Monday, November 28, 2011

Occupy K Street not Wall Street

There is a lot of talk about contrarian thinking and contrarian investing, but there are very few people who actually practice it.  It has long been true in money management that it is better for career management to be invested roughly in the same way as the rest of the crowd even if you lose money than to be out on a limb and be right and make a killing.  This is sad, but true.  Although this is no way to please your clients or to become John Paulson rich, it is certainly the best way to cover your ass and save your job.  It provides the “everyone else was doing it so how could I know” defense.  Indeed, when the financial system is at risk of collapse (e.g. Long Term Capital Management and its aftermath, Lehman Brothers and its aftermath, etc.), a practitioner of this method is unlikely to be one the unlucky few to be made an example of and so will generally be exonerated and not end up in jail or even pay the price of losing his or her job for terrible decision making.  There is also virtually no accountability for poor oversight and bad management these days.  How else can one explain why many of the individual managers at Wall Street firms have generally not suffered at all and losses continue to mount at firms such as UBS that somehow managed to blow through over $2 billion in 2011as its managers remain immune to consequences 



Thus, it is understandable why there is public anger directed toward managers who work on Wall Street.  But although there are a host of problems with Wall Street and much could be resolved with better (not necessarily more) regulation (i.e. get rid of Sarbanes Oxley and bring back the Uptick Rule and much of The Glass Steagall Act), bankers are not a cause of one of biggest problems that the US faces; they are merely one of many agents acting in their own self-interests.  Bankers are perhaps more high profile recently than many other groups, but we could lump pharmaceutical industry executives, oil and gas industry executives and a host of others into the same categories.  One of the biggest problems we face as a nation is that our government is no longer regularly responsive to its own citizens.  It responds to K Street and not to Main Street.  Instead of occupying Wall Street, I suggest the citizens in Zuccotti Park and elsewhere should occupy K Street.



I think this is unfortunately not very likely to happen, however.  The Occupy Wall Street crew in Zuccotti Park in NYC is not a particularly articulate, organized or terribly intellectual bunch.    And today, the real bang for the corporate investment buck is entirely in lobbying and this is a great tragedy. Where else in this market can one get a 6X return on investment   There is practically no better return on a corporate investment dollar than on K street and it does not matter whether a Democrat or Republic is in control of the White House or Congress.  This is an incredibly sad state of affairs and if we want to take back our country, it is where we should focus our reform efforts. 




Unfortunately, the Occupy Wall Street battle is probably merely a prelude to an even greater battle that we are only beginning to touch upon in the US.  Many sympathizers with the Occupy Wall Street movement skew young and I believe that there is an undercurrent of the coming demographic war that we are facing in the US.  As the young graduate with overpriced, unsustainable university debts (and are often poorly trained) and face a job market that does not provide them with sufficient economic opportunities to service those debts, they begin to question the transfer of wealth from the working populations to the retirees of this country who receive these unprecedented transfers because they now have net worths far greater than younger households than ever before.  Indeed, households headed by a person 65 or older have a median net worth 47 times greater than households headed by a person under 35, according to a new analysis from the nonpartisan Pew Research Center.  In dollars, that gap amounts to a median net worth of $170,494 for older households, compared to $3,662 for those under 35.


Government policies make this situation possible and it is not sustainable for the long term.  Wall Street certainly has its own problems, but K Street is causing Main Street real angina.  I suggest the protesters Occupy K Street instead.

Tuesday, October 4, 2011

The Price of Oil is Still a Tax on the US Economy, but it's improving....

Oil recently broke below $80 per barrel and it caused me to reflect on its continuing importance to the US economy even though there is so much brouhaha over the price of gold.  So much has changed and yet so little has changed since 1973 regarding oil.  The US remains heavily dependent on foreign oil and Americans have learned relatively little from the lessons of the 1970s.  Technological advances frequently require more energy – not less – even as individually powered devices become relatively more energy efficient than their predecessors.  Consumers and producers today typically use more products and services and energy use continues its slow but inexorable climb.  Although the US consumes somewhat less oil than it did a few years ago due to recent weakness in its economy, the country still consumes more petroleum than it did in the 1970s. 


And oil is by far and away the largest energy source for Americans.  So when the price of oil goes up, Americans across all industries feel a real and substantial pinch.  So what exactly is the point of the Consumer Price Index (CPI) less food and energy?  Who can survive without food and energy?  Yes, I know, this form of the CPI removes a lot of volatility, but energy has its footprint everywhere in a modern economy and has to be considered in any serious economic analysis or measure of inflation.  And the US is still heavily dependent upon oil as a source of energy.  When the price of oil goes up, it raises the costs to produce a vast array of goods and services in the US and, in effect, serves as a “tax” on the US economy on top of the federal and state taxes already imposed on oil and its derivatives including gasoline.


Since the depths of the collapse in stock market confidence in March 2009, the price of oil rose from the low $40s to the low $90s at thebeginning of this year.   Earlier in 2011, however, the price of west Texas intermediate surpassed $110 per barrel.  Recently, the price of oil per barrel has pulled back below $80.  Much of the price of oil is driven by classic economics of the underlying demand for its use versus the ability of the oil producers to supply oil to meet this demand.  But there is probably at least one additional factor in the price of this commodity that contributes to this painful oil tax on our economy we have to bear as Americans – i.e. the chance of crises, political unrest or wars in oil-producing countries or their neighboring countries that would materially disrupt the world’s oil supply.  This uncertainty adds a premium to the oil price that goes up or down depending on the perceived risks of the moment.  Recently, I believe this perceived risk and the view of future oil demand have come down and accordingly so have petroleum prices. 


Nevertheless, some types of bad news for oil are good news for much of the rest of the US economy.  The professional skinflints of America (better known as CFOs) are acutely aware of oil’s pernicious effects and are among the first to respond to the high costs of oil.  These CFOs are the vociferous critics of their suppliers who are trying to force price increases on them and are the first to come up with cost cutting measure of their own tomeet the challenges brought on by the oil tax on the US economy.  All too frequently and to the detriment of the overall economy, this has recently meant letting employees go. 
 

In corporate America, these CFOs will also be the first to notice now that oil prices are beginning to come down and ease the “oil tax burden” somewhat.  With any luck, these CFOs will inform their CEOs that they will soon have some flexibility to spend on projects near and dear to their CEO’s hearts.  If the US does not enter another recession, a sustained drop in the price of oil should enable them to invest and grow again.  If oil prices can hold in the $60 to $80 range for an extended period of time again, I believe the US will begin to build off its employment base (albeit slowly) and can create net new jobs – especially in industries such as construction, travel and transportation and agriculture/ag-bio where energy costs are high.  Watch the CFOs here.  And with oil in the $40 to $60 per barrel range, the US can witness real new job growth.  Below $40 per barrel and we are talking substantial job growth.  Unfortunately, prices below $40 per barrel would probably lead to long term problems once again.  There would probably be too little investment in future oil production and too little investment in alternative energy sources due to complacency and uncompetitive initial price points.  I guess that is too much of a good thing….
 

In sum, oil prices have an impact on the US economy that is almost the inverse of housing prices.  (See my previous blog on this topic.)  Higher housing prices and new construction can drive the economy out of its doldrums.  Conversely, lower oil prices put more money in consumers’ pockets and give corporate CFOs and CEOs the confidence to begin spending again as long as we don’t experience another banking crisis at the same time.  Such confidence can rescue the US economy as well.   With oil at over $80 per barrel, however, I think it is difficult to convince consumers to dig deep and spend while they are paying down debt or to get CEOs and CFOs to hire new people for growth instead of investing in energy efficient lighting and teleconferencing systems to avoid the high cost of travel.  It will be hard for the US economy to get going again until the price of oil falls.  When the price of oil falls and it holds, that is a positive sign for the future.


Monday, September 26, 2011

Time to Pay the Piper

I posed myself the question: have the Greenspan and Bernanke puts since the 1980s combined with fiscal stimulus to avoid the pain of serious recessions caused the economic problems of today?  If so, is there a way out of our current economic quagmire of high unemployment and low growth without simply working off all of our excess debt accumulated over that time?  Or can there again be economic gain without terrible pain?  Is it as simple as true fiscal stimulus as opposed to some of the measures that have been offered recently?  Or are we headed to another downturn in a couple of years followed by the inevitable pain of war or some type of military spending that is the only way out of this mess?



To answer these questions let’s compare today’s situation to two other nasty economic periods in modern American history – the 1970s and the 1930s.


The 1970s:                                            America lost much of its opportunity for growth in the years 1973 – 1976 + 1979 – 1982.

                                                            Stagflation reigned brought on by a commodity bubble due to an oil price shock.

The 1930s:                                            America lost much of its opportunity for growth in the years 1929 – 1933 + 1937 – 1939.

                                                            Deflation reigned brought on by debt fueled financial asset bubbles and  monetary tightening.

Today:                                                  America lost the opportunity for growth in the years 2007/8  – 2010.  The US experienced an Internet/technology bubble and bust due to 9/11 followed by an even bigger real estate bubble and bust.  If we expect something similar to either of these prior eras, when is the next downturn going to begin?  2013?  2014?  If history is a guide, it is probably not going to occur as early as in 2011, but anything is possible.

                                                            Are we experiencing a combination of Disinflation then Stagflation or a taste of the 1930s followed by a meal from the 1970s?  I think we may very well be in for such an experience brought on by debt fueled real estate and commodity bubbles.  Look at the prices of many commodities and gold today.  The interesting distinction about real estate is that it is both a financial asset (the 1930s part of the equation) and a non-financial asset for homeowners.  Homeowners use their homes as a personal investment vehicle – as a financial asset – and borrow against it and use it to save and help fund their retirements.  Yet they also live in their homes and receive imputed rent benefits from owner occupied facilities.  Moreover, real estate is responsible for a good deal of the use and consumption of commodities (along with the real estate and industrial booms in emerging markets, real estate in the US is the 1970s part of the equation) – e.g. copper, steel, wood, concrete, etc.  It is real estate’s dual nature that may help explain the period of disinflation that appears to be followed by stagflation today.


Although America has not yet exhausted its borrowing capacity, bills for the US appear to have come due.  Since the oil crisis of the 1970s, the US began borrowing heavily from the Middle East and Japan adding to pre-existing European and domestic borrowing.  Since that time, the US has augmented its spendthrift ways by adding borrowing from China into the mix in its efforts to maintain an economy fueled by consumer spending and lessen the impact of “normal” business cycles.  The right hand of loose monetary policy from the Federal Reserve has enabled the left hand of fiscal policy to continue its profligate ways and allowed consumers to stretch beyond their means and enjoy a lifestyle that they cannot maintain across business cycles whose troughs are too shallow.  No one is willing to bear any pain.  We can no longer manufacture booms without any gloom.  It doesn’t work over the long term.



In the 1970s, it took painful, rising interest rates combined with increased government defense spending on the cold war in order to pull the US out of its stagflation mess.  In the 1930s/1940s, the US economy was slowly moving back to health, but it took holding interest rates around the 2 to 3 percent range and a truly massive federal spending effort on WWII to lift the US (and the world) fully out of the Great Depression.


What will it take this time for the US economy to reach escape velocity and avoid the fate of Japan of the 1990s and today?  Low interest rates and large amounts of public spending have not worked for Japan.  The correct monetary policy will depend on where inflation is.   If the US avoids another near term economic downturn, it may only take time to get the economy going again if there is a long term, credible plan for fiscal rectitude along the lines proposed by the bi-partisan commission.  That may be sufficient to restore confidence and the animal spirits necessary to reignite private investment.  Without such a plan, fiscal stimulus is wasted.  And it may indeed take some real fiscal stimulus along the lines of major infrastructure projects (upgrade of US electrical grid, US interstate highway system, universal broadband wireless) to get the private sector moving again.  If history is our guide, however, and if US GDP declines in the next couple of years, it is a dire situation and even most fiscal stimulus will not work.  In that scenario, it is likely to take substantial defense spending in anticipation of a war to get the US back on track as horrifying as that prospect may be.  Perhaps the war against Islamic fundamentalists is closer than we think?

Friday, June 24, 2011

Challenges in Combating Cancer

Summertime is full of walkathons for cancer.  There is absolutely nothing wrong with raising money to help cure disease.  But is this money well spent and have we made much progress toward cures?  Although many view cancer as an evil monolith, cancer is not a single disease.  A glioblastoma took my father’s life roughly 18 years ago this week and yet the prognosis for a patient with glioblastoma today is virtually as awful as it was 18 years ago.  Even now, most solid tumors are treated with a regimen of chemotherapeutic agents, surgery and radiation similar to what my father received.  Rates of remission move incrementally, if at all, over time.  Although we have made some strides, real progress in addressing cancer’s ravages for many indications has been frighteningly slow.  Why is this so with the billions and billions raised annually for cancer and deployed in research for cures by governments, universities and pharmaceutical, biotechnology and medical device companies?

There are several structural problems that have led to egregious wastes of time and money and relatively little progress against most cancers.  First, I believe the typical research approach to creating new anti-cancer drugs is simply ineffective.  Find a marker for a type or sub-type of disease and then find agents that attack cells with that marker.  For the most part, with a few exceptions, we haven’t made much progress using this approach and haven’t extended lives for years or decades by doing so.  Second, our US regulatory system (FDA) is ill equipped (perhaps also institutionally incapable) to reorganize itself to handle new approaches to curing cancer that have a much better chance of long term success.  It still takes forever and costs $180 to $231 million to bring a drug to market.  Ridiculous.  And third, many companies in the industry are organized and optimized for regulatory and marketing operations that do not correspond well with new approaches that may indeed work.  Such organizations are incentivized to create one size fits all solutions.  Moreover, they are motivated not to cure anything, but rather to treat diseases (including cancer) as chronic conditions.

Biological systems are very complex, very sneaky and redundant.  They are created by Darwinian trial and error and the fittest are the ones that can withstand a multitude of environmental blows that can be thrown at them.  So when something goes awry with a cell (such as cancer), it is not typically because one protein is present or missing.  Biological systems must compensate for the odd problem or else they do not survive ruthless Darwinism; it is usually attacks from multiple sources that beat their repair defenses.  It is the breakdown of the entire system (interplay of genetics and environment/nature and nurture) that enables cancerous growth.  It is the rare exception (such as Huntington’s Disease) where one can point to a single nucleotide polymorphism that is responsible for a particular disease state.  Because they are all interdependent, one cannot typically analyze individual components in a biological system in isolation.   Disease occurs because the system as a whole breaks down not usually because one individual part was the “cause.”

With the above statements, I do not mean to denigrate Roche’s Herceptin or Genentech’s Gleevec which are effective for the populations they serve.  See also Pfizer’s Crizotinib and Roche’s Vemurafenib.  But we will probably discover that these drugs will be most efficacious when used in combination therapies that address multiple attacks on entire systems. Most diseases, however, e.g. metabolic disorders, cardiovascular disease, and yes, most cancers have a plethora of pathways to march down to progress to disease.  The way to solve and knock out the various progression pathways simultaneously and arrest tumor formation is to use systems approaches.  Such methodologies require vast amounts of patient data over populations and tremendous amounts of computing power to capture the information in databases and then parse and analyze it 

I believe treatments of the future will usually require a series of diagnostic tests to determine which regimen combination of drugs will be necessary for the sub-type of cancer that the patient possesses.   Blood protein assays for these types of diagnostics will require the next generation of micro-fluidic chips from companies such as our portfolio company, Fluidigm.  The problem is that the markets for each of the individual tests and drugs will probably not be large enough to recover the costs necessary to invest in developing them under our current regulatory system.  Thus, to get where we need to go in the future to create more individualized and effective cancer therapies, FDA will need to undergo a dramatic transformation.  Nevertheless, even if the regulatory system were to adapt, the current research and development arms and marketing divisions within drug companies are not structured to be able to address micro-diagnostic markets with corresponding therapeutics.  And healthcare providers have little incentive to change methods of hacking out tumors through surgery.  Future treatments may involve more elegant solutions such as “signalling nanoparticles” that would function like notification proteins and mark locations where cancer cells exist and further action was required. “Receiving nanoparticles” might then be recruited to cancer sites like platelets, but instead of staunching a wound they would deliver anti-tumor drugs.  Without an economic incentive, however, it will be hard to change behavior and get providers to adopt new techniques.

With all of these factors stacked against real change, I guess I should not be surprised that so little progress has been made since my father passed away 18 years ago.  Scientists such as Dr. Leroy Hood, Dr. Sangeeta Bhatia and Dr. Geoffrey von Maltzahn have made great discoveries, but without more research dollars being directed appropriately, serious FDA regulatory reform and a complete rethinking of pharmaceutical and healthcare company business plans, I fear that we will be in much the same place in the war on cancers 18 years from now.  That is a lot of walkathons for little progress.

Wednesday, June 15, 2011

Whither real estate goest, the country will go. (apologies to Ruth 1:16)

I have had several friends discuss the following question with me recently.  Can the US economy undergo a sustained recovery without any participation from residential real estate?  Moreover, they have forwarded to me several blogs such as the Diary of a Mad Hedge Fund Trader  that point to a chart that prices US residential real estate in gold for the last 40 years.  Many of these chartists suggest that residential real estate prices have another 10 to 15% to fall relative to gold before they can grind sideways or head slowly upwards.  I imagine the gold bugs among them have concluded that if gold falls in price, the US financial system is doomed as all assets tumble in value and anyone who has a mortgage falls further underwater….

Real estate may fall another 10 to 15% relative to gold, but I don’t know how these traders can foresee this future from the chart.  These bloggers contend that gold is the only real store of value and is therefore the “real” benchmark to use in determining where real estate prices are headed.  If you look at the data since 1970, however, for median and average nominal sales prices of new homes sold in the US and real home prices as calculated by Robert Shiller, expecting a return to relative values of the early 1980s is not clear.  If we examine the data, we see that Pearson’s Correlation Coefficient is positive and fairly strong for nominal real estate sales prices and gold, but only slightly positive and weak for real home prices and gold. (r=0.67 and 0.34 respectively)

These relationships between real estate and gold make a lot of sense to me.  Generally, if the prices of hard assets are going up or down on a nominal basis, it makes sense that they will move in the same direction.  But the factors that are driving the long-term, positive, real, upward trend in the prices of real estate are not necessarily the same ones that are driving the more idiosyncratic values of gold.  Moreover, the price of gold in the US was an artificial one until the 1970s.  On the one hand, a house can be a pain to take care of, but you have to live somewhere; on the other hand, gold is cool and shiny and always worth something across history, but you have to make sure that no one steals it from you.

So back to the original question rephrased: are all US citizens going to rent property and hoard gold and watch the real estate market collapse?  If so, what does this mean for the US economy?  Well, I would not completely give up on the American dream just yet, but even a cursory review of jobs reports makes one conclude that it will be very difficult for the economy to recover without real estate making at least a partial comeback and it is probably going to be a while before it does.  According to the Bureau of Labor Statistics 7.4 million jobs, or 5.1 percent of total employees, counted on residential real estate for work at the peak of the real estate cycle in 2005. As the housing market crashed, residential-construction-related employment fell substantially; jobs in the industry fell to 4.5 million in 2008, accounting for only 3.0 percent of total U.S. jobs.   At its current pace, it will take quite some time for the private sector to create sufficient jobs to make up for the shortfall in the real estate and construction industries.   Sad, but true – no matter how rosy a spin you want to put on the data or the outlook….

The US real estate problem is demographics.  Demography is destiny.  I am certainly not the first person to note that relationship.  (That line is usually attributed to Auguste Comte).  But it certainly is one of the forces that will drive real estate sales and prices (and therefore construction and jobs) in the United States over the coming years.  I think it is far more important than the price of gold!  Demographics is also a major force behind my vision of the emerging market consumer  that is going to be one of the worldwide economic drivers of at least the next decade or two.

The aging of the Baby Boom generation (roughly 76 million individuals) here in the US is the demographic trend that is currently having and will have the greatest impact on the real estate market in the medium term until Generation Y or the Millennials can afford the Baby Boomers’ homes.  Generation X alone does not have sufficient numbers to buy the homes will come onto the market.  This is another compelling argument for greater H-1B visa and other legal immigration into the US.  Baby Boomers born just after WWII are currently entering the time of their lives (65+) when they downsize their homes and either move back into city centers to be closer to good medical facilities and entertainment options or into retirement/semi-retirement/vacation areas.  They are slowly unloading their homes and settling into condos and other properties that are easier to take care of.  Ebay, Craigslist and other companies benefit from this trend as Boomers find new homes for their old “stuff.”    

Although mortgage rates will most certainly increase at some point in the next year or two, I do not believe that any initial increase will have much of an impact at all upon prices or demand for residential real estate and it may even be a net positive for the market.  I realize this sounds like economic heresy.  When the cost of acquiring an item rises, demand for it decreases, right?  This is certainly the case for most items with a price that is elastic.  I’d make that bet 99% of the time.

There are certain items for which this relationship between price and demand does not always hold true, however.  For example, when stocks rise in price, momentum investors and many individual buyers want to climb aboard “winning stories.”  Similarly, people like to buy homes when they are increasing in value believing that they will continue to do so.  They don’t like to purchase when prices have been cut or when they are declining thinking that this too shall continue.  Therefore, demand often rises as prices rise and this demand comes not only from speculators.   Prices and interest/mortgage rates often need to rise quite substantially to choke off demand once demand begins to rise.  Indeed, historically, there has been no correlation (it is slightly negative) between the market yield on the 10 year treasury security (which drives mortgage rates) and median nominal sales prices of new homes sold in the United States and real home prices as calculated by Robert Shiller (r=-0.36 and -0.28 respectively).  There does appear to be a very long term and very high correlation between median nominal home prices and population growth, however.  (r=0.98)  Demographics matter.
   
Demographics matter over the long term, but can they guide us in the short and medium term?  Unfortunately, not quite so much.  But they explain a good deal more than interest rates or gold.  For example, a strategy of keeping interest rates low to keep mortgage rates low to encourage home buyers to buy because home prices are held lower is not one that appears to be based on a sound analysis of historical data.  Such a strategy will not work for the long term.  A more effective strategy would be to encourage legal immigration to the US and to promote and encourage population growth and new household formation.    I hope it is not a generation before we see any real return on residential real estate although this could be the case unless the US decides to adopt more open legal immigration policies.  As you can see from the chart above, unless building costs are rising, it can take a very long time to see any real return on one’s investment in housing! 
Without a sufficient ROI in residential real estate, it is hard to envision a revival of the construction industry which is important engine of job growth for the economy.  This is another reason why I believe Fed Chairman Ben Bernanke is pushing for a more explicit inflation target.  With an explicit target, there is no more guessing about objectives and it would help generate at least a nominal return on some residential real estate investment and put some Americans back to work.  Only then can we breathe a bit easier about a sustained economic recovery.

Wednesday, May 25, 2011

Disclosure and Transparency – Too much of a good thing?

What constitutes sufficient disclosure in an organization?  Are we being transparent enough?   Is there a meaningful difference between the two?  I think there definitely is, but these are not easy questions to answer.  At the Bedford Central School District (where I am on the Board) we are unfortunately still paying the price of past sins of insufficient transparency (and perhaps inadequate disclosure as well) even though under the leadership of Superintendent Jere Hochman, the District has made concerted efforts and tremendous progress over the past few years to provide full disclosure and appropriate transparency.  On its website our District provides a fairly thorough and accurate picture of its operations.  If we bombard the public with a plethora of additional reports and educational techo-jargon, then I believe we will merely confuse and not inform.

As a Board member, I still get complaints regarding our lack of transparency.  We will probably be damned if we do and damned if we don’t and it is hard to determine what exactly is the right amount of disclosure that will lead to transparency that will satisfy almost everyone.  At the other end of the spectrum, one can imagine a flood of information that leads to an information overload that can obfuscate the real picture and make it more difficult to form an accurate picture of what is really going on.

We face the same conundrum in the private sector as well.  In private equity and venture capital, there are significant calls for additional disclosure and transparency by CFA Institute and other organizations.  Some of these demands are warranted since limited partner investors in private equity and venture capital funds should be entitled to financial information regarding the performance of their investments.  Indeed, our firm discloses information to its limited partners regarding portfolio company investments, but we specifically indicate that the information that we provide is confidential and not to be disseminated further.  Moreover, we do not disclose information of such a sensitive nature that, if disclosed, would materially damage our portfolio investment or subject us to liability.

Limited disclosure of such financial performance should not pose a serious burden, but more extensive disclosure (especially confidential information regarding portfolio companies) will not necessarily improve transparency materially and may cause harm.  Indeed, knowing that deep, detailed analysis may be disseminated may discourage private companies from even becoming portfolio companies of firms that adopt overly broad disclosure policies.  The law of unintended consequences almost guarantees it.

Private companies are private for a reason and often do not wish to air their laundry – dirty or otherwise.  They choose to operate with the relative freedom afforded by the private markets and accept the capital constraints of these markets in exchange for these freedoms.  Calls for greater transparency are very well and good, but let us keep in mind why many companies choose to remain private and balance their needs with the needs of investors.  Private Limited Partner Investors certainly need to know how well their investments are performing financially, but do they really need to know which big sales deals the companies lost last quarter?  I suggest this information crosses the line for even the underlying principals of the CFA Global Investment Performance Standards (GIPS) “Fair representation and full disclosure.”

No matter how transparent one tries to be, there will always be gaps in information flows and comprehension among parties.  Individuals do not have an unlimited capacity for grasping information in a relatively short time frame nor in many circumstances do they desire complete transparency.  In this way, information is inherently asymmetrical.  It is this asymmetry that enables the above market returns in many markets – especially private ones.  Therefore, call me a heretic, but I believe we should settle on what are reasonable limits for disclosure and transparency and then embrace the rewards.  

Friday, May 20, 2011

Would Newt Pay the OB/GYN for Arnie's Love Child?

I know many will perceive the following as heresy.  Nevertheless, I believe the comments made by Newt Gingrich this past weekend were more important than the revelations disclosed by Arnold Schwarzenegger regarding his heretofore hidden love child.  Yes, I actually believe what I just wrote.  I don't always agree with them, but Gingrich’s comments reminded me of the serious debate that is occurring across this country and the parlous state we are in due to the level of our healthcare spending and the results we get for it.

Healthcare Benefit Costs are the boa constrictors that are slowly squeezing the life out of the companies that we are trying to build in the United States and are choking the state and municipal governments in America.  We feel the pinch in our portfolio companies at my firm.  Moreover, the Hay Group released a report for the Bedford Central School District that I serve that demonstrates alarming annual required contribution numbers.  Our district is accruing liabilities at a terrifying rate and we must change the system or…either the taxes to support the current system will crush us or the costs of doing business through providing traditional healthcare benefits will.  The situation is not all that much different for traditional, low deductible “Cadillac” healthcare plans in the private sector.  They, too, have simply become unaffordable.

I am revisiting a topic that I touched upon back in February when I began a discussion regarding Healthcare IT.  Getting a better handle on how, why and where we spend our healthcare dollars is an excellent idea and mapping spending and tracking procedures, regimens and outcomes is both good business and good science.  Nevertheless, unless and until we move away from a third party payer system except for catastrophic illnesses, we will not make any real progress on costs.  The current situation presents nightmarishly bad incentive structures.  Physicians recommend diagnostic procedures and treatments to patients (everything under the sun to avoid liability) and patients usually accept whatever is recommended because they are not paying for anything beyond the deductible or co-pay amount, which is the responsibility of the insurance company or the government under traditional plans. 

No matter how good we get with any healthcare IT analytics systems, we can never overcome this horrible incentive structure.  All experiments that try to tweak the healthcare system in some way without fundamental reform will ultimately fail.  The only solution that will work to reduce ever escalating costs is for the patient ultimately to have control over the payments to be made to the physician.  The patient will then have a strong incentive to shop for the best physician at the best price.  The debates should be over the amounts and the mechanisms of allocating and transferring funds to the control of the patient.  Patients would then be free to purchase high deductible plans of their own choice, pay directly, or even purchase supplemental private plans.  Since not everyone will be able to afford insurance, there must be consideration of the level of taxation necessary to cover those who cannot afford high deductible, catastrophic insurance and some type of health savings account for regular or preventive care.  It is not fair or a good use of resources to have indigent patients clogging up emergency rooms.   Such facilities would then not be available when truly needed.  If our country were to move in this direction, I believe it would be a system not unlike the one used in Singapore today and it would cost much less than what we spend on the private and public side in the United States. 

Empowered and informed patients are better patients and better consumers and they save companies money.  Their care is equal or better than their counterparts’ at companies with traditional plans.  The Cigna Choice Fund Experience Study simply cannot be ignored. Yes, we can all argue that such a study is self-serving.  But that is far too simplistic an analysis and unnecessarily dismissive.  The logic and the incentive structure behind the Cigna Choice Plan is too compelling to ignore and it is time to move toward a system with a high deductible health care plan and something akin to health savings accounts and that these are funded for those who cannot afford them.  We can do this as companies and as a nation or become less competitive, more highly taxed and poorer.  The choice is ours.

Sunday, May 1, 2011

Even with the Triumph of Hope Over Experience, it's still a Buyer's Market

The recent GDP advance estimates for the first quarter of 2011 reinforce what I (and probably many others) have thought was the case for some time.  Economic conditions have indeed improved over the past two years, but not enough to enable us to adopt the Candide philosophy that everything is fine in this best of all possible worlds.  Our economy is gradually digging itself out of the gigantic hole we created, but there are many forces holding us back from crawling out more quickly.  I have been told several times recently that Mergers and Acquisitions is one area that has greatly improved and is helping the country repair itself, but even there, we are not, in the words of the bard Prince – partying like it’s 1999. 

It is true that companies are paying bankers to do deals and are not firing multitudes of employees when they purchase other firms.  I am currently responsible for 6 companies within my firm’s portfolio.  Many of these companies have improved their economic performance substantially in the past two years and are now in various stages of the M&A process.  The M&A market is far better than it was in the very dark days of late 2008 to early 2009 when it was hard to get a meeting with a potential acquirer much less an offer.  But no matter what companies may hear from M&A bankers today (a naturally optimistic lot compensated by doing deals which remain the perennial triumph of hope over experience), it’s still a buyer’s market.  There are a multitude of reasons for this situation and it manifests itself in a number of ways.

For example, it remains the exception and not the rule that a target company can actually get two or more potential acquirers to engage in a formal process bidding against each other and drive up the acquisition price.  There are very few companies like GroupOn that can spurn offers and seriously contemplate going public.  The whiff of an auction causes such angina among corporate development officers at strategic buyers today that they rarely hang around for more than a second round of bidding if they will even go that far. Few targets are so strategic and irreplaceable that acquirers simply must have them.  Therefore, potential acquirers often do not bid up prices much during a sales process.  Moreover, in almost all market sectors, because there are far fewer public companies today than there were 10 years ago, there are typically only a handful of real, potential strategic buyers.  And all of these buyers know one another and are often in fairly regular communication at conferences and other venues.  Debt is expensive and accordingly financial buyers are at a significant disadvantage during such times.  Even though there is talk that the IPO window has recently opened, very few companies offer a credible threat of an IPO and the data demonstrate a relative dearth of public offerings relative to the pre-bubble 1990s.  Accordingly, buyers demonstrate bidding discipline and it is difficult to break down their resolve.

Once a target company has settled on a suitor and has signed a letter of intent to be acquired, the real fun begins. At this stage, the parties have negotiated relatively few provisions that end up in a Definitive Agreement or the very important schedules that accompany a Stock or Asset Purchase Agreements.   Due to a relative paucity of alternatives, buyers hammer target companies on terms and conditions in final legal documents.  For example, escrows are significantly larger percentages of deals than a few years ago and are lengthening.  Representation schedules are enormous and growing and buyers’ initial positions on warranties are ludicrous.  Providing a warranty for the GDPs of the G20 group of countries for the next 3 years would be easier than some requests I have seen.

So what can a company do to protect itself?  I see two choices.  Don’t play the M&A game until power shifts toward sellers.  Few companies have this luxury.  Unfortunately, I don’t see a power shift happening for a long time given the current regulatory and economic environment.  The other choice is to arm oneself with the very best legal, accounting and consulting counsel necessary to combat the arguments that will inevitably come from buyers.  In the end, targets must be prepared to say “No” if the terms and conditions are simply too onerous to bear.  Walking away may be the only choice that will bring buyers to their senses and back to the table.  Such a threat cannot be a bluff because it may indeed be called.  This isn’t poker where one gets to play a different hand with a new set of cards with the next deal.  A target willing to play the walk card must play the same hand it holds in the current economic game.  And it has to be willing to play these cards after a buyer knows a lot more about the company.

In the meantime, let us hope our leaders will make the changes necessary to provide a more fertile environment for economic growth.  And let us hope that buyers will feel more buoyant and demonstrate a greater willingness to spend to seek growth through M&A.  The former will help drive the latter.  I am ready to party again like it’s 1999.  I hope I don’t have to wait a decade or more for another seller’s market party, however.

Tuesday, April 26, 2011

Much Ado About Nobility -- In Advance of a Royal Wedding

On the eve of a “royal wedding” between Prince William and Kate Middleton and movements toward democracy in the middle east, I began to ruminate on the efficacy of monarchies and aristocracies in modern societies.  I have seen data pointing to the existence of about 50 royal families in the world – far more than I would have guessed.  If countries wish to have them and pay for their security and upkeep, it is certainly their business to do so and I do not begrudge them their decision.  Nevertheless, I wonder whether it really makes sense to adhere either to this form of government and the hereditary aristocracy it creates or to this form of class privilege in a modern society. 

Although there are many arguments (and solid examples) in favor of benign dictatorships, there are just as many cogent arguments (and many more examples) demonstrating that absolute power corrupts absolutely.  A monarchy (and accompanying nobility or aristocracy) does not necessarily imply such absolute power.  For example, a constitutional monarchy as in Spain serves as Head of State but is not politically active.  Nevertheless, a monarchy promotes privilege and it certainly perpetuates an inherited and almost certainly unearned (after a generation or two) class system.   Moreover, if a society has a monarchy, but does not bestow on such a monarch some real executive powers, then it has many of the cons but none of the real benefits of an Executive Head of State who can make a decision without having to go to committee.

Since it is the Easter season, I feel it is appropriate to paraphrase scripture.  The poor will always be with us.  Class systems are bound to arise in societies whether or not they are based on ancestry, history and tradition or wealth, brains, skill, athleticism, good looks or luck.  To a certain extent, nature and nurture will help perpetuate a class system.  Successful people marrying successful people will tend to have more successful children over time.  Parents naturally give their offspring every advantage they can.  What sense does it possibly make to offer state sponsored hereditary privilege for even greater advantage?

It is very difficult to estimate the costs of maintaining a monarchy and a landed gentry in a modern society.  In the United Kingdom, the BBC estimates the security costs alone for the royal wedding will run somewhere between 5 and 20 million pounds and perhaps over $300 million per year.  It is equally difficult to estimate the benefits such as increased tourism as well.  Would the UK really lose out much in tourism if the royal family were no longer “royal?”  The UK’s deep, royal history would not disappear.  The castles and country homes of the royals and the nobles are not going anywhere.

Indeed, what is this “history” that is being celebrated?  Isn’t the genesis of royalty, the biggest, baddest chieftain (e.g. William the Conqueror, née Bastard) who decided that he would band together with some big thug, noble buddies and beat up on other lesser thugs who had land he wanted and declare himself the chief thug of the land.  He would then parcel out the land to those thugs who were on the side of victory and tax it at a level where they would not complain too much but would instead throw their support behind “their” king.  The king would then cement “alliances” by marrying members of his family to members of other important, noble families to keep them loyal by blood and take the sons of other noble families to the royal court for “education and training” so the king could keep these additional noble families in line.  It is all wonderfully Machiavellian.  So that’s the “history” tourists celebrate?

The poor will always be with us.  Class will always be with us. Let’s not have the State pay for and perpetuate an outdated class system.  Isn’t it time for royalty and nobility to exit quietly and gracefully?

Tuesday, March 29, 2011

The Middle East, North Africa and the Ferengi Rules of Acquisition #s 34 and 35

War is good for business.  Peace is good for business.  At least according to two of the Two Hundred Eighty-Five Rules of Acquisition that compose the sacred code on which all of Ferengi society is based.  You just have to love the writers of Star Trek sometimes! 

Last evening, I listened to President Obama tell the nation why America is participating in enforcing a no-fly zone over Libya.  Skeptics on the left and the right will assuredly be pissed off by this recent decision of the executive branch.  The left will abhor any military engagement and the right will hate any Obama Administration action.  I think the President probably waited too long to do what we are doing now (we should have stepped in to assist a couple of weeks ago and not let Qaddafi’s forces gain any upper hand), but ultimately the Administration decided to back the same forces of change in both Tunisia and Egypt that have sandwiched Libya.  Very few in the broader Arab world can complain about preventing a potential slaughter of civilians in Benghazi and fewer still will shed many tears at Colonel Qaddafi’s departure. 

It would be nicer and more convenient if the United States held a coherent, regional strategy.  But consistency is the hobgoblin of small minds.  America is now interested and involved and is doing the right thing alongside the political cover of the UN.  We are the chicken and not the pig in bacon and eggs in this situation.  The Obama Administration appears inherently conservative (I am shocked I am using “conservative” in the same sentence as Obama Administration, but yes, it appears to be so in this case) on many foreign policy issues so this slight delay and ultimate handover of control to NATO should not come as a surprise to Washington watchers.

Ultimately, if a war does not drag on for years on end and if there is a peace that follows and Libya does not evolve into Iraq, this situation is good for business.  I do not think Libya is Iraq.  The Libyan people back the intervention and the insurrection is part of a broader trend.  There is an arc in northern Africa extending from Tunisia to Egypt of well over 100 million people who will ultimately have the opportunity to have some sort of self-government.  Although a peaceful transition to a democratic society where millions of people will finally have the opportunity to enjoy the fruits of their labors and enter the middle class is by no means assured, I believe the chances are far better today than they were one week ago. 

In the meantime, someone will benefit from rebuilding after the bombing raids.  Someone will make money from the explosion and flowering of new commercial efforts that will burst force and erupt once the shackles of the Qaddafi regime are thrown off.  As the Ferengi have noted, “War is good for business.”  Perhaps they should have said “Peace is even better.”

Tuesday, March 22, 2011

Plus ça change....

In May 1999, basically a lifetime ago, I made a presentation entitled “Valuations in La-La Land” for Burt Alimansky at what was then called the New York Venture Group, now subsequently renamed the New York Capital Roundtable.  I came out on record against silly valuations 10 months prior to the NASDAQ high before the Internet bubble crashed.  I am probably at least 10 months ahead of the high again for this new Internet bubble as well. Indeed, I never thought I would see another bubble this soon.  Fortunately, it is not of the same magnitude and does not involve nearly as many companies since it is primarily limited to those enterprises related to the social networking and software as a service (SaaS) arenas.  Still, for selfish reasons I love that Cornerstone OnDemand IPO!

Why do I think there is a bubble forming again?  What are the signs that I see that are similar to what I noted in 1999?  Do I find myself listening to Prince’s ”1999” a lot more often these days?  Well, yes, but that’s only for nostalgia purposes and has nothing to do with any Internet related bubbles. 

Facebook, Twitter and Groupon may indeed have very good business models, but they are in no way worth the tremendous valuations that they are commanding today just as many of the Internet darlings of the late 1990s with good businesses were in no way worth the valuations that they were commanding at that time.  Almost all of the high flying companies of the late 1990s have never recovered their pre-crash highs, but some (Amazon and Ebay to name a few) have been able to re-achieve and even surpass their former glory with a lot of hard work.  These solid companies represent the great exception and not the general rule, however, and even excellent enterprises such as Cisco remain far below their former glory. 

There are a host of factors at work driving the valuation inflation this time around.  Once again, too many dollars are chasing too few deals.  But this time, it is not because too much money has been raised by venture capital funds and it simply has to find some place to be put to work.  This time, I believe much of the money is heading into a few big companies that have serious scale and momentum.  The valuation of several of these good, large companies is simply far too high and is driven often by less sophisticated investors participating in the secondary markets handled by SharesPost and SecondMarket.  And as in the late 1990s but on a smaller scale, lesser companies are getting funded (often by angel groups) with valuations keyed off of these inflated valuations.  A rising tide lifts all boats.  Beware when the tide goes out….

Facebook is a solid company, but it is not worth $50 or $75 billion today.  In order to double investors’ money, the company would need to become worth $100 or $150 billion.  There are fewer than 10 US technology companies worth that amount of money.  Even Ebay and Amazon are not among the number worth over $100 billion today!

“It’s different this time.”  Mashable co-editor Ben Parr told Silicon Republic that this investment phase is different from the bubble of the 1990s, because Facebook, Groupon, Zynga and others have viable business models and are making money.  Members of the public also are more willing to use Internet services than they were before.

“Do I think there will be a day of reckoning? No, I don’t.  Will there be a time where some of these valuations will go down?  Probably, there’s always a cyclical cycle when you talk about markets,” Parr told Silicon Republic.

But it is never, never different this time.  That is the lesson that history teaches us.  The valuations are elevated and they will inevitably come down hard.  The only open question in my opinion is when the bubble pops.  The exact answer is beyond my pay grade, but I would posit 9 to 18 months.  The day of reckoning hits when the companies that need to raise money go out for the next round of capital and get pounded or when the big companies try to raise capital in the public markets and find that institutional money managers are not willing to pay the same high prices in the public aftermarket that private investors are paying in the private secondary markets. 

The fallout will not be as great this time the bubble bursts.   Fewer firms and fewer individuals are involved with this Internet bubble, which will probably be referred to as Bubble 2.0 or something equally clever.  In addition, there will probably be hand wringing about “unregulated” private secondary markets and “asymmetric information” and calls for “government investigations” into Goldman Sachs Investment Partnerships and “new regulations” as well.  There will probably be a Congressional hearing or two, but not much will change.  Plus ça change….   

Wednesday, March 9, 2011

The Big, Big Trends

I have written that US schools are hemorrhaging money, Canada is looking relatively good when compared to America, and the FDA is regulating us to death, but all of these concerns (as important as they are) fall short when compared to some of the really big trends facing the world today.  One of them is the subject of this post.  There is a tremendous transformation going on across the globe right now and it presents perhaps the greatest opportunity of my lifetime – even greater than the rise of web technologies over the past two decades.  In fact, web technologies and mobile smartphones are going to help drive this transformation.

At least two billion people will become middle class consumers across more than a dozen emerging nations according to McKinsey Quarterly  These consumers spend $6.9 trillion today and will spend over $20 trillion by the end of the decade – more than the GDP of the United States today and far more on a purchasing power parity basis!  These are simply staggering, almost incomprehensible figures.  Think about it -- $20,000,000,000,000.  You almost have to use scientific notation for numbers this large. 

These consumers live in countries where the median age is about 25 years old  (give or take).  Much of non-Japan and China Asia and Latin America fall into this category.  These new middle class consumers have very little debt.  For example, Brazil’s household debt is only about 2.2% of its GDP whereas household debt is about 100% of GDP in the US.  Guess which households are keeping their fingers crossed for low interest rates?  Emerging market youth live with their parents well into their 20s.  They save on rent and therefore have plenty of disposable income today.  They own iPhones.  They go to clubs at night.  These consumers are connected to the world wirelessly and are thrilled by the chance to learn about the plethora of options to buy, to see, and to experience new products and services.  The opportunities lie in providing these new consumers and their parents with the consumer goods and services they now have the money to buy.

In the next few years, consumption patterns across the globe will shift dramatically.  Once consumers have some money in their pockets and in the bank, they consume more than just shelter, basic food and clothing items.  They discover they want “housing,” and often “meat” and “apparel.”   With adroit marketing, these consumers can find out about all sorts of new needs.  And beyond the aforementioned basics, new entrants to the global middle class find they desire branded personal care products, transportation such as a motorbike or auto, entertainment, travel and leisure opportunities like gaming, healthcare and education.

Satisfying the changing consumption habits of the emerging global middle class represents the greatest single opportunity of the next 20 years.  Time to sign up focus groups in Hanoi and Rio de Janeiro.  Let the education process begin....    

Tuesday, March 1, 2011

Inflation versus Deflation

My father-in-law and I have an ongoing debate.  Which is the greater evil facing the United States and its currency today – inflation or deflation?  My father-in-law comes down on the side of deflation; I am in the inflation camp.  Thus far, I will concede that he has won the first skirmish, but I am convinced that sometime in the next 24 to 36 months or so I am going to win the war.  Unfortunately, I believe the war will be a fairly long one, but mercifully not as long as it was in the 1970s and early 1980s.

I side with the great Milton Friedman and firmly believe that inflation is always and everywhere a monetary phenomenon.  The Treasury and its co-conspirator, the Federal Reserve, cannot create money and expand balance sheets faster than the growth of GDP without creating inflation at some point.  It is simply not possible to have a zero rate interest policy and continue along the path America is on and not face monetary repercussions down the line.  The effects are not felt immediately; our country did not spiral upward (or downward depending on your perspective) into inflation due to the tremendous expansionist policies of the late 1960s until the 1970s, but once inflation expectations took hold, our nation was only able to halt its pernicious effects through the painful medicine Paul Volker administered in the early 1980s.  We will go through this cycle again but since everything happens at a much quicker pace today, I expect the US will cycle through the process in 6 or 7 years rather than the 15 years or so it took the last time around.

There are many economists and pundits who believe that it is virtually impossible for inflation to take root in the current economy because the United States is relatively open to free trade and global competition and is currently operating at low capacity utilization (especially in manufacturing) and high unemployment.  To those economists, just point to Zimbabwe of this decade, Weimar Germany in the 1920s and early 1930s or even the US of the 1970s.    

Will inflation be as bad as it was in the 1970s?  I think the inflation scenario will play out in one of two ways – either it will not be quite as bad as the 1970s because it will not last as long or it will be much worse because it will spiral out of control and dramatically devalue the dollar.  I think the former scenario is far more likely, but the latter scenario is a distinct possibility that cannot be overlooked.  A repeat of 1970s style stagflation is unfortunately a relatively near term future that I can easily envision. 

Once again, the US mañana culture that gladly pays on Tuesday for hamburgers today, has not learned the lessons of history, has not weaned itself off of foreign oil, and oil will once again be the catalyst for the next round of inflation.  The recent turmoil in the middle east will probably only hasten the onset of inflation as food and energy prices rise and then workers will demand wage increases to cover these food and energy price increases.  Higher price expectations will then flow through the entire system.  Price pressures from imported foreign goods where inflation already exists will exacerbate the issue.  Although we have not yet witnessed much of this pernicious cycle in the United States, one can already see its nascent climb in several emerging markets – especially in Asia.

As soon as consumers believe that they can actually handle the amount of debt that they owe (they cannot quite do so today) and that they can pay off their debts with cheaper dollars tomorrow, they will stop paying down debt at the rates at which they are doing so today and the inflation cycle will begin.  Does this cycle begin in 2012, 2013 or 2014?  Well, that is a question for the big hedge funds.  The answer is beyond my pay grade.