Tuesday, August 31, 2010

Dodd-Frank and Shareholder Rights

The SEC is rapidly going about formulating regulations around the Dodd-Frank bill, which is the first significant regulatory reform affecting share ownership in decades. This process will generate much too much commentary, but I had a few thoughts from where I've stood over the years, as the officer of an issuer, an investment analyst, and as an institutional shareholder.

Congress and the SEC are hoping that institutional shareholders will act like "sheriff's deputies" in the Old West, watching out for bad corporate behavior, taking action, and reporting the behavior to the badge. Unfortunately, having read many hundreds of proxy voting records for my institutional clients over the years, I can say that if I've seen a dozen instances of specific votes against a management proposal, that is an overestimate. Granted, this was before the advent of the proxy voting firms, which I consider overpriced , rife with conflicts, and of little value in their current incarnations. Nothing I've seen recently changes the lack of active voting by institutional money managers or mutual fund managers.

Institutional proxy voting has routinely been handled by legal departments. 'nuff said. They are checking boxes. The typical, diversified mutual fund will have about 2% or less of assets in a full equity position. So, that's fifty positions that the portfolio manager has to care about from the corporate governance side. In order to thrive in the business and generate good investor inflows, portfolio managers focus on short-term, absolute and relative performance, marketing, fund governance, staff supervision, and portfolio inflows and outflows. Finally, the senior managers of traditional funds are really afraid of getting too entangled with their companies. They fear learning of developments that might make them insiders and inhibit trading. Their analysts are focused on working their models to the third decimal point and know very little about corporate governance.

So, though it's romantic to think of fund managers as sheriff's deputies, they are more like the ranchers, who support the marshal, but care deeply about their personal issues like land, water and keeping their own cattle.

The first draft of the regulations hands primacy to shareholders with positions of 3% or above. An interesting, and completely arbitrary number. Ironically, it is very possible to get a 3% position in a diversified mutual fund, and very easy to get it in a concentrated, non-diversified fund. However, it seems as if the Act will hand over primacy to hedge funds which will routinely have large, concentrated positions, assuming they can be measured properly. The last thing American corporations need is to cede their mediocre corporate governance to hedge funds, which can be counted on only to generate benefits for themselves and not for the long-term benefit of the enterprise and its stakeholders.

If you are in a position to comment on the regs, please do: they need a lot of work.

Friday, August 27, 2010

Signs of Financial Froth

The economy may be swooning, but the M&A markets in August are finding a way to enrich managements and bankers while destroying value. The boards of both Dell and H-P ought to be castigated by their shareholders and Wall Street analysts for throwing money at 3PAR's management and shareholders.

What are some signs of financial froth? A headline in the Wall Street Journal, "Valuations May Not Matter," in the 3PAR duel. Someone asking the question which company more desperately needs the acquisition? Discussion in print and electronic media of the strategic importance of the acquisition with no reference to valuation.

Every day that goes by with media comments also raises the prices of any company in the solutions business, even smaller ones like Compellent and CommVault. Volumes go up in the shares and bets are placed, but does it make any sense?

Dell is no longer a technology growth company, but a cyclical growth company dependent on product cycles and replacement demand. It probably needs 3PAR badly to enhance its product offering to larger corporate customers. H-P meanwhile, has undertaken several large acquisitions in recent years, and it isn't clear at all if these have been digested, both financially or operationally into the sales channels. With no permanent CEO in place, it is odd that its bidding is so wild, given that the CFO is acting as the CEO. It goes back to the boards.

With the financial crisis, the press and academics were writing about the primacy of risk management activities. Yes, that's necessary, and it's well and good to have documented processes. However, the fundamental responsibilities of the board include the strategy for evolution, growth and financial management of the company. That certainly includes understanding what is a reasonable or unreasonable price to pay for a target company relative to the opportunity cost of funds and prospective returns.

Since the CEO of 3PAR is a former H-P exec, he surely has some insight into what might be driving their vision for the acquisition, and this will benefit 3PAR shareholders. Dell may lose by winning, and perhaps lose even more by letting this fish off the hook.

Wednesday, August 11, 2010

The Fed Fires Another Blank

Today's readers of the Fed tea leaves were not impressed, as the market decline continued into day two. To paraphrase the press release code, the recovery is underwhelming. Macquarie Asia economist Richard Jerran, quoted in the Wall Street Journal, cites a very interesting paper by Hiroshi Ugai, "Effects of the Quantitative Easing Policy," which draws eerie parallels between the actions of the Bank of Japan (BOJ) in the aftermath of the late 1990's crisis and the current actions of the Fed.

From March of 2001 through March of 2006, the BOJ substantially increased the monetary base by increasing the current account balances (CAB) held by member banks with the BOJ through increasingly massive monthly purchases of securities. Incidentally, JP Morgan estimates that the Fed will account for 15% of Treasury demand as a result of the latest policy guidelines.

At the same time, BOJ made a decisive commitment to a zero interest rate policy (ZIRP) until the day that the CPI stopped declining. Although the Japanese economy showed several, short-lived recovery episodes, prices declined continuously from 1998 until the autumn of 2005.

Instead, Ugai concludes that the real benefit from the BOJ policy was not due to quantitative easing at all, but to the ZIRP, or commitment to keeping interest rates low indefinitely. We know that the Fed has studied the Great Depression, but perhaps the better analogy now would be the Japanese experience.

It was troubling to read in the Fed press release that lending by banks "has continued to contract."

Looking at corporate results from Cisco, which exceeded earnings expectations, we see that revenue was below Street expectations. This in spite of the fact that economic statistics, though reported with a lag, show double-digit year-over-year spending increases for equipment and software.

CIO's Michael Cembalest and Hans Olsen of JP Morgan's private banking group make a very telling point about what's driving the current profit recovery. They note that corporate profits have beaten expectations for the past five quarters. At this stage in the recovery, a 5% growth rate would reflect nominal GDP growth in excess of rising unit labor costs. However, the current profit rebound comes from declining labor costs, low real wage growth and sustained high labor productivity. The JP Morgan team believes that this kind of engine for recovery should not command a very high P/E multiple because it is not sustainable. The latest readings on productivity, the slowing of export growth, and weakness in Britain and Germany all reinforce the notion of a lower market multiple.

The JP Morgan team point out that macroeconomic trends are unusually important in evaluating investments in the current world economic cycle, and we agree.

Tuesday, August 10, 2010

A New Theory about HP

The H-P boardroom has seen the circus come to town on prior occasions, with the board spying on itself. Now, CEO Mark Hurd walks the plank over seeming peccadilloes amounting to $20,000 of expense reports which were reimbursed after audit. These compare to a four-fold rise in the share price over a five year tenure. Institutional investors quoted in the press said that the 8% first day decline in the stock price was overdone, so in their minds, the CEO's management of corporate assets and above-market returns are what matters. Never mind that much of it was market timing, but these investors prefer profits and ROE over peccadilloes.

Meanwhile, much of our avowed governance reform is about codes of ethics, and like the Old West, there's only one code for everybody. In reality, the board made the only decision that it could possibly have made, by taking control of the issue. Had the contractor-in-question remained a mystery, the issue would have been framed in the tabloids and she would have had a much bigger stage, with the company constantly on the defensive. However, just like the Toyota sudden acceleration story, the HP episode makes very little sense, starting from the process of hiring the contractor, to the supposed marketing duties, to the efforts to conceal the ongoing relationship. For the ongoing lack of judgment and circumspection, and for any additional risk down the road, the board took the only appropriate decision it could.

Now, the newspaper stories report employees delirious with delight at Mr. Hurd's resignation because of his"Chainsaw Al"-like crimes of cost-cutting. Quite a few people quoted are engineers. It has always seemed that HP has been dominated from its founding by an engineering culture. I suspect that former CEO Carly Fiorina's difficulties with the board and company culture were not so much about Compaq as they were about offending the inbred, engineering culture.

One of the lead marketing tag lines from her time was "HP: Invent," and that legacy lives one in the "Invent" centers in Geneva and Mumbai. This was probably dismissed internally as being the product of a marketing person who didn't understand innovation anyway. CEO Hurd further went on to attack a bloated cost structure, something that engineers really don't like. In their view, ordinary executives aren't smart enough to understand how difficult good (read perfect) engineering is; putting out new products isn't something that can be held to a quarterly timetable, they whine.

HP is positioned well as a result of decisions taken by recent CEO's, including Ms. Fiorina and Mr. Hurd, but it really hasn't fulfilled its potential yet. I suspect that it still relies too much on profits from its consumables businesses, where it has marginally innovated and effectively raised prices, while completely defeating movements like the refillable cartridge businesses. This was done mainly through marketing and only secondarily by engineering. Giving away printers didn't hurt either, another marketing decision.

So, HP shares continue to look like a value play, but I suspect that there's a very large, cultural elephant in the room that could slow any transformation into a sustainable, growth story. The next choice of a CEO might best be someone who is known and acceptable to the insiders, rather than another, charismatic outsider.

Friday, August 6, 2010

What Recovery?

The Minneapolis Fed has updated charts comparing the current recovery to the ten postwar recoveries, in terms of output and employment. The beginning of the last downturn is dated July 2007, and the recovery is said to have begun in July 2009. What is shown is not a pretty picture.

The decline in employment during the last downturn was significantly steeper than other downturns, and U.S. employment is shown to have declined overall by 5.6% from the onset of the recession. What's worse is that the decline shows no sign of turning upward, and overall U.S. employment numbers are still 1% below those at the start of the recovery in July 2009. This is unprecedented. The consternation in financial markets today is a reaction to what's suggested in these comparisons and in recent monthly data.

The bullish economic commentators, like Joseph Carson at AllianceBernstein, point out rightly that the contribution of consumer spending and housing to the current recovery is about 25% of the contribution expected at this stage of other postwar economic recoveries. However, AB then appeals to strength in manufacturing and exports as reflecting a changing mix of contributors to the economic recovery. I just can't understand how exports can sustain a contribution to growth when it's only China whose economy appears to be having robust growth, and the Chinese economy has not traditionally had a large appetite for high tech, manufactured U.S. exports.

A more fundamental issue is the long-term damage caused by discouragement and loss of productivity and employability of large segments of the labor force imposed by the reluctance of large and small employers to add workers. Extending unemployment benefits for some workers may earn votes but little of any significance for the economy as a whole.

There is very little that the Federal Reserve has left in its toolbox to address lack of income and employment growth as well as deficient demand. It has to get its balance sheet in order and get out of the Greenspan economic wizard business. Business leaders have to get beyond reporting the next quarter and start investing in their businesses. The business leaders should demand that Washington stop trying to phony up numbers for November elections and start working on rational fiscal policies, including revenue raising through an efficient tax system, in order to generate a real recovery.