Thursday, October 30, 2008

Cost Cutting

As a public company CFO, I had to make a 15% employment reduction part of a broader plan which transformed a business that was about running aground into an industry leader for creating shareholder value. As my CEO told me when I proposed the plan to him, "You can't cost cut your way to sucess." There's something to that.

If a retail company closes stores, then it will have layoffs related to the people in those stores, and perhaps some related support reductions at corporate. That's basically what Starbucks announced this morning. However, their employee relations are enlightened by retail standards, so the rest of their announcement talks about customizing their stores to neighborhoods, making them more energy efficient, and basically trying to improve their customer experience by providing a better offering of product and environment.

As long as their employees feel that the layoffs were part of this broader response to over expansion and the economic downturn, and not a knee-jerk response to Wall Street, all will be well. If they continue to feel that the company that attracted them in the first place has a plan to get better and offer more, then this will be a successful transformation. Customers will again be served by barristas with smiles on their faces.

To think about the polar opposite model, think about the major airlines.

Saturday, October 25, 2008

Feds and Corporate Governance

Speakers at a two day National Association of Corporate Directors (NACD) meeting in Washington, D.C., talked about a coming storm for corporate boards and chief executives.

In the first hundred days of whatever administration takes power in January, the winds are blowing in the direction of a significant Federal Government incursion into the board room and executive suite, with governance, executive compensation, "say on pay," and opening up the proxy process for shareholder proposals being high on the list of issues.

If a comprehensive, well-crafted effort is put forward, then the aftermath will be manageable. If there are a series of ad hoc measures on each issue, like Sarbanes-Oxley, then the costs will be very high and much attention will be wasted on checking more boxes rather than on governing like good stewards.

Stay tuned.

Tuesday, October 21, 2008

Small Cap Investors

I've owned the Acorn Fund from the early days of Ralph Wanger's managing the flagship fund, and it's been a fine investment. His shareholder letters were informative, perceptive and witty. At their recent shareholder meeting, Chuck McQuaid, the current portfolio manager, gave an overview of the small cap investment process at Acorn Funds.

Chuck mentioned that Acorn investment managers care about two things at their portfolio companies:
  1. Long term strategies
  2. How their companies were governed.
Not exactly a long laundry list, but simple and to the point. Since their portfolio turnover is about twenty percent, their average holding period is five years, so long-term means something in their process.

He also mentioned that for every investment, in addition to a full array of quantitative data on relative financial and investment performance, they maintained some softer, but very important indicators.
The one that got our attention was a short list of reasons why they owned every stock. During every portfolio review, if they re-read this list and the investor perceived something had changed, or performance was indicating a shift, he did not say they re-evaluated the investment. He said they simply sold the stock.
There's an asymmetry in the investment process for fundamental investors. Their research, due diligence and monitoring periods before buying are often quite long. Their performance requirements, required rates of return, and other reasons for owning (management credibility, for example) are usually very explicit. Once things change, the period before the sell decision is usually very short. Company managements often fail to understand this asymmetry and find it frustrating.
All the more reason to make sure that communications reflect a consistent message, and that performance and incentives are always aligned with the message that you send to shareholders.


This is a big week for corporate governance folks as the NACD is having a meeting in Washington, D.C. centered on the issue.

Top concerns for public company boards are:
  • Strategic planning and oversight;
  • Corporate performance and valuation
  • CEO succession
Shareholder relations, according to the NACD, has been ranked for the first time as a "critical area." In fact, it has always been THE critical area, but boards were unaware of it or they defaulted to management to take care of shareholder relations.
Now, there is a worrisome trend towards tasking boards of directors to add shareholder relations to their burgeoning to-do list. Devolving shareholder relations to the board of directors in the ways being discussed in governance circles is a mistake.
Shareholder relations, aka investor relations, should be a fundamental responsibility of the executive management team, headed by the CEO and the CFO. The first principle at work is to keep a function at a level that is as close as possible to the customer. In this case, analysts--both buy and sell side--portfolio managers, financial media and other capital market participants look to the executive team as responsible for generating results from their current or prospective investments. These are the folks who are grilled on the conference calls, and this is the way it should be. Add to this mix, retail brokers, message board manipulators, hedge funds and their proxies, and you have a combustible brew. SEC counsel and corporate counsel are actively involved in working through issues of disclosure with the management team on a daily basis.
Why would an outside director be injected into this process? The vast majority of corporate directors have no experience with the workings of equity capital markets, and they are not up-to-date with real time changes in the business outlook or prospects. Add to this the complexities added to shareholder communications by Regulation FD and the idea of an information mosaic, to which they might unwittingly contribute, and you have unnecessary risk placed on directors.
As a rule, the most fundamentally-oriented, long-term equity investors do not want, or require, large bandwidth for communicating with their portfolio companies. They are too busy managing their portfolios, staff, money flows and marketing. An individual company's shares may only be 1% of their portfolio. They also do not inadvertently want to be brought over the wall by being given inside information, whence they are unable to trade.
All companies need to be open to their shareholders, and if a communication needs to be established with the board of directors for a specific, limited purpose, then that process needs to be acknowledged, managed and documented through the mechanism of the ongoing shareholder relations program. The board of directors needs to be informed about the shareholder relations program and regularly review components like disclosures and management presentations. Directors should periodically attend management presentations at investor conferences in order to get a flavor of the market communications.
If a company becomes a target of an activist hedge fund, then the process becomes different, but the principles are the same.
Oversight of shareholder relations is part of a board's normal function, but it should not become part of the board's charter. In this way, the customer gets what they need, without undue burden and risk being placed on the board of directors, which already has a full plate.

Performance Appraisals

A recent Wall Street Journal story by Professor Sam Culbert of UCLA lambastes the annual corporate employee performance review. He is absolutely right on point, but his is neither the first, nor the most detailed critique. Tom Coens and Mary Jenkins provided this in the 2000 book, "Abolishing Performance Appraisals."

Best Buy decided some time back to stop focusing on an employee's shortcomings, which are unfortunately the focus of a performance review. The traditional, hidebound review may focus on shortcomings related to outputs, timeliness, ability to work with a team, or even personal habits. Instead, Best Buy decided to focus on the employee's assets and on ways to strengthen and enhance them. This is much more enlightened, and can create an atmosphere where everybody wins.

Here is some text from Professor Culbert's article:
"You can call me "dense," you can call me "iconoclastic," but I see nothing constructive about an annual pay and performance review. It's a mainstream practice that has baffled me for years.

To my way of thinking, a one-side-accountable, boss-administered review is little more than a dysfunctional pretense. It's a negative to corporate performance, an obstacle to straight-talk relationships, and a prime cause of low morale at work. Even the mere knowledge that such an event will take place damages daily communications and teamwork."

It is sad to see that the idea that the archaic performance review tool may not be working could be considered "iconoclastic."

One of the first principles for an effective team manager is to have the right players on the team, and second to have those players assigned to the roles in which they can perform the best and deliver the most value. The manager's task is then to make sure that the employee is empowered to deliver by having the appropriate tools, processes, directions and management support. Very often, a employee's not delivering on performance goals is related to management's failure to provide some of the requirements that empower the employee to deliver.

Hence, it is much better to focus on the positive--namely, how were the employee's assets used over the time period, and what can be done by everyone (the employee, supervisor, team members and management) to improve the asset utilization and performance?

Saturday, October 18, 2008

When Will They Ever Learn?

Ben Graham said it best, "Wall Street people learn nothing and forget everything." These words come to mind reading the news that Business Week believes that the rewards from putting together GM and Chrysler are "huge." This raises a few fundamental questions.

The rewards for whom? I doubt that the current and future purchasers of automobiles will be rewarded by a flowing torrent of more innovative, efficient, environmentally friendly, durable and affordable motor vehicles. These products will most likely be produced by others. Will the huge rewards accrue to employees, communities in which redundant plants are located, retirees, or small suppliers? I don't even want to go there.

Indeed, huge rewards depend on the old evergreens, cost-cutting and synergies. McKinsey research indicates that 75% of all acquisitions fail to add value. Justification of these projects smack more of alchemy than economics. Good business models don't drive into the performance band through cost-cutting.

It's interesting to see what Japanese auto executives talk about versus the GM and Chrysler executives. Honda has recently released an improved, 2009 version of the successful Fit, which features improved driveability and performance, a nicer cabin, and more safety and a quieter ride on the highway. The Japanese executives who talk about the car can hardly restrain their enthusiasm, although it is tempered through their cultural lens. On the other hand, GM execs are locked in rooms talking with people who could care less about cars, talking about debt-equity ratios. There is something fundamental at work here. If you are not passionate about your business, no matter how prosaic, then it is more likely than not that the management will come up short when cyclical or other exogenous pressures mount. By the way, there are full page ads for the GM Volt, but don't worry, no one knows what it is , but the ad copy reads well.

What has been missing in this cycle has been the Schumpeterian force of creative destruction, whereby the companies which cannot effectively create value are allowed to fail. GM still has too many dealers after decades of identifying this as a weakness. Propping up failing banks through the largesse of the Treasury and Federal Reserve imposes massive costs on the currency and on the system, but will it be able to restore confidence by itself? Jim Grant's recent essay in the Wall Street Journal gives a great overview of the issues for the banking system and the economy for which it provides the circulation.

Wednesday, October 15, 2008

Where Were The Boards?

Writing about the global financial crisis, former Medtronic CEO and Harvard Business School Professor Bill George asked this question in yesterday's Wall Street Journal. "The first job of the board," he wrote, "is to ensure the viability--indeed the survivability-- of the firm. By this criterion these boards failed miserably." True enough, and well said.

While no one expects board members to delve into the pricing details of complex derivatives, they rarely even ask the most fundamental economic questions that should draw out useful information. "What happens if all the assumptions in our models are turned upside down? What's the total risk? How much comes back to us?"

It's difficult to ask this kind of question and get a pat response. If the response is waffling, the board member should know there is a problem. Probe further. However, this kind of basic questioning is very often considered "not collegial."

Warren Buffet and Charlie Munger asked these kinds of questions of their own investment valuations in the early days of Berkshire Hathaway. It's the best way to learn: ask questions. It's what savvy investors do. Boards should be no different.