The Informed Observer

The Cohan Letter +15% in 2008

2009-01-02T05:53:00.000-08:00

My investment newsletter, The Cohan Letter, outperformed the S&P 500 in 2008. Specifically, the average stock mentioned in The Cohan Letter rose 15% in 2008. This compares favorably to the performance of the S&P 500 which fell 38.5% in 2008.

The three top performing stocks mentioned in The Cohan Letter were:

URS Corp (NYSE: URS) rose 22% from $33.41 at the end of November 2008 to $40.77 by year end. URS -- a design and construction firm, did win a $3.3 billion contract in December and may be perceived as well positioned to take advantage of an infrastructure stimulus package expected in early 2009;
AAR Corp (NYSE: AIR) rose 15% from $15.99 at the end of October 2008 to $18.41. AAR -- which supplies aviation parts -- saw its sales rise 14%, fully-diluted earnings climbed 21% and its backlog increased 28% in a December report; and
Plexus (NYSE: PLXS) increased 11% from $15.21 at the end of November 2008 to $16.95. Plexus develops and manufactures electronics telecommunications, medical, industrial, and computer companies.

Each month The Cohan Letter mentions three stocks. If a stock mentioned declines 2% after it's mentioned, the stock is "sold" from the portfolio. This 2% stop loss rule contributes to the relatively high average return of The Cohan Letter.

Now in its seventh year of publication, The Cohan Letter's average annual return of 20% since 2004 compares favorably to the -2% average return of the S&P 500 during that period.

Pioneers of Globalization

2008-02-03T05:43:00.000-08:00

Jorge Nascimento Rodrigues and Tessaleno Devezas have written, Pioneers of Globalization, which has a unique take on the popular globalization theme. Their book combines the theory of the long wave, developed by Russian economist Nikolai Kondratieff, with an intriguing analysis of how Portugal's mastery of ocean navigation contributed to this tiny country's domination of global trading routes from South America to Africa and India.

What is perhaps most intriguing about the Portuguese version of globalization is that although the authors focus on a period 500 to 600 years ago, the Portuguese approach to globalization seems very modern to me. Here are the key elements that the authors articulate:

Strategic intent. The authors argue that Portuguese people are proactive when they have "an enterprise to executve"
Globalist vocation. Possibly because Portugal is a relatively small country with a limited market and finite natural resources, it chose to overcome these weaknesses with a global outlook.
Long-term scientific commitment. Portugal invested in research and development.
Knowledge management. Portugal's skills at navigation created knowledge workers who could apply these skills.
Looking ahead. Portugal looked beyond the current geostrategic boundaries and battles of the Mediterranean region.
Control of asymmetric information. Portugal had a passion for choosing the unknown over the known which gave it an advantage over other nations.
Incrementalism. Trial and error and pragmatic correction were the key to Portuguese strategies.
Critical attitude. Portugal employed the scientific method that challenged existing dogma with experiments and facts.
Geostrategic 'cleverness'. Portugal employed secrecy, counterintelligence, and disinformation to achieve its ends.
Organizational improvisation. Portugal employed a mix of improvisation and clear strategic intent to achieve its goals.

Before reading Pioneers of Globalization I had not realized how timeless these strategic principles are. But the authors make a compelling case that Portugal was pioneering them hundreds of years ago.

The Cohan Letter up 28% in 2007

2008-01-01T15:44:00.000-08:00

My investment newsletter, The Cohan Letter, outperformed the S&P 500 in 2007. Specifically, the average stock mentioned in The Cohan Letter rose 28% in 2007. This compares favorably to the performance of the S&P 500 which rose 3.5% in 2007.

The three top performing stocks mentioned in The Cohan Letter were:

New Oriental (EDU) which rose 84% from $43.75 in April 2007 to $80.59 at year end;
CVRD (RIO) which climbed 77% from $18.50 in March 2007 to $32.67 at year end; and
Transocean (RIG) increased 66% from $86.20 in April 2007 to $143.15 at year end.

Now in its sixth year of publication, The Cohan Letter's average annual return of 22% since its inception compares favorably to the 11.8% average return of the S&P 500 during that period.

Web 2.0: Now and Next

2007-05-13T07:12:00.000-07:00

What is Web 2.0? How popular is it? Who is making money off it? How is it leaping the synapse from startup to incumbent? What are its risks and opportunities for business? Where is it heading?

What is Web 2.0?

Web 2.0 – a web of collaboration among individuals -- is a marketing buzzword introduced in 2004 which has gained fairly wide acceptance. Web 2.0 companies includes some successes – such as video-sharing site YouTube, the user-written online encyclopedia Wikipedia, the photo-sharing site Flickr, and social networking sites like MySpace and Facebook, on which users can interact with each other in a virtual setting.

Web 2.0 has become much more refined – in 2007, for example, a Web 2.0 Awards conference cited 41 different categories including:

How popular is Web 2.0?

Web 2.0 is much less popular than the hype. According to a study by the Pew Internet and American Life Project, only 8% of people in America really do a range of Web 2.0 activities.

Who is making money off Web 2.0?

The sellers of these startups and their venture backers are the ones making money off of Web 2.0. YouTube’s founders sold it for $1.65 billion in 2006 to Google (venture firm Sequoia – which invested roughly $11.5 million for 30% of the company, made an estimated $400 million from the sale); Flickr’s founders made an undisclosed amount – estimated between $15 million and $35 million -- selling to Yahoo in 2005; and in 2005 MySpace’s founders made $580 million selling to News Corp.

How is Web 2.0 leaping the synapse from startup to incumbent?

These acquisitions demonstrate how Web 2.0 is spanning the synapse from startup to incumbent. The reason for the incumbent interest is that rapid growth in the number of users of Web 2.0 sites. For example, YouTube’s user base leapt from 0 to 19.1 million between August 2005 and August 2006. More recently, in March 2007 Cisco Systems bought online videoconferencing company, WebEx, for $3.2 billion; Sun Microsystems has been wooing Web 2.0 startups with free software and cheaper computer servers; America's second largest ISP, Comcast, announced a deal to give its 12 million Internet (and cable) customers access to Zimbra's Web-based interface for e-mail, calendars, contact lists and instant messaging.

What are Web 2.0’s risks and opportunities for business?

Many companies are using Web 2.0. A recent survey by the Economist Intelligence Unit found that 85% of C-level executives see the sharing and collaboration aspects of Web 2.0 as an opportunity to increase revenue and/or margins. Companies have initially focused their Web 2.0 efforts on the creation of online communities that can help with product marketing or product development. Companies are also establishing blogs or wikis to initiate conversations and share knowledge inside or outside the company.

But Web 2.0 also creates significant business risks: increasing exposure to viruses and malware and damage to corporate reputation through the release of embarrassing information about employees.

How does Web 2.0 increase risk of virus and malware infection? An executive from Secure Computing noted that Web 2.0 applications like blogs, wikis and social networking sites allow users to post code in chat sessions and other areas. In some cases, hackers corrupt legitimate technologies for their own gain. For example, encrypted HTTP (known as HTTPS) was supposed to ensure sensitive data wasn’t transferred "in the clear" over the Internet. However, attackers can also use secure connections to transmit malware.

And Google researchers have found that Web 2.0 opens up new opportunities to compromise users’ computers. In particular, Google surveyed billions of sites, subjecting 4.5 million pages to in-depth analysis. 450,000 were capable of launching so-called "drive-by downloads", sites that install malicious code, such as spyware, without a user's knowledge. A further 700,000 pages were thought to contain code that could compromise a user's computer. To address the problem, Google has started an effort to identify all web pages on the internet that could be malicious.

What reputational risks does Web 2.0 pose to companies? Former BP chairman, Lord Browne’s former lover posted his personal thoughts on Facebook – accelerating Browne’s departure from his job. And organizations are growing nervous about sensitive information finding its way into the public domain, through the growing network of blogs and social networking sites. At the same time, individuals looking for corporate jobs are worried that views they’ve posted online get them fired if the company runs an internet search of their name.

Where is Web 2.0 heading?

The key to Web 2.0’s future will be whether startups can generate sufficient growth in the number of users to attract the interest of incumbent media companies. With concerned about the decline in advertising revenue to newspapers and TV, established media companies could view Web 2.0 startups which can attract rapidly large numbers of users as attractive acquisitions because they could take up the slack.

One example of where Web 2.0 might be heading is Joost, a start-up that delivers television programming over the Internet. Earlier this month, Joost received $45 million in financing from venture capitalists and content partners including CBS and Viacom. Joost was founded 18 months ago by Skype’s co-founders and has signed up 500,000 users. Joost distributes shows in traditional television formats, like 30-minute or hour-long programs. It collects demographic details of its users and analyzes the profiles to help its 45 advertisers to tailor content to distinctive viewer segments.

But there’s also the chance that many Web 2.0 companies will fail. Web 2.0 has attracted significant amounts of financing -- $262 million in the first half of 2006 alone. But in late 2006, several venture-funded startups have either closed their doors or slashed staff. One is Browster, backed with $6 million in 2005 by VC firms Advanced Technology Ventures and Vanguard Ventures, which is now widely believed to have ceased operations. Even mobile Web 2.0 startup Motricity fired many workers, despite being heavily funded by leading VC firms.

Given its business risks and the low cost of entry, it appears unlikely that companies will invest significantly in Web 2.0 technologies as they did during the first Internet wave in the 1990s. Thus Web 2.0’s future depends on its ability to reinvent the media industry.

Only a handful of these companies are likely to gain such traction to leap the synapse between startup and incumbent.

Applying the Value Quotient (VQ): Experiment Frugally

2007-03-02T06:21:00.000-08:00

To apply the VQ, I measure how well a company follows each of the seven principles of Value Leadership. Here's how I measure how well a company follows the principle -- Experiment Frugally -- which is harnessing happy accidents to create value for customers and partners. I detect whether companies follow this principle by looking at how well they conduct the following four activities:

Grow organically: build new lines of business in markets that are large and growing in which competitive success depends on capabilities that your company can perform better than competitors;
Manage development risk: break new product development projects into pieces. At the end of each piece, decide whether to continue based on results. Be disciplined about investing in projects that pass these tests and killing ones that don't;
Partner internally: when developing new products, form a team which includes a company's different functions such as engineering, marketing, sales, manufacturing, purchasing and so on. By building product prototypes and getting fast feedback from customers, growth and profits are more likely to follow; and
Partner externally: similarly, when a new product development will affect the design standards of an entire industry, companies should work with their extremal partners to create a mutually acceptable solution.

I give a company a score on each activity. For the 24 activities, the maximum possible score is 420 points. So the Value Quotient (VQ) for a company is that company's total points divided by 420.

The Celebrity Industrial Complex (CIC) holds together the two Americas

2007-02-03T14:54:00.000-08:00

As presidential candidate John Edwards pointed out during his 2004 campaign, there are two Americas. My take on his idea is that one America allocates capital – defined broadly as money, technical brainpower, or celebrity charisma -- the other helps operate its machinery.

The capital allocators are benefiting hugely from this administration’s economic policies. Specifically, 36.7% worth of the $1.3 trillion worth of tax cuts went to the top 1% of families. Meanwhile, the ratio of the net worth of the top 1% of families to that of the median family in the US hit 190 in 2005, up from 131 in 1983.

These capital allocators wear many hats. They’re traders at Goldman Sachs who got their share of $16 billion in bonuses. They’re hedge fund managers, the top 100 of whom earned an average of $363 million in 2005. And they’re general partners in private equity firms – many of whom are listed on the Forbes 400 list of the wealthiest Americans. They’re CEOs like Bob Nardelli who decide how to spend shareholders’ investments – and often get rewarded for failure.

Meanwhile the machinery operators face stagnant income and rising expenses – making up the difference through borrowing. Earlier this week, a report was released which indicated that – at -0.7% -- the US savings rate was the lowest it’s been in 74 years – during the depths of the Great Depression.

The reason that these households keep their head above water is debt. And just as the poor seem to be more overweight than the rich, so do the rich use less debt as a proportion of their assets. Specifically, the top 1% of householders hold 30% of the assets and 7% of the debt, while the bottom 50% hold a mere 6% of assets but a disproportionate 24% of the debt.

With 1% of the US population thriving and the other 99% not doing quite as well, a reasonable question to ask is whether our democracy is doing a good job of allocating the wealth of the economy. And if not, why don’t the majority of Americans who are falling further behind do something about the inequitable economic distribution.

In my view, the reason is simply – the celebrity industrial complex (CIC). The CIC is a modern version of the Roman concept of Bread and Circus or Marie Antoinette’s concept of letting them eat cake. The CIC is a collection of TV programs, gossip magazines, and web sites that make the other 99% feel like they have a shot at making the big time.

TV shows like American Idol reinforce the idea that anyone in America – if they have the talent – can go from being an average person to a star. TV shows like Access Hollywood, co-hosted by presidential distant cousin Billy Bush, give viewers insight into the personal foibles of Hollywood celebrities. And the New York Times, Wall Street Journal, Vanity Fair, and many others cover the wealth of the capital allocators.

The CIC cleverly serves a triple purpose:

It keeps the public mesmerized by celebrities – thus increasing the odds that they’ll buy tickets to their movies
It afflicts celebrities by highlighting their weaknesses – thus making people feel less uncomfortable with their relatively weak position
It gives them a glimpse of celebrities’ wealth – which fuels their desire to accumulate more. And deludes them into thinking they can make it into the top 1%.

The CIC is not sufficient to keep the majority voting for politicians who implement policies that favor the top 1%. But it does play an important role in allowing the two Americas to coexist without tearing apart.

Cure for Iraq? Impeach Bush, Cheney

2007-01-15T05:27:00.000-08:00

Vice President Cheney has challenged the Democrats to come up with a better solution to the Iraq problem. Notwithstanding that Cheney's comment mistakenly presumes that all the Republicans support his plan, I'll take Cheney up on the challenge. My suggestion is that it's time for Congress to impeach Bush and Cheney.

This suggestion brings up some reasonable questions, including the following:

What's wrong with the Bush/Cheney plan?
How will impeachment solve the Iraq situation?
On what basis could Bush and Cheney be impeached?
How likely is it that my suggestion will be adopted?

What's Wrong with the Bush/Cheney Plan?

The biggest problem with adding 21,500 US troops in Iraq is that it will not achieve its "mission." There are five key reasons for this:

The mission is vaguely defined. It is unclear why US troops are in Iraq. In 2003, Bush sold the war as a way to eliminate the threat of Iraq's WMDs and to punish Iraq's role in the 9/11 attacks. Both reasons were proved false. So Bush/Cheney redefined the mission variously as "getting the job done", "victory" or "a democratic Iraq." It is impossible to measure whether any of these vaguely defined missions has been achieved therefore there is no logic for ever withdrawing US troops.
The Bush/Cheney plan's real purpose is not consistent with that mission. It will not be possible to learn Bush/Cheney's true purpose for adding the new troops. I speculate that since Bush and Cheney's political careers will end no later than January 2009, they are currently trying to improve how history will judge them. I further speculate that they believe that adding more troops will increase the odds that they can delay a resolution of the Iraq situation into the next administration. By forcing another administration to withdraw US troops, I speculate that Bush and Cheney hope that history will shift blame for the failure of their policy to their successors.
Iraq does not really exist. The concept of Iraq, as a united country fitting into the borders on the map which currently appears in atlases, does not really exist. Under Saddam Hussein, the country appeared to hold together with the help of a brutally repressive police force. In reality, Iraq is at least three separate groups -- the relatively peaceful Kurds in the North, a smaller group of Sunnis, and a larger group of Shiites -- the latter two having been at war with each other for a long time. Since Saddam left power, the fault lines between these three groups have emerged more clearly.
The current Iraqi government is structured to undermine the Bush/Cheney concept of Iraq. Bush/Cheney envisions a unified, democratic Iraq. However, the current government is controlled by the Shiites. The Bush/Cheney plan relies on this Iraqi government stopping Sunni and Shiite extremists -- which Bush/Cheney believes are the cause of the Iraqi civil war. In fact, the Iraqi government supports the Shiite domination of the country and thus the Bush/Cheney plan will be directed to achieve this end rather than the Bush/Cheney concept of the Iraq mission.
The American public does not support the Bush/Cheney plan. Polls suggest that only 29% of the US public supports the Bush/Cheney plan. This lack of support for its Iraq policy should have been clear after the the Democratic Party took over Congress last November. Moreover, the Bush/Cheney plan is at odds with the Iraq Task Force report which seemed to have greater support.
The consequences of not pursuing the Bush/Cheney plan are unclear. Bush/Cheney claims that disaster will follow a withdrawal of US troops from Iraq. This claim is similar to the arguments made about withdrawal from Vietnam. Back then, President Johnson argued that withdrawing from Vietnam would cause a domino effect in which many countries would go Communist. Bush/Cheney are suggesting that US troop withdrawal would create a safe haven for terrorists. Clearly previous Bush/Cheney predictions -- that US troops would be greeted as liberators and that the war would last at most six months -- have proven false. The only consequence of their plan that's certain is that more US troops will die as they become targets for the parties to a civil war in Baghdad.

How Will Impeachment Solve the Iraq Situation?

Impeachment will not solve the Iraq situation immediately. However, it appears certain to me that the US will not form or implement a realistic strategy to solve the Iraq problem until Bush and Cheney are out of office. As noted above, they are not concerned about reelection which in their mind frees them to pursue policies which they believe will vindicate their legacy.

After four years of consistently achieving results at odds with the objectives they stated, it is clear to me that Bush and Cheney are determined to leave the problem to their successors. I believe that the problem will get worse in the next two years and will certainly result in more deaths -- especially as the 21,500 new US troops are added.

By impeaching Bush and Cheney, the US can reduce the number of lives lost and begin the process of minimizing further damage from their disastrous Iraq adventure.

On What Basis Could Bush and Cheney be Impeached?

Although I am not a lawyer, according to Impeach Bush, there are at least three legal bases on which impeachment could proceed:

Violating laws against fraud by lying to Congress to justify the Iraq war. Bush justified the Iraq war based on claims -- later proven false -- that Iraq had Al-Qaeda ties; that it was responsible for the 9/11 attacks; and that it had WMDs -- including African uranium. All these claims have been proven false -- thus violating US Laws related to Fraud and False Statements, Title 18, Chapter 47, Section 1001 and Conspiracy to Defraud the United States, Title 18, Chapter 19, Section 371.
Violating laws against unwarranted spying on US citizens. Bush has admitted to authorizing the National Security Agency (NSA) to conduct warrantless wire taps on American citizens. The spying even extends to postal mail. This violates US law because he was required to get approval from FISA; and
Violating laws against torture. The evidence shows that Bush, Cheney, Rumsfeld and Gonzales are guilty of violating "Federal Torture Act" Title 18 United States Code, Section 113C, the UN Torture Convention and the Geneva Convention by ordering and condoning the use of torture.

How Likely is it That my Suggestion Will be Adopted?

My suggestion could be adopted but only with significant voter pressure. Unfortunately, it appears that an unspoken consensus has emerged that the impeachment process is not helpful for those members of Congress aspiring to the White House in 2009.

In order to move forward with new leadership, Congress would need to do something unprecedented in US history -- impeach a president and a vice president. Just impeaching Bush would not solve the problem since a president Cheney would probably make the situation even worse.

It is likely that neither would voluntarily resign as Nixon did. And achieving the votes necessary to ensure a successful conviction and removal of Bush and Cheney is a long shot -- the failure of which would likely have severe political consequences for all presidential aspirants.

However, everyone running for president or re-election will have to face voters in the near future. And they will be judged on how they handled Iraq. If enough voters push to stop the train wreck, Congress could change its mind.

The Cohan Letter up 15% in 2006

2007-01-01T05:42:00.000-08:00

After trailing the S&P 500 index for most of 2006, the stocks mentioned in The Cohan Letter, my investment newsletter, managed to surpass the index by 1% by the end of the year – ending up an average of 15%.

In thinking over the performance of the stocks mentioned this year, I was struck by how difficult it was to find stocks that did well. Thus the 2% stop loss rule which I’ve been using for the last several years played a very big role in cutting losers before they could do much damage.

Compared to 2005, four more stocks fell at least 2% this year from the price at which they were mentioned. Specifically in 2006, 22 out of 36 stocks fell at least 2% below the price at which they were mentioned compared to 18 stocks cut in 2005.

These figures suggest that most of my stock picks are lousy. In 2005, when the stock picks were up 23.2% compared to 3% for the S&P 500, fully 50% of the stocks I mentioned proved to be money losers while in 2006, 61% dropped at least 2%.

This analysis suggests that a big part of investing success is following a strict discipline for selling losing stocks before they can do much damage.

But merely not losing is not enough to win in the investment game. Finding stocks that go up more than the market averages is also important. And this year, of the 14 stocks that were left in the portfolio at the end of December, six outperformed the S&P 500, one equaled it, and seven under-performed the index.

I found it interesting that the two top performing stocks in the portfolio were both Mexican companies whose stock prices surged in December. Specifically, Telefonos de Mexico, S.A. (ADR) (NYSE: TMX) was up 36% from $20.83 to $28.26 and Wal-Mart de Mexico (ADR) (OTC: WMMVY) rose 28% from $34.25 to $43.85. At the end of November, these two stocks were up a relatively paltry 25% and 10% respectively.

I am not sure why these stocks climbed so much in December but one reason may be window dressing – the decision by portfolio managers to acquire shares in top performing companies at the end of the year so they can show their investors that they owned these top performers.

This strategy strikes me as silly since investors should be able to tell that their portfolio managers did not hold these winning stocks long enough to capture the high returns that the winning stocks demonstrated during the year.

Nevertheless, this predictable pattern suggests there’s money to be made by traders who can anticipate – maybe in late November – which stocks will be the biggest volume window trimmings for portfolio managers towards the end of December.

A report card on Bush's 2006 State of the Union Address agenda items

2006-11-29T06:47:00.000-08:00

DONE

Renew USA Patriot Act. Bush succeeded in getting Congress to renew elements of the USA Patriot Act that empower law enforcement agencies in the hunt for terrorists.

ONGOING

American Competitiveness Initiative (ACI). Bush proposed a commission that would double research in physical sciences in the next decade, train 70,000 teachers to lead high school Advanced Placement math and science classes, hire 30,000 scientists and engineers to work as teachers, and make permanent current tax breaks for research and development. While the White House requested an increase in ACI's budget, Congress had not appropriated the requested funds as of October.
Alternative fuels. Bush called for a 22% increase in federal funding for research into alternative fuels, highlighting the prospect of cars running on hydrogen and ethanol fuel made from corn, wood chips, stalks or switch grass. Representative Jerry Moran (R-KS) introduced H.R. 5346: Alternative Energy Refueling System Act of 2006 in May 2006. It was referred to the Subcommittee on Environment and Hazardous Materials.
Katrina relief. Bush vowed to fulfill the $85 billion recovery effort for those hit by 2005's Hurricane Katrina. Progress is being made to clean up the damage but it is leaving environmental problems and some corruption in its wake.

LEGISLATION INTRODUCED, BUT NOT PASSED

Entitlements commission. Bush proposed a bi-partisan commission to figure out how to control costs of Social Security, Medicare and Medicaid. In June, Representative Frank Wolf (R-VA) introduced legislation (H.R. 5552) to establish such a commission The legislation was referred to the House Committee on the Budget.
Health Savings Accounts (HSA). To control health care expenses, Bush asked Congress to expand HSAs, which allow people to save money for medical expenses tax-free. Account holders then buy low-cost but high-deductible coverage for large medical outlays. In September a House Panel voted to expand HSAs and then Congress adjourned without considering the proposal in the full House or Senate.
Limit medical malpractice litigation. Bush asked Congress to pass legislation to limit medical malpractice litigation. On May 8, 2006 Congress voted against two measures to limit jury awards in medical malpractice lawsuits sponsored by Senate Republicans. No further progress on this agenda item has been achieved.
Guest worker program. Bush called for Congress to create a guest worker program for illegal immigrants. While many immigrant workers marched in support of the proposal, its House and Senate versions did not pass into law.
Line item veto. Bush asked Congress to give him a line-item veto. On June 22, 2006, the House passed a bill (H.R. 4890) that would call for a six-year line-item veto to cut down on the "pork barrel spending" associated with Congressional lawmaking. The bill stopped short of granting a full line-item veto like the one passed in the 1990s, and instead allows the President to send a bill back to Congress within 45 days for another vote to affirm rider bills. The bill passed 247-172 in the Republican-controlled House. In September the bill was placed on the Senate Legislative Calendar under General Orders.
AIDS funding. Bush also asked Congress to reform and reauthorize the Ryan White Act, and to provide new funding to states, to end the waiting lists for AIDS medicines in America. While the House voted 325 to 98 to change the funding formula under the act, the measure was blocked in the Senate. As of November 2006, Bush's call to re-authorize the act went unheeded.

UNSUCCESSFUL

Spread democracy and freedom around the world. On foreign affairs, Bush renewed his second-term promise to spread democracy and freedom around the world. The world has resisted, however. In January, Palestinians used a democratic process to elevate Hamas, which the United States has designated a terrorist organization. More importantly, US efforts in Iraq have spread civil war -- rather than democracy -- which the administration declines to acknowledge.
Permanent tax cuts. Bush repeated appeals to Congress to make his tax cuts permanent. His appeal did not pass into law. With a Democratic congress starting in January, this issue may not be considered until after the 2008 presidential election.
Medical insurance portability. Bush asked Congress to make it easier for people to keep medical insurance without extra cost if they change jobs or start a business. I could not discern any legislative progress on this initiative.
Ban human cloning. Bush called for Congress to pass a bill banning human cloning. While 15 states currently have laws pertaining to human cloning, there are no federal laws on this subject.

Will Falco fix AOL?

2006-11-16T16:39:00.000-08:00

Last night I found out that a new boss is headed my way. As Amey Stone posted, Randy Falco is replacing Jon Miller as CEO of AOL. And it's good news for Time Warner (NYSE: TWX) stockholders.

Falco ran General Electric Company's (NYSE: GE) NBC for years but he did not make the cut as successor to Robert Wright -- losing out to Jeff Zucker -- who himself may or may not actually succeed Wright. In any case, according to the Wall Street Journal [subscription required], Falco is being touted for his "operational experience." To me this means, he will do a better job than Jon Miller of firing up the troops to sell advertising to companies trying to reach you and your fellow visitors to AOL's properties. And since Falco has experience managing a media company, like Time Warner Chief Operating Officer, Jeff Bewkes, my guess is that he'll be able to work more effectively with Bewkes and the rest of AOL.

A review of AOL's most recent financial performance suggests that Miller's strategy -- cutting back on AOL's subscription business while increasing its advertising revenues -- is getting results. According to Time Warner CEO Richard Parsons, third-quarter 2006 advertising revenue at AOL increased 46%, but subscription revenue fell 13%. AOL had 15 million paying subscribers total (10 million dial-up; 5 million broadband)--down from a high of 26 million in 2002.

Back in July I wondered whether AOL would be able to replace $2 billion in lost subscription revenues with new advertising. Since advertising represents a mere 24% of AOL's $1,983 million in third quarter revenue, Falco has a huge challenge ahead of him to achieve that goal. According to its quarterly report, AOL third quarter revenues fell 3% from 2005's third quarter, or $58 million, to $1,983 million, due to a 13% decrease -- $210 million -- in subscription revenues which totaled $1,405 million -- offset slightly by a 46% increase -- $151 million -- totaling $479 million in advertising revenues.

To close the subscription revenue gap, Falco would need to increase the number of people visiting AOL's sites and sell more advertising to companies seeking to reach those visitors. To put this into perspective, during the third quarter, AOL had 112 million average monthly domestic unique visitors and 49 billion domestic page views, according to comScore Media Metrix, which translates into 145 average monthly page views per unique visitor. This represents $4.28 worth of third quarter advertising revenue per average monthly unique visitor.

In September, Falco introduced a plan to start syndicating short video clips to Web sites via NBC's National Broadband Company (NBBC). With the right content coupled with an aggressive sales effort, Falco might be able to boost unique visitors and attract new advertisers -- adapting his NBBC concept to boost AOL advertising revenue.

Let's hope Falco fixes AOL. If he succeeds, TWX shareholders will be richer.

Democrats better for the economy

2006-11-11T13:47:00.000-08:00

Democrats are better for the economy based on the relative economic performance of the 11 post-World War II presidents along the following six dimensions:

Annual GDP growth
Annual growth in real disposable income
Annual growth in employment
Annual change in unemployment rate
Annual change in inflation rate
Annual change in Federal budget surplus

Here's how these 11 presidents rank (with their average ranks on the six dimensions):

1. Bill Clinton (3.5)
2. Lyndon Johnson (3.8)
3. John Kennedy (4.2)
4. Ronald Reagan (4.5)
5. Gerald Ford (5.5)
6. Jimmy Carter (6.3)
7. George W. Bush (7.0)
8. Harry Truman (7.2)
8. Richard Nixon (7.2)
9. George H. W. Bush (8.2)
10. Dwight Eisenhower (8.3)

Based on this analysis, George W. Bush's economic performance is mixed. He is relatively strong in reducing the inflation and unemployment rates; whereas he is decidedly weaker in managing the Federal budget. While I don't want to muddy the waters of this analysis, my hunch is that inflation under the current president has been worse than reported. As Fed Chair Ben Bernanke recently commented, the inflation data are unreliable. And some believe that they don't seem to reflect the rising costs of health care, housing, and energy.

Let's look at how the current president ranks in each of these six areas compared to the top and worst performers.

Annual GDP growth

George W. Bush (7th): +2.71%
First: Lyndon Johnson +5.43%
Last: George H. W. Bush +1.90%

Annual growth in real disposable income

George W. Bush (10th): +2.81%
First: Lyndon Johnson +5.56%
Last: Harry Truman +2.38%

Annual growth in employment

George W. Bush (6th): +1,293,000
First: Jimmy Carter +2,506,000

Annual change in unemployment rate

George W. Bush (5th): -0.05%
First: John F. Kennedy -0.83%
Last: Gerald Ford +1.25%

Annual change in inflation rate

George W. Bush (3rd): -0.28%
First: Gerald Ford -1.42%
Last: Jimmy Carter +1.65%

Annual change in Federal budget surplus

George W. Bush (11th): -$65.0 million
First: Bill Clinton: +$47.7 million

Although Bill Clinton ranked first only on deficit reduction, his overall average rank on all six criteria was the highest of the lot.

Botched PBM merger highlights health care industry challenges

2006-11-02T06:53:00.000-08:00

The changes in the health care industry have led to botched mergers with PBMs in the past.

It's worth explaining the challenges facing drug companies, the emergence of PBMs and their impact on drugstores like CVS. The upshot? Companies are trying to cut the cost of health care for their employees to improve their profits. Up until the 1970s, there was a simple health care model: drug companies would invest hundreds of millions in research to developed patented products; their sales forces would offer doctors in private practice lots of goodies like all expense paid trips to Bermuda; if the drugs worked, the doctors would prescribe them regularly; and insurance companies would reimburse the companies who bought the drugs for their employees, regardless of price.

But with the emergence in the 1980s of Health Maintenance Organizations (HMOs) and PBMs, this profitable club began to collapse. HMOs, whose drug formularies saved money for their corporate clients by encouraging their doctors to prescribe the lowest cost drugs available to treat a disease, took market share from private physician practices. For example, between 1986 and 1992, HMOs share of drug sales rose from 7% to 22% while private physician practices' share declined from 60% to 43%.

In 1946, the Veterans Administration (VA) began to offer drugs to veterans on a mail order basis. Instead of paying a co-payment for a 30 day supply and picking up the drugs in a pharmacy, veterans got a 90-day supply through the mail. In 1983 Marty Wygod, an investment banker, started Medco with the idea of spreading this mail order concept to companies and HMOs. This did not sit well with the CVSs of the world because PBMs could buy drugs at a discount from the drug companies and ship them directly to the patient -- bypassing the wholesalers and drug stores altogether -- and passing the savings on to the companies, HMOs and patients. Medco also worked with companies and HMOs to find the cheapest drug that worked for a particular disease.

Merck's 2,200 person sales force with their trips to Bermuda was of no avail when it came to persuading HMOs to stock Merck's drugs. For example, in 1992 Medco negotiated a deal with Bristol Myers Squibb Co.'s (NYSE: BMY) to distribute its cholesterol drug Pravachol which slammed sales of Merck's cholesterol reducing drugs. In the next year, Merck's cholesterol drug sales rose a mere 2% while Bristol's spiked 205%.

Merck had heard rumors that Bristol was planning to buy Medco -- extending its power over Merck -- so Merck jumped at Medco. Unfortunately, Merck did not add value to Medco -- leaving it to operate independently and never merging the information flows that would have given Merck the ability to develop better and cheaper drugs. Merck also angered its retail pharmacy customers by buying one of their competitors -- causing them to substitute $400 million worth of Merck drugs for a competitors'. And Merck got into regulatory trouble when Medco failed to disclose its Merck connection when setting up drug formularies in 17 states -- leading to a $1.9 million settlement.

Republican auto de fe

2006-10-25T17:18:00.000-07:00

The rage driving Republicans as they face a historic loss of power in a couple of weeks is causing their vicious attacks to bounce off of their intended victims and to ricochet back on themselves – setting these human rage torches up in flames.

When Deval Patrick won the Massachusetts Democratic gubernatorial nomination in September I thought his upbeat, charismatic style would invite the traditionally vitriolic attack ads from Patrick’s Republican opponent, Kerry Healey. Furthermore, I hoped and anticipated that Healey’s campaign would backfire because I thought that the Massachusetts electorate was looking for a change from the divisive political tactics that have helped Republicans gain office in recent years. According to the Boston Globe’s Joan Vennochi, this is just what’s happened as Patrick is now favored to win 53% of the vote to Healey’s 26%.

A similar auto-de-fe is happening on a national scale in the form of Republican radio host, Rush Limbaugh’s mockery of a video supporting stem cell research produced by Parkinson’s Disease sufferer Michael J. Fox. Video of Limbaugh’s reaction is making him look just a bit insensitive and off his rocker. It’s unclear whether people who claim to have religious values would view his reaction charitably or not.

If the polls are anywhere close to being right, America is finally waking up to the downside of the rabid Republican hate machine. Let’s hope that the Republican control of the polling places is not able to overcome the great blue wave on its way to Washington to put out the Republican fire.

Is HP's spying campaign just investigative reporting by other means?

2006-10-24T11:38:00.000-07:00

DealBreaker took me to task for a post last week which suggested that journalists and Hewlett Packard's board were after the same things -- damaging dirt -- but they simply use different means.

A New York Post reporter sent me the following e-mail in response:

read your article on the WSJ reporter's reflection on her connection to this whole HP mess.

Investigative reporting is legal. To be fair, i am one, but still. Its done in the daylight, using open or at least notionally public sources, with little effort made to conceal footprints. The source of the story almost always has full knowledge of the investigation and is given a chance to respond in detail in advance of publication. There is careful legal and editorial vetting of the process; the reporter would get fired for breaking rules of the paper, let alone the law.

example: if a reporter on a "project"--news speak for investigative reporting--told an editor that he spent the day trailing the target of a story's husband around all day, or nicked some trash, he'd have spent his last day on the job.

on the other hand, HP spent 6 figures to go through a woman's trash, illegally obtain and monitor her phone use, and trail her husband around. this was done at the order of the chairwoman of the board.

Here was my reply:

was not trying to diminish the illegality and immorality of what HP did. I just noticed that both HP and the reporter were digging for telling details using different methods.

I was also trying to make an uncomfortable point – investigative reporters and spies are both after the same thing – damning details -- they just use different methods. And reporters probably think that their methods are perfectly ethical whereas I think that their methods can sometimes be kind of sneaky – particularly when they’re trying to dig up dirt on someone.

Are there examples of reporters who might have done something sneaky -- even if they believed they were acting for the public good?

I was thinking that the use of anonymous sources is not on the very highest ethical plane. There are many reasons why a source would want anonymity. But in some cases, a source is commenting off the record because to do so on the record would result in the person losing his job – in effect the reporter is an accomplice to the employee violating corporate policy.

But the employee and the reporter are engaged in a mutually beneficial transaction – the employee may be blowing the whistle on a corporate policy which he believes is wrong and the reporter is getting a good story and possibly helping to right what the reporter perceives as a wrong.

Both believe that the ends justify the means. The employee knows he is violating company policy by sharing corporate secrets with the reporter but he also wants to keep his job so he agrees to talk only off the record. And the reporter knows that he is an accomplice to the source’s violation of corporate policy but the reporter’s boss allows him to do this because it’s accepted policy within the journalism field.

But in so doing, the quality of reporting may be compromised. A reader doesn’t know how much credence to give to information provided by an anonymous source. How can a reader judge the reporter’s judgment about what is reality and what is spin?

The HP case involved a CNET reporter getting information from an anonymous source who turned out to be an HP board member. If the reader had known that the source was that particular board member, then it would have been easier to judge the accuracy of the information provided. But in the process, the reporter was an accessory to the board member violating corporate policy against revealing confidential information. The board member may have even violated SEC disclosure laws in the process.

My conclusion is that reporters’ hands are not completely clean when they use anonymous sources. But they’re a lot cleaner than HP’s hands after using the tactics that Tam described.

Profiting from real estate's decline

2006-10-01T13:01:00.000-07:00

Real estate is falling down. That much has been well established. What remains to be seen is who will profit from that decline and how they'll do it.

Being "right" too early can be a big investment mistake. Back in July 2002 Amey Stone wrote Housing: Is It a Bubble If It Doesn't Pop? in which I commented on the coming real estate collapse. We revisited the topic in May 2005 with Getting Crushed in a Housing Collapse in which I recounted how I bought my house at the market peak in June 1986 only to watch its value decline about 20% and to wait nine years before it recovered to the June 1986 price.

From what I've read, the latest surge in housing peaked in about July 2005. This is also about the time that housing stocks reached their high – from which they've tumbled about 40% through September 2006.

It has seemed to me for years that the flood of money that the Fed pumped into the economy when it began cutting interest rates in January 2001 has – in effect – kicked the aftershocks of the dot-com collapse down the field. More specifically the flood of cash took the wind out of one bubble and pumped it into another one – namely real estate.

The value of real estate more than doubled from $12 trillion to $25 trillion between 2000 and 2005. Since the Fed began raising rates, though, it appears that this balloon has slowly begun to burst. Foreclosures are skyrocketing -- up 53% in the last year -- and prices are reversing direction even as $500 billion worth of Adjustable Rate Mortgages (ARMs) will reset their interest rates at a higher level by the end of 2006. This will probably accelerate the foreclosure rate and throw more properties onto the market as banks attempt to minimize their losses on the loans.

The potential problem is not limited to residential real estate -- it could affect commercial real estate as well. Having lived through the early 1990s collapse of the commercial real estate market -- which wiped out New England's second biggest bank -- Bank of New England in around 1990 -- I am attuned to possible signs of a recurrence. With antennae buzzing, I note that on the national level, commercial real estate loans climbed to $1.3 trillion in 2005, up 16% on the year.

The Office of the Comptroller of the Currency (OCC) has found that a third of nationally chartered banks have commercial real estate loans that amount to 300% or more of bank capital. And the OCC has said that banks with more than 100% of their capital in construction loans or more than 300% of that capital in commercial real estate generally need more thorough scrutiny from regulators. Such scrutiny has in the past resulted in bank failures.

A collapse in real estate could slam the broader economy. Since Goldman Sachs estimated that the real estate boom accounted for 10 million new jobs I'd expect many of those jobs to disappear as builders cut back on new construction and consumers slow their pace of buying houses and borrowing to finance them.

The big question for the economy is whether investors who are taking their profits in real estate -- one estimate is that at least $125 billion could be available -- will reinvest them in the stock market. If so, the effect could be beneficial for the stocks in which this real estate cash finds a home.

But as money is pulled out of real estate and mortgages default there will also be some big losers -- potentially real estate developers who borrowed too much to build properties that are not likely to be occupied and issuers of risky mortgages to borrowers with limited incomes and poor credit ratings.

Big profits await the investors with the risk appetite and analytical skills to short the right stocks before they file for bankruptcy. I'll be looking for these kinds of opportunities over the next several months. And if you own real estate, such opportunities could be a prudent hedge.

Memo to next president

2006-09-17T05:28:00.000-07:00

When the next president takes office in January 2009, there'll be four burning problems that need fixing:

We'll be trapped in Iraq;
Osama bin Laden and friends will be living in Pakistan;
the West will be funding terrorists through its dependence on oil; and
the Federal budget and balance sheet will be out of alignment.

It's common to read this litany of problems and rare to see proposed solutions. The reason is that most politicians believe that their odds of getting elected are greater if they rail against the problems than if they propose solutions. Nevertheless, the fact remains that the next president will need to take action once in office. So here are my thoughts on what action ought to be taken:

Iraq. I agree with the three-state solution originally suggested by Leslie Gelb and taken up by Senator Joseph Biden. My observation is that Iraq is an artificial construct that through dictatorship was able to unite three separate groups -- Sunnis, Shiites, and Kurds. The US ought to let go of the Iraq concept and with the help of the world community create a new state for each of these groups. This solution is not without problems -- there needs to be an equitable way to distribute Iraqi oil resources and the city of Baghdad. But once the three states are created, there is some hope for an end to the civil war which today results in scores of people killed every day by endless retaliation between Sunnis and Shiites.
Osama bin Laden. I agreed with the idea of going into Afghanistan to eliminate this Al Qaeda refuge and punish the authors of 9/11. I disagreed with letting bin Laden go during the battle of Tora Bora in December 2001. We need to devote more resources to capturing these Al Qaeda leaders. From what I've read, there appears to be a lack of political will to carry out the job but the next president could bring that will back and finish the job. More generally, I believe that the next president has an opportunity to restore America's standing by pursuing a more open and integrative role for the US in world affairs which will enable us to battle the threat of terrorism more effectively.
New sources of energy. I agree with the suggestion of creating a Manhattan Project-like commitment to finding new sources of energy to lessen our dependence on oil. Last month, MIT announced that it was doing something about this. The US has become overly dependent on Saudi Arabia -- the source of 15 of the 19 9/11 hijackers. The reason for our dependence on Saudi Arabia is our consumption of oil through which we finance the teaching of a hateful ideology that wants to destroy us. Through focused presidential leadership, the US can multiply the effectiveness of MIT's initiatives and accelerate their implementation. By freeing the US from oil, we'll be hurting US energy companies that don't adapt. But we'll also be making the US safer and taking action to reduce the threat from global warming.
US balance sheet. The US is currently borrowing a record $8.5 trillion and the administration projects the Federal Budget deficit to hit $295 billion in the current fiscal year -- $352 billion of the 2005 budget went to interest payments on the debt. While my knowledge of US budgeting is limited, I believe there are opportunities to clean up the US balance sheet by paying back our Federal debt which will cut the crowding out of interest expense, reducing wasteful military spending, roll back part of the $3.3 trillion worth of tax cuts passed during the dacade, and better managing Social Security and Medicare liabilities.

You may not agree with any of these ideas. But I challenge you to move beyond the personal attack and frame your thoughts from the problem/solution perspective outlined here.

Skeletal executive presence cans Freston

2006-09-05T07:50:00.000-07:00

This morning’s business blockbuster is the canning of Tom Freston, whose 20 years at MTV helped turn it into a cultural beacon. With its stock (VIA.B) down 18% since the corporate split between CBS and MTV at the beginning of the year, 82-year old Chair Sumner Redstone – who owns 5.7% of VIA.B and 71.2% of CBS -- must be disappointed with a corporate strategy that he thought would boost the value of his holdings.

But Sumner has failed to boost value when he created a one-stop shop for advertisers through his acquisitions of CBS and Paramount. And his idea of splitting up the company between CBS/Paramount and MTV has done little to help the value of his shares either (although CBS.B shares are up 10% since the beginning of the year). This is not to say that his acquisitions and spin-offs have not been beneficial – the investment bankers who did these deals no doubt reaped hundreds of millions in fees.

Meanwhile Freston, who was able to adapt MTV to rapidly changing tastes among viewers, will be replaced by a lawyer Philippe Dauman -- and an accountant -- Tom Dooley. Sumner’s skeletal executive presence is showing its impatience and its loss of skill at creating shareholder value.

With VIA.B down 6% in the wake of this morning's announcement, Sumner's holdings have lost another $106 million in the last couple of hours. Clearly investors see problems with this move that Sumner did not.

One-in-a-million shot: I agree with a WSJ editorial

2006-08-09T07:13:00.000-07:00

Yesterday afternoon, I suggested that the Federal Reserve erred by not raising interest rates. This morning I was surprised to learn that the Wall Street Journal [subscription required] editorial page shared my view that the evidence of inflation in the economy was sufficiently clear that the Fed should have raised rates to damp inflationary expectations.

The WSJ cited Richmond Fed President Jeffrey Lacker, the one dissenting vote at yesterday’s Fed meeting, who found the 4.2% increase in unit labor costs in yesterday’s productivity report to be a strong piece of evidence supporting the need to raise rates.

I have been reading the Wall Street Journal and its editorial pages for about 30 years. In many recent cases I have skimmed these pages because I feared that reading them in detail would cause me to spontaneously empty the contents of my stomach.

This morning’s editorial was the first time I can remember actually agreeing with a WSJ editorial. I guess if you live long enough, such coincidences are bound to happen.

Stewart settles: smart

2006-08-07T08:54:00.000-07:00

So Martha Stewart has finally settled her insider trading case – agreeing to pay $195,000 and accept a ban as serving as a director of a public company, and limiting her ability to serve as an executive at Martha Stewart Omnimedia.

I thought she would settle because her odds of winning at trial were not great and that it would be better for potential advertisers if she could get the charges behind her.

This settlement sends a tough message to executives but it also lets her maintain her current role.

This May I gave some thoughts to a Business Week reporter on two key questions. Stewart evidently came to the same conclusion I did then – her best option was to settle.

Here are the questions:

If she pleads not guilty, and appears for a deposition, do you think this “precarious” legal position is worth regaining her title and clearing her name for Martha Stewart Omnimedia?

Martha Stewart’s legal situation would make an excellent case study for a class on decision analysis. What she must do is estimate the expected value of the financial outcomes that would result from taking each of the branches of a decision tree. That is, she must estimate both the likelihood (say, 40%) of each outcome and the value of that outcome (e.g., a $50 million drop in MSO market capitalization). To calculate the expected value, she would multiply the likelihood by the value (e.g, $20 million).

I am not a lawyer so it is hard for me to assess the odds of her prevailing at a trial. But last time when she went to trial, there was a very unexpected result -- her company’s stock price quadrupled from $9 in December 2003 to $36 in March 2005 when she went to jail. I think the reason was that a lot of her fans bought the stock as a sign of support for her. I don’t know if this would happen again. Nor do I think that it really matters to her company whether she regains her title.

If she appears for a deposition, it will remind corporate advertisers that she is in legal trouble. Especially in light of today’s Enron convictions, many of these corporate advertisers might fear being associated with a publication owned by someone in such visible legal trouble. So it could hurt her business. And my hunch is that I don’t think she will get the same stock market support this time as she did before – her stock is now way down from its peak. And investors may realize that they may have overestimated the importance of Martha to the company’s performance

What do you think the effects of (1) Settling (2) Denying or (3) Asserting her 5th Amendment right would be on her empire?

These three are the key branches of the decision tree. I think the best option would be to settle and get the whole matter behind her. Even though it will cost money, settling would get the legal uncertainty behind her which would thus limit corporate-advertiser-skittishness-due-to-her-legal-problems as a factor in the value of the magazine and TV businesses.

Denying the allegations might fail as they did earlier. They would cost legal fees and generate bad publicity for her company. And it would take time away from her TV programs and other business promotion activities.

Asserting her Fifth Amendment right would have a similar effect from legal, PR, and business opportunity cost standpoints.

Abelson on private equity

2006-08-05T05:18:00.000-07:00

Barron's editor Alan Abelson quoted from my previous post in his August 7th Up & Down Wall Street column.

Here's an excerpt (with Barron's spelling errors corrected):

Money, both institutional and individual, has been coming out of the woodwork in staggering quantities and pouring into private equity. (Admittedly, we're envious, since whenever we tap our woodwork all that comes out are carpenter ants.)

As Peter Cohan of Peter S. Cohan & Associates writes: "Private equity, the business of using debt and a sliver of equity to take companies private, borrowing to extract big fees and multiplying the equity through an IPO or acquisition, is getting long in the tooth." He likens it to the venture-capital boom of the 1990s in "stretching outside its comfort zone to find big deals into which it can pour the new cash." In the process, it's suffering a rash of busted IPOs while its supply of "cheap debt is drying up as credit quality falls and interest rates rise."

Noting the rush of mutual funds into private equity, Peter purposefully recalls that the handwriting was on the wall for the venture-capital boom when in December 1999 a venture-capital firm, Draper Fisher Jurveston, launched meVC, a venture capital mutual fund. All you innocents out there, beware smiling brokers offering the private equity equivalent of meVC (which sounds like something Tarzan might have put a few coins into when he and Jane were a tree-swinging couple eager for financial security preparatory to starting a family).

Peter cites the deals to take private HCA, the hospital chain recently reviewed in Barron's, and Philips Electronics' semiconductor unit as indicating the private equity gang is struggling to find deals big enough to put all that gusher of capital to work. Plainly dubious about the buyout, he relates that it'll leave HCA with debt that'll be a cool six times earnings before interest, taxes, depreciation and amortization.

In like vein, the Philips Electronics' deal strikes him as highly problematic. In light of the "high capital intensity and rapidly changing technology in the semiconductor business," he contends, "it's difficult to see how KKR and Silver Lake Partners," the winning bidders in a bruising bidding war, will be able to generate attractive returns on their $10.2 billion investment.

And, all the while, borrowing costs are mounting sharply.

Maybe private equity should have stayed, well, private.

Is private equity past its prime?

2006-08-02T06:30:00.000-07:00

Private equity, the business of using debt and a sliver of equity to take companies private, borrowing to extract big fees, and multiplying the equity through an IPO or acquisition, is getting long in the tooth. Similar to the venture capital boom of the 1990s, private equity is attracting scads of new money from traditional and retail investors, it’s stretching outside its comfort zone to find big deals into which it can pour the new cash; it’s suffering more busted IPOs, and its supply of cheap debt is drying up as credit quality falls and interest rates rise.

To be fair, private equity returns were great last year, with Cambridge Associates’ private equity index rising 27% compared to 5% for the S&P 500 (including dividends). But the trends outlined above suggest it will be harder to achieve these returns in the future. Here’s why:

New money. With fundraising up 43% in the first half of 2006, the private equity industry this year will easily blow past the $151.8 billion raised in 2005 and may even surpass the record $177.9 billion raised in 2000. And money is flowing into private equity from retail investors as the Wall Street Journal [subscription required] today highlighted -- retail mutual funds are investing in private equity from T. Rowe Price, Morgan Stanley and Deutsche Bank. Back in the dot-com days, I sensed a peak was coming when in December 1999 venture capital firm Draper Fisher Jurvetson launched meVC, a retail mutual fund for venture capital. I wonder whether history will repeat itself with private equity.
Stretching for deals. The recent deals to take private HCA and Philips Electronics’ semiconductor unit suggest that firms are struggling to find deals big enough to put all the capital to work. While HCA had a successful round trip in the past -- HCA's ratio of debt to earnings before interest, taxes, depreciation and amortization may more than double to six times after the buyout – suggesting that there is little margin for error to make this $33 billion deal work. And with the high capital intensity and rapidly changing technology in the semiconductor business it is difficult to see how KKR and Silver Lake Partners will be able to generate attractive returns at the $10.2 billion they’re offering after winning a brutal bidding war. If these deals don’t work out, the lower returns will make it tough to raise funds in the future;
Busted IPOs. Two recently busted IPOs could make it harder for private equity firms to find the exits. Bain Capital and others lent Vonage (VG) $200 million before taking this money-loser public. VG has lost 62% of its value since the May 2006 IPO. That same month Bain Capital and others took a $30 million “management termination fee” out of Burger King (BKC) before taking it public. (This fee is chump change compared to the $367 million dividend Bain Capital and its partners extracted from Burger King in February.) BKC has tumbled 26% since its IPO and it just announced that it lost $9 million in its fiscal fourth quarter due in part to the management termination fee. Investors will lose their appetite for private equity IPOs if there are more such busted deals;
Rising interest rates. With the Fed having raised interest rates from 1% to 5.25% since June 2004, the cost of borrowing has risen dramatically. Moreover, the borrowing rates that private equity investors must pay are higher than they’ve been in five years. For example, in the HCA deal, the investors will pay 2.15 points more than the London Interbank Offer Rate (LIBOR) – which last reached its current level in early 2001. With the credit ratings of LBO debt declining and LIBOR rising as the Fed tries to squelch inflation, private equity borrowing costs will rise – making it more difficult for them to find businesses which generate sufficient cash to pay off lenders and still maintain that sliver of equity on which private equity returns depend.

If private equity is indeed peaking, there’s nothing to worry about. Top hedge funds managers are still enjoying their average $363 million annual compensation. Unless hedge funds are in trouble too…

First and second Americans

2006-07-31T16:52:00.000-07:00

The broad trends and industries I analyze in my investment newsletter, The Cohan Letter, paint a clear picture of two Americas: one that was wealthy in 2001 and is even wealthier today and another that has seen its income stagnate while its costs have climbed.

For a while, lower interest rates made it possible for the Second America to cope with rising housing costs and all the rest by making cheap the debt needed to stay afloat. Over the last several years, this second America has used the equity from a steroid-injected housing market to finance its survival.

The first America – which represents a fraction of the top 1% in income -- meanwhile has been feasting at a banquet table of tax cuts and corporate welfare that it has been dreaming about since the FDR took away the punch bowl.

The Cohan Letter's industry analysis section shows that private equity firms and M&A bankers have secured their place in the wealthy firmament of economic superstars.

Regrettably, there has been no trickle down effect. Unlike the 1990s which enriched venture capitalists, startup company employees and executives, and the average shareholder; this decade has impoverished the average shareholder.

Since January 2001, the S&P 500 has lost 4% of its value. And the future for the majority of Second Americans will become worse as interest rates rise along with prices even as housing values tumble. Meanwhile with the $363 million average earnings of the top 100 hedge fund managers, the future for the First Americans continues to burn brightly.

Winning in November

2006-07-16T07:03:00.000-07:00

If the Democrats wish to win in November, they need a compelling message. Today's Washington Post suggests a way to win -- show pictures of people filling up their gas tanks panning to an image of the prices they're paying.

This article focused on the political uses to which 9/11 images have been used. The Washington Post hired Stanford University professor Shanto Iyengar. His research suggests that showing pictures of smoke plumes off of the Twin Towers is good for Bush while images of high gas prices are good for Democrats.

Specifically, images of the Twin Towers under attack were shown to 2,925 adults. According to the article, 53% of Democrats who saw the video said Islamic extremism was extremely important in causing terrorism, compared with 40% of Democrats in a control group, who saw no video. This tends to favor Bush and the Republicans.

When showing economic images, however, the tables turned towards Democrats. Here's the key passage:

Economic images, however, demonstrated considerable power -- greater than the video of the Twin Towers, but strictly limited to attitudes about the state of the national economy and personal finances. Different groups were shown images either of bad news (rising gasoline prices) or good news (jobs growth). Among those who saw the reports of gas prices, 42 percent said their family is worse off than a year ago, compared with 29 percent of those who saw the good news video. The spread was even greater among independents. Those who saw the gas prices video also were more pessimistic about the national economy.

There appears to be a linkage between the Iraq adventure -- which has spurred global instability -- and the rising price of oil. It is not enough to describe the problem though. To win, Democrats must propose a solution.

Thus Democrats aspiring to victory could show images of the high gas prices and argue that a program of US energy independence from Middle Eastern oil could be the solution. Since Republicans are so dependent on oil companies for campaign contributions, they are not likely to be able to credibly copy this strategy without damaging their interests.

Wagoner and Ghosn at center court

2006-07-15T08:00:00.000-07:00

GM CEO Rick Wagoner loves to boast about his basketball career. Based on his relatively weak management of GM, it looks like the better performing Nissan/Renault’s Carlos Ghosn should win when the two face-off at center court over the next 90 days. GM needs a turnaround general manager like Ghosn, not a finance expert like Wagoner.

Their respective track records suggest that Ghosn will win hands down. Since taking over Nissan in 1999, Ghosn has overseen a 7.6% compound annual increase in sales to $79.8 billion, a turnaround from a loss of $216 million to a profit of $4.8 billion, and a 156% rise in stock price to $20.45. By contrast, since Wagoner took over in 2000, GM’s sales have risen at compound annual rate of 1% to $199 billion, it’s gone from a $4 billion profit to a $9 billion net loss, and its stock has lost 64% of its value tumbling to a current $29.79.

How did Ghosn do it? According to BusinessWeek, Ghosn is great at cutting costs, developing new product lines, working with dealers, and listening to employees. He sets out specific plans and overcomes resistance to change that comes with the territory when a Lebanese-Brazilian-French executive tried to make headway in a Japanese company with proud traditions. Moreover, he demonstrated a skill at identifying where in the world core activities – such as manufacturing, design, and purchasing – are best performed to achieve optimal outcomes.

As part of his "Nissan revival plan", Ghosn closed five factories, reduced the workforce by 21,000, sold non-core assets, paid down debt and redesigned the cars. More importantly, he set specific targets and not only met but surpassed them – winning over even his most vocal critics.

Why has GM faltered? According to BusinessWeek, under Wagoner, GM’s relative costs remained high, its SUV and truck-laden product line generated profit when gas prices were low and then failed to adapt when gas tripled and steel prices climbed. Moreover, Wagoner’s background in GM’s highly profitable finance arm has not helped him figure out an effective strategy to fix the car business.

Kirk Kerkorian is clearly forcing the center court face-off between Ghosn and Wagoner. With his investment in GM just about at breakeven, he would be better off with Ghosn in charge. Turning around a moribund global automobile company is a task for a general manager like Ghosn, not a finance guy like Wagoner.

Wagoner should be able to realize this intellectually. The challenge for him will be overcoming his understandable desire to keep his job.

But for GM shareholders’ sake, the 6’ 4” Wagoner should let the diminutive Ghosn get the ball.

US venture capital goes abroad

2006-07-12T07:23:00.000-07:00

I found quite useful a May 19. 2006 report from American Venture Magazine, "US Based Venture Capital Firms that Invest Abroad."

Since I am working on analyzing the impact of global capital investment on entrepreneurship, I have been seeking information about how US venture capital firms are investing overseas. This report lists 102 US venture firms -- 53% are venture capital firms, 45% are private equity firms and 3% are investment banks. For each firm, the report provides contact information -- including a lead partner, the location of its offices worldwide -- and a list of the primary industries in which it invests.

This information is a useful starting point for my research which will attempt to supplement the information in this report with details about the amount of capital each firm invests in the US and in the countries where it has located its international offices.