MSFT Lowers Expectations and Declares Victory

Microsoft's PR flaks must be encouraging the CEO to get in the news more, and he has been placed in two recent, high visibility stories.  In one, there is a rambling, philosophical interview about long-time insider, CEO Satya Nadella being, in fact, an "outsider" at Microsoft.  There seems to be little evidence so far that (a) this is true, or (b) that it would be making a difference to making this behemoth more nimble, responsive to consumers, and consistently innovative.

In 2014, we wrote,

"The Nokia acquisition could easily become this company's Waterloo.  Value creation at Microsoft won't happen with the Ballmer-created organizational rabbit warren, bloated cost structure, and dysfunctional culture that we've written about in our most widely read posts."

Well, Steve Ballmer has gone to play with new toys, including basketballs.  Microsoft wrote off 80% of the the value of the Nokia acquisition, according to the WSJ; this was inevitable, as we wrote when the Windows Phone forecast of 15% market share was first given.

Now, CEO Satya Nadella has pared back the plans for new Windows Phone launches to what looks like a very singular offering for corporate users.  So that leaves me, an early adopter, and a somewhat satisfied user of the first Nokia Cyan an orphan.  Typical Microsoft.

My first experience with Windows 10, which was okayed for my aging but perfectly functioning Windows 7 laptop, was tremendously dissatisfying. Windows 10 comes with bloated, self-serving products like Microsoft Edge, and it doesn't seem to work well with the free version of Outlook Live. My local copy of Outlook from Office 2013 froze up, crashed, and lost many of my contacts.

Of course, the Waterloo analogy is a bit overwrought, as this company can financially slough off this economic fiasco.  However, this company badly needs a cultural evangelists inside the company that can speak for the consumers, not the corporations.  Inside Apple, that person happened to be Steve Jobs at the top, and throughout the organization it was populated with people obsessed with the user experience and feedback.

Windows is really betting the farm on Windows 10, and Waterloo may be down the road apiece unless things really change.  I hope that the CEO gets a machete and hacks away at the culture inside Microsoft that could have allowed the Windows Phone to be relegated to a meaningless share of the mobile phone market.

Satya Nadella Shuffles Executives: Microsoft Still Too Ponderous

One of our best read and most forwarded posts was about the accession of Satya Nadella to the Microsoft CEO chair, which really excited us, in the midst of all kinds of Wall Street consternation.
Perceptions about Microsoft among its customers, developers and Wall Street really picked up quickly, and the contrast with the imperial Ballmer Reign was also a refreshing change.

Microsoft continues to be a cash flow behemoth, with untold flexibility to speed up product development and to rebound from its historical behavior of misreading consumer trends and being a clumsy, heavy handed late follower.

But really, the latest executive shuffling is just the traditional reversal, which puts more and more onto the plates of two existing executives.  Here is the relevant quote from the CEO,

"To better align our capabilities and, ultimately, deliver better products and services our customers love at a more rapid pace, I have decided to organize our engineering effort into three groups that work together to deliver on our strategy and ambitions."

Delivering better products and services faster, which work together the way customers want, is something that needs to be achieved now, not ultimately. Making this change doesn't really seem to be demonstrably positive for the important goal.

Microsoft still seems like a big, ponderous organization that is hanging the hat on making the "Windows experience" available across all platforms.  That may be a noble goal, and Windows 10 seems to be generating a lot of excitement among Microsoft store employees, but so many of its features and capabilities, though a move up for Microsoft, will probably be leapfrogged by the far more consumer-aware and organizationally agile Apple.

If the culture of Microsoft is ever going to change it has to be at the layers below the EVPs and deep into the structure of the organization.  I still wonder how this can be done, and how long it will take.

Pimco Executives Hit the Phones

The Wall Street Journal says that executives at Pimco are hitting the phones trying to staunch the outflow of more than $10 billion from the Total Return fund. The CEO is even talking to brokers himself!

Maybe this is the kind of "all hands on deck" connect with the customers tactic that wasn't implemented when more than $65 billion left the fund before.  Perhaps this is why BG got very upset with the marketing executive and the CEO himself?

Seems like a reasonable hypothesis, doesn't it?

Bill Gross Leaves Pimco

Back in January we posted our answers to the question of "What's Wrong with Pimco?"  One of the issues was succession for Bill Gross, and that was answered today as the author at the top of our fixed income reading list for the past several decades is leaving to go to Janus.

Again, it has little to do with fund outflows and all to do with organizational issues at PIMCO and perhaps a heavier hand being exerted by its German owners.

We wrote about Pimco's astonishingly inept roll-out of equity mutual funds, and the wave finally hit their bellwether product the Total Return Fund and its high profile manager.

Janus was a hugely mismanaged organization for decades, but perhaps it is living up to the name of the Roman god of new beginnings with the hiring of Mr. Gross.  Love your essays, Bill!  Keep 'em coming.

Revisiting Marissa Mayer

Jason Alden/Bloomberg via Getty Images and the New York Times.  

I thought Yahoo's appointment of Marissa Mayer as CEO a few years back was a great move for the company and would bring a sharp, decisive, enthusiastic leader to the company and perhaps to other corporate boards.  The first thing I notice from this New York Times photo and story is that the gleam has gone from her eyes when compared to her taking the reins at Yahoo.  There is clearly a look of weariness, perhaps even resignation.

The articulation of a clear direction for the Yahoo turnaround, milestones and a fast pace of change have all been missing.  One analyst says that Yahoo needs to be "rewired."  But everybody knew this years ago, and it seems incredible that so little has seemingly been accomplished.

I also guessed that her having been in the Google inner sanctum would have been a source for inspiration, guidance, and even partnership in some areas.  Yahoo seems like the armadillo walking slowly down the center line on a Western highway while the semis roar by.  

The acquisition game from here is riskier than a few years ago. For Yahoo to move its needle, a big acquisition is required, but those will have a variety of suitors, all of whom are stronger financially and organizationally than Yahoo. The limited track record so far hasn't been good.

As the Yahoo CFO points out, shareholders don't need to whine incessantly because $1.3 billion has been spent on acquisitions in the past two years, versus returning $6 billion to shareholders.  Ms. Mayer shouldn't obsess about a fifty-fifty split in free cash flows, but she needs to start articulating her playbook in greater detail.

I wonder if her management team has the right roster with the right incentives. I would guess not, otherwise you would read more about them in the press.  I don't want to look up their board members, because they clearly haven't been doing their jobs if the CEO looks wan and beleaguered by shareholders after the stock has bounced off the bottom due to the Alibaba stake. 

Here's hoping for some positive changes and good news. 

Alibaba: Open Sesame To the Uber Humongous IPO

In a recent post about emerging markets as an asset class for foreign equity investors, we wrote about some things they should look for in selecting their markets and their issuers:

"In order to translate these into growth in corporate earnings and portfolio returns, investors need: political stability, strong respect for property rights, effective dispute resolution, a predictable regulatory and tax regime, a positive foreign investment climate, efficient markets, strong corporate governance, reliable corporate auditing and financial reporting, ethical managements, transparent corporate structures, and economies balanced between exports and internal consumption. Divining the strengths and weaknesses of an EM in these areas can only be done by active management, with experience in the markets, boots on the ground and a disciplined investment process." 

Despite the fact that the Alibaba IPO will be a record breaker in all investment banker metrics, it seems to lack these basic, critical features and it seems ripe for momentum investors and flippers, aka hedge funds.

A June 2014 staff report of the U.S.-China Economic Security Review Commission goes into the issues clearly and raises the potential legal, investment and governance issues for U.S. investors.  The Chinese government itself makes it a public policy to keep foreign equity investors in disadvantaged positions in their companies.  Yet, Chinese Internet companies have pursued foreign listings with a structure called Variable Interest Entities, which the report says may in fact be illegal under Chinese law.

Templeton's Mark Mobius points out the two-tier equity structure that clearly entrenches management and gives it and the preferred class effective control over corporate assets.  Disputes, he notes, must be settled in Chinese courts, despite the overseas listings.  Good luck with that venue for the poor common equity investor.

The reporter interviewing Mr. Mobius notes that Hong Kong regulators passed on allowing Alibaba to list on their exchange, in part because of the opaque corporate structure.  Asked why U.S. regulators allowed the listing on NYSE, he quietly notes several points, which I may paraphrase a bit:

• U.S. markets have never reformed, post-crisis.
• U.S. regulators serve their customers, namely the broker-dealers and their investment bankers.
• Out equity markets are driven by short-term investors who will flip the shares.

Ironically, some part of Templeton may get a few shares and flip them too.  If they are passing out free candy, why not take it?  But, the comments are sobering coming from one of the oldest companies in the emerging foreign equity investment business. 

Professor Anant Sundaram of Tuck Business School has made comments on the deal from the governance standpoint that worth reading, published in Barron's and the New York Times. 

When Ali Baba opened the door, it was to a wonderful land.  It will remain so until the door closes and investors long to return to the other side.  

Exxon's Solid 2013 Positions It Well for The Near-Term Future

Mutual fund investors who managed to avoid the global, integrated oil companies in the fourth quarter did well, and those who bought oil field services companies improved their performance relative to benchmarks. But, as prosaic and unloved as these companies (Exxon Mobil, Chevron, Shell, Total, and BP) are, they will be important to global development and to portfolios in the future.

Value oriented investors tended to take positions in Chevron, which has awakened to the importance of returns on capital for growth and portfolio management in the future.  If their returns improve, their stock should do well, since it is relatively cheaper than Exxon.

Exxon's 2013 after-tax earnings from Upstream activities were $26,841 million, down about $3 billion from 2012.  This decline was driven by foreign operations with after-tax earnings of $22,650 million, down $3 billion from 2012.  U.S. operations had a good year. Higher gas realizations ($4.60/kcf vs.$3.90/kcf worldwide) were offset by lower realizations on petroleum liquids; the net increment to earnings was $390 million. Adjusted production was flat.

Upstream activities generated a return on average capital employed of 17.5%, with average capital employed at $152,969 million and capital expenditures of $38,321 million.  The portfolio mix of projects coming on stream around the world (six major projects including the Kearl Athabasca tar sands project in Canada) is well balanced from fuels, geography, and technology viewpoints.

Chemicals had 2013 after-tax earnings of $3,828 million, and a ROACE of 18.5%; the capital base was $20,665 million and capital expenditures were $1,832 million.  The bulk of chemical earnings, $2,755 million, came from U.S. operations, and this is where continuing opportunities for volume growth and profit improvements exist out to 2018 in the current plans.

Exxon is the largest chemical and natural gas producer in the United States.

Downstream operations, including retail gasoline operations, generated after-tax earnings of $3,449 million, with an ROACE of 14.1%.  U.S. operations generated earnings of $2,199 million in 2013. Overall, Exxon's returns on capital continue to be superior to its four peers listed above, no matter what the macroeconomic environment.

Over the next five years, the company expects oil-equivalent production from North America to grow from 32% of production currently to 35%.  Over the same period, LNG production is expected to increase to 55% of production on an oil-equivalent basis from 45% today.  Both of these mix shifts should be positive.

Exxon's $19 billion LNG project in Papua New Guinea is slated to load its first cargo in 2014.  This 6.9 million metric ton per annum project is extremely complex from the engineering, logistical and environmental management standpoints.  PNG is a difficult environment in which to get projects done, as they dithered for years on a seabed mining project, putting it though endless hoops that, along with a global recession, eventually put the project in a deep freeze.

This project's output will be primarily for export,and so it should be a great laboratory for our domestic cries to export LNG from the U.S. Exxon's project, in which it has a 33% operating stake, includes 253 miles of subsea pipelines connecting eight gas fields, with a gas conditioning plant and the liquefaction plant.  One of the real moats that Exxon has around its business is the depth and scale of engineering, procurement and project management expertise that permits it to work in all kinds of challenging physical environments.

Regulatory and compliance expense for all the global majors has been increasing much faster than revenue or profit volumes.  It is good to see the company organizing itself into nine or more cross-organizational teams to deal with global issues like Risk Assessment and Management and Incident Investigation and Analysis. This seems like a way of organizing that makes sense for the business, as opposed to checking a box required by incoherent legislation.

Despite having a robust capital spending plan and returning $25.9 billion to shareholders (the stock has a 2.6% dividend yield even after the run-up), Exxon filed a $5.5 billion shelf for a multi-part debt offering, with a AAA rating from both Moody's and from Standard and Poor's.  Proceeds will be for capital spending, acquisitions, and for refinancing of commercial paper.

A strong balance sheet along with disciplined capital utilization is a good tonic for shareholders.

Satya Nadella: The Best of All Possible Directions for the new CEO of Microsoft

If the Wall Street Journal is right, then the agreement being hammered out this weekend for Microsoft executive Satya Nadella to take over the reins of Microsoft as CEO means that the company is making the best possible decision for succession, changing the internal culture and for its strategic direction.

This is quite a different position from the comments in the finance and tech press that this would be a 'safe decision.'  I'd take the polar opposite position.  The choice of a superstar CEO from the automobile or aviation industry would, in many ways, have been the "safe" decision.  The cult of the superstar CEO is alive and well in corporate America.  The buy and sell sides of Wall Street would have applauded a bold choice, like looking beyond technology, and at the same time they would be forced to hold off judgment until the new CEO learned more about the business and about Microsoft. Valuable time would have been wasted. The new CEO would be beset by the culture, as the heads of fiefdoms nipped at his heels trying to protect their empires, while undermining the CEOs effectiveness. If, at the end of the day, the superstar failed, a big severance would have been payed and Microsoft would have little credibility with investors or customers. Microsoft would then be in real danger of becoming irrelevant.

Instead, there's no question that Mr. Nadella not only knows technology, but he understands software for the powerful SQL server business, and he understands search from working with Bing.  He also, according to the Journal, had to apologize to an international customer for business losses arising from an outage of the cloud-based Azure service.

Two things about that last point.  Mr. Nadella has been on the line with a customer taking the heat for the failure of a product. Software glitches and loss of service are routine. Mr. Nadella understood the importance of an outage to a smaller customer.  His choice of personal accountability to a customer is something that has not a hallmark of Microsoft's customer relations, especially on the Windows side.  Don't think that the internal development and sales teams didn't notice what Mr. Nadella did either. All of this is a big deal for the future.

Also, don't underestimate the impact on international markets and on Microsoft's sprawling operations in countries like India.  A Redmond-centric culture may finally start to understand what it means to be a truly successful global technology leader, and that belief will be made manifest in its new CEO.

From his position within the company, it will be much more difficult for intransigent insiders to dig in their heels to cultural changes. Here again, the story talks about an executive whose personality is the antithesis of his predecessor; it also talks about people coming out of conversations feeling better than they went in. Again, things like this are a big deal.

When Mr. Ballmer launched Bing! it was a venture widely criticized by Wall Street, which said it should be shuttered. Mr. Nadella was part of the leadership team that made this venture, which we've supported in this blog, a necessary and successful part of Microsoft's technology portfolio.  Mr. Nadella's relationship with Mr. Ballmer provides a good foundation for the future.

Finally, whether or not this is speculation, the notion of founder Bill Gates taking the time and specific interest to mentor the new CEO, while relinquishing his board chair for another acceptable role would be another inspired decision for the future.

Ray Ozzie wrote, "Those who can envision a plausible future that’s brighter than today will earn the opportunity to lead." I expect that Mr. Nadella has earned this opportunity, and he would be leading with a lot of help from inside Microsoft. 

There's reason to put Microsoft back on the radar screen again, after this announcement has been made.

Mutual Fund Ratings Need Lots of Work

Morningstar and Lipper are the market leaders in mutual fund ratings, just as Standard and Poors, Moody's and Fitch are for credit ratings.  Their benchmarks for mutual fund ratings are widely used by sponsors and consultants for corporate defined contribution plans. 

Morningstar uses traditional MPT statistics in their evaluations, but the reports are still like beauty contests, formerly based on "stars" and now on a fuzzier system of "Gold," and "Silver."  Even funds which have mediocre performance and high expenses are not rated "Sell" or "Avoid."  In this way, the ratings have the same issue as sell-side equity research: too many 'buys" and few "sells."   For an illustrative example,  I want to focus on two well known funds with large asset bases, Fairholme and Sequoia.

Both of these funds have received accolades from Morningstar: Fariholme's founder and manager Bruce Berkowitz was named "Manager of the Decade," and Sequoia's co-managers Bob Goldfarb and David Poppe were named "Domestic Equity Managers of the Year for 2010." 

In the case of Fairholme, the meteoric rise in assets under management is well documented, but hard to understand. Fairholme created a catchy slogan for itself, "Ignore The Crowd."  It suggests a Warren Buffet-like value investing, or contrarian discipline. 

While Fairholme's assets were growing, I visited their website many times and even printed out the fund literature.  Besides the slogan, I couldn't understand what kind of analyst support was there for all the contrarian stock picks.  When Morningstar talks about the T. Rowe Price funds, by contrast, the Morningstar analysts often comment about the size of the analyst staff supporting the manager of a T Rowe fast-growing fund. 

Managing money, at the very root of the process, requires experienced, diligent, market savvy, financially and analytically sophisticated analysts who aren't afraid to challenge market valuations and assumptions.  Looking at Fidelity Management and Research, for example, the manager who oversees FMR's single biggest slug of assets with a long, consistent and distinguished track record is Will Danoff.  Will was Fidelity's retail sector analyst early in his career, when I called on him from the sell side.  Will Danoff, Rich Fentin and other portfolio managers who were former analysts, would always come to meetings with notebooks in which they had carefully recorded data from every previous interaction they had about a particular stock and about the company's management team.  You always had to be on your toes and remember your previous conversations with them, because they certainly did with those composition notebooks! 

Fairholme, by contrast, was always a black box.  Assets continued to pour in, the fund rode the market upward, and more assets followed.  Then came a series of peculiar investments, St. Joe, and Bank of America, which we have written about in earlier posts on this blog.  One of the funds periodic reports had a puff paragraph about St. Joe being a real estate play on the Florida Panhandle becoming the next Riviera, after a new international airport was built, on land adjacent to St. Joe holdings.  Sounds good, but it didn't pan out, and Bruce Berkowitz eventually became Chairman of St. Joe in a bizarre turn of events. 

Then, after saying that financial stocks were black boxes with poor disclosures and questionable asset valuations, Fairholme plunged into a large position in Bank of America.  What was this based on?  What changed in the philosophy towards megabanks?  This investment also culminated in a farcical conference call sponsored by Fairholme with the hapless Bank of America management.  The call was supposed to clear the air with Wall Street by allowing the skeptics to ask their toughest questions.  Nothing of the kind happened, and the stock went down right after the call. 

Soon after that, came the soap opera surrounding the departure of the mysterious Charles Fernandez, who was made co-manager of Fairholme Fund, director of the Fund, and President of the management company in 2008. I couldn't find anyone in the investment management business who knew anything about Fernandez.  This strange appointment raised no alarms among the fund rating companies.  In the fall of 2011, Mr. Fernandez left in more public, but equally mysterious circumstances to his arrival.  We'll stop here, but remember that through this long time period, Morningstar gives their rating of  Manager of the Decade to Mr. Berkowitz.

All the while, investors who rely on Morningstar got no insight into the people, processes, culture, analyst support, and compensation at Fairholme Funds.  However, reading analyst reports on other funds and fund families, those kinds of items were covered, to some extent.

Switching to the Sequoia Fund, the fund management company Ruane Cunniff Goldfarb has a long history, dating back to the predecessor company, Ruane Cunniff, co-founded by legendary value investor Bill Ruane, who I had the pleasure to meet and call on early in my career as an analyst.  The philosophy behind the Fund was, and remains, a Graham and Dodd, fundamental value approach.  Turnover is extremely low, which is beneficial both for trading expenses and for taxes. 

An interested investor, or an analyst at Morningstar or Lipper, could find decades of financial press and fund publications all telling an unchanging story about the approach and culture of the management company.  The importance of people, namely analysts, was always stressed.  Process was evident.  Sequoia had a long period of under performance relative to its peers, in the large value segment.  It held way too much cash for my tastes, something which I don't understand when you're collecting a healthy fee; its concentrated portfolio was dominated by holdings of both classes of Berkshire Hathaway. 

The bottom line is the fund continued to be managed according to its philosophy and beliefs.  Eventually, day-to-day management of the fund passed to Bob Goldfarb and David Poppe. Nothing changed.  However, when markets collapsed and valuations came in, the portfolio was transformed pretty dramatically.  Now the fund is classified as a Large Blend fund, because it has some growthy stocks in it, as opposed to down and out value plays.  People, process, philosophy, culture, analytical support, and compensation were all transparent and consistent.

I read carefully the published transcript of their Analyst Day, where the fund managers and analysts are made available to answer investor questions about their stock positions and anything else on the minds of the owners. An investor can count the number of analysts, learn their names and read about them speaking about valuation techniques and about the investment thesis for a stock they recommended. This transcript  is supplied by the management company, and so an owner doesn't have to mount a due diligence effort or rely solely on fund rating companies. 

 The fund rating companies seem to be putting out journalistic marketing pieces and are inconsistent in how they treat different funds.  There are no "Sells" in their research, which is something for which sell side equity research was castigated.  They can and should do a much better job.

Winding Up The HP Conversation: What's Missing

Perhaps the most curious remark made by new CEO Meg Whitman on the recent HP conference call was her characterization of HP as a company that grows at GDP-like rates (it was a bit inaudible on the webcast).  While this kind of remark makes total sense from a longer-term perspective, it isn't what an institutional investor wants to hear.

Trees don't grow to the sky, and to be sure "long term growth rates" of 15% projected by most analysts for S+P 500 growth companies make little financial or economic sense.  Some of my savviest institutional investor customers spent lots of time trying to determine the "earnings power" of potential investments, i.e. what returns could they earn on the assets they had in place if volumes were growing at above-GDP rates, the company had pricing flexibility, and the economic and competitive backdrops were favorable.  For cyclical companies with significant leverage, the turnarounds in EPS were dramatic.

Stephen Penman, Professor of Accounting at the Columbia University Graduate School of Business, recently wrote a book, "Accounting for Value," in which he updates the Graham and Dodd approach made famous in their pioneering work on security analysis. He concludes that most investors overpay for growth and leave no "margin of safety" when they buy a stock.  The "margin of safety" is one of the key tenets of Graham and Dodd's approach.  Warren Buffett, a longstanding student and disciple of Graham and Dodd, recently announced a large equity stake in IBM, and not HP.  One would think that HP would show a reasonable margin of safety at current prices. 

HP was described by some analyts as trying bring expectations down as low as possible.  That's usually a tactic pursued by second rate companies.  Tweedy Browne is a distinguished value shop which has habitually avoided technology stocks.  They recently initiated positions in Google, which doesn't fit traditional value metrics.  However, they argue that given their huge cash flows, and large investments made to date in technological backbones like data centers, incremental revenue growth, acquisitions and entries in adjacent businesses can have large impacts on EPS. 

Their one concern about Google is a cultural one, namely that the management seems intent on changing the world, in their own words, as opposed to always making shareholder-friendly decisions.  HP on the face of things looks like a traditional  technology value stock.

Dodge and Cox, another traditional value shop, has a five percent or better ownership position in HP equity, between the Stock Fund, the Balanced Fund, and the International Stock Fund.  The company has a long standing position in HP bonds through the Income Fund, which has long been overweight corporates.  It looks like the Income Fund recently sold out of HP bonds because of their strong price out performance.  Aside from HP and extensive index fund ownership, we will see in coming months which other value investors may be accumulating shares in HP.

What's missing from HP in our opinion is leadership, both from the board room and from the revolving door of the executive suite.  This is a serious cultural issue, more worrisome than any cultural issue at Google.  It is the same board in place, and a CEO who came from the very same board which made any number of large, foolish decisions.  The IBM turnaround had a clear beginning with Lew Gerstner. It was fortified by Sam Palmisano and is being handed off to Virginia Rometty; the entire process had gravitas, circumspection and strong hands at the tiller.  HP has under performing assets, a portfolio of businesses with no unified vision or mission in the marketplace, low expectations and a new CEO with smaller company experience driving this very large ship.  Without a cultural transformation, it might become a nice short-term trade, when stronger 2H 2012 earnings become visible, but it's a long way from being a great investment yet. 

Pimco's Kashkari Gloomy About Equity Returns

Pimco has always been a bond house, but lately they've made a concerted effort to develop mutual fund products for equity investors.  The equity mutual fund field is like the favela in Sao Paulo: dangerous and overcrowded.  Neel Kashkari, a Goldman and U.S. Treasury alumnus, is leading that charge into equity.  In a recent interview with Morningstar, Neel  didn't take a sunny view of equity returns.

Instead, he says that the U.S. is in a long period of adjustment which will mean much lower economic growth and lower asset returns than historical norms.  Like our posts on the so called consumer deleveraging, he says that it has barely begun and has a long way to go.  Large corporations, and to some extent the mid-market firms, have completed their deleveraging and are flush with cash.  However, they will find precious little sales growth here at home if the consumer sector continues on life support.  It's an interesting interview.

Of course, what's the conclusion following from Kashkari's world view?  Get connected with emerging markets. Brazil is apparently fully valued.  China has already produced negative surprises and may have more skeletons emerging from the closet.  Apparently, selected Russian companies may be value plays.

How can a U.S. investor, particularly an individual investor, take these kinds of risks in a low return world without significant risk premia?  Macroeconomic data for all these countries is barely acceptable, the financial press is weak or non-existent, corporate governance is of poor quality and not monitored by strong watchdog groups, and the auditing function is hostage to low quality national partners and shielded from accountability by the structures of the major accounting firms.  Does this sound like an answer to low U.S. returns? 

Look at what happened to Southeastern Asset Management, which runs the Longleaf Funds, very successful long-term value oriented investors.  Mason Hawkins and Stanley Cates have put together the ingredients I look for in a good equity mutual fund manager: good people, an ethical culture, a sound research process and approach to valuation, and manager incentives that are aligned with shareholder interests. Their employees are the largest shareholders across their family of equity mutual funds and have been since time immemorial.  This is the way it should be, but it's rare.

Southeastern has been rattled by being a long-term 5% plus shareholder in Japan's Olympus Corporation, which may have been hiding trading losses for a decade or more.  This is a Tokyo Stock Exchange listed large capitalization company with good businesses and a long track record.  I understand the statistical issues of this being "an n of one" on the TSE or in a diversified portfolio.  My point is look what is still happening even in foreign markets which we consider "developed."

Think now about the same investor's position in a Brazilian oil company, software company, or REIT?  The outside investor is at a tremendous information disadvantage.  Even depending on analysts stationed in the country is no assurance of risk mitigation.  It depends on culture, people and processes in those local operations, which are difficult to manage from afar.  If emerging market investing is an answer, it will have to be on a company-by-company basis.  I don't think it makes sense for investors to buy into, for example, the "Brazilian Miracle," or the "Indian Miracle," or any other gold rush country. 

Reading Kashkari's piece made me lament for the eras of 8% equity returns, which are still embedded in the long-term projections of many public and private pension funds.  The maiden of high returns has vanished, as Neel suggests.   I had to turn to Bill Withers and his baleful tune, "Ain't No Sunshine When She's Gone."  I can go back to my investment statements with some comfort.  Thanks, Bill.

Steve Jobs and The Engineering Culture

A previous post tried to put a damper on the Jobs hagiography in its most quasi-religious version.  I had to laugh when I saw a blog posting that the Jesuit journal La Civita Cattolica had compared the late Apple CEO to St. Ignatius Loyola and Pope Piux XI.  As Johnny Carson often said, "I kid you not!"

True engineering cultures are often inimical to running product businesses with fickle, demanding customers.  I'm not talking about engineering services firms, but that's another story.  When I was growing up, I got to meet quite a few IBM engineers and executives through our family's network in Westchester County.  One of them gave me a gift of a leather note pad, inscribed in gold leaf with Watson's motto, "Think!"  There's no doubt that their engineers were the best and brightest of their breed. 

Fast forward to the time before Lew Gerstner was brought on as IBM CEO in 1993, when market pundits were calling for the company to be sold off in pieces.  Coming from Amex and RJR Nabisco, the engineers in IBM were dismissive about what a non-engineer could do to help their business.  One of them said, "His biggest decision at Nabisco was probably to decide the new colors on a box of Shredded Wheat."  A bit arrogant, don't you think? 

IBM could always afford to be arrogant because in much of their product business, they had a quasi-monopoly and they shoved price increases down their customers' throats.  As technology and new competitors buffeted them, the engineers got further entrenched in their own ideas and lost touch with what customers in changing markets wanted from IBM.  Among the many other dimensions of Gerstner's turnaround, he managed to change this engineering culture to a customer-centric culture, while also funding basic research which had really put the company on the map in the first place. 

COMPAQ too had an engineering culture, and their products were known for their extremely rugged construction.  "Unbreakable," we were told as Merrill Lynch paid their high prices to get average performance and lots of ruggedness.  I had the pleasure of having to carry the first portable computer in the economy cabin to a client location for some forecasting work.  It worked fine, but it was unbelievably heavy and unwieldy to carry.  There was no thought about design beyond basic functionality.  Here's a picture in case anyone else had to deal with this elephant:

HP has a legendary engineering culture going back to the earliest days of Silicon Valley.  Imagine when the two engineering companies were merged.  Then investors had a company that was truly out of touch with the fickle and demanding consumer markets.  Carly Fiorina and her successors failed to change the engineering culture at HP. 

Engineers believe that customers should buy products based on the spec sheets.  They also like to endlessly tinker with product designs and specs, in the guise of seeking perfection which also kills product launch timetables.  They also believe in their hearts that product design reflecting consumer ergonomics and user experience is something that they can do also, because "it's easy, not like engineering."

That's how you release a product like that pictured above.  Steve Jobs was able to talk with engineers and get to the kernel of their issues, and he had their respect because of this ability.  I don't believe that he tried to be a product designer, but he really looked at product design as a sort of consumer ombudsman.

So when a button came back and he used it the way a consumer would, he would say, "It's too big. Make it smaller!"  This wasn't imperious or micromanaging, but he was a proxy for the Apple customer, and a good one.  There's no doubt too that he had some visionary insights about how businesses could work, as in electronic music distribution.  I really believe that his eventual taming of Apple's engineering culture saved them from depending on products like LISA, shown below, to products that redefined consumer experiences like the iPod and iPad.

When Apple had too many new products on its strategic plan menu, Jobs was able to cut through the knot of empire building and engineering egos to say, "Give me that phone and that music player."  He used his own passion, ego, market intuition and business savvy to prepare the market place for these products in a way that catapulted Apple from a niche player in the education and graphic design PC markets into a true technology leader.  It's a great story.  

Apple's Future May Not Be Its Five Year Past

Steve Jobs' tenure produced a almost eight-fold increase in Apple's stock price, something which will likely not be duplicated in the next five years, no matter who is at the helm of Apple. In the nineties, Apple was a generator of mediocre products that were neither innovative nor priced to deliver value to their customers. The list includes corporate gaffes like Newton, Pippin, Lisa ($9,995 in 1993), the 20th anniversary Mac, portable Mac ($6,500), and the G4 Mac cube ($1,600). Hand picked CEO John Sculley from PepsiCo grew revenues but disastrously chose to have the company sell against IBM in corporate markets, which led to declining profitability.

Technology companies have growth cycles, with the attendant valuation cycles. As we've written before, Apple has become a cult stock. The recent explosion of revenue, returns, and valuation metrics was generated, in our opinion, from the ability of Steve Jobs to cut through the thicket of product development projects to identify the iTunes and iPhone projects as the "must haves" for the company's success. The troops at Apple all rallied to his call, and for such a large organization to focus with great energy and deliver is a testament to executive management, leadership and organizational depth.

The Wall Street Journal asks, "How can ordinary companies turn themselves into Apples?" The answer is easy, "They can't." As framed, it's a vacuous question.

Apple's adolescence, was exemplified by lousy products and a failed strategy, as discussed above. These describe an ordinary company. However, it grew out of adolescence into the young adulthood of the digital era with ideas that revitalized music publishing and enjoyment, as well as giving consumers the iPhone which converged entertainment, information, music, video, and computing in a great package. This is not an ordinary company by any stretch.

As Chairman of the Board, Mr. Jobs has the chance to interact with his hand-picked CEO Tim Cook and form a partnership which will guide Apple through another decade of adding value, but probably not at the rate of the recent past.

Bank of America: Heavy Clouds, Low Visibility

I finally read through the transcript of Bank of America's conference call, "hosted" by Bruce Berkowitz of the Fairholme Fund. There was really no visibility offered into the very few good questions. There was a discussion about selling "core versus non-core assets." The discussion then turned to Merrill Lynch, at the behest of a questioner.

I was truly flabbergasted by the response of CEO Brian Moynihan, who said that Merrill, to paraphrase, was fully integrated into the culture of Bank of America. No serious institutional investor would have tipped their hand by challenging this assertion, but it is totally implausible.

Ever since the Eighties, when commercial banks first bought asset managers to reduce their earnings cyclicality, the cultures have never meshed, particularly over compensation issues. Over time, the targets for commercial banks became the investment banks, which themselves had wealth management businesses, as well as proprietary trading desks and investment banking. Now, the cultural and compensation issues diverged more sharply from the commercial banks, although bank CEO compensation exploded sharply because they ran bigger balance sheets.

I once worked for Merrill Lynch when they were located in the old US Steel Building on Liberty Street. The idea of costs and internal controls were about as well understood as Mandarin Chinese. There was a complete disconnect between the huge retail brokerage network, "The Thundering Herd," and the institutional business, both of which were totally oblivious to the asset management business located in New Jersey. Fast forward to 2008, Merrill Lynch was being run by a distant, isolated CEO who wasn't excited by either the brokerage business or by the lackluster asset management business. Instead he led it into the world of creating Collateralized Debt Obligations, instruments that the board and the CEO didn't understand. As this out of control empire started to collapse, along came Bank of America to acquire Merrill Lynch.

US Bancorp bought Piper Jaffray in 1997, and dividended it back to shareholders in 2003. USB bought it at the high point of the cycle and divested at the low point, just before the market turn. In the interim, ownership added no value, and Piper subsequently thrived as an independent public company. Citicorp's acquisition of Smith Barney was described as follows by the Wall Street Journal in 2009, "Ever since Smith Barney became part of Citigroup 10 years ago, the brokerage has been whipsawed by integration problems and troubled deals." Smith Barney was eventually disgorged by Citi.

Citi couldn't integrate Smith Barney after ten years, and yet we are to believe that Bank of America has integrated the bigger and more sprawling Merrill Lynch in less than two years? Not likely. I had the misfortune to have some dealings with Merrill Lynch recently, trying to transfer an old account. I ran full tilt into a total lack of communication, record keeping, and computer system issues between Bank of America's systems and those of Merrill Lynch.

Integration in the best possible case might involve computer systems. The cultures can never be integrated. Institutional traders, salespeople, analysts, and capital markets executives are masters of the universe, and brokers are not part of the club. Retail banks can't sell brokerage services effectively. Why did Charles Schwab return to the business he founded? My point is that the Bank of America CEO's assertion about Merrill Lynch's complete integration would represent the first such successful integration in corporate history.

Beyond this point, which is not small, there is the issue of Countrywide Financial. Nothing on the call added any more clarity to the risks associated with this disastrous acquisition. The "see you in court" challenge to AIG was false bravado and would not give me comfort as a shareholder. Bank of America's asking Secretary Geithner for relief against mortgage fraud issues being brought by State Attorneys General has not worked, and this will be a protracted, multi-front battle which probably won't end cheaply.

After all is said and done, Bruce Berkowitz's Fairholme Fund's investment in Bank of America is very hard to understand. In 2009, Forbes Magazine asked Berkowitz why he was avoiding financials. He is quoted as saying, "Well, we don't know how to value them...It's impossible to know what they own...Five years ago, you could read AIG's report on derivatives. Maybe it was a paragraph. It didn't tell you anything. You had to just assume that these people knew what they were doing. Today you can read ten pages on it and still not know what's going on unless you go through the underlying collaterals. Almost impossible."

Fairholme should have followed its own advice, and this conference call shouldn't have made them any more comfortable with their investment.

Corporate Governance: Nothing New

McKinsey's Quarterly Survey of Corporate Governance shows interesting comparisons with the same poll taken in 2008, before the collapse of Lehman Brothers. The results should be disappointing for shareholders concerned about board effectiveness.

44% of the respondents say that their boards simply review and approve the strategies proposed by management. 58% of the board members responding said that their knowledge of the company's current strategy was lacking. Roughly the same percent said that their knowledge of the value creation process, company risks and industry dynamics were also lacking.

Have the boards been spending more time on issues? Afraid not. The amount of time spent on strategic issues was about 23% of board time in 20111 versus 24% in 2008. The amount of time spent on talent issues was also roughly unchanged in 2011 versus 2008, at 10% vs. 11% of board time spent on the company.

In order to make things better, board members felt that more time should be devoted to board work, and that a better mix of skills and knowledge should be brought into the board rooms. They also called for "better people dynamics that enable tough, constructive boardroom discussions." Instead of focusing on long winded, uninformative C,D&A and prattling on about sustainability, investors need their boards to work on the fundamental activities which comprise the fiduciary duties of boards.

Berkshire's Woodstock

While the whole David Sokol issue has been disappointing and out of character for Berkshire Hathaway, all of a sudden there are articles about breaking up the company because of the "sum of the parts" opportunity to create value. I'm sure that the financial press received spreadsheets and analyses from all the major investment banks on this hackneyed idea.

The fundamental issue is the durability of the BH business model. In my opinion, it's built on a few key elements. First, there is the enduring Graham and Dodd foundation, which is the basis on which Warren Buffett and Charlie Munger invest and look at companies. After all, Buffett himself studied at the feet of Graham & Dodd at the Columbia Business School in 1949, and his longstanding support of the value-oriented philosophy led to the creation of the Heilbrunn Center for Value Investing and the Graham & Dodd breakfast, which has always attracted top notch business leaders. Along with a disciplined analytical focus, the team of Buffett and Munger have added a fantastic intuition for simple businesses with good models and good leaders.

The next feature is the ability to reallocate cash flows among the businesses in the Berkshire portfolio. Past Chairman's letters have told stories like redeploying over a billion dollars in excess cash flow from See's Candies to other portfolio companies or for new acquisitions. This is an art that cannot be taught in a corporate finance course. Again, it comes from an analytical discipline, an ability to isolate the key issues, and a good sense for people. Looking at M&A experience in public companies, this is indeed a rare and valuable skill. This is "alpha," not "beta," and it is a skill investors should be willing to pay for.

The fact that they have done it over such a long period of time, as shown by their long and consistent growth in book value above the S&P 500 would suggest that investors are not being fooled by randomness.

Finally, there is the skill of the founders in retaining and properly motivating the founders of the portfolio companies to invest 100 percent of their energies in growing their business and in making a contribution to the portfolio by, for example, stepping to lead troubled assets from time to time. Of course, there are many, many additional subtle personal elements to the way the Buffett-Munger team operates, but these are the key elements, in my view.

Add them up, and it's quite a potent model that has proved durable and effective. Breaking up the company means that "The Song is Over," as Roger Daltrey would sing. But, if Buffett and Munger are good at leadership development and succession planning, there's no obvious reason why it should be so. However, their continued waffling about a successor, while dropping occasional hints about Ajit Jain, David Sokol and others, has really not been a good service to shareholders. While "Trust us," is okay for a time, ultimately shareholders deserve some sort of answer. I doubt that it will come in Omaha this weekend, which will do nothing but add to speculation and rumor mongering.

The David Sokol Affair: Shareholders Should Be Glad

Berkshire Hathaway, in surprisingly plodding fashion, has 'fessed up on L'Affaire Sokol.

Any executive officer of a public corporation with any sense would just feel in their gut, without recourse to a statute, or Code of Conduct, how to evaluate the following scenario.

December 13th, you direct Citi investment bankers to ask their client Lubrizol, if they would like to have a conversation with you, a senior executive of Berkshire Hathaway, about a possible fit for Lubrizol within the Berkshire Hathaway portfolio. The bankers would assure Lubrizol that Berkshire does not do hostile deals, and that a conversation that went nowhere would remain confidential.  The following day, the executive places a LIMIT ORDER (!) to buy 50,000 shares of Lubrizol.

Question: Doesn't everything in your business experience tell you that this is probably not a good idea? Does that little green cricket on your shoulder tell you anything? Even if it passed some legal test, isn't the question, "How would it be seen by the market?" Even better, "Wouldn't it put my boss (Mr. Buffett) in an awkward position?" If you were especially dense, you might just call your legal counsel.

It's impossible to comprehend. But a friend who's a lawyer and a corporate governance guru put it best when he drew this insight. Berkshire shareholders were fortuitously spared the terrible burden of having Mr. Sokol being appointed successor to Mr. Buffett. They should spin the track from Cream's first album, "I'm So Glad."

Is Shareholder Control Beneficial?

I perused a recent paper about the optimality of shareholder control, and though it didn't generate any interesting conclusions, it raised a good question. The recent issue with St. Joe Company comes to mind. The institutional shareholders are making a move to take control of the board and to steer the company in a completely different direction.


The board and the management of the company have only themselves to blame for being in the cross hairs of savvy institutional investors like Fairholme Fund and Greenlight Capital. They made a huge bet on development in the Florida Panhandle, centered around the binary event of whether or not a new airport would be built. The airport is built, but it turns out to be only a very small piece of the puzzle, and the board and management took an expensive and unhedged way to place this bet. Unfortunately for them, Fairholme drank the Kool Aid when they bragged in one of their annual reports about the unrealized value in all the Florida land their investment owned. Now, we'll see what shareholder control does in this case.


The recent case of Sears comes to mind. Much was made, rightly so, of the fact that the management simply couldn't run or merchandise stores very well. Shareholders voted with their feet and sold the stock. The story then became the value of the underlying prime real estate that Sears owned or controlled. Meanwhile, another terrible cast of executives were busy fiddling while Kmart burned slowly. Enter hedge fund manager Ed Lampert who took control of Sear merged it with Kmart, while confusing both sets of customers, who were distinct segments of consumers. Years later, Sears' repeated experiments with soft goods have failed miserably, but we didn't need to a change of control to know they couldn't execute. The appliance and home and garden segments are still the reason most people enter the store. An iconic brand of American retailing seems on the precipice of going the way of Woolworth, W.T. Grant and Montgomery Ward. Last year ended with Sears comps down 6% for December and 3.8% for the year. The environment in Sears stores is positively funereal. Most of the analysts have downgraded to neutral or under perform, with a few sells. Has shareholder control been beneficial in this case? I don't believe so.

Most institutional shareholders are good at what they do: constructing and managing portfolios, which is a very profitable business where mediocrity is rewarded since most money managers under perform their indices. Running a business, other than money management, is something that seems to be outside of their comparative advantage. St. Joe will be another good data point on the question of benefits of shareholder control.

Fairholme Stops Standing Still on JOE

There is a flurry of news today about St. Joe Company (JOE), a subject of a few posts a while back, first triggered by the informative presentation by Greenlight Capital. Into the argument came Bruce Berkowitz and the Fairholme Fund, owners of almost 30% of JOE, who poo-pooed all the arguments brought forward by Greenlight. Well, it appears today that Fairholme has finally awakened from its romance with the stock and has come out swinging MMA style.


CNBC reported today that Fairholme will seek to nominate Bruce Berkowitz and Charles Fernandez, directors of the company and executives of Fairholme, to the positions of Chairman of the Board and Vice-Chairman, respectively. CNBC reports that Fairholme will seek to dramatically shift the business model, including cutting the expense structure, perhaps stopping some planned asset sales, and looking for partnerships and new acquisitions.

A Morningstar analyst who has been quite bullish on the company, and who carries a $40 fair value on the stock, is fearful that momentum now being built up in the company's value-creating activities will be blunted by the Fairholme moves. It's hard to see what he means by this, as it's clear that some progress has been made--the company is not hip deep in a peat bog any more. However, to characterize anything JOE is doing as "momentum" seems a real stretch. Institutional investors control about 65% of the shares, and so it would seem that the Fairholme play should be a fait accompli barring the ability of the company to divide the shareholders, which would seem unlikely.

It's good to see Fairholme waking up, and its initially glib, dismissive attitude to the Greenlight Capital report has now been replaced by a sense of urgency. It should be good for the shareholders, once their plans are made more specific.

Tata's Nano Experiment: Lessons Learned?

The Tata Nano experiment was a very noble undertaking. Ratan Tata, the Chairman of Tata, is said to have tasked his engineers to build an affordable car for Rs. 100,000. This is the repeat of the Volkswagen undertaking, which was to create the "people's car." When Fiat came to the United States market, it came with low end 128's aimed at students and new graduates taking their first jobs. The first Datsuns weren't bad, but they were cars powered by motor cycle engines. When the Yugo came to these shores the mission was the same: affordable transportation that would launch a brand and open up other market segments.

What went wrong in all these cases? First and foremost, they were all lousy cars, but the Volkswagen's were the best of the lot. Mr. Tata should have modified his charge to his engineers: "Build me a Rs. 100,000 car that's safe, reliable, fun, and that you and your families wouldn't be ashamed to be seen in!" That would have ruled out the Fiats and the Yugo right away. The next, primary mistake is that these cars weren't really designed for their markets or their customers. The Fiats were badly underpowered and couldn't merge onto an onramp at 55 mph. The Yugo was a laundry list of disasters: incompetent, post-Soviet style engineering and low manufacturing quality were the real problems.

The Nano has the advantage of derivative styling that looks stolen from Nissan and others, but it's passable. The wheels are way too small, and the tires way too narrow for the awful Indian roads. Building small cars well is not a skill that confers itself automatically from being able to build light trucks or large sedans. It's a completely different engineering and consumer mindset. The Chief Minister of Gujarat is photographed supposedly entering the passenger side of a Nano in the NY Times, but judging from his girth and the opening of the door, he might have needed a shoehorn. Again, this is a design issue that a small car maker should be able to deal with.

The worst part of this story? The communications debacle. The Nano has been reported to have experienced a small number of fires. Instead of dealing with it quickly and decisively, foot-in-mouth disease broke out. First the company denied there were any issues. Beating a retreat from that untenable position, the company blamed the problems on "foreign electrical equipment." I'm sure that their supplier-partners loved to read that news. Just to be mensches about it, the company extended the warranty period marginally and said that they were going to improve the exhaust and electrical equipment, just for kicks. This pattern is the same one followed by Suzlon when their carbon fiber composite wind turbine blades failed on deployment in Minnesota. The excuses were just that. Not understanding the markets, not doing the homework, and not dealing with issues head on are present at every post-mortem of these commnication fires.

Tata will eventually get better, but the corporate mindset will have to become more open to change and listening to the market.