Thursday, March 31, 2005

Is shareholder democracy an oxymoron?

Do you want to unseat a CEO? On the surface, the two best reasons for doing so are stock shock and cooked books. But thanks to constraints on shareholders’ power, they can only toss the CEO through very specific tactics.

Recent events illustrate the point. Carly Fiorina at HP and Michael Eisner at Disney are among those deposed due to weak stock market performance. Phillip Purcell appears to be at risk due to Morgan Stanley’s weak stock. And Hank Greenberg at AIG lost his job on the back of an expanding accounting scandal as did executives at WorldCom, Enron and others.

If stock shock was the real reason behind these CEO ejections, however, then surely Wal-Mart’s Lee Scott, Cisco’s John Chambers, and Microsoft’s Steve Ballmer would also be out of their jobs. After all, Wal-Mart stock is down 24% since Scott took over as CEO in January 2000, Cisco’s stock is off 78% from its all-time high in January 2000 and Microsoft stock has tumbled 60% since Ballmer took the top spot from Bill Gates in January 2000. Granted, it is easy to blame the bursting of the tech bubble for this stock drop.

But these companies have all done well financially under their CEOs. Wal-Mart’s 2004 revenues of $285 billion are up 49% and its net income of $10 billion climbed 67% since 2000. Cisco’s 2004 revenues of $22 billion are up 16% and its net income of $5 billion climbed 85% since 2000. And Microsoft’s 2004 revenues of $37 billion are up 61% while its net income of $8 billion has declined 13% since 1999. This financial performance does not seem to explain these companies’ loss in stock market value.

But it certainly begs the question of why some CEOs get a pass for presiding over huge losses in stock market value and others get fired for them.

If you want to depose your company’s CEO, the Disney, HP, and Morgan Stanley cases suggest three tactics:

  • Exploit the conflict between heirs and new blood. In some cases, the founders’ heirs lack the skills needed to run the business but they still hold much of the stock. At Disney, Walt’s nephew Roy Disney remained on the board and got involved in animation operations. While he helped bring in Eisner in 1984, he also helped push him out. At HP, the co-founder’s son Walter Hewlett’s resistance to Carly Fiorina’s Compaq acquisition was futile, but Hewlett was ultimately proved right. And the eight grumpy old men of Morgan Stanley leading the effort to dethrone Purcell represent the old guard that could not keep Morgan Stanley independent -- and sold out to Purcell’s Dean Witter;
  • Tap into anger at the CEO’s autocratic management style. In the interests of shaking things up and asserting control, the ousted CEOs incurred substantial ill will among employees and heirs. At Disney, Eisner angered scores of executives in many different parts of the company due to his unwillingness to give others credit, his tight-fisted ness, and his decisions to pass on projects, such as Survivor and American Idol, which became huge successes. Fiorina succeeded in annoying HP rank and file with her use of perks and her scapegoating of lower level executives for problems she caused. And at Morgan Stanley, the departure of talented executives in the wake of Purcell’s aloof, hardheaded management style contributed to the anger of the eight grumpy old men.
  • Use guerilla dissidence to overcome the power of a CEO-stacked board. Corporations hire and fire CEOs in a unique mixture of shareholder democracy and autocracy. At Disney, large shareholders on the board were able to oust its CEO in 1984 and bring in Eisner. But Eisner stacked the board with supporters and fired dissident board members in order to keep his job. Ultimately, the two dissident directors who brought Eisner in were able to outmaneuver him. But it remains to be seen whether Eisner will retain control over his designated successor, Bob Iger. At HP, Fiorina quickly lost control of the board as Silicon Valley veteran Tom Perkins, abetted by HP veteran Richard Hackborn, was able to bring to a head the board’s dissatisfaction with Fiorina’s performance – forcing her resignation. And at Morgan Stanley, it remains unclear whether board members loyal to Purcell, including the McKinsey Mafia Four, will be able to overcome the power of the eight grumpy old men’s 11 million shares and the negative impact of continued hemorrhaging of Morgan Stanley’s high level talent.

As the cases of Wal-Mart, Cisco Systems, and Microsoft demonstrate, shareholder democracy is somewhat of an oxymoron.

These three companies have put in strong financial performance despite losing stock market altitude. Since it is hard to demonstrate a link between financial performance and stock price, it remains to be seen whether HP, Disney, and potentially Morgan Stanley shareholders ultimately benefit from replacing their CEOs.

What is clearer is that they’ve stumbled their way towards exerting some corporate influence.

Tuesday, March 29, 2005

HP's Hurd instinct

HP’s decision to hire NCR CEO Mark Hurd strikes me as an odd one. It is easy to explain to the public that HP hopes Hurd can do to HP stock what he did for NCR’s. But it may be a big stretch to assume that this is possible because the NCR veteran will have a tough time being accepted in the insular HP culture and managing a much more complex company.

On the plus side NCR’s stock price has done phenomenally well since this 25-year company veteran took over as CEO in February 2003 – up 300% before today’s announcement which whacked 14% off the stock. During Hurd’s CEO tenure, NCR sales grew 10% while net income increased 5-fold on cost cuts.

But NCR is much smaller than HP and its primary business is selling ATMs to banks whereas HP sells to many kinds of businesses and consumers. Specifically, NCR had revenue of nearly $6 billion in 2004 and 28,500 employees while HP has $80 billion in revenues and 150,000 people.

HP has a very strong culture and it would be a mistake to assume that Hurd who spent most of his career at NCR will be accepted at HP fast enough to make the kinds of changes needed to satisfy impatient HP shareholders.

Sunday, March 27, 2005

Limits, triggers, and jeremiads

Over the last several years, I’ve contributed to the jeremiads on the woes that will befall us due to excessive government and consumer debt. So far, these jeremiads have been wrong – or more precisely, they have laid out a gloomy future without specifying the timing or the triggers that would unleash this cascade of gloom.

Over the last couple of decades, there have been many localized burst bubbles, including these four:

  • S&Ls. In 1988, the US government bailed out the Savings and Loan (S&L) industry at an ultimate cost of $600 billion. The S&L collapse resulted from 1980 to 1982 deregulation which raised the size of individual deposits insured by the US, lowered S&L capital requirements, reduced the number of S&L regulatory staff, and permitted S&Ls to diversify into new businesses such as real estate investment. Small S&Ls expanded by taking brokered deposits which paid high interest rates and were insured under the new regulations. S&Ls invested these deposits in real estate and other risky financial assets whose yields exceeded the deposit interest rates. In order to maintain their “hot money” deposits, S&Ls reached for ever higher loan rates until the borrowers defaulted – causing the deposit rates to exceed the loan yields. The trigger for the S&L collapse was the cumulative impact of 1987 losses at Texas S&Ls which comprised more than 50% of all S&L losses nationwide – of the 20 largest losses, 14 were in Texas. The Texas economy was in a major recession: crude oil prices fell by 50%, office vacancy exceeded 30%, and real estate prices collapsed.
  • Japan. Japan. Between 1975 and 1989, Japan’s Nikkei average rose 700% from 5,000 to 40,000 only to lose 75% of its value over the subsequent decade. The value of the Nikkei climbed fastest during the 1980’s, as the world feared that Japan’s economic productivity would cause it to take over the world economy. Japan became the world’s largest creditor and had the highest GDP per capita. Japanese corporations built skyscrapers in Tokyo and Osaka. Between 1986 and 1988, the price of commercial land in greater Tokyo doubled. Real estate prices soared so much that Tokyo alone was worth more than the United States. To cool the inflated economy, the Japanese government raised rates. Within months, the Nikkei stock index lost 30,000 points because so many people had borrowed to invest in the Nikkei using Japanese land as loan collateral. Japanese housing prices plummeted for 14 straight years. The Japanese government and corporations are still suffering under unwieldy debt loads taken on since the late 1980’s. This debt was used for stock speculation and buying overpriced land. Even today, the Japanese economy remains in the doldrums.
  • Long-Term Capital Management. In September 1998, Greenwich, CT-based hedge fund Long-Term Capital Management (LTCM) ran out of money and was rescued in a $3.75 billion bailout by lenders such as Deutsche Bank, Barclays, Chase Manhattan and JP Morgan. LTCM borrowed massively so when Russia effectively defaulted on its short-term GKO bonds in August 1998, LTCM’s capital dropped from $4.6 billion to $250 million as lenders tried to get their money back from LTCM. LTCM’s use of borrowing expanded its exposure to $80 billion, 17 times its capital. If the New York Federal Reserve had not stepped in to organize a bail out, LTCM’s collapse would have a more wide-ranging economic impact.
  • Dot-com. In March 2000, the NASDAQ peaked at 5,048 only to plunge 3,000 points in the subsequent year leaving NASDAQ 60% below its peak in March 2005. Venture capital flowed into the Internet sector after 1995’s successful IPO of Web-browser vendor, Netscape. By January 2000, things were looking toppy when internet service provider America Online proposed to buy Time Warner for $166 billion in AOL stock, 350 times the combined company’s net income. But the dot-com collapse was probably triggered by Burning Up, a March 18, 2000 Barron’s article by Jack Willoughby, which detailed how 200 publicly traded dot-com companies would run out of cash within a year. The stampede for the exits, magnified by massive amounts of margin-driven selling of dot-com stocks, wiped out trillions in market value, hundreds of thousands of jobs, and millions of employees’ retirement funds.

What can these examples teach us?

  • Economic bubbles generally start with the germ of a good business idea, but high initial returns attract so much capital that the amount of money invested exceeds the number of worthy places to invest it;
  • Signs of an impending collapse are widely known before the event that triggers the collapse. What is scarce is the willingness of investors to act on the early warning signals;
  • The event that triggers the collapse is always unexpected but not incongruous – particularly when looking at the collapse with the benefit of hindsight; and
  • Lenders generally pull the bubble-popping triggers. When a collapse in collateral values spurs a margin call, the waves of panic selling reverberate loud and long.

What are the implications for our current state of economic affairs?

  • Real estate and the US Federal Government could be candidates for bubble bursting
  • Early warnings on real estate include a March 25th New York Times article on real estate as the new dot-coms;
  • Ominous comments abound on the current account deficit exceeding 6% of US GDP; the record $413 billion US Federal budget deficit; the declining dollar; the lifting of the debt ceiling to a record $7.84 trillion; and 50% dependence on Asia and other foreign countries to finance this debt; and
  • Last week’s Fed comment about inflation could be the first warning shot of rapidly rising interest rates which could trigger a collapse since Real Estate and the Federal Government’s ability to carry so much debt depend on low interest rates which could vanish quickly if the Fed decides it needs to fight inflation more fiercely.

I still don’t know what might trigger the next collapse or when it might happen. But it won’t be different this time.

Tuesday, March 22, 2005

Inflation matters: the Greenspan lag

With today’s 25 basis point interest rate increase, the Fed included some language about inflation, noting “pressures on inflation have picked up in recent months and pricing power is more evident.” It’s about time!

I have been ringing (an unheard) bell on inflation for two years. In February 2003 I sent an e-mail “Are you better off today than you were four years ago?” which highlighted the dramatically higher inflation rate between January 2003 (2.6%) and January 1999 (1.7%). In January 2004, I wrote another e-mail “Is inflation roaring back?” which noted, “The price outlook for 2004 suggests that many big components of the typical family budget will continue to increase. For example,

  • Housing prices to continue climbing. David A. Lereah, chief economist of the National Association of Realtors, predicts that despite an expected rise in mortgage rates, the median existing-home price will rise 4.7% -- nearly half 2003’s 9.1% gain -- while the median new-home price will rise 5.1%, up from 3.6% in 2003. This national median masks wide regional variations. For example, the median price of a single-family California home is forecast to increase 13% from $369,500 in 2003 to $417,500 in 2004;
  • College tuitions up. 2004 college tuition increases are expected to range between 6% and 14%. Over the last 10 years tuitions have increased on average from 42% to 47%;
  • Oil prices expected to remain high. In 2004 Raymond James predicts an average of 1,155 drilling rigs will be at work this year, up from 1,030 in 2003. This increase will help out the Houston economy (useful in this election year). Energy represents 45.7% of the jobs in the area's economic base, according to the University of Houston's Institute for Regional Forecasting. That base represents industries that export goods and services outside of the region; and
  • Food price increases to exceed inflation rate. According to the USDA’s Consumer Price Index forecast, food prices are expected to increase 2% to 3% percent in 2004, twice the expected rate of inflation. Households could see annual food bills jump more than $270. This is higher than 2003’s food price inflation rate. Higher prices for beef products and eggs were the main factors behind a 1% increase in food prices during 2003, according to the year-end Market Basket survey released by the Wisconsin Farm Bureau Federation.

But thanks to demand from China, the prices of many industrial commodities and services are expected to increase dramatically in 2004:

  • Nickel prices up 40% due to an acute shortage of new nickel production capacity in the pipeline to offset the expected strength of demand from stainless steel mills, particularly in China;
  • Copper prices up 25% due to ever-tightening raw material supply and accelerating demand growth -- China is absorbing the vast bulk of supply;
  • Coal prices up 13% to 20% The tight coal supply situation that currently exists in the face of strong demand from traditional US coal customers and from new customers in China;
  • Steel prices up 19% due to hikes in prices of raw materials coupled with increased demands from China;
  • Aluminum up a “mere” 12% due to some excess supply; and
  • Shipping costs to continue spiking due to China's voracious demand for raw materials, particularly for iron ore and coal as the world's most populous country wrestles with power shortages. This has fueled the demand for Capesize ships, vessels in excess of 80,000 deadweight tons in size. The Baltic Dry Index, a measure of shipping rates, increased 174% in 2003 – hitting an all time high."

I concluded mistakenly, as follows “Given the way these commodities eventually find their way to consumers as automobiles, plastics, utilities, and others there is only so long that price increases of these magnitudes can be kept out of the official inflation statistics.”

Last October, Business Week Online published an article which highlighted this mysterious absence of inflation in the official government inflation statistics in an article entitled,
“A Federal Inflation Conspiracy?”

As Alan Greenspan’s two decade plus term in office comes to a close, his skills and ambitions as a politician are far greater than his commitment to communicating and acting on economic reality.

Sunday, March 13, 2005

Three rings of market information

People make money in the market by trading on secrets (sometimes dubbed information asymmetries). The law has placed boundaries around the kinds of secrets that are tradeable. It is illegal for a corporate insider to trade on the insider's knowledge of a corporate event.

But it's legal to profit from the sheer market moving power of a large trade. When, say, a big buyer wants to purchase a large volume of shares, traders disguise the buyer's intent by breaking up the transaction into little pieces to hide the buyer's identity and intent. An executive at a mutual fund company described to me how when the company's largest fund wants to execute a large transaction, the fund doles it out to "hundreds" of brokers. This little game allows the buyer to pick up the shares at a lower price while masking the buyer's intent.

Recent events have reminded me of how some traders can profit from these information asymmetries by exploiting the three rings of market information, which I first wrote about in e-Stocks. The inner ring profits from its superior control of trading to the detriment of the outer rings. The theory of the three rings has important implications for individuals and their ability to rely on stocks as an investment. Here are the three rings:
  • Inner ring (e.g., traders at major investment banks, hedge funds, and mutual fund complexes);
  • Middle ring (e.g., intermediaries between the inner ring and individual investors such as stock analysts, brokers and NYSE specialists); and
  • Outer ring (e.g., individual investors).

Different media seem to cover different rings. The inner ring is somewhat swathed in mystery; however, I think that certain publications, such as's premium content and certain investment newsletters, provide insights into the thinking of those in the inner ring.

The middle ring is fairly well covered by the mainstream financial press. But sometimes this coverage leaves out important information that compromises its objectivity. An investment banker told me that he spins reporters on his client's M&A transactions. Readers may not realize how much reporters depend on investment bankers for such "news." The economic interests of reporters and their sources could compromise the objectivity of what passes for analysis in the articles. Thus investors should understand how these economic interests might skew the analysis of of the deals.

And the outer ring is covered in ways that create sell signals by publications such as Time, Newsweek and USA Today. For example, when's Jeff Bezos was named Time's Person of the Year on December 27, 1999 savvy insiders took it as a cue to sell.

Martha Stewart Omnimedia's (MSO) stock performance since December 2003 illustrates the theory of the three rings of information. MSO rose from $9 in December 2003 to $36 on the day of her release, March 4, 2005. Since then the stock has lost 22% of its value.

The inner ring in MSO's case is represented by Jeffrey Ubben of hedge fund ValueAct Capital Partners who joined MSO as Chairman in July 2003 after Martha Stewart left that job. Ubben bought 22% of MSO for $68 million in January 2002 not long after MSO plunged in the wake of allegations that Stewart dumped her Imclone stake based on insider information. While MSO dropped 37% between January 2002 and Ubben's appointment to MSO's board, the stock seems to have recovered nicely despite a 35% plunge in MSO's revenues and a huge net loss.

And Ubben got out in time. In a financial disclosure filed on March 8, 2005, Ubben revealed that in the days just before Stewart's release, ValueAct dumped 1.24 million shares of company stock for $42.7 million. That was most of Ubben's investment in the company. The general public has no way of assessing Ubben's impact on MSO's price during the tenure of his investment. Perhaps he bought MSO thinking that Stewart's legal problems had driven the stock too low. But surely as Chairman he was aware of MSO's deteriorating financial performance. The timing of his exit from the stock suggests that he realized that MSO was enjoying an artificial levitation due to the public's loyalty to Stewart combined with short covering.

The middle ring, the analysts who covered MSO, were mostly bearish about the company's prospects. They noted that MSO was losing revenues and increasing its losses. These analysts expressed concern about those who were buying the stock because they believed that at some point the weak performance of the company would hurt the stock.

The outer ring, individuals who bought MSO as Martha Stewart went to trial, seemed to be ignoring the weakening financial prospects of the company. Instead, recognizing the Stewart was MSO's largest shareholder, these individuals wanted to demonstrate their loyalty to Stewart by purchasing shares of her company.

While some of the outer ring may have profited if they sold their shares prior to Stewart's release, there may be many who bought the shares in the excitement of the days prior to her release when the mainstream media was flooded with reports about Stewart's TV programs -- whose benefit to the company were hard to quantify. Those in the outer ring must now be licking their wounds in the wake of the stock's 22% decline since her release.

Much of this analysis is speculation because the market operates without providing investors with insight into what is going on in the three rings of market information. If the outer ring had real-time answers to the following questions, then perhaps stocks would be better investments:

  • Who is in the inner ring on each transaction?
  • On each transaction what factors motivate the inner ring to buy or sell?
  • How do inner ring participants coordinate their transactions on individual stocks?
  • What are the links between the inner ring and the middle ring on individual transactions?
  • What are the links between the media and the three rings?
  • How would the real-time release of the above answers influence stock prices?

Thursday, March 10, 2005

Is energy this decade's tech?

Today’s five year anniversary of NASDAQ’s all-time high of 5048 is passing with little notice from the Mainstream Media (MSM). Since NASDAQ is down 60% from its high, conventional wisdom among the MSM is that energy is the new tech.

But conventional wisdom is a bit off. My e-stocks index has climbed 140% since the post 9/11 lows (10/1/01) while my W-Industrial Complex (WIC) Index, consisting of energy, defense, and selected media and retailing companies which benefit from the current president’s policies, has climbed only slightly more: 149%. The e-stocks index consists of companies in nine Internet business segments which I analyzed in my book, e-Stocks (HarperBusiness, 2001). Since the post 9/11 lows, the e-stocks index is up 140% with Web content stocks faring the best and internet service providers the worst:

  • Web content: +373%
  • Web portals: +303%
  • E-commerce: +218%
  • Web security: + 149%
  • Web consulting: +127%
  • Internet venture capital: +46%
  • Web tools: +33%
  • Internet infrastructure: 13%
  • Internet service providers: 0%

Web content has been driven up by the MSM’s need to boost advertising dollars by acquiring companies like CBS MarketWatch (by the New York Times). Web portals and E-Commerce have been the real stars in the last five years, however, as profit has shifted from the infrastructure builders to the customer value creators.

No question, with oil broaching an all-time high, the market forces appear to favor WIC index stocks which rose 149% between 10/1/01 and yesterday’s close. The WIC index’s components varied in their performance with oil refining doing the best and integrated oil and oil services the worst:

  • Oil Refining: +334%
  • Natural Gas: +212%
  • Coal + 210%
  • Upscale retailing: +102%
  • Conservative media: +87%
  • Defense: + 86%
  • Oil Services: +83%
  • Integrated oil: + 81%

Wednesday, March 09, 2005

Peter Cohan Posted by Hello

Day One

I am a late adopter of new technology. So it should come as no surprise that I am only today starting a blog. Last summer a professor at UCLA, asked if he could post one of my e-mail missives on his blog and I gladly agreed. His post is here.

And this week a reporter for BusinessWeek Online asked me the same thing. Here's hers.

She suggested that I start my own blog and when I found out how easy it was, I decided to do one.

I don't really know what will be about. But there's a good chance it will deal with topics like technology, the economy, management, finance, and politics. Based on a suggestion from a Babson College colleague, I decided to give the blog a better name. Fortune's StreetLife columnist Andrew Serwer referred to me on May 20, 2005 as an "informed observer" in reporting on my analysis of how firms like Morgan Stanley and GM are cutting advertising to newspapers that report negative information about the companies. This gave me the idea for the current name of this blog.

I hope that I can continue to live up to the sobriquet -- "The Informed Observer" -- and that over time the blog transforms itself from a soliloquy to a dialogue. I invite your comments.