Friday, October 28, 2011

Algae Factories In Our Future?

There have been some interesting meetings about using algae as a renewable fuel source, which motivated a quick review of what's been happening with alternative fuels.  As corn-based ethanol has rightly been fading as a meaningful solution for our hydrocarbon dependency, cellulosic ethanol once seemed extremely promising. 

One of the emerging leaders was Iogen Corporation in Canada (  Goldman Sachs was an early investor in the company.  Pilot plant results using wheat straw were very promising, and the energy balance for cellulosic ethanol looked a lot better than that of corn-based feedstock.  In 2011, Goldman Sachs was hired to look at strategic alternatives. 

The company formed Iogen Energy, which is 50/50 percent owned by Iogen and by Royal Dutch Shell plc.  Plans for a full scale commercial plant in Canada are taking longer than planned for "technical design and feasibility" issues. Abstracting from the technical process issues, the other big issue for plant economics will minimizing transportation costs for the low value per unit volume feedstock while also getting the fuel efficiently to a wholesale distribution point.  Things still look promising for this fuel, but it will be part of a portfolio of transportation fuels. 

Several industry experts have pointed out that naturally occurring algae won't be able to produce on a large enough scale without having uneconomically large areas devoted to production.  Renewable biofuels fron algae will almost certainly require synthesizing some specialized organisms which produce the fuel in a manner in which it can be easily "skimmed" or recovered without necessarily breaking apart the producer organisms themselves.  This has been described by Craig Venter as requiring the "invention of a new agriculture."  Since ExxonMobil has committed to researching algae-based biofuels, there is optimism for the future.

A large NSF research grant led by investigators from Penn State University aims at developing genetically engineered bacteria for production of liquid fuels will be completed in early 2012.  This has been a four year effort and hopefully, it will advance the renewable fuels effort forward.

While this area continues to show promise and leverages our scientific, engineering and production expertise as a nation, renewables as a class of fuels will be a part of a fuel portfolio that will be dominated by hydrocarbons for decades to come. 

Tuesday, October 25, 2011

Pandora's Risk: Goodbye to Efficient Markets

Kent Osband's book, Pandora's Risk from Columbia University Press is the best book on financial markets I've read this year.  It's not an easy read, but stimulating and worthwhile.  He made a related presentation in 2005 to the Irish Society of Actuaries titled, "How to Mismanage Portfolio Risk: A Guide for the Fiducially Challenged."  I can't find a link to the slides on the Web, but it's got the same tongue-in-cheek style.

In Osband's view, one of the strangest features of financial markets is their self-absorption.  In the continuous experiment that is a trading session, the actors are also observers.  Invoking Keynes, a financial market is not like a beauty contest aiming to pick out the greatest beauty, but it's aimed at finding out which contestant the other judges would pick as the best. 

As each piece of new information comes in, including about the previous trade, market participants make adjustments in a never ending process, until the bell rings and the market closes.

When thinking about the CAPM formulation, the intrinsic value of an equity is like a port into which the market eventually puts in, through fundamental valuation and incorporation of all relevant information.  In the weaker formulations, it may zigzag its way into port, overshooting and undershooting, but the ship puts in.  In Osband's world, he models us away from the nice Gaussian distribution and takes us into beta and gamma distributions, where risk is not so neat and where uncertainty abounds. Volatility is high, trading volumes are high, and buy and hold strategies are not value producing. 

He doesn't have kind words for pension consultants who focus on tracking error to evaluate mutual fund managers.  Tracking errors, he shows, are good for fund managers' job security, but not for their clients.  Conventional indexes contain most of the market risk and reward, so clients should be taking MORE risk on the residual element not less.  His preferred model for a typical investor would be an index fund combined with a delevered hedge fund vehicle to produce superior returns. 

Most mutual funds diversify TOO much given their investment profiles, where the benefits of risk reduction are quickly outweighed by mediocre holdings and inability to monitor the portfolio quality, which means defaulting to tracking error. 

Talking about the melting of the global financial ice cap, he poses and answers the following questions:
  • "Did we measure risk incorrectly?"  Answer: Yes
  • "Did we measure the wrong risk?"  Answer: Yes
  • Did we wrongly expect too much from our risk measures?"  Answer: Yes
Of course, he's not alone here, but Osband pillories VaR models as delusional, except for the fact that every investment bank used them. 

In my continuing search to understand what we really know about enterprise risk management, I found this comment particularly insightful:  "Most risk managers have detailed knowledge of individual trade exposures, largely redundant with that of the traders they're checking on."  What the risk manager doesn't know, both for model limitations and data limitations, are how these individual risks fit together.  Given mark-to-market and Osband's model for market price behavior, the possibility of a nuclear portfolio event is never far away.  As he writes, "Mankind can aspire to mastery of the universe but never achieve it.  To err big is human." 

He doesn't have kind things to say about US monetary and fiscal policies, and in particular the endless rolling over of public debt.  We have seen the sovereign downgrade of US debt come and go.  However, domestic sovereign default is the biggest risk facing the global system, Osband says.

Although he doesn't write about this, the second biggest risk is probably the slow unwinding or collapse of the Euro. 

For state and local pension funds, his outlook is red on the Uncertainty Meter.  We should "stop exempting public agencies from private sector standards for estimating the NPV of future (pension and bonding) obligations."  Amen to that, and it's something that could be easily enacted although there might be casualties among the stampede of lobbyists in opposition. 

And so it goes.  Have a peek into Pandora's box with Osband.

Monday, October 24, 2011

Arab Spring's Prescursor: Algeria

I just finished John Kiser's fine book, "The Monks of Tibhirine," which provided the basis for the screenplay of Xavier Beauvois' wonderful movie, "Of Gods and Men."  Kiser's deft treatment of Christian-Muslim relations is depicted against the violent background of French colonialism in Algeria.

The Western press has romanticized the so called "Arab Spring," as a prelude to a golden age of Western democracy and modernity in Middle East nations oppressed by their own dictators.  Some of this is wearing off as the reality is showing something different. 

In Kiser's book, Ali Benhadj, a popular preacher who resonated with disaffected Algerian youth says,"For Muslims liberty is constrained by the law of God, not by the rights of others....rights change, and liberty is an illusion that can be trampled by the state.  True liberty comes from submission to God."  Benhadj wrote this in  the newspaper El Munguid ("The Deliverer") around 1988. 

So the Western concept of a secular, political democracy in which the state regulates religion to being a solely private matter, is anathema to the population in the Middle East.  It's interesting to read about the commonality of ideas and mutual respect between the local Algerian Muslim population and the Cistercian monks, who are People of the Book. 

In a speech at the Es Summa mosque in November 1989, Kiser writes that Ali Benhadj said, "They (the Algerian ruling elites) are just like the French before them.  They believe that God can be separated from life, visited perhaps once a week in a mosque.  They have adopted the so-called Enlightenment thinking of the French, which is at the root Greek, an insolent idea that man is the measure of all things.  Everything comes from God. Secular thinking separates man's spirit from God. Islam teaches that it is man's duty to be humble and to serve God in accordance with his commandments." 

The Syrian, Tunisian, Egyptian and other elites bring their own philosophical, political and economic baggage to the discussion about the future of the Arab Spring.  Reading about Algeria's history through Kiser's book was very instructive in thinking about the future of the countries which are trying to throw off the shackles of authoritarianism.  It will not be a short struggle.

Thursday, October 20, 2011

A Coupon For The Groupon IPO

What could be better than daily deal coupon issuer Groupon giving a rebate on itself?  Back in June, we posted on the absurd $15-20 billion valuation range  being suggested  for Groupon. Many investment bankers are probably poker wizards with the requisite "poker face," which allows them to make the most ridiculous statements without blushing or bursting out laughing.

In today's Wall Street Journal, we see that investors can get a coupon on Groupon:

"In a stark comedown for what was expected to be one of the hottest stock offerings of the year, Groupon Inc. is scaling back plans for its public debut. The Chicago company and its bankers will begin meeting with investors in the next few days to sell them on a deal that values the daily deals pioneer at less than $12 billion, according to people familiar with the matter. While that would still mark one of the biggest Internet IPOs since Google Inc. in 2004, it is well below the valuations that were bandied about when the company filed to go public in June. Groupon's IPO was originally expected to value the three-year-old company at between $15 billion and $20 billion, according to people familiar with the matter"

In the meantime, we've had IPO metrics blessed by the company and its auditors, and then the same metrics were withdrawn.  An email from the CEO suggests that investors should ignore marketing costs because they can be scaled back at any time, which could sound like "managing earnings," assuming that Groupon had earnings.

With the powerhouse banks behind the deal, a deal will get done.  Lucky flippers will have a nice payday.  The Groupon model is not healthy for most restaurant businesses, but if this industry manages to get a footing, then it will take its profits out of the hides of their small business customers.  In the meantime, I can't wait to see which mutual funds wind up listing Groupon as 2% of their fund assets. An absurd valuation is now merely ridiculous. Caveat emptor!

Wednesday, October 19, 2011

Auditor Term Limits: Another Irrelevant Idea

Arthur Levitt, former SEC Commissioner, has weighed in favor of "auditor term limits."  This will do nothing but impose costs on companies, and, as usual, those costs will fall disproportionately on smaller companies which don't have armies of people in finance, tax, treasury and accounting.  As a stockholder, already facing meager returns, I wouldn't get excited by this proposal.

It will also add to SOX expenses for no value-added, as auditors will not agree on the identity and number of key controls, which in turn will lengthen audit committee deliberations, particularly for companies which are trying to remediate already existing weaknesses and deficiencies.

This foolish idea will not:

  1. Result in higher quality audits
  2. Reduce risk for institutional investors.
  3. Improve transparency or utility of financial statements produced by issuers.
  4. Make auditors work harder on existing engagements.
  5. Have any economic benefit beyond political window dressing.
Expect to see board expenses go up because of more audit committee meetings, legal fees go up for outside counsel reviews, and watch audit fees and SOX consulting fees rise also.

As we enter the campaign season, it makes for good headlines, though. 

Monday, October 17, 2011

Tsar Bloomberg's Free Pass to Occupy Wall Street

I have nothing but admiration for Mayor Mike Bloomberg as a successful entrepreneur, builder of a global business and as Mayor of one of the world's most ungovernable cities; but in his third term as Mayor, he has stayed on too long and appears to have lost any enthusiasm for the shin whacking necessary to exert leadership in Gotham.

Inviting the Occupy Wall Streeters to be our guest and see New York on "$10 a day" was irresponsible.  The dynamics since then mirror what happened on the Columbia campus during the strikes of 1968-69. What then began early as a quasi-student protest quickly got taken over by professional agitators with no investment in the University and loyalty only to their political agendas.  Columbia College, its professors and students, and the City picked up the tab, while the "movement" got its legitimacy.

Demonstrations in New York require lots of overtime for the Police and Sanitation Departments.  How is a strapped municipal budget going to absorb this expense? Now that the OWS crowd has expanded to include professional agitators, their supervisors and videographers, municipal expenses are going way up, and since there's no deadline for clearing out the demonstrators, the sanitation expenses will be ongoing.

The choice of Zucotti Park as a focal point for the demonstrators now brings in Brookfield Properties as another target, since Zucotti is not strictly a municipal park.  The brain trust for OWS made a good strategic choice, as the City and Brookfield will now be pitted against each other to see who bears what costs.

The Mayor's debacle with his Schools Chancellor and one of his top aides demonstrates that he has gone off his game and lost interest, and it's perfectly understandable.  However, passing the buck on dealing with this Sixties-style demonstration is an unnecessary affront to NYC residents, taxpayers and property owners.

As Wall Street execs arrive at work in their livery cars, I don't think they are giving OWS any thought beyond how to make a good trade on the news stories.

Thursday, October 13, 2011

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.  

Sunday, October 9, 2011

Steve Jobs: He Wasn't John The Baptist

With the recent passing of Apple CEO Steve Jobs, the financial press has gone into paroxysms of religious fervor in writing about this refreshing and iconoclastic business leader.  The blogosphere is flooded with Tweets of ecstatic reverie, calling him a "prophet."  Here is the ridiculous, pandering headine from the online Wall Street Journal:

"Steve Jobs turned Eve's apple, the symbol of fallen humankind, into a religious icon for true believers in technology. But can salvation be downloaded?" (Wall Street Journal)

The analogy with the apple in the Genesis story is sophomoric, and more fitting for the Onion than the Journal. "No," he is not a religious icon, and "No" salvation can't be downloaded.  As long as we're entertaining outlandish theories, what if the apple in Apple comes from Magritte's "Son of Man" painting that figures in "The Thomas Crown Affair?" 

A couple of things to note.  In Rakesh Khurana's book on corporate leadership, he notes that the most frequently occurring post-graduate credential among CEO's has been the MBA from the Harvard Business School.  Against that background, the story of Mr. Jobs dropping out of Reed College and taking the path less travelled to corporate leadership of an iconic company is refreshing and worthy of study. 

Talk about a diverse background!  Steve Jobs describes taking a course in calligraphy as giving him the eye and the insight to realize the importance of unique typefaces to the first Mac.  I suspect an interest in Zen informed a lot of his insights.  He helped create, was defeated by, and ultimately remade the culture of Apple, defining it through his unique, personal lens. It gives anyone interested in business a lot to think about, but it's business not messianism. 

Monday, October 3, 2011

The Big Issues for Risk Managers

AON Risk Solutions released its 2011 "Global Risk Management Survey," which covered 960 respondents worldwide, about equally divided between public and private companies.  The Top 10 Risk Issues for the managers were:

  1. Economic slow down
  2. Regulatory/legislative changes
  3. Increasing competition
  4. Damage to corporate reputation/brand
  5. Business interruption
  6. Failure to innovate and loss of customers
  7. Failure to attract and manage talent
  8. Commodity price risks
  9. Technology/system failures
  10. Cash flow and liquidity risk
Historically, 5,8,9, and 10  have formed the bulk of the content for a corporate risk management program, and it was probably indistinguishable from the purchase of insurance coverage and from  financial hedging, probably through the treasury function. 

The AON sample companies are 89% from the Americas and Europe.  In total, 31% of the respondents say that they have a position of Chief Risk Officer (CRO), and these tend to be regulated industries, including banks and insurance companies. 69% of the respondents have a dedicated risk management department. 

Interestingly, in Asia the #2 concern of risk managers is the attraction and retention of talent, which falls to #7 in the total survey sample.

Less than 40% of the companies responding to the survey monitor their Total Cost of Risk.  These include, according to AON's framework:
  • Risk transfer costs (premiums paid for insurance coverages)
  • Risk retention costs (retained risks and claims adjustments costs)
  • External costs (brokers, consultants, regulatory compliance)
  • Internal costs (personnel and systems)
The AON susrvey concludes that it is for companies with revenues in excess of $1 billion that a dedicated, fully integrated Enterprise-wide Risk Management system begins to make economic sense.  Smaller operations can take a holistic view through good management in the CFO/financial function. 

Much of the literature written for NACD members is written as if  ERM could apply to smaller companies, and it seems clear that this not cost effective. 

One Way Out for the Eurozone?

The capital markets have Eurozone fatigue.  Day after day, hour after hour, we await the same news: an answer is forthcoming from the next meeting of EU finance ministers.  There's a Monty Python sketch in which the characters play around with an innocent question, "How big is it?"  Well pundits at the IMF conference have suggested a rescue/bailout/fiscal equalization fund of 1.4-4.0 TRILLON euros would solve the problem.  There is no answer to "How big?"

A facility of that size is out of the realm of possibility, for a union in which the strongest member has a GDP of 2.5 trillion euros.  Eventually, Germany will have to deal with the reality that its interests diverge not only from the weaker members of the union, but from those of France as well.  Then, Merkel and Sarkozy will no longer be able to pose as figurative, "Brothers in Arms." 

Greece has announced that its austerity measures will not enable it to meet its budget targets in today's WSJ. So, really we are moving, like a slow motion train wreck, towards a default of some kind, semantically within or outside the euro.  We wrote way back in June about the likely fate of the euro and about the attractiveness of Treasuries despite all of our fiscal management issues. 

A country's exchange rate is the most effective market price for adjusting imbalances in merchandise trade and external capital  accounts.  With the euro, Greece or Italy don't  have an exchange rate for the market to devalue until their economises  adjust to a new equilibrium.  Playing with tax and fiscal policies are not primary tools for these adjustments, as Greece is finding out.  Italy is waiting in the wings, and I don't believe that the Berlusconi government would have any inclination to drive itself down a path as Greeece has done. 

Thinking back to the Lehman crisis, one of the justifications for the absurd bailout concocted by Treasury was the fact that nobody could really map out the complete counter party network for Lehman/AIG/Bear Stearns and the other SIFI's, along with the amounts at risk.  Nobody knew how bad it would get and whose hands would get blown off. So we implemented a really bad deal.

Likewise, the structure of the EU and the obligations of its members were built without contemplating the alternatives we're now facing, namely an exit from the euro.  However, if one member exits, the utility of the entire common currency mechanism is mortally wounded as an economic construct. I'm not sure anyone really knows how the default//exit scenario would play out in practice.  Markets need to adjust and move one, but that means a paralyzed Europe has to come to terms with the failure of the notion of their common currency union. 

It doesn't matter how many times the finance ministers meet and where they meet, there may only be "One Way Out."

"Ain't but one way out, baby,
  Lord, I just can't go out that door.
  Ain't but one way out baby,
  Lord, I just can't go out that door.
  'Cause there's a man down there,
  Might be your man, I just don't know."
  (Holland/Dozier/Holland) EMI