Tuesday: Haikus and Mysteries XIII

March 29, 2011

I’m amused to write
in today’s haiku

Today’s mystery: This year’s Final Four.


Next to Normalized

March 28, 2011

Investment analysts are trained to (try to) understand the drivers of the economic performance of the companies they follow, and to translate that understanding into a view on the valuation of those companies’ securities (i.e., stocks, bonds, and the like).  In theory, this is a pretty straightforward exercise.  A company’s securities represent claims of varying priority on its assets, which correspond in turn to claims on the expected future cash flows derived from those assets.  The challenge in practice, of course, is that forecasting the future is difficult; and even if such forecasts were perfectly predictable and widely known (i.e., so that the market had no disagreement about what they are) the market can be fickle in how it prices future cash flows at any given time.

Readers familiar with very basic concepts in corporate finance can probably skip this, as I won’t really get to My Point until the next post.  I think this will be helpful background for the rest of the audience, however.

Imagine two companies, A and B, that are absolutely identical except that they exist in parallel universes.  Imagine them as exceptionally unglamorous companies: say, manufacturers of dental floss.  Assume that, year in and year out, they generate about the same amount of annual free cash flow: this is a term of art, which essentially means the amount of cash earnings that are available to distribute to company’s creditors and equity owners, and to pay taxes, after setting aside an appropriate amount of those earnings to reinvest in the business (for example, to replace depreciating equipment) in order to continue generating that same level of cash earnings (the term of art would be “maintenance capital expenditures,” which we’ll also assume is about the same each year).

We would expect A and B to have virtually identical valuations in the market, since their assets produce identical levels of free cash flow and are expected to do so indefinitely.  If the companies borrow money, clearly some of that valuation would represent claims of their creditors on the free cash flow of the companies.  But, in general, we wouldn’t think of A and B as having fundamentally different values as enterprises just because A and B have different amounts of debt; the salient difference would be what proportion of that value is attributable to creditors and equity owners in each case.

Imagine that the fates of A and B diverge as you are reading this.

In A’s universe, there is a surge in demand for dental floss as the result of an unusually troublesome corn harvest that experts warn, as summer grilling season approaches, is much more likely to become stuck in your teeth.  Such corn harvests are once-in-a-blue-moon phenomena, thanks to advances in modern agricultural science.  But we have every reason to believe, when the books are tallied for the year, that A will have doubled its free cash flow relative to 2010.

In B’s universe, happily, we also expect B to double its free cash flow in 2011 relative to 2010.  But, in this universe, the surge in demand for dental floss is due to a nationwide oral hygiene panic!!  We’ve finally gotten religion about flossing.  Prominent dentists make the rounds on cable news and morning talk shows, warning of newly-discovered dangers of gum disease.  (Impotence! Death!)  Congress declares War on Plaque and appropriates $50 billion of Federal funds to fight it.  Professional-class parents compete for status through the quality of their children’s gums.  (Harvard is watching!)  And when hip-hop stars rap about flossing, they really mean it.

Each company will report the same free cash flow for 2011.  But should the market still ascribe the same value to each enterprise?  Our intuition is clearly no.  Company A seems to have experienced a nice windfall, but we don’t expect that its ability to generate cash flow has changed meaningfully.  It should more or less go back to the same predictable performance it has always delivered.  Put another way, it’s hard to imagine the market will be expecting a once-in-a-blue-moon corn harvest every year.  On the other hand, Company B seems to be riding a major structural change in demand for floss.  In the short run, it may well max out the capacity of its factories.  In the medium-to-long run, it may consider investing in new factories, going to market with different products, consolidating with other operators – all while potentially fending off competition from new entrants.  The Company is clearly on a different trajectory in terms of its likely ability to generate free cash flow in the future, even if we’re not sure what exactly it will be.

This example illustrates why investment analysts attempt to distinguish between recurring and non-recurring drivers of companies’ financial performance.  Related dichotomies in the jargon would be normalized versus reported earnings, and earnings excluding extraordinary items versus including them.  These drivers may play out in a particular quarter or, as in my example, fiscal year; but they may also play out over a longer time horizon.  For companies in highly cyclical industries, analysts often try to deduce a notion of mid-cycle earnings, to mitigate the temptation to take an overly optimistic or pessimistic view of companies’ potential to generate future free cash flow just based on where in an economic cycle we happen to be.

Part of the fun of investment analysis is that companies like to argue that negative performance is generally due to non-recurring factors — and that they are actually brilliant managers if earnings are measured on a Double-Secret-Adjusted basis that, in the company’s unbiased view, represents a true picture of the earnings power of the company.  When performance is unusually positive, however, the brilliance of management needs no further qualification.

Why do I bring this up?

Generally, I think it’s useful to distinguish between the recurring and non-recurring factors that influence one’s life in various ways.  Is your credit card bill high because you just moved into a new apartment, or because you are updating your wardrobe for every season?  Are you striking out romantically because you haven’t been compatible with your last few dates, or because there’s some deeper barrier to intimacy?  This is common sense wrapped in Wall Street jargon.

Specifically, though, the WSJ had a brilliant piece this past weekend that argues that the absence of this type of analysis from debates about public finances, taxes, spending, the deficit, etc., has helped bring America to its current precarious fiscal position.  Partisans of all stripes are guilty, which made this essay a refreshing if grim change from the typical rehash of religious arguments about what constitutes a “fair” distribution of income or a “right” size for the state.

As a starting point for my own opinions, which I’ll get to next time, I’ve provided the background above to show why I think it’s troubling (if not surprising) to consider that those in charge of the public purse consistently make the rookie analyst mistake of confusing the self-interested account of Double-Secret-Adjusted earnings with a more sober view of normalized financial performance.

If such mistakes would get a lowly analyst fired, why not our legislators?

Numbers Game

March 27, 2011

The question is sometimes asked, among trusted colleagues, as they suffer together through a particularly grueling stretch of work: what’s your Number?  If you left the office tonight, checked your bank statements one last time before bed (as one does…), and discovered that some magnificent windfall had increased your net worth to the point that you no longer felt you needed to come back to the office tomorrow: what would that Number be?  At what point would you decide you had ‘enough’ and could choose from then on to do only that which you actually wanted to do, rather than continue to make compromises to get to that point?

In polite company, one rarely discusses matters financial in such concrete terms – one prefers to hint instead at one’s level of compensation through one’s branded possessions, vacation destinations, taste or consciously-affected lack thereof.  Discussions of the Number, however, seem to fall outside this prohibition.  I think this may be because the people with whom I’ve had such discussions over the years all generally believe, with good reason, that everyone in the discussion is likely to be able to hit their Numbers eventually, assuming they choose to maintain their professional status quo.  It’s not a question of one’s pole position (i.e., how much do I have?) as much as one of where the checkered flag is.

I’ve tended to arrive at my Number through pretty simple analysis.  What amount of after-tax cash flow do I think I’d need each year to maintain my desired lifestyle (which does not necessarily involve Per Se for dinner every night, but probably does still involve seeing my trainer twice a week)?  What pre-tax income is required to produce that amount of after-tax cash flow?  Assuming this pre-tax income can be generated from an endowment that produces a fairly conservative 4-5% annual return (net of inflation), I multiply this pre-tax income by 20-25 and have my range of Numbers.  Clearly the definition of “lifestyle” is the driver.  My Number would be much lower if I planned to live in a less expensive city that New York (i.e., basically anywhere) and lower still if my game plan were to retire to a beach in, say, Belize.  It will probably have to be significantly higher if I decide I want to have children.  In any event, I can see a path to getting there while I still have a few decades left to enjoy it, God willing.

By happy coincidence, I read Graeme Wood’s piece from April’s Atlantic shortly after having refreshed my mental calculations and having steeled myself for another 15 or so years of the status quo before I’d expect my Number to be within reach.  I’m still in such (pleasant) shock from this essay that I’m struggling to hone in on what, exactly, was so shocking to me.  Wood paints a balanced, nuanced portrait of the “Secret Fears of the Super-Rich” as they emerge in a Boston College study of people whose net worths exceed $25 million.  Among other gems, I keep coming back to the chilling finding that, “most of [the families in this study] still do not consider themselves financially secure; for that, they say, they would require on average one-quarter more wealth than they currently possess.”  These are people with tens of millions of dollars! People who have done a swan-dive past my Number, straight into Scrooge McDuck’s money bin!  Could these stories really mean that there’s always a white flag after every lap?

There’s nothing particularly novel about the observation that money can’t buy happiness (or, one of hip-hop’s great lessons in causality: Mo Money, Mo Problems) but I had never really considered that it can’t even necessarily buy a sense of financial security.  Or that the price of even hard-earned wealth could be disenfranchisement from the shared human experience.  On feeling unable to discuss one’s everyday problems with those who haven’t hit their Numbers: “The poor-little-rich-kid retort is so obvious—and seemingly so sensible—that the rich themselves often internalize it, and as a result become uncomfortable in their interactions with the non-wealthy. Once people cross a certain financial threshold, they have a tendency to hang out with one another, to enjoy the company of other people who know that money relieves some burdens but not others.”  It must be excruciating to feel as though one has permanently surrendered one’s right to complain or commiserate.

I recommend Wood’s article highly and I expect to use it as a prompt to try to stop counting laps and, instead, start to learn to enjoy driving.

You’re Not Gonna Reach My Telephone

March 26, 2011

The Gray Lady, bless her heart, has such a way with real-time anthropology.  Much as the academic literature in psychology is, out of necessity, a generalization from studies of the hearts and minds of undergraduates, the NYT has a gift for spotting the evolution of American norms and tastes through its authors’ careful observation of a few of their well-educated, cosmpolitan friends – sprinkled of course with references to a few boldface names and experts in implausibly narrow fields.  Were you aware, for example, that the unscheduled phone call, except in cases of emergency, is actively inconsiderate?

Now, I happen to sympathize with this sentiment.  I have some professional contacts who seem hard-wired to interact only by long phone calls throughout which I can actually feel my time being wasted; a bit like the queasy light-headedness that immediately follows a blood donation.  (I think this is partly generational and partly regional.  Where a New Yorker might pay me a call to “quickly catch up,” I’ve found that among contacts in Texas they’re more likely to call to “visit with [me]” – which is kind of a quaint and adorable way to put it.)  And my friends know that I’m unlikely to answer a phone call, even though I’m happy to turn around 80% of my e-mails and text messages just about as soon as I receive them.

I dislike the phone.  Sometimes the pace of conversations is awkward.  Sometimes I can’t hear what is being said, even after several repetitions.  Sometimes calls drop in the middle of an emotionally-rich line of discussion.  I’d prefer to have most meaningful interactions face-to-face, where I can give my undivided attention; or via chat where I can at least edit myself as I’m “speaking.”  For simple coordination, by contrast, I think e-mail and text messaging are usually more efficient.  I tend to agree with the Times that conversations with family are the main exception, but even then any variance from our usual patterns (a call in the middle of the day, for example) usually require the preface that it’s not an emergency.

I try to train my friends, and particularly my professional contacts, to call me sparingly.  The pattern goes something like: I ignore a phone call from X, a relatively unimportant professional contact with whom I interact on issues that are rarely a priority for me (these aren’t personal judgments; the people in question are lovely).  X calls me back several hours later, and I ignore it again.  X calls me back the next day, and I ignore it a third time.  X finally cracks and asks me the factual question that prompted his phone call via e-mail.  I respond instantaneously.  X calls me again immediately, thinking that he has outsmarted me and found a time when I am at my desk.  I ignore it and e-mail back that I am on the other line.  X replies that it’s ok, his call wasn’t important.  I resist the temptation to scream, if it wasn’t important, why in God’s name are you calling me??? I eventually call back, at my convenience, to shoot the breeze, and confirm that there was indeed nothing important to talk about.  It’s amazing, though, that no matter how many times I smack the dog on the nose with a newspaper, the pattern doesn’t change.

Perhaps the Times is overstating the extent to which people really believe in the case against the phone, but it’s a worthwhile prompt to be thoughtful about the channels we use for communication.  Good written communication provides a wonderful efficiency gain to the reader.  I can summarize two days of progress at work in a memo that may take me two hours to write, which can be digested by my manager in two minutes.  It’s scalable, too.  The Times is at its best when it is bringing its legions of readers up to date on developments as distilled by their journalists and editors.  By contrast, there is no time-efficiency gained in spoken communication.  What takes me five minutes to say takes you exactly five minutes to hear, and it’s likely that my spontaneous commentary will lack precision relative to whatever I could have written for your consumption in those same five minutes.  There are certainly benefits to real-time communication: it’s usually the easiest way to resolve misunderstandings, for example.  But for simple transmission of information, it is hard to outweigh the gains from ‘time compression’ afforded by the written word.

I find it infuriating when content that could have been delivered in a time-compressed format is not; and vice versa.  My orienation at my new employer, for example, required me to spend two hours listening to our earnest HR professional talk to me about content that could have taken me ten minutes to read.  Had I been sent the information in advance, I might have needed another five minutes in person to ask questions, and both she and I could have walked away a combined three and a half hours richer.   The mindless drive to generate “multimedia” content on the websites of organizations like the Times has spawned an even greater time-evil: the video interview.  Even if the content were interesting, there is no good reason not to provide the time-compressed format of a transcript as an alternative (here I must give a shout out to the McKinsey Quarterly for following this practice).  But, more damningly, one has little sense in advance for whether an interview is going to elicit interesting content or, more likely, produce a few banalities and talking points.

The ‘vice versa’ case is most obvious where attempts are made to reach decisions or forge consensus over e-mail, which induces all participants to spend hours reading and responding to issues that could have been resolved in a quick phone call or meeting.  But it also manifests in shoddy PowerPoint presentations that so butcher the subject matter in order to reduce it to bullet points that one is left feeling more confused than when one began.  When a time-compressed format produces insight-compressed content, that is generally not a good thing.

I’ve been thinking about better integrating my cell phone with Google Voice, which has the life-changing feature of transcribing voicemail and sparing the wasted minutes of dialing through voicemail menus just to find out if someone has left me an interesting message (that they should have e-mailed me instead!!).  I believe there’s a “Visual Voice Mail” feature on my phone that does this, too, but I object on principle to paying the small monthly fee for it.

I appreciate the irony that as my cell phone has become more of a fixture in my life, I’ve become less inclined to use it for, well, actually being a telephone.  But I think it’s exactly this ubiquity that makes it so important to be selective in who, when, and why we call.

Tuesday: Haikus and Mysteries XII

March 22, 2011

woke in a panic!!!
dreamed that it was 9am…
really, 5:30

Today’s mystery:
     The spring is sprung, the grass is rizz
     I wonder where the birdie is?

     The little bird is on the wing…
     No, that’s absurd:
     The wing is on the little bird!

                                                               (in loving memory of EGS)


March 22, 2011

Winning” is one of the many inexplicable (and, one hopes, short-lived) memes to emerge from the Charlie Sheen meltdown porn that has swept pop culture.  Something about the simplicity of the concept and its urgent, manic delivery seems to have struck a chord.  We like winning.  Winning games, winning prizes; even winning vicariously through sports teams.  We tend to think of winning in a clearly-defined and, usually, zero-sum context.  It’s not ambiguous whether you have a winning lottery ticket, or whether you won that game of Monopoly.  But the assertion that one is winning, full stop, has a certain audacity because of its ambiguity: What exactly is this person winning?  Am I playing, too?  Does this mean I’m losing?  And if this is apparently the worldview of a drug-addled celebrity, could there be something messed up about the pursuit of winning-ness?

I’ve been thinking about what a general formula for what winning, full stop, might look like.  I add a few constraints.  First, I think it should be actionable.  “Be happy” or “Reach a level of celebrity where you are sent to ‘Good Morning America’ rather than prison for your drug use” aren’t terribly helpful formulas because they are too vague and too specific, respectively.  Second, I think it should acknowledge the connotation of competition in how we use the word.  The formula: “Develop deep, meaningful, personal relationships throughout your life” seems like unambiguously good advice, but intuitively it feels more like a recipe for win-wins than for winning.  Third, I think it should be sufficient or nearly-sufficient, but it need not be necessary.  Sufficiency is a tough condition to satisfy — it’s hard to imagine how a self-destructive person would win even with a perfect formula — so I see this constraint as something like: “a reasonably well-adjusted person would set him or herself up for winning by following the formula.”  But this would rule out the tried-and-true formula of “Marry rich,” as that path is full of ways to lose (not least of all, the pre-nup).  Finally, I think it should be parsimonious.  Good formulas usually are.

My winning formula, for your consideration: “Possess and commercialize a scarce resource”

If you can do this, you will be equipped to win, full stop.  It’s not a guarantee — money can’t buy happiness, after all; although I think this formula is actually about more than money — but it’s a reflection of the reality that it’s just easier to think about an abstraction like “winning” when one isn’t concerned with the rent or the kids’ college tuition.

I think this formula is pretty self-evident, but I’ll parse it in reverse.

– A scarce resource.  Greater scarcity of a good generally creates a greater premium for it.  In this case, the scarce resource need not be tangible, but it might be.  Natural resources, talent, intellectual property, monopoly power, political influence, even celebrity — all of these count.

– Commercialize.  This is probably the most debatable premise, but I think it’s important.  Winning is about converting a scarce resource into whatever it is one desires.  A starving artist is not winning to the same extent as Damien Hirst because he or she is, well, starving.  He or she may be more talented than Damien Hirst, i.e., in possession of a more scarce resource; but to what end?  He or she may be happier than Damien Hirst, but my formula is not solving for happiness; although I think Damien Hirst is not likely to be less happy as a result of his commercial success.  Similarly, consider Federal Reserve Chairman Ben Bernanke.  He possesses some incredibly scarce resources (intellectual gifts, academic heft, and the ability to move markets by sneezing).  But I would argue he is not winning because he’s constrained (and, ideally, prohibited) from using those resources for whatever ends he may personally desire.  He will certainly be a bigger winner when his Chairmanship has expired and he is free to pursue intellectual interests unrelated to central banking, become rich on the lecture circuit, or whatever else he actually wants (see: Alan Greenspan).

– Possess.  I was debating whether “control” is a sufficient weaker condition, but I don’t think it is.  Mark Zuckerberg wins in a way a non-executive director of Facebook can’t; he owns and directly benefits from his ability to commercialize numerous scarce resources (the most obvious of which being an extremely valuable (at least for now) internet business).  A member of the Board nominally has more control over the company, since a Board generally has the (theoretical) authority to remove the CEO.  But this power is worth orders of magnitude less than ownership of the company.  Similarly, a musician controls his or her talent, but I’d argue he or she doesn’t really possess it if the record label, agent, iTunes, and the like are all taking huge cuts out of the fruit of his or her efforts to commercialize a scarce resource.

Some obvious conclusions follow from this rule; consider them corollaries to stay a winner. 

First, one stops winning when a scarce resource becomes common.  Business in particular is ruthless about developing ways to commoditize inputs as a way to reduce costs.  Well-compensated financiers, lawyers, and medical professionals may be set up to win today, but it is possible to imagine futures where their proprietary knowledge, powers, and privileges are diminished.  For example, software that is amazingly good at legal document review could conceivably displace the bottom quartile (or more) of legal professionals who currently command the scarce resource of “being better at document review than the best alternative” – but this in turn would create winning opportunities for the lawyers best able to leverage the new technology, and for the technology’s owners.

Second, one stops winning when a scarce resource loses its commercial potential.  The skill to repair a typewriter is very scarce, and it was probably quite valuable at some point to own the world’s greatest typewriter repair business; but good luck winning in that line of work today.

Finally, one stops winning when one dies from a drug overdose.  Food for thought.

Tuesday: Haikus and Mysteries XI

March 15, 2011

imposing facade
but the fault plane beneath it
is invisible

Today’s mystery: Is anyone surprised that a New York City mother is apparently suing her 4-year-old’s private school for insufficiently preparing her daughter for admission to the Ivy League school of her choice?  That’s gonna be one mighty well-adjusted young woman someday.  I suspect, though, that she will turn into an amazing cultural critic by her mid-thirties.