Tuesday, December 30, 2008

Dusting Off the Bookshelf

One of the dustiest parts of my library is the business book section, and that's probably because most of these volumes are not worth rereading and have a short half-life. I'm getting better at not spending money on these "made for flight delays" books. However, I found one that I have always liked, "Memos from the Chairman," by Alan C. Greenburg of Bear Stearns. The foreword to the book is by Warren Buffett.

A 1984 memo to all general and limited partners contains the following advice from Haimchinkel Malintz Anaynikal--Greenburg's imaginary mentor. It resonates with me every time I read it:

1. Stick to thine own business
2. Watch thy shop
3. Limit thy loss
4. Watch thy expenses like a hawk
5. Stay humble, humble, humble
6. When dealing with a new account, know thy customer and know thy customer's money is up.

Reflecting on 2008's rubble of corporate and financial debacles, I think Haimchinkel's tenets could have helped stave off disaster. Banks didn't stick to their traditional lending businesses and standards and got involved with market segments, customers and instruments that they didn't understand. Nobody was watching the shop, and that means managements, internal and external auditors and boards of directors. Number three has been turned upside down in the world of exotic derivatives. Expenses were irrelevant, as the size of the book was all that mattered.

To talk about humility in financial markets or in corporate board rooms seems "New Age," but when I read Greenburg's book in 1996 it was really refreshing. I never thought of Alan Greenburg as a soft and squishy type of executive, but he lived his beliefs and expected Bear Stearns employees to do the same. Somehow, as the culture of Bear Stearns evolved after the retirement of the charismatic Greenburg, all of this sound thinking was abandoned.

Corporate cultures are not immutable. Instead, they seem to radiate downward from the C-suite and seem to be inextricably associated with one individual. This can create what Nikita Khruschev called the "cult of personality." When the personality departs, the culture does as well, which means that the culture was really not something alive and durable. In the case of Bear Stearns, the management succession process was not able to preserve the culture and values cherished by Greenburg. Pity.

Wednesday, December 17, 2008

Some Cultures Don't Fit--And We Know It.

When I started on Wall Street in the Eighties, I first encountered the fashion of commercial banks purchasing asset management companies. You know the justifications: diversification and entry into a high margin, recurring revenue stream business. Walking past the Chemical Bank on Park Avenue in New York City on the way to work, I read about Chemical buying an outfit named Favia Hill. Bankers Trust, which was across the street, soon followed with their own announcement, and the trend started in earnest.

Not too long afterwards, rumors of tensions started surfacing. Asset management companies gave free rein to their senior portfolio managers regarding decision-making, and the compensation arrangements were quite generous. Of course, the commercial bank owners, who were used to heavy regulation and lots of bureaucracy, could not abide the free wheeling culture, but especially could not accept the compensation levels in their asset management subsidiaries. A few years later, most of the banks disgorged their asset management groups, while time, management focus and shareholders' monies were wasted.

Here we are decades later, and Bank of America buys Merrill Lynch. The press releases sound similar, except they are written more in the vein of "we've created a true financial bazaar, including advisory services and retail brokerage." Now however, the pay gap between the two executive cultures has narrowed, as C-suites in banks also have robust pay packages. However, the cowboy culture of investment banks and high-end wealth management groups has also become more extreme. Remember the Internet Bubble and "PO!" stocks rated "Strong Buy?"

The cultural mismatch is exacerbated today by SOX concerns, conflicts of interest, the uncertain role of equity research, and quasi-independent wealth management groups operating under a corporate umbrella. This was never a match made in heaven, and it's hard to see why it would be different in the markets of today and tomorrow.

The 4.5% Solution

Again, Professors R. Glenn Hubbard and Christopher Mayer of the Columbia University Graduate School of Business have reiterated their idea for putting a floor under housing stock price declines, avoiding foreclosures, and for enabling consumers who refinance to increase their consumption. We've written about this idea for some time in previous posts, and it sounds as if something like it might be forthcoming.

This would be a much bolder move than the much-ballyhooed but largely symbolic easing announced yesterday. To paraphrase Alan Blinder, "A for effort by the Fed, but an Incomplete for results."

Given that the lateness of the calendar, we're a little concerned about the ability of the Congress,the Bush and incoming Obama administrations to agree on the Hubbard-Mayer plan, but there's always hope.

Here is the link again:

Monday, December 15, 2008


I've been in a number of discussions lately where everyone has cried out for greater accountability. The pleas for accountability are always directed away, at other groups, either on the same rung, or most often up the hierarchy.

In my soccer team coaching, I have always emphasized mutual accountability. A soccer field is too big, and the power of any one individual--no matter how skillful--is too small to carry the day in a match. So, a back line defense must be accountable to each other, in deciding how to patrol the defensive areas, how to shield the goalkeeper and how to supply the midfield. A goalkeeper is accountable to everybody, but especially to his back line in helping them manage their assets. The midfield is accountable to both the back line and to the attackers. Without being able to supply the attackers, the team can't score; without shielding the back line, the defense will eventually be pierced by a well-organized team moving the ball. The attackers are the ones with artistic license, but they too have to take their chances when they come and finish them. If the team is under pressure, attackers are accountable to defend.

Within each unit, the members are accountable to each other, so that if ball possession is lost it has be be recovered, as soon as possible, and it doesn't matter how. This means that there is constant communication within and across groups. By contrast,communication in corporate groups is episodic--daily or weekly meetings--and stylized. There's no time for that on a field. It's live, it's constant and it relates to an immediate problem.

High level executives love golf, the most solitary of games. This seems ironic to me, especially since team work is one of the most overused corporate cliches. A report about the former CEO of Merrill Lynch noted that he preferred to play golf alone. After the demise of the firm, a consultant to the board of directors noted that this might have been a red flag!

Accountability is really for everybody, and it should not solely be regarded as being directed upward, as it is in most organizations. Every working group or project team can employ the idea of mutual accountability to great benefit.

Friday, December 12, 2008

It's Not Rocket Science

As the details begin to emerge about a Guinness Book of Records-size Ponzi scheme by Bernie Madoff's "asset management" company, there were two interesting items about investors who passed on giving assets to the Madoff funds. In some cases they hired firms to perform due diligence. So, did these investigative firms send in laptop-toting, analysts with high-powered statistical packages to back test the firm's strategies? Not at all. They asked the very basic, but penetrating questions.

One firm simply looked at the name of the accountants overseeing the financial reporting for Madoff's $50 billion in assets under strategies that involved indexes and options. They actually called and then visited the accountants and discovered a three person firm, one of whose principals was 78 years old and lived in Florida (the office was in New York). You don't need to turn this over to your risk management committee. It makes no sense, smells bad, and it is highly improbable that they could exercise the proper level of auditing oversight and control. The investigative firm recommended that their investor pass. Bravo!

Another item relates to a simple thinking through of the most basic conflict of interest, namely the trustee that held the securities for the asset management business was indistinguishable from Madoff's entire enterprise. So, this investor rightly concluded that it would be extremely difficult, if not impossible, to independently verify the existence of assets, especially cash which had seemed problematical during several reporting periods. Simple, clean, elegant logic. Maintain independence and verifiability. Avoid conflicts. This same market professional wrote a letter to the SEC of his findings and characterized Madoff's investment firm as a Ponzi scheme in 1999.

Academic research has talked about why people sell winners early and hold onto losers for too long. One of the theories can be summarized by the phrase, "Pride and Regret." This phrase can also apply to the due diligence process for buying into alternative type investments. If you have to ask silly questions, like "Who holds the assets, and are they independent from you, the manager?" you probably don't have the native intelligence, didn't go to the right schools, and are otherwise not worthy of the high returns that are being handed out. Nobody wants to feel like they are unworthy, that is basic pride. Similarly, suppose that a friend at a cocktail party points out that she has never heard of your hedge fund accountants. You might start to feel a twinge of regret, not to mention anger at someone raising something that seems obvious after the fact. "Could she be right? Did I make a bad decision?" It's much easier to assuage the regret by feeling that you will surely cash out before anything catastrophic happens. Or, the "SEC and the regulators watch out for this stuff." Other rationalizations abound, but they revolve around "pride and regret."

Emotions still matter in the matters of money and markets.

Thursday, December 11, 2008

Can You Spare $15 billion?

A hedge fund has come up with a great idea for Microsoft and Yahoo! Microsoft should immediately overpay in cash for Yahoo's search engine business, which is becoming less valuable by the minute. The $15 billion bonanza for Yahoo's shareholders would generate higher future cash flows and result in shares being bought back returning money to impatient shareholders, like the hedge fund. Microsoft may be anxious for a deal, but surely they haven't lost sight of reality.

What about carving out the search business into a separate entity? I would call it "Yahoo?", as opposed to the parent Yahoo! Let Microsoft buy a stake in the entity, take a board seat, and get some cooperative ventures signed and a right of first refusal to an unsolicited bid; sell the rest to the public. Over time, let's see where the value of the entity goes. Instead of a windfall bonanza to Yahoo!, this probably puts a floor to the valuations and could wind up developing more value over time and result in a bidding war later, when companies are more flush and valuations richer. In this model, cost-cutting benefits accrue to both parties in the form of higher earnings for the carve-out. A secondary benefit would be a large injection of fees into the beleaguered investment banking M&A business.

Tuesday, December 9, 2008

How Not to Get Better Corporate Governance

Professor Jonathan Macey of Yale Law School has written a book, "Corporate Governance: Promises Made, Promises Broken," which is the basis of his op ed piece today in the Wall Street Journal.

He proposes "market solutions" for improving governance. This certainly sounds like a well worn mantra. Then, he actually writes, "Hedge funds and activist investors...are the solution not the problem." Whether or not they are a problem can be debated, but it is unbelievable that they could be generically portrayed as a solution to corporate governance issues.

Hedge fund managers are transaction oriented, and they establish ownership positions with their agendas in mind. Witness, for example, Pershing Square Capital's ongoing dialogue with the management of Target Corporation. Perhaps in response to Pershing's first idea, Target sold off part of their credit card portfolio. Then came the "Big Idea," to sell off Target's entire real estate portfolio into a REIT and then to lease the properties back for seventy-five year terms! After lots of dueling press releases and competing analyst meetings, the company properly rejected the proposal as being against the long-term interests of the company, as it would reduce its financing flexibility, lower its debt rating, increase its expenses, and divert management attention from its core competencies of merchandising and retail management, all for a one-time payout.

The much ballyhooed combination of Sears and Kmart engineered by hedge fund manager Ed Lempert has been a disaster for both companies, their consumers, employees and investors. A merry-go-round of executive management changes has taken money and time, but produced nothing. This is better governance?

A well-run company, with a strong management team and an effective board of directors has to look to the long-term and not put the company at risk for a short-term transaction. News today of the Tribune Company's bankruptcy again shows the pitfalls of defining shareholder interests narrowly and exclusively, to the exclusion of other legitimate stakeholder interests, like employees. Those Tribune employees who took buyouts to facilitate a hare-brained transaction now stand to lose their promised payouts and stand in line as unsecured creditors. To treat important stakeholders like this is not enlightened good business practice and violates basic principles of fairness.

Hedge fund managers, and indeed many traditional, value-oriented institutional investors often come up with interesting thoughts for strategic initiatives in their portfolio companies. All of these suggestions should be listened to and considered thoughtfully. An open, constructive dialogue with the shareholders is something that benefits both parties. However, it is the responsibility of the board to keep its hand on the strategy tiller and to let management focus on execution and financial performance.

There are cases where an activist hedge fund has prodded a complacent company into better use of underperforming assets, most often through a transaction. However, the notion that hedge funds broadly are a panacea for better governance defies both history and logic.

Thursday, December 4, 2008

The Fed Wakes Up to Foreclosures

Fed Chairman Bernanke expressed concern today about the foreclosure rate which he says is running on track for 2.25 million proceedings this year. Forcing lenders to lower published mortgage rates accomplishes nothing, because if home values are down, credit score requirements are more stringent, a household has a job loss and reduced income, and the lender's margin has risen, mortgages won't actually be closed at those rates to the people who really need help. The banking industry has never been set up to effectively and humanely handle large volumes of foreclosures, because it is something that they're not good at and something that was never anticipated on a large scale. The participants in the foreclosure business are yet another unregulated, unseemly lot. Unleashing this process on a large scale is like introducing termites into a house.

The Hubbard-Mayer plan, which we discussed in an earlier post aims to keep people in their homes, while resetting rates and loan amounts to realistic values. Lenders will have some write down issues, holders of securitized paper will cry foul, and there may be windfall gains to some homeowners. It certainly has some implementation challenges, but no more so than those created by the potpourri of ineffective plans and programs out there now. I believe that a form of this plan will in fact resurface, and hopefully we can decisively address the foreclosure problem in the near future.

Here is the earlier link to their publication:

Tuesday, December 2, 2008

GE Capital: Take Away the Doubts

Investors bid up the beleaguered shares of GE today, and looking at the slide presentation relating to GE Capital, there appeared to be some substantive reasons for to be optimistic.

The presentation conveyed the key strategic messages:

1. GE Capital was integral to the non-financial parts of the business going forward.
2. The business was going to be stabilized, refocused, and the business model tweaked to put it onto a more stable, long-term footing. Looking at the business model under drastically changed conditions is critical, and they did it.
3. There was no risk to the dividend from GE Capital. The whisper was that the dividend's in jeopardy. They took away that doubt.
4. GE Capital was number 1 or 2 in all of its key business segments. This is the long-held GE mantra that if they can't be a leader, they would exit the business. Thus, they measured themselves by the same strategic yardstick, not something new or invented on the spot.

This was a story that was well told. Of course, the devil is in some of the aspects of the markets unfreezing, but it looks like they have worked through likely scenarios.

Looking out beyond the current crisis, when investors are once again looking at global infrastructure plays, GE should look attractive on the commercial and industrial sides of the business.

Friday, November 28, 2008

Someone Doing Her Job

Managing Partner Susan Glass of KPMG threw cold water on what was described as the "largest leveraged buyout" of BCE, Inc. of Canada. The deal was predicated on the company taking on $32 billion of new debt, along with sales of various assets now deemed "non-strategic." Spending four weeks or so running numbers under various scenarios, the conclusion of KPMG was that the entity post-buyout would be non-solvent.

We've written before about roots of the current crisis being found in the failure of boards, regulators, and auditors to execute their basic responsibilities. It's really heartening to see an auditor stand up and do their job. Presumably, having done the audit on the company for a while, they understand how their financials work, and something of their businesses. They can run spreadsheets out into infinity as well as as associates at investment banks. Based on this, along with some auditor skepticism and conservatism, BCE received a non-solvency opinion, which kaboshed the transaction per the deal documents.

Their are noises being made about essentially shopping the opinion, or rather engaging an accounting consulting firm to "check" KPMG's assumptions. Let's hope that common sense prevails. This is what the auditor was paid to do, and they have opined. Now let the board and management come up with their own plan to create shareholder value without the risk of insolvency.

Wednesday, November 26, 2008

The Basics of a Corporate Mission

One of the first times I heard Harvey Mackay speak about Mackay Envelope's corporate mission, I was taken aback. He said that it was the following "To be in business forever." A few uncomfortable chuckles broke out, and other CEO's in the audience shook their heads at each other. Shouldn't this be the fundamental mission of every corporate organization?

Look at the U.S. auto makers. In the Seventies and Eighties, they were reeling from bad products, poor management, burdensome labor contracts, and retirement costs. However, in the Nineties, with the economic recovery in full swing, things got much better. Cash flows were strong, as the SUV phenomenon swelled profits per vehicle, but the managements succumbed to the short-sightedness of Wall Street and its hedge fund activist investors. Shareholder value fell onto everyone's lips, and lots of stock was bought back and dividend payouts raised.

Reinvestment in the company's basis business, which is a key to a company being in business forever, was ignored. What about new plants, new processes, new ways of manufacturing, right shoring? What about looking beyond a wave that surely would not last forever and investing in the ability to build smaller, more innovative vehicles?

It's easy to guess what the Japanese did: Toyota and Honda ignored the self-interested and short-sighted cries of vocal institutional investors and they continued to innovate around their basic business, making vehicles.

Lots of traditional mission statements flow from the basic one uttered by Harvey Mackay. Looking beyond the current crises, one wonders which ones of today's industrial leaders plan on being around for a long time.

Friday, November 21, 2008

Corporate Jets

Grandstanding on Capitol Hill is national pastime. Surely the auto industry executives appearing, hats in hand, in Washington should know that by now. Instead, they walked into a buzz saw when asked about their transportation mode to the hearing. Now, the use of corporate jets will be inextricably linked in the popular mind with the arrogance--real or not--of the executives.

The economics of using corporate jets makes perfect sense in many cases, depending on the number of people flying, the destination city, its airport conditions, and the specifics of the destination site and the plans for the day. Almost two decades ago, a brokerage firm I worked for used a "plane share" system on a King Air. With six of us flying into Chicago for client calls-- the price for peak hour commercial flights, being able to land downtown versus O'Hare, avoiding rush hour traffic, spending more time with customers--the economics were a no brainer. Surely, a similar case could have been made on the Hill.

Instead, some of the press proxies for the auto executives had the chutzpah to talk about the risk of kidnapping flying from Detroit to Washington! Why not just explain the simple economics of the decision, including non-pecuniary benefits like being able to work full-time on presentations during the flight? End of discussion.

In Washington, DC, as in most places, perception trumps reality. This is a total non-issue in the current systemic crisis, yet it will be used as a defining moment for characterizing the industry. As ridiculous as it sounds, this question should have been anticipated in a well-prepared brief for the executive team.

Saturday, November 15, 2008

Fundamentals in a Down Market

David Katz of Wachtel, Lipton & Katz and his co-author, Laura McIntosh published a survey article about the results of the 2008 proxy season. Here is a link to the article via a Harvard Law blog:


Shareholder communications are vitally important, and they do yield tangible results in cases where there are direct inquiries about executive compensation plans, for example. The authors cite a union that withdrew more than half of its proposed pay-for-performance proposals after direct negotiations with the target companies. So, when a company is under the gun, well constructed outreach to shareholders yields results.

Looking beyond the state of the current market, investors still care the most about fundamentals, like the strategic direction of their portfolio companies, returns, and on management's creation of long-term shareholder value.

Tuesday, November 11, 2008

A Great Idea Lost in the Din

Glen Hubbard, the Dean of the Columbia University Graduate School of Business and Professor Chris Mayer, came up with a bold proposal for the residential mortgage mess back in early October. Here is a link to FAQ about their plan on the Columbia University GSB site:


I look at it this way. 1. Q: What is the home owner's worst nightmare? A: Being foreclosed out of one's home, creating heartache for the family, and losing your credit rating for the future.

2. Q: What is the last thing that banks want? A: To foreclose on a home and to be an owner of residential property. Why? Homes in foreclosure go into a parallel universe with fly-by-night service providers who promise a lot and do nothing. The home sits there and deteriorates through a winter, the grass goes unmowed, and this quickly affects the market value of adjacent homes that might themselves be coming on the market. This process does not work for the bank. It is a remedy that is worse than the disease. So, we come to the conclusion that avoiding foreclosure is not an issue of moral hazard or of bailing out people who made foolish decisions, but something that is really in no one's interest.

The Hubbard-Mayer proposal is the only one I've seen that addresses this reality. Much of the current Wild West buffet of bailout-du-jour strategies serve only to address the balance sheets of the financial institutions. There is much more at stake than this, as the banking system contagion feeds back, through the mechanism of declining GNP and employment,onto home prices. Since this has already begun, the proposal probably needs a bit of tweaking, but this is minor.

Their proposal excludes investors and speculators, and basically resets all interested homeowners to a 5.25% fixed rate mortgage based on a reasonable loan-to-value ratio, provided the homeowner can support the new mortgage. A new SPE would administer the program and write-downs from the current mortgage and value situation would be shared between the originator of the old mortgage and the new Federal SPE. The homeowner would give up 20% of the future home appreciation to the government when the home were sold.

There is a lot to like about the proposal, because it doesn't whittle away at the problem, it cuts the Gordian Knot.

Edwards Life Sciences

Here is a solid, low-growth, small cap medical device company with good cash flows that was always underwhelming at analyst conferences, where I got to listen to their presentation, after having presented for Possis Medical. I posted earlier today about acquisitions, and just got an email from the Canaccord Adams medical device analyst about Edwards ("EW")

"EW signed an agreement with Dexcom to develop continuous glucose monitors for the hospital market, which represents a multi-billion dollar annual revenue opportunity, in our estimation. That said, product and market development are long-term projects at this point." (Nothing wrong with that!)

Access to this opportunity costs a small upfront R&D payment, plus ongoing product development support for three years, the net effect of which, according to Canaccord Adams, is to raise the ratio of R&D to sales by ten bp or so in that period. Big deal!

For Edwards, which has historically had free cash flow not returned to shareholders, this seems very much in the spirit of our thoughts in the previous post about acquisitions. Good luck to Edwards and congratulations for not standing pat, but for taking what seems like a minimal, measured risk for a potentially large reward.


Everyone loves and needs transparency, right? So, with $2 trillion in taxpayers money being doled out for emergency aid to financial companies, there is almost no information about the assets being accepted as collateral for our money. This is so despite assurances to the contrary and invocations of the mantra "transparency," by Secretary Paulson and Chairman Bernanke.

Dan Fuss of Loomis Sayles, a very savvy and experienced fixed income investor who manages about $17 billion in bonds, points out that the lack of disclosure is particularly critical in a market that is "very nervous and very thin."

Congratulations to Bloomberg News for suing under the Freedom of Information Act for details on the Fed's lending. Let's see how this plays out.

Isn't It Strange?

During the pre-crisis market euphoria, M&A activity was robust. Multiples offered by buyers were rich, and premia to market prices of public companies sometimes took the breath away. Think about the many deals that were put on hold or which are no longer on the radar screen of the acquiring company's board. Does this make sense?

If an acquisition fills a legitimate strategic need, bankers are hired, spreadsheets are cast, fairness opinions abound, the acquisition is now teed up. Markets freeze and the deals wither. However, if all the reasons for looking at the acquisition were truly of strategic value, then all that should have changed--in many cases--is just price. Markets handle this issue all the time.

I remember some McKinsey research that said in market downturns, 60% of companies that made acquisitions in frothy markets choose to do nothing in a downturn. Isn't that strange?

Seller's expectations will be brought back down to earth. This is particularly true for private companies that are now facing a change in the capital gains regime from a new, activist administration in Washington. Weakened currencies of the buyers hamstring their ability to be indulgent with their owners money. If the strategic reasons are still there, come up with a new deal structure, or start with some form of partnership that leads to a deal later.

There are a number of microcap public companies that are profitable, with cash on their balance sheets that can earn higher valuations if their growth prospects are visibly enhanced. Acquisition targets for these companies are most likely private companies. It would seem that CEO's and their boards, instead of worrying about next quarter's earnings--which are probably going to worse than plan--should be looking at acquisitions.

Some key criteria for the acquisitions? A business with good long-term economics. A business that adds luster to the portfolio. Honest, trustworthy and committed management. A reasonable price.

Boards and management almost never talk about overpaying in a frothy market, and yet it is almost always the case that the acquirer does so. In these kinds of markets, there is some risk that prices continue to decline for targets, driven largely by macro issues that diminish the economic value of the target. Again, these are things that can be negotiated into a structure provided that both sides see the strategic benefits of the acquisition.

Thursday, November 6, 2008

Restoring Confidence..or Not

Financial markets, and particularly credit markets, rest on a foundation of confidence, the first principle. When banks lend to each other, when strong industrial companies float commercial paper, there is a confident belief that the lenders will be paid back on a timely basis. This belief is fostered by due diligence and analysis of the credit, for sure. However, it really rests on experience, a history of transactions, and on a belief that a market player will play by the rules.

So, in traditionally deep and liquid markets, like the interbank markets and commercial paper, the risk premia applied to the cost-of-funds rate are usually thin. Now, despite all the Treasury and Fed's opening of the checkbook, the markets still remain frozen, albeit with a thin layer of melted water on top.

The confidence to make credit markets work has not been restored. Massive amounts of liquidity have been injected, but the liquidity has become trapped, to borrow a usage from John Maynard Keynes.

Jim Grant's observation is on point: "The bear market is truly a value restoration project. Wall Street will be going on sale--if the government will let it." We need to get on with the "creative destruction" process. First the cleansing, then the renewal. Forty government folks sitting in a building deciding who is going to survive and who will not is no way to get us out of this fundamental crisis. The Federal Government needs to stand down and let the markets work. There are certainly some legal, administrative and regulatory adjustments that need to be made to facilitate this process. But, no more, "Ready, fire, aim."

Thursday, October 30, 2008

Cost Cutting

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

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

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

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

Saturday, October 25, 2008

Feds and Corporate Governance

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

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

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

Stay tuned.

Tuesday, October 21, 2008

Small Cap Investors

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

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

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


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

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

Performance Appraisals

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

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

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

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

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

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

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

Saturday, October 18, 2008

When Will They Ever Learn?

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

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

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

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

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

Wednesday, October 15, 2008

Where Were The Boards?

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

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

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

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