Tuesday, September 30, 2008

What Went Wrong With the Bailout

First of all, let me say that I have the utmost respect for Hank Paulson.  When I worked at Walgreens, Hank was the Goldman Sachs partner in charge of Chicago and I had the pleasure of dealing with him on a number of transactions.  He has a terrific knowledge of the financial markets and knows how to get things done on Wall Street.  However, that doesn’t necessarily mean that he knows how to get things done in Washington.  Herewith are a few modest suggestions that could have helped get the legislation through the halls of Congress, based on my years of dealing with communications issues, investors, and corporate management.


The people at Treasury never should have let this proposal see the light of day if it was going to be called a bailout.  They should have labeled their efforts the “Financial Securities Reform Act or, better yet, something that made a snappy acronym that highlighted the fact that they were going to take charge of the markets and wrestle down to earth all of these mortgage backed securities and collateralized debt obligations.  The agenda should have been reform, not bailout.

Offer Terms

Treasury treated Congress as if it were corporate management of a bank that was about to be seized by federal regulators.  The original proposal for legislation contained provisions that simply were not politically palatable to Congress – giving huge new powers to Treasury that were not reviewable by Congress or the Federal Courts and putting no limits on corporate compensation of executives of firms that benefited from the legislation.  Yet these were the same people who would have to vote on approving the funds, and are facing re-election in a month.  Then the people at Treasury proceeded to argue about it when Congress tried to make changes.  If the people at Treasury really wanted to get things done quickly, a more middle-of-the-road proposal that recognized some of the political realities would have worked much better.

Educating the Public

Your average American (and Congressman) does not understand the workings of the credit markets and how it affects them personally.  The perception of the legislation was that the U.S. taxpayer was going to buy all of these distressed securities from the big, bad banks leaving the banks free and clear and the taxpayer with the bill.  The reality is far more complex.  Banks are required to mark their securities to market. When fear grabs the credit markets and securities can’t trade, marking to market results in a cascade of lowering valuations that feeds on itself and erodes banks’ capital position.  With eroding capital, banks can’t lend and the economy grinds to a halt, and everybody from Wall Street to Main Street suffers. Treasury should have made it clear that their role was similar to that of a specialist or market maker.  They were going to step in, provide a market for the securities, initially as a buyer, but eventually as a seller as well. Banks, in selling to Treasury are going to take a loss, albeit not as big of a loss as if there were no buyer.  The point that needed to be made to the public was that banks were going to suffer here, not get off Scott free, and the ultimate beneficiaries are all people that borrow from banks, which is pretty much everyone in the U.S.

Treasury is not subject to mark to market accounting rules and can wait until the markets return to a semblance of order before selling.  In all probability, Treasury will probably make money on these trades as they can afford to wait the market out.  We may not know exactly what these mortgage backed securities are worth, but they clearly are not worthless and probably worth more than panicky sellers will unload them for.  One of the axioms of Wall Street is that you can make a lot of money if you can afford to be patient during a crisis.  So the second big educational point that needed to be made was that the intervention into the markets by Treasury would eventually be to the benefit of the U. S. taxpayer.

You can argue that the folks at Treasury and the Federal Reserve were in crisis mode and not thinking about communications issues, but if you want to get things done in Washington, communicating the story in the right way is half the battle.

Wednesday, September 24, 2008

When Culture Meets Financial Theory

How often have you seen this: A company makes a big public announcement regarding a new strategic initiative designed to bring wiz-bang methods and profitability to the way the company does business.  Investors are intrigued because what the company has announced seems eminently reasonable and conforms to what the analysts were taught in business school. (Of course, the consultants that the company is using all went to the same business schools, so there is a bit of circular reasoning at work here, but leave that for another day.)  Following the initial splash of the announcement, investors clamor for more details on the big new initiative.  What they are usually greeted with are phrases such as “It’s still early days”, “It’s too soon to see anything out of this” or “This is a big project that touches many areas of the company and it’s very difficult to measure”.  Eventually, the amount of information about the project coming out of the company slows to a trickle and then stops.  In the noise of the market, investors forget about the project and look at other things.  No one ever really finds out if the project had an acceptable return on investment.

What’s going on here?  It’s not as if the company is no longer working at trying to implement the new project.  It’s not as if they don’t have internal measures that gauge the progress of the project.  If the news were great, would the company stay silent on the issue?  Maybe, but probably not - they would be much more likely to be trumpeting the triumph of new technology.  I would suggest that what is happening is the corporate version of a shell game: the company would prefer that you direct your attention to something else so they don’t have to explain why their vaunted project is not living up to it’s initial promise.

Large, radical new corporate initiatives almost always represent a break with existing corporate cultures.  I have a favorite saying about this situation: “When culture meets financial theory, culture almost always wins”.  The corporate culture in many organizations is part of the corporate DNA and will fight off attempts to change it.  The result is generally that the big new project will wind up costing more than initially planned, take longer than estimated and do less than the original projections.  When companies start to see this, they begin to build up a barrier around the project by limiting further disclosures.  I’ve seen this any number of times.  For example, during the 1980s Walgreen embarked on a “Strategic Inventory Initiative” designed, among other things, to lessen the amount of inventory carried in the stores.  Millions were spent on computer systems to help achieve optimal inventory levels.  Unfortunately, the culture of the Walgreens store managers was that they wanted their stores to look as if they had lots of inventory.  Their culture was to never to be out of a product if they could help it.  As a consequence, inventory levels never went down.  More recently, Home Depot went through a big reorganization to centralize many functions that had previously been done at the store level, running smack into a culture that had been centered around the store managers.  The result was a lot of dislocation and same store sales that were anemic for a protracted period of time. 

I’m not here to say that corporate cultures are always right – they’re not.  Many times corporate initiatives to change ingrained methods of doing business are both necessary and difficult.  But as I look at the way such projects are disclosed to investors, and the short-lived way that investors pay attention to the projects, I think things could be better.  Herewith, a few modest suggestions: For companies – if a project is important enough to announce to the public, it is important enough to continue to report about it until it reaches maturity.  Recognize that the project will vary from its original projections and provide sufficient metrics to enable investors to judge the progress of the project.  The ability for investors to determine if an adequate return is being achieved on the company’s investment seems to me to be a reasonable goal.  For investors – make the company continue to disclose.  Have a long-term outlook when it comes to this type of project.  Try to figure out how the project fits into the overall fabric of the corporation, not just whether it sounds like something your business school professors would recommend.  

Perhaps if corporations and investors take a longer tern view of these projects both sides will benefit – after all, more disclosure about things the company thinks are important should be better for investors as well.

Wednesday, September 10, 2008

How to Read 10K and 10Q Reports

The Annual and Quarterly Reports on Forms 10K and 10Q are documents that come under the heading, “Important, but boring”.  If you are an investor trying to read one of these things, it’s equivalent to drinking a glass of warm milk just before bedtime.  It’s guaranteed to induce drowsiness.  And that’s just the way companies want it.  These things are written by teams of accountants and lawyers, whose job it is to comply with the law and regulations set out by the SEC and the courts, while saying as little as possible.  While the SEC may mandate the use of “plain English”, there is no obligation to make the language interesting.  It is yet another example of the focus of our corporate disclosure system on complying with regulation rather than attempting to clearly state what is going on. 

Yet there’s lot of good information in there, if you can persist and find a way to dig it up.  The tricky bit is that often the interesting information is what’s changed from what they used to say or what is no longer being said.  And that’s hard to figure out.  If you are a sell side analyst who has intimate familiarity with the company filing the report, things that are not being said may instantly pop up at you, but for the rest of us, remembering what is not there, but should be, or what has been subtly changed, is a much more difficult task.  As I thought about this it occurred to me that these reports are rather lengthy documents, which no one could write from scratch every quarter.  What the writers of these documents do is take last year’s document from the same time period and mark it up for changes.  Certain things have to get changed – after all, the numbers aren’t going to stay the same every year; but other changes give you some insights into what the company may not be saying and how they view their disclosure obligations.

So the thing to do is to lay out this year’s and last year’s report side by side and work your way through the important sections.  Just to take an example, I looked at CVS, the large drugstore chain.  Picking a subject at random, I went to see how many pharmacists they have on staff, as it might be an important indicator of service levels.  Here’s what I found:

2007 10K

“As of December 29, 2007, we employed approximately 200,000 associates, which included more than 20,000 pharmacists…” 

In and of itself, this snippet of information doesn’t tell me a whole lot – if you combine it with the number of stores they had open at the end of the year, 6,301, you have a ratio of 3.17 pharmacists for every store.  So I laid it next to what they said the previous year:

2006 10K

“As of December 30, 2006, we employed approximately 176,000 associates; of which approximately 20,000 were pharmacists…”

Now things start to get interesting – did CVS really add 24,000 new employees but no net new pharmacists?  Or are they hiding behind the weasel words “more than 20,000” in 2007 versus “approximately 20,000” in 2006.  Further digging showed that CVS completed a big merger with Caremark in 2007, so they could have added a significant number of employees, but they also added 99 net new stores from 2006, so the ratio of pharmacists to stores fell from 3.22 in 2006 to 3.17 in 2007.  Just to maintain the same ratio of pharmacists to stores in 2007, CVS would have had to add 318 pharmacists.  Furthermore, the old Caremark was a pharmacy services provider, so presumably they had pharmacists on staff that transferred over to the new combined CVS. 

So what does this tell me as an investor about CVS?  It sure raises a lot of questions, none of which CVS tries real hard to answer in their filings, to wit:

1.  Did CVS reduce service hours and staffing for pharmacists in their stores?  Have they suddenly gotten more efficient?  Were 2006 staffing levels too high?

2. Is CVS having trouble hiring enough pharmacists?  This was an issue with them several years ago, causing a decline in earnings and should therefore be of interest to current investors.  It might even rise to the level of what an investor would consider important in making an investment decision about their stock.

3.  Why doesn’t CVS use exact numbers when describing how many pharmacists they employ? Can’t CVS be bothered?  Or is it that their systems aren’t good enough?  You would think they would have records and systems that tell them, especially at yearend.

4.  Does the use of weasel language such as “more than” and “approximately” about a key type of employee make you nervous?

5.  Where are all the pharmacists from Caremark?

6.  Should an investor start to look at other numbers CVS uses to see if they tie out?

The drafting of an Annual Report on Form 10K passes through many hands in a large corporation, from the internal accountants, internal securities law lawyer, investor relations personnel, outside securities law lawyers, the General Counsel, senior executives and the Disclosure Committee.  When you see a change such as the one above, you have to conclude that there was a deliberate choice to be vague on the topic and hope nobody would notice.

Tuesday, September 2, 2008

The Shifting Sands of Activist Investing

For about the past 6 – 7 years there has been a quiet revolution occurring in corporate governance. It has been an interesting process to watch as shareholders, usually led by union pension funds, have pushed for reforms in anti-takeover provisions, executive pay and director elections.  

The fact that it is the unions pushing for reform strikes me as ironic.  Regardless of how you feel about the need for collective bargaining, unions are not known as reforming forces.  Many union pension plans, in particular, have been grossly mismanaged, so for them to lead the charge for reform in corporate governance seems to be rich indeed.  When I gave this some thought, my conclusion was that a governance system has to be pretty broken for a group of union people to see an opportunity for reform.  So I took a hard look at the issues they chose to contest. 

Start with anti-takeover measures.  Companies usually experience a takeover bid in the form of an offer to purchase the company’s stock that is higher than the current stock price.  So anti-takeover measures, when all is said and done, are designed to allow management to turn down an offer that is higher than the current market price, but less than the managers think the company might be worth sometime in the future.  Presumably this is because the company managers know more about the company than the market and are in a better position to assess the true value of the company.  But wait, aren’t markets supposed to be efficient and incorporate all available information about a company into the stock price?  And aren’t managements supposed to disclose all material information about the firm to investors?  So anti-takeover measures really boil down to company management saying we want the ability to say no, because we believe that our two birds in the bush (the future value of the company) are worth more than the bird you have in hand (the takeover bid), because of information which we haven’t bothered to disclose, but which could make us real valuable in the future.  Sounds like a losing issue to me. 

Executive pay is an issue where corporations ceded the moral high ground a long time ago.  The pay packages you see for most CEOs of major corporations today are obscene.  The irony here is that the unions have persuaded Wall Street money managers, who often make almost as much as CEOs, to vote for reforms aimed at lower pay.  Maybe there’s a touch of envy involved. 

Finally, think about director elections.  I lived in Chicago for many years, so I’m not shocked by elections that are lopsided in favor of incumbents.  But under the current system for electing directors, you only need a single vote in favor of the director to get him elected.  You can’t vote against him, you can only withhold your vote.  This bears a strong resemblance to the old Soviet era politburo elections. 

If this were just about the obscure ways in which companies conduct their internal workings you could file this piece under important, but boring.  However, it seems that by allowing activists to learn how to win votes on easy issues, corporations are now starting to encounter a more sinister foe. 

According to a speech given by John Siemann of Laurel Hill Advisory Group at the NIRI 2008 Southwest Conference, hedge funds have become much more involved in the proxy activist arena.  ISS, the proxy advisory firm, now counts almost as many hedge funds as clients as it does union pension funds. For the hedge funds, the preferred method of attack is the “Short Slate” proxy fight, where an activist hedge fund nominates one or two directors for the board.  Once on the board, the new directors use their positions to agitate for items that may boost the near term stock price, such as special dividends, share repurchases and the sale or spin-off of non-core assets, at the expense of longer range initiatives.  According to Laurel Hill statistics, in 2006 – 2007, there were almost 200 short slate fights and in more than 66% of these situations, hedge funds won at least one seat on the board. Moreover, in almost 80% of the contests, ISS recommended in favor of at least one member of the dissident slate.  

So it would appear that having allowed the camel’s nose under the tent on issues that were hard to defend, corporations now find that they have provided a road map to investors to actively challenge the manner in which a corporation is being run.  I guess you really do reap what you sow.