August 25, 2008

Letting the stock analysts drive the business

Bigger Isn’t Always Better describes how short-term stock prices are often poor measures of business performance. Excessive concern with them takes management’s eye off the real economics of the business, and often breeds failed growth strategies. One reason for this is that managing a company to stock analyst expectations delegates the business’ strategic direction away from management to Wall Street bystanders who have no real accountability for business performance.

Recently three Harvard Business School professors documented how this process of (mis-) influence works. Download their working paper (CEO and CFO Career Consequences to Missing Quarterly Earnings Benchmarks by Rick Mergenthaler, Shiva Rajgopal, and Suraj Srinivasan) via the link above to see the details. Here’s the short version:

"We find that missing quarterly earnings benchmarks, especially the analyst consensus earnings number, is associated with career penalties in the form of a reduced bonus, smaller equity grants, and a greater chance of forced dismissal for both CEOs and CFOs during the period 1993-2004.

These results are obtained after controlling for the magnitude of the earnings surprise, operating and stock return performance, and are significant in a statistical and in an economic sense.

Career penalties for failing to meet the analyst consensus estimate are higher for firms that give quarterly earnings guidance and in the post-SOX period. Our evidence suggests that (i) boards appear to react directly to managers' ability to meet earnings targets or to the information that is reflected in meeting such benchmarks; and (ii) senior managers' preoccupation with meeting earnings benchmarks might be based at least partly on career concerns."


August 23, 2008

The wolf in sheep’s clothing

Joe Nocera, in today’s New York Times, nailed two key enablers of the current economic crisis:

“Whenever the mortgage finance giants, Fannie Mae and Freddie Mac, find themselves in a tough spot — and boy, are they in a tough spot now! — they always seem to find a way to blame their problems on “the mission.” “We exist to expand affordable housing,” says Fannie Mae on its Web site …”

He makes a convincing argument about how this noble mission provided fig-leaf cover for a bigger-is-better approach to growth, one aimed at pumping up (alas, only in the short run) their stock prices (and the value of the stock options and executive bonuses they drove). A path to growth that, in the end, crippled both organizations and the mission they espouse.

The courses I teach on management always start with a discussion of mission - what it is, how it can be used and abused. This article will make for a great case study to discuss in class.


August 09, 2008

Faith-based economics buys its temple

If economics has strayed from a scientific to a faith-based endeavor, the late Milton Freidman is surely one of its high priests.

This spring his old academic home, the University of Chicago, announced plans for a $200 million economics institute to be named after him.

Guess where the institute is to be housed?

Would you believe ….

…. the Milton Friedman Institute is taking over the space currently occupied by the Chicago Theological Seminary?

I kid you not. Follow the link above.


August 08, 2008

Faith-based economics

Each damaged company – and sector of the economy – has it’s own story to tell. Many of these (the home mortgage crisis, the airline industry’s free fall, the Detroit automakers’ demise, Starbucks’ slump) have been well documented in the business press. But some of the underlying dynamics, less so.

Many accounts of the housing bubble/mortgage crisis/credit crunch focus on greed as the primary culprit. True, greed has been in ample supply throughout this mess, but there is another key contributor that is often overlooked – the rise of “faith-based economics.”

Economics should be an evidence-based behavioral science. But in recent past decades it has also morphed into a quasi-religious belief system.

Its main pillar is belief in the market. Markets are wonderful mechanisms for information processing and goods exchange. But they are things to observe, study and use - not deify. They can be manipulated and they do fail (an entire industry, social entrepreneurship, has been built around market failures).

A corollary to market-worship is an uncritical belief in the goodness of deregulation – the less fettered the market, the better for all concerned, or so goes the mantra.

Of course this is a pile of nonsense. Totally unregulated markets are at the mercy of bullies and thugs. And they make no economic sense in many types of industries.

My account of how constraints guide sustainable growth in Bigger Isn’t Always Better quotes a famous conservative British politician:

“We are for private enterprise, with all its ingenuity, thrift and contrivance …

“ … and we believe it can flourish best within a strict and well-understood system of prevention and correction of abuses.”

Excesses of self-defeating self-interest can’t be wished away by believing they don’t exist. They need to be channeled in constructive directions, and restrained when they can’t. This is something Winston Churchill, author of those words, understood well.

In addition to his call for a “strict and well understood system” I’d add intelligent. Too many regulatory regimes have been designed in dumb and thoughtless ways, leaving them open to well-justified criticism, thereby feeding proponents of deregulation-as-religion.

Combine the widespread rationalizing use of economics-as-a-belief-system with an unquestioned and popular Federal Reserve chief overfeeding the capital markets (possibly for reasons of political partisanship and personal ideology) and you have a formula for economic disaster.

Which is what we have on our hands.

Josef Ackerman, CEO of Deutsche Bank whose missteps and complex financial engineering helped propel the current crisis, also seems to have come around to this point of view in a New York Times interview:

“But it’s not only the banks that made mistakes,” he said. “Monetary policy was clearly very generous for a very long time, and helped to create these kinds of bubbles. The regulatory framework had deficits too.”

Ackerman is right. It required a near-impossible-to-summon degree of discipline for Wall Street to practice smart self-restraint when the belief-guided, chief federal regulator was talking temperance while continually refilling the drunkard’s glass.


August 05, 2008

A smart – and profitable – approach to banking

Financial supply chains also become problematic when they become too long. Cause gets separated too far from effect. For details, look at any account of what’s caused the current mortgage mess.

Sometimes the best way to understand a problem is by looking carefully at an entity susceptible to it that didn’t succumb. This week’s Newsweek provides a good case study. Read it closely. It describes how Hudson City Bancorp’s second quarter profits rose over 52%, and its stock grew 50% in a year when many bank shares were in free fall – all by following a smart growth strategy.


August 03, 2008

Global supply chains – longer isn’t always better

“Globe-spanning supply chains — Brazilian iron ore turned into Chinese steel used to make washing machines shipped to Long Beach, Calif., and then trucked to appliance stores in Chicago — make less sense today than they did a few years ago” says this New York Times article. So do “price-driven oddities like chicken and fish crossing the ocean from the Western Hemisphere to be filleted and packaged in Asia not to be consumed there, but to be shipped back across the Pacific again.”

Rising fuel prices cause rising shipping costs and make the flat world a little bumpier. In recent years the cost to ship an ocean-going container from Shanghai to the US has almost tripled in the past few years. To the extent fuel price increases are driven by increased demand from China’s fast-growing economy, they might eventually also drive the delivered price of China’s goods high enough to reduce it’s export growth.

It’s in the nature of all rapidly-growing systems to eventually self-correct. Mortgage-bubbles tend, after a time-lag, to beget credit-crises.


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