source of power is to effect corporate eco-change.

Failing to nab the EPA job, which would be a power portfolio in a Democratic administration, Immelt could easily try for Commerce or Treasury, citing Carlos Gutierrez or John Snow as recent precedents.

With his tens of millions of dollars of cash compensation from GE, and much more in deferred compensation, Immelt is well-positioned to leave GE considerably wealthier, personally, than he has made his shareholders. No need for further headaches trying to lift GE out of the dumpster of long term, consistent total return under-performance. Just declare victory, or frustrating eco-defeat, and head off to Washington.

In the wake of Immelt's departure, GE will perhaps fall to a group of private equity firms, newly-emboldened by the Fed's newly-cheap funds, and be split up into its constituent parts. Which, as I have argued in prior posts involving GE, would be a natural and beneficial end to the company, as it is currently structured, in terms of shareholder returns.

Admittedly, it's a wild card scenario. But if something like this happens, you read it here first.

On MBA's, Financial Institutions, and Market Pundits

GM's Short-Term Surge

Saturday's Wall Street Journal carried the usual broadbrush coverage of the prior day's equity markets activities.

The headline of this edition's article, however, caught my eye. It read,

"GM Shares Surge 16% on the Week"

Do tell!

My equity portfolio, run according to my proprietary equity strategy, is up just shy of 20%, gross, as of the end of Friday. So GM's performance, while not quite up to my portfolio's, is indeed, well, eye-catching.

As this nearby Yahoo-sourced chart of GM's recent six-month price shows, it's been very choppy.

You would have had to hold GM for just the right period to gain this 16%. Sell to early, and you're out of luck. Buy too late, same thing.

For instance, this chart of the past year of GM's price performance is much less appealing. Over the past twelve months, the stock is up just a little over $2/ share, or less than 10%.

It's a lot like the market dynamics which I profiled in this recent post on the S&P's total ten-year performance tending to be concentrated in just 10 best days of the decade!

For reference, here are the same two GM charts, with the S&P500 Index added.

For the last six months, GM is significantly ahead of the index. Of course, much of this is a result of the past week's speculation on the outcome of the current labor contract negotiations between the firm and the UAW. Prior to that, GM's return had bounced down to 0%. Twice, since August first.

Over the past year, The S&P has outperformed GM for nearly the entire period. In the few days or weeks where GM was on top, it was briefly, and not by much.

Clearly, much of the play in GM's stock has to do with the UAW contract risk.

Hardly a company in which to make a long-term investment, is it?

Thus my continuing emphasis on consistently superior total return outperformance. Attempts to capture short-term, speculation-fueled returns like those of GM are fraught with excessive risk.

Greenspan's Non-Monetary Opinions

I was going to write this post in a few more days, but given all the hoopla surrounding Greenspan's weekend tour of the media, I think I'll post it today.

Let's face it, Alan Greenspan is an economist. He was a Fed chairman. He's a monetary guy.

Why do we care what he thinks about fiscal policy, more than any other economist who is not a sitting Fed member? Granted, Greenspan is a good economist. But we don't need him to tell us that the Republican Congresses of the past few years failed to restrain spending. And that President Bush might have used his veto more than he did.

I already knew this, Alan.

Frankly, who really cares what he thinks about Congress and the Fed?

And, further, why do I care what Greenspan thinks about Iraq? He happens to agree with Bush, and, therefore, with my own views. But I honestly do not care. He wasn't Secretary of Defense. He was Fed Chairman.

Do I look to Don Rumsfeld to remark on the Open Market Committee's actions? I do not.

Now there's even discussion that Greenspan botched the handling of LTCM. Greenspan is on the record as re-writing his reactions to that debacle. He was never as 'pre-emptive' in his own chairmanship as pundits now criticize Bernanke and his Fed for not being now, amidst a credit market turbulence.

Further, as Joe Kernen remarked pointedly this morning on CNBC, Paul Volcker never did what Greenspan is now doing- breaking silence with his retrospective, and forward-looking, views on the Fed, the economy, etc. Kernen noted Greenspan's response to Leslie Stahl, that he 'has to make a living,' as the reason why he's written the book he is now touting on the talk show circuit.

But, as Kernen further observed, Greenspan doesn't need the money. Both he and his wife, Andrea Mitchell, have done very well in private industry- he as an economics consultant, she as an on-air media personality.

I think Greenspan is doing the country, and himself, a great disservice with his book and outspoken second-guessing of current monetary policies. It seems to me to be a lot of hand-wringing and excitement over nothing.

The Future of Streaming Video

The Wall Street Journal's guest column, 'breakingviews.com', had an interesting, if misguided piece on the future, or lack thereof, of streaming video.

Robert Cyran, evidently someone connected with the firm/website, writes in today's column that Netflix, among others, is pursuing the wrong technology/strategy, by concentrating on delivering video content via streaming.

Cyran argues that with download speeds allowing storage of a movie in only 20 minutes, more people will buy movies, rather than just view them via streaming. He cites the migration of audio from streaming to the iTunes model as further evidence that streaming can't compete with storage/ownership, once bit transfer rates are sufficiently high.

I think Cyran is dead wrong. Here's why.

First, most people whom I know, other than children, which is to say, adults, don't watch a movie very frequently in a short space of time. The desire to own a movie for frequent viewing is, I contend, not all that common.

However, music is different. We take our favorite music with us everywhere on iPods and MP3 players. I have listened to some songs, I'm sure, many hundreds of times. And will hundreds more. So I own that music.

At the iTunes store, I buy tracks, rather than use alternative systems which make me pay monthly to store rented audio content.

Thus, I contend, the audio example is not relevant to video content. Too, audio tracks are priced less than a buck a piece. It's almost a mindless purchase.

But what about all those sales of movies on DVD? Well, that's different.

When VHS came out, and movies were duplicated mechanically on VCR tapes, buying a copy of a movie was expensive. Some people did that, but it was pricey.

DVDs, in contrast, requiring a much cheaper duplicating process and materials, were, thus, less expensive to buy. The difference between buying and renting would be so small that, at volume retailers such as Wal-Mart, people just bought a copy of a movie, rather than pay little less, and only rent it at Blockbuster.

Now, however, the content is available digitally. On demand.

And that, I contend is the difference.

Now, I know that, in time, any movie or TV program episode I want to view will almost certainly be available somewhere, for 'on demand viewing.' Netflix prices by time, not title, so there's no reason to buy any single title. I can watch the same movie constantly, for no additional charge, other than the time I spend viewing it. Which works out to something like $1.50/movie.

So with all this content coming available as on demand streaming, why would I pay money to own video content I don't view too often, when the same dollars provide me with constant access to any video content?

Personally, I think Cyran has it backward. Even with computer storage devices becoming larger and less expensive, more applications are moving to the 'net. Look at Google's office productivity suite. Even Microsoft has quietly begun moving that way.

Cyran closes his piece with this statement,

"From a technological perspective, a song is similar to a small movie. It is likely that video will follow in music's footsteps."

Cyran may be correct, technologically, but he's totally overlooked the different behaviors people have toward music and video. You may listen to music as passive background filler, but video tends to command your total sensory attention. They're not at all the same, and I don't believe the future of their digital delivery will be, either.

Apple In The News Again

I noticed Apple corporation has been in the news again recently. In fact, I wrote a post about Apple's latest product introductions here, within the past week.

On that point, Herb Greenberg, a periodic contributor to the Wall Street Journal's Weekend edition, and columnist/analyst for MarketWatch, penned a piece calling Apple's recent price cuts into question. Essentially, Herb noted the recently-emerging disparity between volume growth of iPods, and the revenue growth rates corresponding to those unit growths. The price cuts, say Greenberg, should cause shareholders to worry that product maturity has finally caught up with Apple and its signature product line.

I like Greenberg. He's one of my favorite guests on CNBC, even if I don't always agree with him. His irreverent, often-minority viewpoint attracts my attention.

Even in his Journal column, Herb quotes another analyst, one Charles Wolf, as noting that the real growth in revenues for Apple's iPod line come from the halo effect it has on other Apple products and services- the Mac computres and the iTunes online store.

In this, I think Wolf is correct. Apple has more than a single hot product line. It has an entertainment system. As I've noted before, you can quibble all you want about its compatibility with MP3 players, and the copyright protection. But nobody forced anyone to buy iPods. They simply are compelling price/performance offerings.

All those iPod owners have helped fuel the iTunes store revenues, no matter what Jobs wrote earlier about how much stored iPod music is ripped off of CDs already in the owners' possession.

Granted, Greenberg charts Apple's declining rates of unit and revenue growth of iPods over the last two years. I don't think this is news to either Jobs, or the firm's management team. In fact, I'd say the recent spate of new products and lower prices is calculated to ignite both growth rates, due to totally new price/performance points. Certainly Apple has done for the iPods, by adding video screens and capacity, something Forman's grills, with which Greenberg compared them, never could.

One Forman grill is pretty much like another. Yes, the larger sizes and removal grill plates are nice product line extensions. But not so vital that most people would replace their existing grill. I haven't. Part of their original allure was the incredible ease with which they can be cleaned. Who really had to have them removable?

The new iPods are very different. Whole new, valued functionalities are included, at dramatically lower prices.

Speaking, or writing, of Apple's entertainment system, another Journal article mentioned that NBC is removing its video content from iTunes after their contract expires in December. Apparently, Fox and NBC hope to collaborate on their own, new online video site.

While I still believe there won't be just one site which all video viewers learn to visit, as Comcast's CEO contended some months ago, I believe a few, such as YouTube and iTunes, tend to predominate their respective product/service spaces.

Will people re-learn to visit iTunes for music and some videos, then skip over to Hulu.com (the new NBC-Fox site), remembering their TV program shopping list while they buy more content there? Perhaps so, perhaps not. I suppose die-hard program fans will do that, if they haven't already visited the free replay sites right after the episodes aired. Or wait to rent them on Netflix.

Personally, I think Apple is still in the driver's seat on this one, because of formats. Will the downloads on Hulu support iPods? If not, will iPod users bother?

GE/NBC is too diversified and sprawling to have anywhere near the intellectual horsepower and financial incentives to attract sufficiently talented people to out-manage Apple on this. Fox is similar. Apple, by contrast, tends toward laser-like focus on their few product lines- music players, downloading services, computers, and now, phones.

Besides, Apple has Jobs. Neither Fox nor GE appear to have a similarly motivated, talented key executive facing off against Jobs in this matter.

In accordance with my recent piece on financial institutions, competitiveness, and diversification, it should be no surprise that my money is on Apple in this fight.

Equivocation from the Pages of The Wall Street Journal

Last week, the Wall Street Journal published a rather equivocating piece by one of it's columnists, Justin Lahart. I found the piece to be, at best, a waste of time and, at worst, supporting and advocating specious analysis regarding Fed rate cuts and subsequent investment performance.

Consider these quotes from the Lahart's piece,

"Perhaps some of the rules are changing. Investors tend to believe that interest-rate cuts are good for stocks. Research seems to bear that out....

But interest rate cycles don't always appear to be a great guide to stock performance. In the 1960's, for example, stocks did well even as interest rates were rising. It would be unwise to ignore the past 33 years of history, but it might also be unwise to put too much weight on them."

Gee, thanks Justin. Glad you could add value on this issue.

Does Lahart fill us in on inflation rates during the periods involved? That might help us understand the effect of Fed rate cuts, in that the overall market and economic contexts clearly matter. How about GNP growth during the periods, too?

Oh, and what about the market impact of technology in at least three ways: the advent of derivatives trading; computerized trading technology, and; availability of information via computerized technology, to more rapidly and thoroughly react to fundamental and technical information?

Does anyone really believe that you can just compare one activity or measure, such as Fed rate cuts, over time, and assume it will soak up/account for total variance of something like overall stock prices?

Not only is Lahart's piece of no actionable use, it questions credulity as to its reasonability.

I wonder if this thesis would even rate a grade of "D" in any graduate economics course. I expect better from the Money Section of the Wall Street Journal.

Don't you?

Money Center Banks as Investments

Last Thursday, the Wall Street Journal ran an article entitled, "Do-It-All Banks' Big Test."

In it, Robin Sidel focused on how the nation's largest three commercial banks- Citi, Chase, and BofA- will be able to whether the current turmoil in the credit markets.

Her emphasis was on profitability, losses from exotics and mortgage lending.

She quoted one Robert Maneri, a portfolio manager at an also-ran bank, KeyCorp, of Cleveland, as saying,

"These banks rarely hit on all eight cylinders at the same time, but they can make a pretty good profit hitting on six out of the eight."

True. My old boss, Gerry Weiss, one-time SVP of Corporate Planning and Development at Chase Manhattan Bank, used to note,

'Despite our ineptitude, we still make a lot of money. Can you imagine how well we'd do if we really tried?'

Sadly, they never actually try. I conducted extensive research into the performance of a wide variety of financial service firms, while Director of Research at Oliver, Wyman & Co., now the financial services unit of Mercer Consulting.

What I discovered is that universal banks and diversified brokers/investment banks almost never attain consistently superior total return performance, relative to their industry index. Later, I found the same to be true for them regarding the S&P500, as well.

The Yahoo-sourced price charts for Citi, Chase, BofA, and the S&P500, for periods of 1, 5, and longer numbers of years, appear in this post.

All three banks have drastically underperformed the index over the last year, as shown in the one-year chart.

The five-year chart, which appears nearby, finds only Chase outperforming the index over the past five years. But most of the outperformance can be traced back to early 2003- well before the current conglomeration. Otherwise, Chase has more or less mirrored the index, and the other banks.

Only looking back much further, to the mid-1970s, do we see Citi significantly outperforming the S&P. In this case, we see BofA and Citi even with the index in 1996.

It is essentially the next five years that account for Citi's current return lead over the index during this 30-year timeframe. Even then, it experienced a severe dip during those five years, in 1998- the Asian crisis and LTCM debacle.

Hardly 'consistently superior total return' performance, is it? More like a lucky five years over a period of 30+ years. The other two banks, ending up below the S&P over the same period, couldn't even manage that and hang on.

Avoiding risk and loss is not the point of super-money center banks. Consistently superior total returns is. And none of them have demonstrated the ability to do it. Ever.

It's extremely unlikely that these companies will ever achieve such performance going forward, either.

Why?

Basically, because they are too diversified. Last December, I wrote this post, in which I quoted Kirk Kerkorian said,

"Diversification is for people who aren't sure about what they are doing."

Just so. Money center banks are in so many businesses that one is always blowing up. Same thing with large investment banks. This is what I learned in my research at Oliver, Wyman.

The only types of financial service firms which showed themselves capable of consistently outperforming their sector index were mono-line firms: credit card companies, asset managers, and mortgage bankers. They would have streaks of several years of outperformance, then fall back to earth. It's just the way Schumpterian dynamics works.

However, by being focused on one or just a few businesses, these companies were able to actually grow fast and profitably. Money center banks just can't do this. They're too big, complicated, and costly to run.

Even back over a decade ago, when I was a senior strategist at Chase, my SVP, Gerry Weiss, noted how complicated a money center bank was to manage. That it was probably beyond most of the best CEOs in the country- and we didn't get them. We got loan officers who had been promoted too far.

So I think Ms. Sidel is focused on the wrong measure of success. Money center banks may well avoid disaster in the near future. But they won't be worthy of investing, beyond some lucky timing plays.

Countrywide's Mozillo's Irresponsible Letter

The weekend edition of the Wall Street Journal carried an article focusing on Countrywide Financial's 20% cut of its work force, and selected quotes from the related letter by CEO Angelo Mozillo to employees of the firm.

In my opinion, at least one part of the letter was totally irresponsible, as well as misleading.

For instance, the Journal article cites Mozillo as writing that current downturn is the

"most severe in the contemporary history of our industry."

Let's consider that statement from a few angles.

First, it appears to let Mozillo off the hook as CEO of Countrywide, as he is about to fire 20% of his employees. It's as if he's saying,

'Hey, people.... It's not my fault...look at this terrible market...yep, most severe ever.....'

Nice try, Angelo. But didn't you lead the charge with alt-a and sub-prime loans? Aren't you CEO? Shouldn't you have been appropriately hedged, and have obtained longer-term, secured lines of funding, to avoid cashiering a fifth of your workforce? Just weeks after declaring that this shakeout was great, as your firm would take increased market share in the mortgage sector?

Then there's the lack of context of Mozillo's comment. Does it not arguably follow that the 'most excessive upturn' in the industry's contemporary history was followed by its 'most severe' downturn? Seems reasonable to me.

Was that excessive upturn not led, in part, by Angelo's company's "innovations?"

It's not only the mortgage banking industry that has had trouble with explosive growth. Look at, in their time, Boeing, the railroads, Advanta, and Atari, to name just a few.

This is pretty much your average story of a firm letting details go, loosening operating standards and, as befits a financial firm, scraping ever-lower down the creditworthiness scale to find customers. All of this finally came home to roost, and Mozillo would have you believe it's someone else's fault.

Maybe he's watched Bear Stearn's Jim Cayne's attempt to blame 'the market' for Bear's fund management woes, which I described here, and figured he'd give it a try, as well.

Apparently one of the behaviors we must now live with in this age of instant electronic communications is that of CEOs getting out in front of an issue and pointing their fingers at anyone and everyone else in blame, rather than take responsibility for their own actions, or inactions, as the case may be.

(Southern) California Dreamin' : Real Estate Woes

A friend of mine who works in the Southern California real estate industry spoke with me at length about a week ago regarding the status of the sector, buyers, and her own firm's experience.

In order to disguise her firm and the major project on which she works, I'll leave details vague.

However, what she explained both reinforced my sense of the nature and extent of the country's mortgage problems, as well as highlighted how detached from reality a particular locale can become.

One clear signal that the credit woes of the housing market are having real effects is that instead of her project's escrow closing late this fall, she now casually remarked that it won't close until, I believe, sometime late next year. In fact, there was evidently some question as to whether the entire venture was still viable. Which is why I'm being careful to completely avoid any reference to the project, beyond noting that it is residential in nature, and in southern California.

When I related MarketWatch's Herb Greenberg's observations that southern California real estate "values," meaning notional asking prices, in places like Riverside, had risen far above the national average home price, my friend agreed that the regional real estate market had become unsustainably over-valued.

Thus, her firm's project was already selling into an over-priced market, on a national basis.

Yes, I know, you're saying,

"But don't you realize, real estate is local?"

Well, yes, and no. Yes, if it's priced within reasonable, national parameters. No, if it's not, because of the securitized nature of the broad market, and the specialized nature of jumbo mortgage financing.

Put the two together, and you have expensive real estate projects which rely on short-term construction financing, and consumers taking jumbo mortgage loans to buy them, depending upon a very precarious long term credit market.

As I spoke of this situation with my business partner, we agreed that the only way my friend's project could have become insulated to credit forces was to have secured long term lines of construction financing, and, then, secured forward commitments to lend to its buyers who met certain criteria, from jumbo mortgage lenders. Absent such arrangements, a project such as my friend's, located in an area of stratospheric housing prices, was bound to be among the first to experience difficulties, once the credit market tightened.

Did I mention, by the way, that my friend told me she does not know of one person, directly, who has not bought a home in southern California without using two mortgages? The main mortgage for 80% of the purchase price, and the piggybacked alt-A or sub-prime for the remaining 20%.

That second part? That's what we in the Midwest, where I grew up, and even out here, in the East, call the "down payment." That's the part that assures all other parties that you have sufficient personal equity invested in your commitment to buy and pay for your home.

My friend is well aware that the California market, like Las Vegas, Florida, and a few other well-contained markets, simply became over-priced, with respect to what the now-national, if not global, ultimate holders of mortgage paper, would consider affordable by the borrowers.

Thus, new residential purchases on the same old terms is finished. And my friend's project is in somewhat dire straits. Essentially, they can only complete their sales by attracting buyers who can afford the full 20% down payment, in order to take a conventional jumbo mortgage for the balance.

It's ironic. My friend is educated, intelligent, and very competent. She chose to work in an area that, until recently, added considerable value to the local economy, and promised her substantial rewards for successful job performance.

No more. As she told me recently,

"I might well be able to visit you next week, or the week after. Because I may not have a job tying me down."

Such is the manner in which a thousand or more similar stories, combined, make for a national economic event. Everyone in California, in the housing-related sectors, knew that some of their real estate values were indefensible to the larger financial markets, should credit conditions change in a tighter direction. But they still behaved as if it would not, did not, matter.

Perhaps this fact, more than any other, demonstrates why financial-related businesses need to remain vigilant about creditworthiness. Financial lending bubbles and high-growth businesses always implode when lowered lending standards at least meet initial defaults and delinquencies. It has ever been thus, and, probably, ever shall be.

Today's Jobs Numbers: CNBC Fans The Flames of Panic

Where does one begin on this topic?

First, the facts, so to speak. Today's non-farm payroll numbers came in so low that they recorded a net loss of jobs in the US economy recently. Expectations were for a much higher number.

The questions now on the table:

Is the US economy now in, or about to enter, a recession?
Has the Fed dithered in the face of obvious data requiring a rate cut?
Does Ben Bernanke now 'have mud on him,' as a CNBC on-airhead anchor so callously asked?
Will the Fed now cut the Funds rate later this month and by how much?

As I write this at 11AM, EDT, the equity markets are falling. The S&P500 Index is off by about 1.5%.

It probably will not help that CNBC is prominently featuring guests who are screaming that we are now in a full-blown recession. Among those CNBC chose to lead this ill-advised, partially-informed charge, is none other than their resident self-annointed know-it-all, Jim Cramer.

Cramer, a journalist and lawyer by training, has no bona fides in economics. Nonetheless, he was featured this morning on CNBC, loudly and confidently proclaiming that 'we've been in a recession for months.'

I'll believe it when Brian Wesbury and/or John Rutledge confirm it. But on Cramer's uneducated hunch? No, thanks.

Is it necessary, or even ethical, for CNBC to be featuring such uninformed babbling in the guise of news?

Throughout this morning's coverage, the anchorman named Carl (I can never recall his last name) and most of their guests continued to look for the darkest implications of the jobs number. Carl was the one asking several guests if this single employment number did not now sully Ben Bernanke's entire reputation as Fed Chairman?

The way I view this is as follows. A single month's payroll number is announced. Whereas, in years past, some experienced, educated and trained economists would work with the data to arrive at some tentative conclusions, now we have a world full of amateur economists, analysts, and investors all reacting at once to the news.

Remember, too, that roughly 90% of those hearing this news are less skilled at investing or analyzing than the top decile. But they may well control the movement of more money in financial markets.

Thus, we are probably in for several days, if not weeks, of poorly reasoned reactions by the vast majority of (mediocre) investors.

Are we genuinely in a recession? It's not clear yet. I read some interesting information in the Wall Street Journal today referencing some research out of Goldman Sachs. The work is based upon dividing the US into 20 regions, and forecasting recession based upon how many regions are simultaneously losing jobs. In the past, eight regions with shrinking employment led to recessions. Currently, as I recall the article, twelve are in decline.

Time will tell. On one hand, one payroll report does not tell all. On the other hand, as another CNBC guest noted, the monthly payroll numbers have been shrinking, though still positive, for a year.

It could well be that the Fed will cut the Fed Funds rate by a quarter, or even half a point later this month. However, now it's likely to be to cushion the pain of a softening economy, not simply to bail out New York and Connecticut hedge fund managers.

Who Wants To Compete with Steve Jobs & Apple?

After Wednesday's announcements, would you want to walk into the CEO job at a competitor of Apple's?

Let's review what just happened.

After only 2 months on the shelf, Jobs has slashed prices and increased capacity/functionality of the iPhone. This is not because the iPhone was a failure. This is Jobs and Apples putting the big competitive squeeze on their competitors.

How can you compete with someone who moves the yardsticks so significantly in so short a time? I'd guess that if the firm you joined as CEO had hoped to have a competitive phone out by Christmas, now you will toss it in the dumpster as already obsolete, in terms of price/performance.

Jobs is now racing down a value-added/volume curve, pricing ahead of current volume, and about to reap tremendous value-added from the market for new iPhones, iPods, etc.

Rather than bid down the price of Apple's stock, as sellers have effectively done this week, I think the price will ultimately head the other way. Once the mediocre investors have finished dumping the stock, and the wiser investors scoop it up at a cheaper price.

Sellers of Apple stock miss the big picture. The firm has quickly and consistently improved every element of its product lines- computers, music players, phones, and the new AppleTV. These are the actions of a strong competitor which is getting even stronger and more dominant.

So a few iPhone buyers got stuck paying a lot to be early adopters! So what? This is normal in the electronics sector. Being first with a new toy (remember the Apple Newton?) always means paying full list, and then some. Boo-hoo.

From Apple, they should expect rapid follow-on at better price/performance points.

Everything I see in Apple's broad new product announcements screams strength and improved sales and profits going forward.

This is classic, textbook Schumpeterian dynamics at work. Jobs is cutting the footing out from underneath his competitors as he introduces new features to Apple's products and raises the bar for what is now default performance.

Personally, I own one of the original iPod Shuffles. If memory serves, I paid $100 for a half-gig model. Now, a new Nano has several gig of storage, a video screen, and costs only $150. I'm seriously considering an upgrade, just because of this new product introduction.

You couldn't give me a job as CEO of one of Apple's competitors in phones or music players and/or online music purchasing right now.

CEOs, Corporate Performance, and Houses

Yesterday's Wall Street Journal featured, as one of its three front page articles, a piece by Mark Maremont describing academic research into the relationship between various events and actions in the private lives of CEOs, and the stock price performances of the companies they headed.

The fact that this article was given such prominence tells you that the editors of the Journal feel it is important and reputable. Perhaps the most interesting and methodologically valid piece of research presented in the article was one by Yermack (Penn State) and Crocker (Arizona State) relating CEO home building and subsequent stock price performance of their companies. While it's worth reading the Journal article in its entirety, the short version of this particular research effort's result is to find that those CEOs who built/purchased large homes ( >10,000 sq ft) saw their companies' stock prices, on average, decline 25% in three years, while those with 'other' homes saw, on average, increased stock prices of roughly 20% by year three.

No measures of statistical significance were provided in the Journal article, although one surmises that one is available in Yermack's and Crocker's paper. Their approach was novel and inventive. They chose a single point in time, the end of 2004, and secured housing data on 488 of the S&P500 CEOs.

The basic premise being described, of course, is that of a CEO engaged in building or buying a large home is taking his mind and attention off of shareholders' welfare, and concentrating, instead, on spending his compensation on luxurious trappings of power. Among the CEOs mentioned in this manner, by name were: Leslie Wexner (The Limited), Stephen Bollenback (Hilton), and Trevor Fetter (Tenet Healthcare).

So far, so good...and simple-minded.

You see, there is another possible, and reasonable explanation for this phenomenon. But you'd have to be open-minded about observing and measuring corporate performance in order to see it.

My proprietary research has indicated that once companies have consistently outperformed the S&P500 Index on a total return basis for five or more years, the chances of this performance continuing falls precipitously.

Thus, a CEO building a large house with the fruits of her/his successful efforts at outperforming the S&P in the prior years would make sense. And the probabilities of continued outperformance would be slim, anyway.

Thus, Yermack and Crocker may have simply validated that succesful CEOs reap the rewards of their efforts for shareholders, and the game is over for a few years.

As I look at the nearby, Yahoo-sourced stock price chart of The Limited (Brands), Hilton Hotels, and Tenet Healthcare, all mentioned by name in the research piece, I draw a different conclusion than the study's authors.

To me, up through 2004, while the Limited struggled from 2000 onward, staying roughly even with the S&P, Hilton outperformed the index, and Tenet outperformed for about 4 years, then fell sharply.

Thus, I find Hilton and Limited to not be examples of the behaviors suggested in the Yermack and Crocker research. Tenet may be. It's declined has persisted since 2003.

The frame of reference you use, and what you know about potential corporate total return performance, matters in how you evaluate subsequent CEO behaviors after a period of good or great performance versus the index. I don't find the study that the Journal article spotlighted to be so bullet proof now as I did when I initially read of it.

Now, I would be very interested to know how their results would differ if they applied my knowledge of the probabilities of corporate consistently superior performance over time, versus the S&P, to their existing work.

The Union Picket Line: How To Explain This Anachronism?

It's funny how some things grow to be anachronisms, yet we don't stop to notice until someone else points it out.

For reference, Merriam-Webster's Online Dictionary defines anachronism as:

2 : a person or a thing that is chronologically out of place; especially : one from a former age that is incongruous in the present

The anachronism du jour is the union picket line. Let me explain.

Recently, the school which one of my daughters attends began construction on a new building. As a letter from the school's head noted, the construction contractor was selected on the basis of price and quality. Evidently, the lucky winner does not employ unionized operating engineers. We know this, because members of said union now constitute a small pair of picket lines across entrances to the school property which are used for construction materials, workers, and other school visitors.

Thus, throughout the long, hot summer, we have been treated to the sight of unkempt, largely overweight males standing, sitting, or sprawling on the nearby sidewalk, sometimes sporting signs which I have no doubt purport to explain their presence. On occasion, one of them dons a cloth suit made to represent a rat. On other occasions, a large, presumably inflatable rat is located at the other entrance.

I frankly didn't give all of this hoopla much thought, until my daughters each asked, independently, what this odd-looking display was on the sidewalk outside the nearby school, and why these men were engaged in this activity.

Thus it occurred to me that there no longer is a plausible explanation for these sorts of picket lines. Eighty years ago, they made sense. Not in my town today.

In order to explain what strikes and picket lines were supposed to do, I asked my daughters to think about what would have to happen for these anachronisms to have a function. Together, we discussed how local customers of the picketed business or institution would have to behave in such a manner as to support the striking union members, refuse to give their custom to the struck entity, thereby causing it to succumb to the union's demands.

Further, we discussed how this might work if: the community was experiencing significant unemployment; the union members were visible, known community members, too; the organization being struck was viewed as unfair or with some suspicion; the replacement workers were viewed as accepting, or known to have accepted unfairly low compensation, and; the unemployment of said union members had a significant effect upon the community at large.

None of these conditions obtains in the present situation involving the striking union members. They are, for the most part, from other towns or states. Nobody local to the school or neighborhood knows them.

It turns out that schools undergoing building projects are a favorite target of the operating engineers union. My business partner noted that they recently struck a public school in his nearby town when it, too, was doing new construction. Public and private schools are hardly the sort of organization you consider to be borderline criminal or shady when doing something like constructing new buildings. Further, the taxpaying residents and/or parents paying tuition to the relevant schools know they will be paying for the construction, one way or another. Thus, seeing union members striking might actually give them a feeling of comfort, that the price of the construction is not artificially inflated by absurdly high union wages and benefits.

Construction in this area continues to be very active, so it's likely that any competent laborer who wants to work at this trade is employed. At competitive wages. The striking, non-working union members, if anything, look foolish and incompetent. They refuse to take available jobs at good pay, choosing instead to spend their day sitting in the hot sun wearing silly-looking signs and/or animal suits.

Finally, since they don't live in the area, their unemployment has virtually no effect upon the local economy.

To sum up, there is zero support from the local populace for this strike. The picket line fits the definition of an anachronism. It's a tool from a bygone era.

Perhaps in the deepest Bronx or Queens, such a picket line might have an impact. Or in some smaller, poorer, more blue-collar rural town in a predominantly "blue" state.

But not in this upscale, economically well-off, predominantly white-collar town in which many residents commute into New York City to work in the financial services sector.

Thus, the image of scabs being physically assaulted as they cross the picket line at the school across the street from my home, resulting in news coverage of the conflict, is fantasy. The strike, and its picket line, is an exercise in futility.

What does this tell us about the mental capacity, sensibility, and awareness of modern times of the leaders of the local operating engineers union in my area?

An Apocryphal Tale: The Ten Best/Worst Days In Ten Years

There's an old aphorism with which I am acquainted that goes something like this:

"In any ten year period, if you miss the ten best days of the S&P, you'll lose half (or some similar value) of the return during the period."

To some extent, while the concept seems reasonable, I have treated it somewhat apocryphally.

Until now.

Last week, in the midst of the recent market turmoils, with various pundits calling for, demanding, expecting, etc., a Fed rate cut later this month, I thought it propitious to revisit this old tale.

Here's what I did. Using a daily adjusted S&P500 price series from Yahoo, I created a ten year series, from which I calculated daily total returns.

I then sorted the total return series by returns, in descending order.

For the ten years beginning August 29, 1997, the S&P500 statistics are:

6.5% average annual return

.03% average daily return

.05% median daily return

1.14% standard deviation of daily returns

+5.73% best daily return

-6.87% worst daily return

So far, so good. We see that the past ten years have, largely due to 2001-02, provided an average annual S&P500 return which is slightly more than half of the long term annual average return of 11%. The median daily return is above the mean daily return, informing us that the distribution of daily S&P returns is skewed positively. This is despite the worst daily return being lower, in absolute value terms, than the best daily return. The standard deviation of the daily returns, at 1.14%, is far greater than the mean or median daily return, indicating a very volatile daily value.

But, what about the aphorism that led to this ad hoc research? What are the returns of the ten best (and worst) days of the S&P over this ten year period?

+48.4% summed return of the ten best days of the S&P during the period

-48.% summed return of the ten worst days of the S&P during the period

This gives us:

65.2% summed actual daily returns for the S&P over the ten year period

16.8% summed daily returns for the S&P over the ten year period, without the ten best days

113.2% summed daily returns for the S&P over the ten year period, without the ten worst days

Each group of 10 days, best and worst, comprise approximately 74% of the ten years' summed total returns of the S&P. If we compare these two 'ten day' returns to the long run average annual S&P return of 11%, they comprise only +/- 44% of the total return of an average ten year period.

So, if we took a number of samples of ten year periods of the S&P, we might very well find that the aphorism is true. Something approaching half of the value of the S&P returns over a ten year period may be accounted for by just the ten best, or worst, days of the S&P over the period.

So what?

Well, it demonstrates how good your 'market timing' had better be, if you are a market timer. Miss a few days, either way, and you have an entirely different return than the market, even if you are only invested in the S&P500.

Frankly, it is simply stunning. At least to me. I can think of no other word.

To learn that missing only 10 out of some 2,500 days of S&P daily returns can remove between 50% and 75% of the total return of the ten year period confirms my belief that market timing is folly. Or making daily market calls, like Jim Cramer did this morning, on CNBC.

My own equity investment strategy approach distinguishes between markets in which we should be long, and those in which we should be short. Long term. Period. No attempts to predict daily, weekly, or monthly market moves.

Our equity strategy typically mirrors large daily moves in the S&P, but with larger magnitudes.

Now that our major focus is applying the equity strategy via long-dated, out of the money call options, this is doubly true. Although, relative to comparable S&P500 calls, it's not yet clear if this behavior extends to options.

Nonetheless, the validating of this little apocryphal tale heavily reinforces my belief in remaining invested, long or short, continuously, and abstaining from going to cash, unless very briefly, amidst noisy long term market signals.

Wendys' Fall: Another Case of Schumpterian Dynamics

Wednesday's Wall Street Journal featured a piece on the demise of Wendy's, the fast-food, hamburger chain built by Dave Thomas. It's a classic story of Schumpeterian dynamism, and the ability of otherwise apparently reasonable people to become deluded into thinking that companies last forever.

The real story begins with the absence of founder, builder and pitchman, Dave Thomas, in late 2001, when he focused on the final stages of a cancer that would take his life early the next year. According to the Journal article, Thomas was no longer "deeply involved" in the company's operations by late 2001. The fact is, nobody could convey the chain's quirky image and its food's comparative advantages like Thomas did. At this point, sane people would have begun to question if things could ever be the same.

Would Apple be Apple without Steve Jobs? It wasn't when he left years ago, replaced by John Scully. Some firms are, like it or not, iconic. Shareholders need to be sanguine about this.

After Thomas' death, the remaining management bought a Mexican food chain, Baja Fresh Mexican Grill, for $275MM. But the new unit never performed up to expectations.

Kerrii Anderson, hired as Wendy's CFO in 2000, became interim CEO after the departure of Jack Schuessler in 2006. Her compensation rose from $3.4MM as CFO, to $4.2MM as interim head of Wendy's.

The particulars of how Wendy's performance began to slide are almost immaterial. Take your pick- an accountant running a consumer food business, meddling in the kitchens, manipulating franchisees to push for her as permanent CEO, and her oversight of inept commercials using a male in a wig with red pigtails to replace Dave Thomas as the Wendy's image.

Between disgruntled institutional investors, including Nelson Pelz, and poor sales growth, the company was in trouble. It sold the Baja Fresh unit for only $31MM- a little over 10% of what it paid for the chain four years earlier.

The remaining Thomas family members- his wife and children- were appalled at how the company was faltering. Quotes in the article have them saying,

"You can't tear the company apart to satisfy shareholders," in answer to Pelz' demands to sell Tim Horton's, and that,

"Mr. Thomas's widow and several of his children say they were sick over the news (the sale of Wendy's to another owner) and couldn't understand how management had let the company become so vulnerable (my italics)."

The inept Ms. Anderson 'remained remarkably upbeat' about Wendy's growth prospects. However, as I have written in prior blogs about CEOs such as Jeff Immelt, of GE, when a CEO has earned upwards of $15MM in compensation, they no longer have the same goals as their shareholders. Ms. Anderson had, by this year, been paid at least $20MM (five years as CFO at at least $2.5MM, plus the $3.4MM in 2006, and $4.2MM as CEO). She no longer cares whether the company actually prospers. As my partner, a native of Ohio, noted,

"Do you know how far $4MM goes in Dublin, Ohio? You can't spend that kind of money out there."

The fact is, from a business history perspective, Wendy's had to slow at some point. It was Dave Thomas' passionate creation, and was inevitably destined to either grow too large, or miss some market trend. Companies don't grow forever. Changes in management, especially the loss of a gifted, passionate, insightful CEO, can cause irreparable damage.

If anyone should have had the sense to realize that Wendy's was finished as they once knew it, with Thomas' death, it should have been his family. Odds are, Nelson Pelz is more realistic about Wendy's than the family or its management. He realizes that it now is probably worth more in pieces.

A little perspective, and a lot less emotion, might have saved all the actors in this drama some grief, energy, time and money. Wendy's was destined to falter after the loss of Thomas, without some equally-passionate, experienced leader. Certainly, a relative newcomer, and an accountant, at that, wasn't going to be going toe to toe with McDonalds and winning. Or with Nelson Pelz, for that matter.

Sometimes, it's better to simply acknowledge change and get it over with.