Saturday, November 28, 2009

Ethanol On Life Support

With overall gasoline consumption declining and with inventories still high, the ethanol industry will be lining up at the Federal trough to accelerate the mandated move to E-85. This mandate will be negative for food prices and for environmental (soil, water, and air) quality. It is somewhat disappointing to see Cargill dabbling in trying to resurrect ethanol plants, when it was Cargill that was among the first to rightly point out the folly of putting food into the fuel tank of an SUV. This might have been a distressed asset play, but it looks like their experiment may be coming to an end.

E-85 would require substantial improvements and upgrades to the pipes, seals and fittings of gas stations, a sector that is not very attractive for investment right now. The auto manufacturers are wondering how much the E-85 mixture would affect the life of our expensive catalytic converters and other engine components. Only the Renewable Fuels Association would argue that ethanol would put us on the path to energy independence.

Poet, one of the consolidators in the ethanol industry, has reportedly lowered their pilot production plant costs per gallon of cellulosic ethanol to about $2.35, which is progress. However, the costs of having reliable cellulosic feedstocks in proximity to a nationwide plant system would intuitively seem uneconomical. Cellulosic is preferable to corn-based ethanol, but it is a second-best choice. If we were serious about giving life to this biofuel, we should probably eliminate the tariff on Brazilian, sugarcane-based ethanol. This would take the pressure off corn prices and stop a mad rush to increase acreage for this crop that has such intensive input demands for water and fertilizers.

Like NINJA mortgages, corn-based ethanol was an idea without environmental or economic benefit that was hyped completely out of proportion. Let's not be afraid to take the patient off life support.

Thursday, November 19, 2009

How to Hurt Our Capital Markets

The Financial Accounting Standards Board (FASB) is governed by the SEC, and it is the independent and definitive body that sets standards for financial reporting and investor protection. Largely populated by auditors and lawyers, some of their pronouncements were overly arcane and difficult to implement for the small company CFO. However the pronouncments were always conservative in nature and aimed at investor protection. We have a good system that is widely respected by domestic and foreign investors.

Now, there is a proposal to vitiate the FASB and transfer its duties to the yet unnamed and yet to be constituted, "systemic risk regulator." The sad thing is that the hare-brained proposal has the support of the American Bankers Association, mother hen of the folks who got us into the current mess. Of course, the ABA doesn't want to face up to the realities of marking its members' assets to market with the resultant hit to earnings and implications for capital ratios. Former SEC Commissioners, like Harvey Pitt, who has always been visonary, practical and sensible, are against it. Were this proposal to be accepted, it would be a blow to the integrity of our capital markets, just when they need to be reinforced and not called further into question.

Monday, November 16, 2009

Old Economics: Still Good Economics

Despite the bad rap given to traditional economic models in the aftermath of the global financial crisis, economic theory and economic history together still best point the way to understanding the rhetoric surrounding U.S. deficits, the role of the dollar in trade, and the Chinese trade surplus. Today's New York Times Op Ed page contains two related articles by Ferguson and Schularick ("The Great Wallop") and by Paul Krugman that discuss some of the issues.

First, there is no doubt that the biggest contribution that the U.S. can make to global welfare is to get our fiscal house in order over some reasonable time horizon and secondly, to reform financial system regulation to choke off future systemic crises before they become lethal.

However, it is equally fair to say that the behavior of the Chinese in managing the RMB exchange rate vis-a-vis the dollar is deleterious to the world economy, especially Third World countries with large volume of potential exportables and to the U.S. adjustment to its twin deficits. We all know from economic history that this "beggar thy neighbor" policy of artificial devaluation results in a diminished volume of world trade and large welfare losses to the world economy. The Chinese government is doing this to protect their global export engine, which is rational only in the very short-term.

There is some occasional rhetoric about "replacing" the dollar as the primary instrument of world trade. However, the dollar enjoys this primacy not because of a popularity poll but because there is a large, low risk, highly liquid market in short-term Treasury bills. What about purchasing power risk associated with higher U.S. inflation? Right now, the Federal Reserve governors have almost been unanimous in saying that significant inflation is not a risk given all the slack in capacity utilization and in the labor market. Even if it were a prospect, interest rates would adjust to compensate the holders for this risk. So far, so good.

What about the using the euro or the yen as alternative reserve currencies? Despite the growth of the Euro capital markets, they remain fragmented and nowhere as deep and liquid as dollar markets. Since reserve holders cannot hold the euro directly but rather hold euro-denominated securities, one has to look at a potential issuer of euro-denominated, government debt with large outstandings. As Richard N. Cooper of the Peterson Institute points out, the largest issuer of euro-denominated government securities is the government of Italy, with $1.8 trillion in outstandings. It's highly unlikely that the world will place its confidence in the reliability and transparency of Italian monetary and fiscal policies in order to switch to the euro through this issuer. The government of Germany is a possibility, but only $266 billion of their outstandings are in short-term maturities, which is inadequate to finance world trade and reserve movements. The yen has significant outstandings ($7.9 trillion in government debt) and $2.3 trillion in short-term maturities, but the near-zero rates and the long-term fiscal issues cast a pall over using this issuer as the bulwark for global trade and finance. As Cooper notes, "none of the other leading currencies in the world today is ready to replace the U.S. dollar in its international role." The reasons are based on fundamental market economics, which are still the optic through which currency traders view the world, however fancy their trading instruments.

I won't go into the idea of using SDR's for trade and private settlements. It makes for nice conversation in the halls of the European Parliament, IMF, BIS, and World Bank, but it's not an idea whose time will likely come in the near future.

Global trading partners are really inter-dependent. We don't call the shots because of our fiscal and economic issues, and neither do the Chinese because of their unsustainable policy to grow exports at the expense of domestic consumption in a fifteen year orgy of subsidized export growth. Everyone has to adjust, and the biggest traders will have to adjust more.

President Obama's trip to Asia puts him at the top of Presidential travellers measured in mileage. It's hard to imagine the Chinese taking anything he says seriously. By all means, let us get our domestic fiscal and foreign policy houses in order and focus the agenda on jobs and economic growth. The markets would really take notice.

Sunday, November 15, 2009

Why Did They Do It?

I attended an interesting workshop at the University of St. Thomas Law School, sponsored by the Holloran Center for Ethical Leadership entitled, "Crime, Punishment & Redemption: Three Unique Reunions." Three panels discussed three cases of white collar crime. Each panel was composed of the perpetrators, the judge who sentenced them, and the U.S. Attorney who brought the case. Additional comments were made by very senior Federal judges. I am not a lawyer, but the human side of it all was very hard to listen to without some emotion.

The first panel concerned Stephen Rondestvedt, who came from a middle class background with a record of high achievement in his undergraduate studies and then in law school. Steve started a solo practice in the area of workman's compensation and disability claims. He said that his clients were not well-to-do generally. He got caught up in the pressure to upgrade his home, and his wife wanted to badly close on the new home before the old one was sold. So he had to come up with a $28,000 down payment, which he did not have because the business was sucking up his liquid resources. Under the emotional pressure to satisfy their aspirations, and with an inability to say "No, we can't do this now," he tapped the trust fund of claims money held for his clients. He firmly believed that he would pay it back so rapidly that it wouldn't matter, though as an attorney he fully realized the ethical and fiduciary violations the withdrawal represented. From there, the sense of entitlement got worse and eventually morphed into a fraud of $789,000. He served 20 out of a 46 month sentence in the Federal Penitentiary in Yankton, South Dakota. He was clear and candid about his weaknesses and his bad judgment. He has rehabilitated himself and is now Executive Director of Axis Medical Center in Minneapolis, which provides services to the primarily Somali community in Minneapolis. Why? Financial pressures to upgrade the lifestyle and an inability to postpone satisfaction led to a bad judgment in a moment of weakness. There was a perception that the act would not linger around long enough to constitute theft and betrayal of trust; it did much more and morphed into fraud. It ultimately cost him his marriage. Tough stuff.

The second case was David Logan, who while a City Administrator in Pipestone, took bribes from companies looking for city business over a long period of time. What started out as a legitimate desire to cut red tape and generate development, turned into a career of working with his hand out. Again, there was a sense of entitlement--after all, he was working harder than his peers and he was actually bringing development revenues to the city of Pipestone. From there, in a desire to flee the history, he became CEO of an industrial hog farm, where he got involved in generating fraudulent loans that were tied to hog prices as part of the terms. Ironically, while perpetrating these fraudulent loans, the history at Pipestone was being uncovered and he received the notice of Federal Court proceedings relating to his city career while he was in his new CEO job. In the end, the U.S. Attorney recommended a sentence in the lower range of 34-71 months, as part of the plea agreement. Here's where it got interesting.

Michael Davis is the Chief Judge of the U.S. District Court in Minnesota. While on the dais with Logan and the U.S. Attorney, Judge Davis who had not seen Logan since the sentencing, proceeded to tease out a much less sympathetic portrait of Logan, whom he sentenced to 71 months in Federal prison, the maximum term according to sentencing guidelines. Logan made the statement that the bank loans were eventually repaid, with the implication that no one was harmed. Judge Davis noted that this happened only because Logan "had made the right bets," that is hog prices rose dramatically during the loan period assuring repayment. It seemed to me that Logan, of the three cases, had not really acknowledged to himself the real extent of his crime.

Judge Davis then gently, but forcefully excoriated the system for focusing almost entirely on punishment of offenders as opposed to rehabilitation and for treating white collar crime, dealing with large amounts, as somehow more benign than a black kid sticking up a store for $100. He raised a lot of interesting questions, most of which I first ran into when I read the "Autobiography of Malcom X," in high school. We cannot incarcerate large segments of our population for longer and longer terms with no plans for what these individuals might do when they are released. No easy answers, obviously, but Judge Davis' quiet indictment of the process was worth listening to. The program was recorded by Twin Cities Public Television, and the Holloran Center will publish a transcript.

The third case was a couple where the husband was a senior HR executive for a large company, who told his wife to start a personnel consulting company in her maiden name. Nick Ryberg then hired his wife's company to provide "research support" for HR recruitment programs, for which no work was done. The false invoicing scheme billed more than $1 million! What was the motive here? Nick said it was "corporate ego," the feeling that he was smart enough to manipulate the system, that he was entitled because he was a corporate hitter and that he could deflect any questions and explain everything away. Corporate ego. Hubris. A sense of entitlement....

The person's background was not predictive of whether or not they would be lured into fraud and white collar crime. In the case of Steve, for example, his background, early family life, and parental values were all exemplary. Moments of weakness where the person loses their bearings seems to be the common descriptor. They all also seem not to have had confidantes who might have pushed back on their decisions. As the frauds grew, so did the sense of isolation and even desolation. Alcohol was the "drug of choice" to make the pain go away. The frauds were clearly toxic to relationships both with spouses and with children, who are often the forgotten victims.

Board Engagement with Shareholders

Recent academic research, such as the paper by Simon C.Y. Wong of the Northwestern School of Law (Brunswick Review, No. 2, pp. 53-56, Winter 2009) suggests that boards of directors engage directly with shareholders on a regular basis in order to establish relationships of trust. We believe that this is an inherently risky strategy, without commensurate benefits.

It is certainly true that institutional owners want to feel comfortable that they understand the character and motivation of the managements of their portfolio companies. It is less clear what they expect, and have a right to expect, from the board of directors. The primary charter of the board of directors is to appoint, incent and monitor the performance, character and integrity of a professional management team. Very, very few members of public boards are conversant and current with the character and personality of institutional investors, particularly with the momentum investors, hedge fund investors, and activist investors.

Sad to say, but widely reported, is the fact that boards of many financial service companies are not fluent with the business models of their companies or where the risk resides on the balance sheet. Were it otherwise, we wouldn't have had the recent debacle and the subsequent conversation about enterprise risk management in director forums.

This conversation with investors should be the meat and potatoes of the CEO and CFO duties. There should be at least one director whose brief it is to follow these issues carefully and to provide additional color to the board, as required in quarterly meetings. It is an area where professional advice from skilled and knowledgeable outside professionals pays large dividends and mitigates risk.

If a conversation were to take place between, let's say a hedge fund investor and an untutored director, the conversation would quickly be steered to eliciting material, non-public disclosures from the director. These investors are Zen masters at filling out the information mosaic with repeated, seemingly unrelated questions. The management would never know what had been divulged or not. An additional question would be "Which investors merit a private meeting with a director?" Is it a question of size? If so, then the information playing field is not level, which is something about which past SEC commissioners have felt strongly. So much so that they passed Reg FD.

If the relationship with a company's larger institutional owners is poor, this is a critical problem that needs to be addressed, but the academic solution proposed is one that should be avoided.

Wednesday, November 4, 2009

GM and Opel Re-Revisited

From the early days of government intervention in the auto industry, some White House policy wonks decided that the sale of Opel be a mandatory part of the GM restructuring. We thought this was a foolish move back in July when we wrote about it. Opel is a valuable brand in Europe, where there is a long history of building smaller, more efficient and fun to drive cars. The new GM board has apparently scuttled the plan to sell Opel to a group led by the Canadian parts supplier Magna International. It remains to be seen in the German government will stand up to their unions and go along with the board's directive. Retaining Opel, if labor relations can be managed, should be a smart move for GM in the medium term, as the consumer markets rebound and world demand switches to more smaller, multi-fuel vehicles.

Monday, November 2, 2009

Oh, Cisco!

Robert Cyran writes an interesting "" column in the New York Times, about Cisco Systems. This stock points out a number of evergreen issues that affect investors. First, there is the slowly receding aura of the charismatic, larger-than-life CEO. John Chambers famously claimed that Cisco could grow sales by 50% per year for the long term, whereas the actual growth rate has been 7% per year, with acquisitions, according to Cyran.

Next is the continuing froth surrounding acquisitions, including the mysterious "Cisco model," and its vaunted ability to "integrate acquisitions." If this were true, it would have shown up in increasing returns on capital employed, which usually merits sustained stock market out performance. Five years to date, Cisco is up about 15% which closely tracks the performance of the NASDAQ Computer Index. At the height of the 2007 bubble, Cisco diverged from the index and strongly outperformed before falling back into the pack. Over the same period, the prosaic IBM was up more than 30%.

Over ten years to date, the performance is worse. Cisco looks as if it lost about 40%, while IBM was up 30% over the same period. Clearly, the market did not see promises materialize, and apart from commodity-like trading cycles, Cisco's fundamental performance was not significantly different from its index.

Peter Lynch in his classic book, "One Up on Wall Street," coined the term "diworsefication." He was right then, and he's still right now. Conglomerates like Allied-Signal and Tyco failed with their models of acquiring companies in diverse industries. Cisco in theory is acquiring companies in its space. But what is that space today? Earlier marketing campaigns from Cisco touted the fact that the company provided the plumbing for the Internet. Today, it's unclear what Cisco's mission is, apart from getting bigger.

Shareholders can do a better job of diversifying their portfolios with less risk than can the management of a public company driven by short-term pressures like stock prices and option values. Cisco has always received plaudits for share repurchases, but what these have done, at best, is partially offset the hugely dilutive effect of option grants, which were supposedly integral to the ability of technology companies to retain and recruit talent.

Cisco clearly has overpaid for its $22 billion in acquisitions since 2002, and when it was enjoying high multiples itself, management could feel good about overpaying. The New York Times says that Cisco employs 59 internal boards and standing councils to "involve more people in decision making." Shareholders benefit when they know where the decision making buck stops, and the better they understand the minds of the decision makers. With these invisible councils, it's a crap shoot for them.

Cisco, like Microsoft, is a mature company. Paying a dividend, and hewing to the discipline of writing a quarterly check, is a good thing for shareholders because they can diversify as they choose. However, management has a hard time choosing this option because as a CEO might say, "It says that we're out of ideas, and that we can't grow any more." Certainly this is an overwrought sentiment, but not uncommon.

Talking about conglomerates, what about Berkshire Hathaway, isn't that a collection of diverse businesses? There are at least two distinct features of this company that are notable for me. First, when a business is acquired, it is for the management as well as the cash flows, and the management is incented and stays in place. Their performance almost always improves over time, as evidenced by the Annual Report commentary. Second, the real magic, in my opinion, is the redeployment of cash flows from the operating companies by Warren Buffett, Charlie Munger and the rest of the executive team. So a company like Sees Candies throws off consistent free cash flows which are then redeployed into buying other attractive businesses completely removed from confectionery. The net effect is that the portfolio diversifies and gets stronger.

Investing in mature technology companies looks like it's most efficiently done by buying the appropriate technology index, judging by the performance of bellwether Cisco Systems.