Out of Time for the JIT model?

For decades now, the benefits of the Japanese-pioneered JIT inventory models were trumpeted in every sort of business and management textbook. Looking at the aftermath of the tsunami, the net economic benefits of this model need to be reexamined. For practical purposes, two sets of forces came into play with the widespread adoption of JIT. The first was consolidation for things like automotive seating, in which a large, global company like Johnson Controls emerged by acquiring weaker competitors and scaling up the model for these larger automotive components. For these bigger ticket items, capital could be profitably employed and their size allowed them some bargaining power versus the manufacturers.

For traditional auto parts that involved metal bending and forming, there was also consolidation, but the economic benefits to this consolidation led to lower quality parts in response to continuing manufacturer pressure for price reductions. Medium and smaller size suppliers always operate on life support, and JIT is what took them there. Finally, all of the pressure leads to the complete lack of R&D in the parts business, so there's very little innovation.

The auto industry needs a vibrant network of parts suppliers who can provide a decent financial return to their owners on a consistent basis. In the end, consumers probably benefit too. A poorly designed accelerator assembly for Toyota cost it thousands of times more than a little more margin would have for a better designed part. I'm not saying that the industry should vertically integrate once again, but it certainly needs to look beyond the "penny wise, pound foolish" siren song of JIT.

Backdoor SEC Registrations

SEC Commission Luis Aguilar recently gave a speech about regulation and its effect on capital formation. He made a distinction between capital formation and capital raising, which is important for our current financial markets. Capital formation is at the heart of modern economic growth theories, from Hicks, Samuleson, Solow and others. Its aim is to deploy tangible capital, together with labor and other economic inputs, to productively increase output and growth. CEO's looking to grow and sustain their businesses have to look for capital investment projects that generate value in excess of the required rate of return.

Modern captains of industry seem to have forgotten about this aspect of their economic briefs as they continue to sit on large hordes of excess capital, especially in the form of cash and equivalents. We've written about this before, so we'll move on. Commissioner Aguilar then notes that capital markets have become fixated on capital raising. He rightly talks about the importance of transparency and utility in financial disclosures, which are aimed at helping investors make better estimates of the intrinsic value of a business. Disclosure ought to be meaningful, transparent and provide a level informational playing field for all investors. Better disclosure offers investors an elment of protection too.

When he turns to the current state of capital markets, he identifies the phenomenon of"backdoor registrations," particularly by Chinese companies using public shells in the U.S. to float their businesses to domestic investors. Ironically, this past week, I discussed the case of a NASDAQ-listed company, China Media Express Holdings, Inc. briefly with my MBA Investment class as an example of risk in emerging market investing. I got the idea of discussing this stock by reading John Hempton's blog. China Media Express was touted by bulletin boarders and even by some boutique research houses, but a cursory review of their SEC disclosures made their business model seem like a financial printing press. As Hempton identified, it was too good to be true. After their US auditor resigned and the exchange threw up its hands and delisted the company, the patient prognosis is not good. The cracks in our regulations that allow these reverse mergers into public shells have been crying out for a remedy for years.

Yet, we were so mesmerized by pursuing "comprehensive" reform of the financial sector, that we still can't incrementally move towards a better solution to a specific problem. When Arthur Levitt's SEC moved on Reg FD, it seemed simple, and a "one off" kind of solution, but it yielded real benefits to all investors through better disclosures and the elimination of side channels for information. We can do better for US investors looking to get involved in emerging market issues by acting on Commissioner Aguilar's ideas.

S&P Puts A Stake In the Ground

S&P, one of the three rating agency enablers of the housing debacle, today took the astute position of downgrading the outlook for U.S. Treasury debt, ostensibly because of the forecast for budget deficits into the foreseeable future. The Treasury Department put out an insipid press release, in which a spokesperson bemoaned S&P's bad political judgment. In fact, S&P deftly succeeded in differentiating themselves from their rating agency competitors and in showing gumption by restating the blindingly obvious. There's no downside risk to S&P from their move--congratulations to their marketing department.

Xcel's Wind Project (Not) for The Birds

Xcel recently announced it was scrubbing plans for a $400 million Merricourt wind farm in North Dakota which has almost optimal conditions in the frequency, duration and strength of high winds. The issue turned on the dangers to migrating whooping cranes and a charming bird named the piping plover. Of course, there is some level of risk for these species: the cranes because their populations are near endangered levels, and the plovers because of their small size and large migratory squadrons. Xcel realized that no one had a good remediation scheme, and without it, they couldn't know the level of cost risk that they would be exposed to in order to meet their increasingly uneconomic mandate of 30% of electricity generated from renewables by 2020. If a project by a motivated utility in the optimum location is scrubbed what does that suggest for the absurd notion of huge, offshore wind farms off Nantucket? As an energy class, wind is a "clean" energy source for campaign speeches, but it's an improbable choice for leading us to "energy independence." MIT has a long-standing Energy Initiative Project that has done the kind of work that industry and policy makers need to think about. Their recommendations for working on the next generation nuclear power plants has sat in the file cabinets since 2003. Indian Point, Fukushima and other plants around the world are older designs, and MIT's scientists argue that a truly carbon-free source like nuclear needs to be considered through the lens of the best designs, construction materials, safeguards, and risk management. They also note that conservation is the great, relatively low cost energy source, which has long been persuasively argued in the "stabilization wedge" methodology by Princeton University researchers. MIT scientists did a heat scan of the Boston skyline to visually display the heat losses through the skins of their most famous towers. The shots looked like scans of the coronary arteries of a triple bypass patient--not good. They argue that putting money into the least efficient buildings would yield the best returns, and shave the Boston utility's peak loads substantially. Not glamorous, like wind turbines, but definitely more realistic, economic, and meaningful.

Wachtell, Lipton, Rosen and Katz on Beneficial Ownership

As a public company CFO for a growing medical device company, I always thought of myself as being on top of our capital markets position, both for purposes of understanding our ownership base and for handling our corporate share buyback program.

Imagine my chagrin when I got a phone call with the following stylized conversation: "Hello, this is Mike from Freefall Ventures. Looking at your 13D's, I'm your largest shareholder. I have a few questions." I'm somewhat confused, as I have never heard this name among our ownership base. Opening my database, and a split screen of the NASDAQ issuer's ownership screen, I see no entry for any level of ownership by this person's firm. If he were the largest, his position would have to have been a double digit percentage, as our largest holder was a well known mutual fund.

"Excuse me for asking, but I don't see any filing for your firm. Let's go ahead with your questions, and perhaps you can enlighten me later about your position and why I see no 13D filing." Of course, Mike never does. After the conversation, a call to the NASDAQ Market Intelligence desk yields absolutely nothing but a scripted commentary about the complexity of reporting. That gave didn't give me the warm fuzzies about informational efficiency in our capital markets.

Marty Lipton's firm recently sent a letter to the Secretary of the SEC on Rulemaking Under Section 13 of the '34 Act. It clearly makes the case for updating the rules to prevent the current "market manipulation and abusive tactics" by aggressive hedge funds. The firm was excoriated by the New York Times as being supportive of entrenched managements at the expense of shareholders. This argument is either woefully naiive or aimed at currying favor with the hedge funds.

Dating back to Artuhur Levitt's time as SEC Commissioner, the idea of a "level playing field" for information was articulated. In fact, this is the same underpinning behind "informationally efficient capital markets," a concept that is taught in most MBA courses on investments and modern portfolio theory. It became one of the driving forces behind Reg FD, to the benefit of all capital market participants. As an issuer, I have a right to know who owns my equity on a timely and current basis. The issue of being entrenched or not, is a red herring. As an officer of the company, I need to be able to formulate and maintain a communications and relationship building strategy that makes efficient use of management's time. This can't be done if I don't know who my audience is. As a market participant in the company's own shares, I also have a right to know where potential demand and supply might be coming from, and current positions are a useful starting point. Again, being "entrenched" or not, is irrelevant.

Examples of abuses within the current system abound and have been discussed since 1983. In the WLRK letter, they point out Pershing Square's acquiring 4.9% of JC Penney's stock (under the reporting threshhold) through open market purchases, and subsequently acquiring a total 27% position through forward purchases, call options and total return swaps BEFORE filing a 13-D! Whatever one thought of Penney management, this is an egregious example of "hedge fund activists who have gamed the window to their own advantage." This has no place in any financial market that purports to be modern, fair, equitable, transparent and informationally efficient.

We don't need to focus on things like high frequency trading and invisbility for dark pools to maintain our capital market leadership. These kinds of practices confer no economic benefit but are redistributions of benefit between classes of market participants. The WLRK letter clearly states that the window for filing a disclosure should be shortened, as have other disclosure periods like the 8-K and insider trading periods, and that ownership be defined as to capture the ability to exert economic ownership through derivatives and synthetic positions.

This is how Mike acquired a position in my company. He made a lot of money for himself, and came and went like the wind. Other shareholders who could have sold on the upticks as positions were being built or his filing was being announced were out of luck. Let's put everyone on the same level, informational playing field--we know how to do it, and it's not at all burdensome, and there's no excuse for our waffling and regulatory inaction.

Shigeru Ban's Take on Japan's Rebuilding

Today's New York Times has an encouraging article about architect Shigeru Ban and his use of paper as a construction material for housing victims of natural disasters. Mr. Ban has been doing this work internationally since 1995, and his work spans locations such as Kobe and Chengdu after earthquakes.

In addition to the "poetic" (to quote the Times) quality of his materials and ideas, I liked what he had to say generally about what needs to be done to help homeless Japanese, particularly the elderly. In a response to a question about "innovative" solution for shelters, Mr. Ban says, "We don't need innovative ideas. We just need to build normal things that can be made quickly and easily." Nicely said. There's no need for commissions, multi-year studies, and comprehensive national housing plans...just get rebuilding. He also believes that private initiatives can help in the Japanese context. Let's see if the Japanese government can get going; there are plenty of creative people with experience, who can help. Here's one of them.

Cembalest and JP Morgan on Japan

Michael Cembalest is Chief Investment Officer for JP Morgan Chase Private Bank, and I always enjoy reading his global investment research bulletins. His current piece has some great insights about Japan from the geopolitical and historical sides. He shows that after the WWII, when Japanese industrial production hit its nadir in 1946, it took just six years to recover to the normalized prior high, and Japan was not advantaged like Europe by the Marshall Plan.

As economic writers have talked about "Lost Decades," and we read consistent gloom about the demographics, high savings rates, and interest on government debt being fifty percent of revenues, here is an excerpt from the recent JP Morgan Chase bulletin:

"Japan faces a lot of challenges, such as poor demographics, ongoing deflationary pressures and the worst debt dynamics in the world. However, as we wrote last August, Japan’s domestic debt market is held 93% domestically, rather than relying on the kindness of strangers (like the U.S. or parts of Europe). Japan also has the ability to mobilize the investment accounts of nationalized banks and insurance companies (Yucho, Kampo), which have accumulated over 300 trillion yen of JGBs in the last decade."

Not relying on the kindness of strangers or on their currency being a global reserve currency is a big deal. Cembalest also puts together their Middle East research to say that Japan, and the world, should not feel a secular sting from rising energy prices:

"Japan is the world’s third largest oil importer, the largest importer of thermal coal, and the largest importer of liquid natural gas (2). One would think that with 6%-7% of the electrical grid permanently offline (3) and another 7% of the non-nuclear grid temporarily affected, that energy prices would be surging across the board. But there are 3 caveats contributing to lower crude oil prices:

** First, to replace lost electricity, Japan needs ~300 thousand barrels per day of oil equivalents (mostly for diesel generators). In the context of the global oil supplies and 3.5-5.0 mm bpd of spare capacity, this should be manageable, particularly since much of Japan’s incremental energy imports will take the form of liquid natural gas
** Second, the decline in economic output associated with a disaster like this tends to depress energy demand
** Third, the Saudi Day of Rage passed without much incident, and Qaddafi has retaken most of the oil facilities. On our conference call today, Vali Nasr highlighted that this calm should not be interpreted as a broad sanction for the status quo. Saudi Arabia is still caught between what he described as 3 pincer movements of Shi’a populations (in Yemen, Bahrain and Saudi Arabia’s own Eastern Province; see chart on last page) looking for some combination of wealth, political freedoms and religious autonomy. But for now, the stability of oil exports in the Gulf region looks secure. As we discussed on the conference call today, the history of supply interruptions based on weather or geopolitical events mostly points toward a recovery in exports once the immediate event has passed. Only in the case of the double-barreled 1979 Iranian Revolution followed by the war with Iraq, did we see a country experience a sudden and unrecoverable decline in oil exports." Source: "Matter over Mind," JP Morgan Chase, Inc. ,2011.

On the philosophical side of things, there's often nothing like a crisis to bring people together. After 9/11, I always felt that one of the terrorists' misjudgements was to have planned their heinous strike on New York, which they felt to be the center of global capitalism. It is also the singular, global metropolis with a virtually unlimited well of resourcefulness, grit, fortitude, compassion and openness to working together for a common cause. When the disaster struck, petty squabbles and power grabs were forgotten; for the rest of the country, the old "let Manhattan drift out to sea" sentiments were replaced by the feeling that "we're all New Yorkers now." The images of President Bush throwing a baseball from the mound at Yankee Stadium vividly showed everyone that we had taken the blow and that, as a nation we wouldn't be overcome, even by a well conceived strike at the heart of our greatest city.

If the political leaders are up to it in Japan, a similar, great national unity and drive to rebuild can come out of the current crisis. Even as Japanese society has become secularized in the press, there are deep spiritual traditions among the populace that can provide a firm foundation for the months and years ahead. All the people will be looking for is leadership from the major parties. Emperor Akihito's remarks were of more than symbolic importance, as he is a revered figure to the Japanese; his urge to "live strong for tomorrow" is an aphorism straight out of Japanese martial arts traditions.

It certainly is in the tradition of U.S. international engagement to help a major trading partner, and Western European leaders should also follow suit. Hopefully, GE is sending their best teams of reactor engineers and scientists to learn from what went wrong with the containment vessel design and safeguards, and to also help their customers right things without looking at their lawyers for approval. There will have to be much grieving, since no one knows what the death tolls are; there's also a lot of uncertainty about the levels of continuing radiation exposure and their spread, but let's hope that this crisis and its aftermath can be a catalyst for Japan coming out of its economic desert experience, which would benefit the entire global economy.