Saturday, July 30, 2005

Innovation still pays

That’s the conclusion of an analysis I did of a Boston Consulting Group (BCG) survey of the Top 20 Innovative Companies in the World.

I reached this conclusion although – to paraphrase Justice Potter Stewart’s quip about obscenity – I can’t define innovation but I know it when I see it.

BCG surveyed 940 senior executives in 68 countries and asked them to pick the most innovative company. BCG recorded the votes and I calculated the profits and investment returns of the 16 companies on the list which are publicly traded in the US.

I found that these 16 companies significantly outperformed their peers. On average they earned five-year returns on equity that were 2.2 times their industry levels; their net profit margins averaged 10% compared to a slightly negative net margin for their industries; and their stock prices surged 34% over the last five years while the S&P 500 tumbled 18%.

The most popular company with survey respondents is far from the best performer from a financial or investment perspective. Apple Computer got the most votes in the BCG survey but its return on equity (5%) and its net margin (3.4%) trailed its industry and its stock price (+70%) put it in the middle of its innovative peers.

While the stock market rewards these innovative companies’ profitability, it seems that the most profitable firms have generated disappointing stock market results. For instance, Dell whose 40% return on equity led this pack of innovators; saw its stock price fall 8% during the last five years. And Microsoft, whose 28% net margin trounced the competition, watched its stock lose 27% of its value during the period.

The stock market winner from this group of innovators was actually eBay which earned a 21% net margin and saw its stock soar 225% over the last five years. I think the key to eBay’s stock market success has been its profitable growth – after all eBay’s sales have grown an average of 60% a year for the last five years. That is an exceptional performance for a company with $4 billion in sales and a market capitalization of $57 billion.

Despite recent customer frustration, eBay enjoys substantial barriers to entry due to its market leadership. But eBay and Microsoft are
losing talent to another one of the innovators – Google – whose stock has soared 190% since its IPO last year.

Investors recognize the flow of talent as a canary in the coal mine for a company’s prospects. Shareholder value will flow out of firms that are losing the talent and into those that are hiring it. At the moment, Google offers the intoxicating potion of big impact on millions of users, cutting edge technical challenge, the most brilliant professional colleagues, and a culture that pampers innovators through touches such as giving them a day a week to work on pet projects, gourmet cuisine, and digital toilets. As I noted in my 1997 book,
The Technology Leaders, this kind of entrepreneurial leadership is a critical ingredient of innovation.

But ultimately this talent transfer suggests that the magic elixir that draws top talent is fated to shift from established companies to new ones. Ironically, Microsoft –
which used to mock competitors who resorted to the legal system when they could not win in the market place – is suing Google to stop this flow of talent. While Microsoft held the magic wand for two decades – between 1975 and 1995 – that power to draw talent has shifted to Google.

Wednesday, July 27, 2005

WICked (big) profits

The W-Industrial Complex (WIC) index continues to pay big returns on the back of questionable government policies. The WIC index, which tracks a basket of energy, defense, high end retailing, and conservative media stocks, is up 130% since January 19, 2001 compared to an 8% drop in the S&P 500 and a 21% decline in the NASDAQ.

What government policies drive these profits?

  • The Iraq war has been a boom for defense firms which have reaped a windfall from the $314 billion spent so far. Defense profits could continue to surge on future Iraq war spending of $458 billion according to the Congressional Budget Office;
  • As you pay $2.50 a gallon for gas, you can derive comfort from the knowledge that the Iraq war has also raised the perceived risk to the steady flow of Middle Eastern oil – increasing oil speculation and raising its price; and
  • $1.6 trillion in tax cuts 36.7% of whose benefits went to the top 1% of earners has resulted in a windfall for those who buy $125,000 Maserati Quattroportes as Christmas presents.

In case you feel at risk as a portion of every gallon of gas you buy pays jihad preachers in Saudi Arabia, these WICked big stock profits may balm the wounds.

Saturday, July 23, 2005

Be careful what you wish for

For years, the US has been jawboning China to un-peg its currency from the dollar. On July 21st, the US’s wish came true. But will the impact of this move help or hurt the US? It could hurt more than it helps.

I think the short-term impact of this change is instructive. Following the announcement, the yuan rose 2% relative to the dollar. More importantly, the interest rates which drive the mortgage market rose 11 basis points from 4.16% to 4.27%. The latter effect could help burst the many “mini bubbles” in the US housing market.

In the longer-term, the impact of devalued Chinese currency is complex. On the surface, the devaluation would make it more expensive to import goods for China to the US and cheaper for Chinese to buy US products and services. China's trade deficit with the U.S. could easily top $200 billion by the end of 2005, 20% higher than 2004’s deficit. And it looks like China’s global trade surplus -- which in recent years has been a modest $30 billion or so -- could jump to $120 billion in 2005. In theory, a floating yuan might reduce the trade deficit between the US and China.

But China is also a big holder of US debt. Specifically, China holds $700 billion in foreign currency reserves, 70% of which are in dollar assets like U.S. Treasuries. If the Chinese are getting their interest payments in dollars, then those dollars are worth less to Chinese debt holders than they were before. So China could either hedge these dollar based interest payments or start to demand higher US interest rates to offset the impact of the weaker dollar relative to the yuan.

And the impact of China’s currency moves could affect Japan’s purchases even more since China – with $190 billion in US Treasury holdings -- is only the second-largest holder of Treasury securities after Japan, with $243.5 billion. If the mysterious basket of securities against which China is allowing the yuan to float includes the Euro, it is possible that China and Japan will decide to shift more of their spare cash into Euros or other currencies and out of the US dollar and its debt.

In reality, China will probably try to control tightly the change in the relative value of the yuan to the dollar. Because of that, I suspect the impact of the change will be mild in the short run. China does not want to trigger any big problems for its own economy by letting its currency rise too quickly in value. Nor does it want to induce a slowdown in the US economy since that would lessen the exports of Chinese-made goods.

But hedge funds and currency traders are likely to bet that the dollar will weaken relative to the yuan over the long run. Depending on the magnitude of these bets, the 10-year treasury could yield a lot more than it does now which would accelerate the bursting of the housing bubble, slow down US GDP growth, and accelerate inflation by raising the cost of Chinese-made goods to US consumers. Whether China would offset these negative effects by importing cheaper US goods remains a mystery.

Wednesday, July 20, 2005

Unocal/CNOOC/Chevron Q&A

Today Unocal’s board moved in an apparent willingness to accept Chevron’s cash and stock bid over a higher all-cash one from CNOOC. Here are my thoughts on 10 questions.

1. In this case, compared with Chevron, What are the advantages and disadvantages for CNOOC?

From the perspective of Unocal's board, it has to weigh the price paid, the quality of the consideration used (cash is better than stock, for example), and the risk that the deal will fall through. To explain this, I want to introduce the concept of expected value -- which is the probability of an event happening multiplied by the value of that event. For example, if company B is willing to pay $100 a share for company A but the chance of the deal being completed is 50%, then the expected value per share of that deal is $50 (50% times $100/share). In effect, Unocal's board must calculate the expected value of the competing offers.

Chevron has offered $63 a share in cash and stock while CNOOC's bid is a higher $67 a share -- all in cash. CNOOC's bid is higher and is all cash which is an advantage over Chevron's. But Unocal's board believes that the CNOOC deal will be blocked for political reasons so it has a lower probability of being completed and thus a lower expected value.

2. Usually, for such big multinational merger, what steps should the company taken in order to ensure the success of this merger? And how to bring into effect?

This merger brings into play the complex relationship between China and the US. Many US companies are manufacturing goods in China and selling the goods at a competitive price in the US. Furthermore, the US is running a large Federal deficit and China is a major buyer of the bonds needed to finance this deficit. Third, oil and gasoline prices are at record levels in the US. Fourth, CNOOC is a state-owned company which makes some in the US nervous. And finally, a Chinese general recently threatened a nuclear attack on US forces should these forces get involved in a military confrontation in Taiwan.

This specific combination of factors makes it particularly difficult for CNOOC to manage the merger. CNOOC has certainly hired well connected advisors to assist with its bid. And the editorial pages of many newspapers are filled with discussions of the proposed merger -- many of these discussions downplay the strategic risks. Ultimately, CNOOC has a chance to prevail if it can lower sufficiently the political, legal, and regulatory risks which threaten the completion of a deal.

3. Is it necessary for CNOOC to study relative laws during the merger? How to adapt to these laws?

CNOOC must study political trends, legal issues, and regulatory concerns and develop a comprehensive plan to tailor their approach in a way that makes the expected value of its deal higher than that of Chevron.

4. Looking from the strategic sense, do you think the offer that CNOOC has offered is reasonable?

CNOOC views Unocal as a rich source of Asian energy assets -- specifically oil and gas fields in Asia, mainly in Indonesia, Thailand, Myanmar and Bangladesh, as well as a scattering of assets in North America, which hold a total of 1.7 billion barrels of proven oil and gas reserves.

From CNOOC's perspective, it makes sense to increase Chinese energy self-sufficiency and thus obtaining access to relatively close energy assets helps achieve that objective.

Furthermore, CNOOC is bidding a higher price in cash for these assets which indicates their value is very high for CNOOC. This also suggests that Unocal has important strategic reasons for the bid.

5. How to do the PR with US government? Facing the opposite voices from US congress and public, what are the breakthrough points for CNOOC?

CNOOC's biggest problem seems to be that its strategy does not fully reflect the complexity of China's relationship with the US which I outlined in my answer to question 2 above. I do not know whether it is possible for CNOOC to coordinate its strategy for Unocal with other aspects of China's policy towards the US. However, in my view the US is looking at the CNOOC bid as a component in this broader US strategy rather than as an independent business transaction.

6. Chevron has claimed that they are competing with Chinese government, and say this is unfair. Moreover, they want to indict China on WTO issue. In your views, how should CNOOC respond to such attack?

CNOOC should try to coordinate its response with the Chinese government's broader US policy. Chevron is trying to fan the flames of protectionism in the US so that it can increase the political risk to CNOOC and thereby lower the expected value of CNOOC's bid for Unocal while paying less for it. Chevron's effort to link the CNOOC bid to the WTO issue is another effort to increase the perceived political risk of the CNOOC deal to Unocal's board.

7. What are the risks for CNOOC after the merger? (such as oil exploitation/organization management/operate mode/culture amalgamation etc.) How to ensure the successful integration?

I think that the big question facing CNOOC, if its bid succeeds, is whether it should retain Unocal's existing management or whether it would be better off putting its own managers in charge. If CNOOC wins the bid, it will probably need to reduce costs quickly to earn back the price premium it paid to control the assets. So it will face another challenge about how to identify and cut costs that do not add value to the combined company.

Furthermore, CNOOC will need to draw on the best practices of companies that have made successful multinational mergers work effectively -- such as forming cross-company integration task forces that identify ways that companies can work together in a productive manner while achieving short-term cost savings and putting in place longer-term revenue generating initiatives.

8. What are your overall judgments about the CNOOC’s gesture? And why?

CNOOC's gesture makes strategic sense from its perspective and it could lead to a better deal for Unocal shareholders if CNOOC can increase the likelihood that the deal will close. In my judgment, CNOOC has not yet done enough to increase its chances -- as reflected in the Unocal board's willingness to accept a cash and stock offer from Chevron that is $4 a share lower than CNOOC's.

9. Up to now, what’s your prediction about this merger? And why?

If CNOOC raises its offer enough or can lower the risks that the deal will not close, then it may ultimately succeed. Otherwise, I think this bid can be thought of as another valuable learning experience for CNOOC's management. It may then wish to consider whether it should make a bid for another company or to use the money that it would have spent on Unocal to explore for oil and gas in Asia.

10. Anything else you want to say about this topic.

I think the world is a better place if there is more economic integration between the US and China. Unfortunately, the political climate in the US seems to be leaning more towards the idea of limiting that integration. I hope that cooler heads will prevail in both countries.

Wednesday, July 13, 2005

W stands for whopper

It seems that the cumulative weight of five years of lethal lies is finally catching up with the administration, according to the latest Wall Street Journal/NBC poll. Only 41% of those polled thought the president was honest, down from 50% since January.

While it is not uncommon for politicians to prevaricate, the current president has come up with some costly whoppers:

Compared to all these false claims, it is interesting that the one evoking the most focused press furor has far lower human costs – Karl Rove’s involvement in violating the cover of a CIA operative, Valerie Plameabout two years after fervent White House denials of same.

However, this firestorm ties together some of this administration’s important operating principles:

  • Fixing the facts – here a link between Uranium and Saddam -- to fit the president’s will;
  • Destroying political opponents – Joe Wilson and his wife – through fingerprint-free machinations; and
  • Protecting the loyal – Karl Rove and Bob Novak – while punishing the enemy – The New York Times.

Whether or not Rove emerges from this battle unscathed, history will well remember this presidency and its headline will be: W Stands for Whopper.

Sunday, July 10, 2005

Hedging terror

Last week’s events in London raise many questions, including this: ‘Can investors hedge against terror attacks?’ 13 months ago, I offered some thoughts on this topic in the wake of former attorney general John Ashcroft’s May 26, 2004 assessment that the US had a 90% chance of being “hit hard.” That day the following security industry stocks climbed an average of 23%:

Our research found that following 16 terror alerts between February 2002 and September 2004, these stocks rose an average of 9%, compared to no change in the S&P 500. Since the president’s reelection, terror alerts have evaporated but terror attacks have not. On July 7th, these security stocks rose an average of 26% after news of the London attacks:

  • TBUS: +48%,
  • MACE: +22%,
  • MAG: +15%,
  • IPIX: +37%, and
  • ASEI: + 10%.

To be sure, all but one of these companies – ASEI, a maker of x-ray inspection devices -- loses money so holding them as long term investments would be risky. Furthermore, their stock prices tend to decay within weeks after terror fears subside.

But as a short-term hedge against terror attacks – and warnings thereof should they recur – the following strategy may prove effective:

  1. Buy a basket of these stocks several weeks after a terror attack or warning;
  2. Sell the basket of stocks a few days after an attack or warning; and
  3. Repeat step 1

Given the poor financial condition of many of these companies, investors will need to alter the makeup of the terror stock basket as the weakest companies go out of business. But this should be a small price to pay for a financial hedge against a world of terror without end.

Friday, July 01, 2005

Winning and losing stock market behaviors

During the first half of 2005 the S&P 500 lost 1% of its value. Fortunately for followers of my monthly investment newsletter, The Cohan Letter, the average stock mentioned there – taking into account my 2% stop-loss rule -- has risen 12%.

Since I began following the stock market, I have found that it’s a jungle out there with no simple rules for making money. I have won some and lost some. Based on this experience here are five winning stock market behaviors and five losing ones.


  1. Buy studiously into momentum. Sometimes there is a good reason that stocks in an industry are going up. If you can convince yourself that the trends driving up the stocks are sustainable – invest in a market leader.
  2. Read all financial filings. Financial filings contain a lot of data that can really help you understand the company. While they are often tough sledding, reading them can make a big difference because so few investors actually take the time.
  3. Talk to customers, employees, distributors, and analysts. Even fewer investors take the time to talk with a company’s customers, employees, distributors, and analysts. As a management consultant, this research is a natural part of my job. It should be the same if you want to buy a stock.
  4. Get out before the news hits the cover of Time. I remember that’s Jeff Bezos was named Time’s Person of the Year in December 1999. That date would have been a pretty good time to have sold the stock which now stands 69% below its December 1999 peak of $108.
  5. Use stop losses rigorously. Since none of these rules are fool proof, winning investors must prepare for the possibility that they will be wrong. I like a 2% stop loss – while this might keep you from making money if a stock rebounds, it is better than continuing to hold onto a loser with no real logic for why it should be sold.


  1. Buy into hot tips. About fifteen years ago I worked with a fellow who seemed to be constantly trading multiple stocks. This seeming market guru convinced me that he knew what he was doing. When he told me to “back up the truck” on a Mexican waste management firm, I decided to invest in the company. I never read the financial statements and lost most of my money.
  2. Ignore the cockroach theory. Once you have made an investment, a piece of your ego goes into making money in that stock. If there is a piece of bad news about the company, such as an accounting problem, that could be a cockroach – and if you see one there have to be at least 10 more waiting to emerge. But if your ego is attached to the stock going up, ignoring the cockroach theory will likely lose you money.
  3. Fail to take risks seriously. Stocks that have been going up tend to continue going up – until they don’t. One of my recent favorites was Taser International which seemed on a rocket ride from 50 cents at its IPO to the December 2004 peak of $33 – only to tumble to a recent $13. Readers of the financial statements would have known that there were all sorts of lawsuits against the company and that the company was grossly overvalued – it peaked at a P/E over 100.
  4. Wait too long to sell. Not having a stop-loss can be disastrous. But it is also important to have a way to take profits. One of the luckiest things I ever did was to set an automatic sell on a stock which I had purchased at $6 a share. It had since risen to $80 and I was convinced it would keep going up. But I was persuaded to set an automatic sell order – which I set at $100 -- before I left for a trip to Korea. Amazingly enough the stock hit that price while I was asleep in Seoul. A year later it was trading in the teens. Most investors during the dot-com boom did not have this kind of luck and they lost bundles as a result. The same thing could happen to today’s real estate investors.
  5. Sell short on a hint of bad news. Selling short – borrowing stock from a broker, selling it at current market prices, with the hope of paying back the stock loan with lower priced shares – is extremely risky. In theory, an investor’s liability is unlimited. For example, if an investor sells short at $20, the stock could keep rising and unless the broker forced the investor to cover – which in practice they would – the investor might be forced to cover the position after the stock had risen, say 20-fold. Selling short can be a great way to make money – as several investors did on Enron back in 2001. Those investors had done a lot of homework on Enron but they were going against the tide of public opinion before the truth came out and they made their fortunes. But it is far more common to get wiped out trying to short stocks.