Google millionaires opting out… Monday, Apr 30 2007

An article in today’s Guardian newspaper, Money can’t buy you loyalty, discusses problems Google is apparently having retaining employees who joined the company via acquisitions. Often these individuals make a lot of money on the transaction and subsequently find it hard to adapt to a different culture and their new subordinate status.

It is no surprise that Google is subject to this, because the problem affects every company that makes acquisitions. Entrepreneurs accustomed to calling their own tune usually find it hard to accept the role of employee. A typical complaint is that the acquirer is not giving enough priority to the acquired business. This comes across as more high-minded than “After five years as a CEO, I didn’t enjoy having a boss”. It usually occurs to the new employee that he has sufficient money in the bank to avoid having to put up with this grief. Similarly, the acquirer finds that frequent unsolicited advice on how to run his business grows tedious. A parting of the ways occurs and another prospective baseball team owner joins the workforce.

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Trade Liberalization and Alan Blinder Monday, Apr 30 2007

Alan Blinder, the former deputy chairman of the Federal Reserve and advisor to the Clinton administration, has commented publicly on his growing reservations about the benefits of global trade liberalization. A recent article in the Wall Street Journal, entitled Pain from Free Trade Spurs Second Thoughts outlining Blinder’s thoughts has drawn much comment. With this recantation of his previously-held position that free-trade is always beneficial to all parties involved, Blinder is feeding the increasing protectionist thinking in the country. There is certainly plenty of that sentiment about, what with Lou Dobbs on CNN, a Democratic Congress that is unlikely to extend a “fast-track” authorization that the White House has so far done very little with, plus a general sense that the country is losing out to pitiless corporations bent on outsourcing everyone’s job to Bangalore or Shenzhen.

Alan Blinder may be a distinguished economist, but his argument is flawed. To start with, he seems to have adjusted his opinions not because jobs are being outsourced, but because middle-class jobs are now suddenly at risk. He cites lawyers, doctors and even (gasp) economists, as being now likely to fall victim to low-paid foreign workers. So long as only factory workers were affected by outsourcing it was all fine, but when people with college degrees start feeling the pain, then maybe we should revisit the theory. Is this reflective of a concern in academia that if a college-education is no longer seen as the “silver bullet”, it will become hard to justify continued above-inflation increases in tuition? This argument seems like cynical pandering to the anxious middle.  At best, whether the middle class is anxious doesn’t prove that there aren’t benefits from global trade that may indeed accrue to everyone.

Secondly, Blinder’s revised thesis displays a pervasive failure of imagination. When a job is outsourced, an immediate benefit to the economy results. Like it or not, wages and salaries are inputs. When input costs go down either end prices also fall or profits go up, putting cash in someone’s pocket – a consumer or an investor. This generates an incremental demand for goods or services that did not previously exist. Sometimes this demand is for something completely new and unimagined, something that an entrepreneur can provide. Instead of saying, as Blinder does, that the next generation should strive to get into professions that cannot be off-shored, it would be better to advise them to identify new industries that tap into the increased wealth created by international trade. We are surely better off when college graduates try to invent a new Google than when they become a generation of divorce lawyers.

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Gun violence Sunday, Apr 29 2007

To me it seems that we haven’t really had an honest debate about gun ownership in this country. One side points to the high level of gun violence and to examples in other countries which support the idea that a reduction in the ownership of certain weapons, and in particular making it harder to buy a gun, would go some way to reducing the frequency and severity of mass killings we saw recently in Virginia Tech. However, in this group there is a sub-group of unknown size that is opposed to anyone owning a handgun and wants to move towards prohibition. On the other side is a group that points fervently to the Second Amendment (always capitalized), treating it as only slightly less fundamental than the tablets carved by Moses. (Having Charlton Heston as President of the NRA conflates the Moses linkage further, presumably deliberately). Behind this is the unspoken acceptance that this kind of atrocity will occur from time to time, and is simply the price one has to pay for having the right to own a handgun, a right available to any wishing to take advantage of it. Since these events cannot be avoided any restriction is simply a concession to the step-by-step prohibitionist in the opposite camp, a group determined to ban all guns.

I am sure that each camp feels that the other is being intellectually dishonest, but also considers that their own basic message is too unpalatable to be used in public, permitting a certain level of disingenuousness.

Certainly the toll on the public from general gun ownership is not comparable, say, to the burden in lives and injuries from private ownership of automobiles. Society has never considered banning car ownership on the grounds that people get killed in significant numbers every year, although perhaps a significant difference is that murder by vehicle is relatively rare compared to death by accident.

There is a general precept that some burdens exist in society and are frequently worth the associated benefit. The problem with gun ownership is that the “benefit” of owning a handgun, whether psychological or practical accrues to the owner or purchaser, whereas the burden is borne by society in general. This is not true of automobile ownership. It is fairly clear that, despite what the NRA says, members of society do not themselves feel greatly comforted by other individuals carrying concealed handguns. The large number of establishments that ban concealed guns from their premises seems to support this. The NRA makes the implausible argument that if this freedom goes, all other freedoms will follow. The Association could make the argument that we cannot always expect the costs and the benefits to be borne by the same segment of society. Some people want to become private pilots, resulting in a certain risk that some small planes will fall out of the sky onto uninvolved passersby. Some people want to be able to have abortions, despite the fact that this is morally repugnant to other members of society. The proportions vary but typically costs and benefits don’t go hand-in-hand. When it comes to broad rights and privileges the payer and the player are often not the same person. The idea that this should be so – the costs and benefits should absolutely impact the same group of people – is a dangerous principle to adopt wholesale, although that doesn’t imply that society cannot adjust the way these costs and benefits play out via reasonable regulation of the activities under discussion. For that reason I think banning automatic and semi-automatic weapons, particularly handguns, while preserving the right of people to buy almost any other firearm, makes sense.

Unfortunately for the sake of progress on this and similar debates, neither party in the gun-control discussion will acknowledge the force of this argument. Each side would probably see it as too risky to advocate, sticking instead to a scorched-earth position that leads nowhere.

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Carbon Sequestration in the Global Economy Saturday, Apr 28 2007

Like many people, I am inclined to treat global warming as Pascal cynically suggested one should approach belief in God: the consequences to an atheist of finding out that he was wrong about God are sufficiently serious that being a believer is a position of low risk and modest cost. (The religious argument is logically suspect, because there are many possible religions, only one of which may be correct, but that is a separate matter).

The probability that there is some validity in the global warming thesis is sufficiently high and the consequences of ignoring it are sufficiently serious, that making reasonable efforts now to reduce the future impact makes sense. I suspect that this will end up being the general public opinion in Western countries, providing greater support for political action. A recent New York Times/CBS News poll would seem to support this.

However, there is unlikely to be a global consensus any time soon. Developing countries see things somewhat differently, expecting the Western economies to go first, since these countries are (still) richer and have produced most of the greenhouse gases anyway. In the worst case this lets everyone off the hook, since countries can argue that of course they would get on board if the other parties would only do so.

In fact there might be a real benefit for Western economies to go first. Here is one such scenario:

Western government enact mandatory caps on carbon emissions and establish an international market mechanism enabling allowances to be traded

Caps are set at level that do not allow everyone to trade, a proportion of polluters need to physically get rid of carbon. A number of companies develop long-term methods of converting carbon dioxide into a solid, stable substance, and in the best fashion the biggest polluters start to outsource the problem. An industry is born.

In response to a combination of protectionist sentiment in developed countries and genuine concern about global warming, tariffs are applied on carbon-generating imports (or products where large carbon emissions were produced in the manufacturing process). Exporters to Western countries are forced to conform to the caps, and find it impossible to buy the allowances.

These tariffs are applied as a subsidy to the carbon sequestration process, and this becomes viable compared to trading allowances, which are reducing rapidly anyway. Access to Western markets, which will be a key requirement for developing economies to maintain their growth, becomes conditional on co-operation in global carbon reduction.

This may be a Pollyanna-ish view of the world, but I know of one applicable example: the new small engine emissions regulations being implemented in by the California Air Resources Board. These are being adopted by all small engine manufacturers, most of which are in Asia, for all their products. Since they have no means of knowing where a small engine will be sold or used, unlike with an automobile, the tighter regulations are applying to everyone. It isn’t impossible that this should apply to the broader question of carbon emissions generally. Continued access to wealthy markets is a powerful incentive to conform.

This example suggests that the strategy of simply waiting until India and China are on-board before developed countries enact sensible carbon reduction plans may, at the very least, not be as sensible as it appears.

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Share buy-backs and the 13,000 Dow Thursday, Apr 26 2007

The stock market has done well recently and some commentators have ascribed this, in part, to the influence of share buyback programs. This is puzzling on the surface, because in theory this is not an effective use of a company’s cash. If you assume that the cash is simply an asset that is factored into the stock price completely, then a buy-back should make no difference. In many cases the shares fall, suggesting that the objective of trying to raise the stock price may not easy to achieve. However the enduring popularity of these programs suggests deeper explanations.

One way to look at share repurchases is that company management is sending a signal to the market that inside information (which by definition is not in the price – one assumes), would value the stock at a higher price. Given that, the sellers would ask for more than the existing price to sell their stock, so bidding up the price to a sustainable higher level. Most repurchases are indeed at higher than market price. Maybe, though, the managers are bluffing, and are sending a false signal, since it is in their personal interest to get a higher share price.

A second approach is to consider what the company is signaling about its interest rate expectations. Share buybacks make sense if the interest rate is low and is expected to remain so for the immediate future, i.e. before the cash pool can be refreshed by more profits. Maybe the stock market views this as a generally bullish sign. More subtly, managers might see a large cash holding as a sign that the company expected a decline in its credit rating and a subsequent increase in borrowing costs, against which it needed a cash hoard.

Possibly the market sees this as a positive sign that the company is not going to make foolish cash-financed acquisitions. Since most of these schemes are wealth-destroying, investors may see this as a positive signal.

So, if a buyback succeeds in raising the share price it is more because of a change in investor sentiment than any reality in corporate finance. Why do these then sometimes fail, being followed by a fall in the share price? Well, to start with, the market capitalization will logically fall following a purchase, since there is a certain asset, cash, that has been taken out of the company and given back to former shareholders. Earnings will also fall, because whatever interest income the cash yielded is no longer available to the company. This, as I said earlier, should theoretically be compensated completely for by the reduction in the number of shares outstanding, leaving price unchanged. My point is that there is no law that says the price should go in any particular direction.

One can certainly think of negative messages the market might infer from a company’s share purchase. “They have nothing better to spend their cash on…” or “If they think they are going to throw off cash regularly, why don’t they just increase the dividend”

Maybe the deciding research would be to examine all share repurchases both announced and unannounced and determine the results some time afterwards. My bet is that unannounced, stealth buybacks have little impact on the price. Programs announced with much fanfare, involving a large proportion of the shares outstanding will have the most impact, especially if there is rather less stock actually purchased than the company announced originally.

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Incentive Programs for Managers Wednesday, Apr 25 2007

We all want to be involved in an incentive program.    These programs represent our opportunity to participate in the success of the enterprise (the downside, after all, is seldom our fault).   We also (naively) believe that incentive programs are good because they align the interests of the company with those of the individual employee.    However, almost any incentive system devised by mankind, is strongly subject to the law of unintended consequences (LUC).   Here are just a few LUC effects that will kick in for some incentive measures: 

• EPS.   If you measure executives on Earnings Per Share, there will be a sudden massive interest in buy-back schemes.  If we can’t raise E let’s reduce the number of shares.     At best it will probably bias the business towards other sources of equity than issuing new share capital.
• ROTC.   Return on total capital seems logical.   However, the equally logical executive will tend to under-invest in response.    A range of investment opportunities will be ranked by expected return, and although this may not always correspond to reality, it will be approximately correct.   To raise ROTC he or she simply avoids investments that are below the objective.   If you set an objective of 25% and your cost of capital is 8% then you can forget about all those possibilities between 8% and 25% that would make your company wealthier because these will reduce the average ROTC.  The effect is to have a much more conservative investment policy than would be the case.  The higher you set the objective, the worse the problem.
• On-time Delivery.  OTD is a favorite measure that is supposed to show how good plant managers are.   Good plant managers are experts at gaming the system.   Typically an ERP system will report OTD by comparing actual ship dates against the planned ship dates.   Changing how the plant operates to make it more flexible and customer-friendly is a lot of work.  Much easier to push lead-times out so that we can make sure that we don’t disappoint customers by late shipments.    The ERP system will only register a late when something is actually shipped, so if a date is missed, an enterprising plant manager will call a customer and ask him to cancel the order and resubmit it under a slightly different part number (maybe there might be a discount involved for the new part), so that it will appear to go out on time.
• ROI.   Return on investment is usually measured at a point in time.   The R is probably operating income for the trailing twelve months, but the I is most likely to be an instantaneous reading at the end of the reporting period.  Under-investing will help here (see under ROTC), but so will deft management of working capital.   The easiest way to reduce WC is to stop paying suppliers for a month, and really pound on receivables.  (Inventory is harder to control).  You can let it rip again the month after the bonus is calculated.
• Revenue per employee.    This is easy – just outsource swathes of production and revenue per employee will surge.
• Gross Margin percentage.    Brace yourself for a rapid slowdown in growth as lower margin products get dropped.   In the worse manifestation you will find that gross margin (and revenue) will actually fall, as managers drop lower-margin products (or raise prices, thereby killing demand) and find that plant fixed costs are under-absorbed, causing aggregate margin to fall.  This scenario is particularly painful because not only do managers make poor decisions but they don’t even get the bonus they are aiming at.

 All this isn’t to say that one shouldn’t have an incentive program.   Overall, they probably are good.   Just don’t be unrealistic about its effectiveness.  Be alive to the gaming of the system, and be ready to change the criteria regularly.   Also, referring to an earlier posting, don’t make closing a specific number of acquisitions an objective.   Remember, people will respond, and will meet the objectives.  After all, that’s the idea, isn’t it?

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The bias towards big events Tuesday, Apr 24 2007

The Economist has a leader about the massacre at Virginia Tech, pointing out the scale of gun violence in the US. The article makes a point about the overall level of gun violence:

“some 14,000 routine killings committed in 2005 with guns, to which must be added 16,000 suicides by firearm and 650 fatal accidents (2004 figures)”

Two points occur to me. One is that this is truly a staggering number of deaths. The article does acknowledge that the vast proportion of suicides would take place anyway. Nevertheless, we are talking about close to eighty fatalities per day!

The second point is our complete inability come up with any rational response to statistically unconnected data. A large set of unrelated events is hard to bring any meaning to, so it isn’t discussed. We look to aggregations to try to find meaning. Place crashes are highly newsworthy, as are tragedies such as last Monday’s.

This is not to say that we shouldn’t report on and examine what makes someone go on a killing rampage and what we can do to prevent it. Merely that the remaining 14,000 gun murders in any year also deserve some consideration.

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The Cost of Homeland Security Tuesday, Apr 24 2007

I fell to wondering the other day about the total cost to business of the lines at airport security. Forget about the average person going on vacation, just think about the business traveler.

You can think about this two ways – one is to think about the amount of time spent actually going through the security line, which is probably around fifteen minutes extra per trip. Another is to look at the injunction to be at the airport much earlier than before because these lines can occasionally be very long. Let’s ignore the second case, because at least some of this time is on the employee’s tab – if I have to get up half an hour earlier for the Monday flight to Boston this isn’t really a reduction in my productivity. Also when people are waiting at the airport they can often work (although quite evidently not always). Just consider the 15 minutes extra every trip. If the average business traveler makes two trips a month, this is fifteen minutes a week (one security line in each direction). Say he costs his employer $100 an hour (probably a low estimate), and that there are 10 million such travelers in the country:

$25/week * 50 weeks * 10 million = $12.5bn

Even if I am out by a factor of two, which I could accept, or even by ten, this is a huge cost on top of the other costs to the economy. These include buying the equipment, paying the people in the TSA (the acronym really means “Thousands Standing Around”), training, administration and so on. You would think that this would be some incentive to put the regular traveler on to a pre-cleared system. (I freely acknowledge that this isn’t original).

What would a pre-cleared system offer? A separate line with the ability to go through quickly, based on a fingerprint ID, retinal scan etc. No special searches, just a brief walk through the scanner. One could presumably imagine a scanning protocol that would be adjusted to the lower risk profile of the pre-screened traveler, i.e. laptops in briefcases, liquids allowed in suitcases, faster belt speeds… If we cut the average wait by 50% you would, in theory have an extra $6bn or so or productive economic activity. Now whether the business traveler would do anything productive with that time is a separate question…

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France votes Sunday, Apr 22 2007

The first round of the French Presidential election is going on today, with the second in two weeks, if, as expected, no candidate gains 50% of the vote. It is worth pointing out that Intrade has viewed it as a done deal for some weeks, pricing Sarkozy at 75 and Royal at a mere 28. Poor old Francois Bayrou, having hit 30 some time in March, is now pretty much worthless, as is Le Pen. This is a remarkably large spread given the apparent state of the polls, which placed the Sarkozy and Royal only a few points apart. If these results are borne out, will we start to see so-called prediction markets replacing opinion polls? The French authorities ban the publication of polls in the final days before voting, but they will be able to stop people reporting on the state of prediction markets?

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Acquisitions I Sunday, Apr 22 2007

Everyone is doing acquisitions these days. Some companies actually say to senior executives “To achieve this portion of your bonus you must close x number of transactions by year end”. This is silly beyond words. At the very least it fuels the tendency to overpay and is bound to result in some poorly thought-out deals. In many cases the author of an acquisition doesn’t have to live with the consequences. The average corporate executive is in any position for four or five years, often less, and will most likely not to have to endure the bad consequences of any acquisition made towards the end of his or her tenure. Urging a person in this position to make an acquisition is like a parent urging marriage on his heir, “oh, and by the way, you can move on after a few years and someone else will have to make the relationship work”. Many of us have had to try to make bad deals work after the fact, usually fruitlessly, and one can think bitter thoughts about the architects of these deals, who typically basking at that time in the success of other peoples’ wisdom in their new positions.

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