A few years ago a CEO of a major US company testified to Congress regarding his role in the mortgage/housing/construction/banking debacle.  Why did he place such risky bets?  Didn’t he see the crash coming?

He said:  When the music is playing you have to dance.

$150,000,000,000 (Fannie & Freddie) and thousands of lost jobs later, it rings pretty hollow. How did he fail?  Did he actually know?  Should he have known?  How could he not know?  He managed current profits successfully (for a while), should he have first managed the future?

What happened and how it matters to those of us who risk our capital on whom others rely is the subject of these Labs.

The title, Divergent Forecasts, has clinical sound to it.  It is directed toward blood and guts, toward exploring whether there is a difference between managing and leading and whether we can see the future clearly enough to walk around trouble and soar into opportunity.

Some have told me I keep looking the abyss.  I demur, as I see it the subject as finding how to soar on the wings of an eagle.  Besides even if I were a pessimist, there is no need to apologize studying what and where an abyss.  I don’t want to step into it.

I confess this subject has high personal interest for me.  Then so is pricing and business planning for the entrepreneur.  Pricing, properly valuing the entrepreneur, has its practical resolve in proper pricing.  The entrepreneur’s peculiar and inexplicable impact on value for the customer is uniformly under priced and often by a great deal.  And I like business planning, not for the potential of really complex numbers crunching, but for another potential, at the way we assist, to advance the entrepreneur’s idea and avoid its burial in common business matrix.

I argue that we can know the signs of coming major economic convulsions.  We can avoid the worst of the damage, that there is no need to survive a convulsion by bloodying our capital, cash or employees.  But the focus is how; more exactly how can we avoid being swept up into the thrill of what become a tragic convulsion.

In such times there is overwhelming press, community, political and neighborly support for exuberance.  We have all heard such expressions as; this time is different, we know better, we have better economic guidance, a paradigm shift, a new economy and so on.

How do we defend our emotions, our reasoning and our common sense?  What we will present is Divergent Forecasts as an answer.  The idea is that the flood of good new is one forecast, but buried inside is another forecast, which does not assume good news.  The divergence tests whether what is buried in the good news forecasts are other data which draw a radically (sometimes) different forecast.

I can’t now take the space to discuss how at the company level, how what is scarcely practically macro, can be applied practically at the micro level of our companies.  But only take space to state what I think, in the instance, is most valuable in divergent forecasts.  To keep out head about ourselves for the loud voices will be contrary and the quiet voice is your own preparation.

Divergent forecasts keep owners who are leaders first, and only mangers second, help still the brain and stomach in the inevitable turmoil, not only to avoid the abyss and ready to size the gains after.

See you on the 24th.  Please register — www.praexisbusinesslabs.com/lab

My parents divorced when I was 13 and I was raised by my mother to dream about getting out of that small town someday to make the most of my talents.  We both knew that higher education was the key to my exodus which led me to attend South Dakota State University in Brookings upon graduating high school.

SDSU was known as a great value in education and was selected by U.S. News and World Report as the best value in college education 2 of the 4 years I attended the institution.  Between working part-time during the school year, full-time in the summers, financial aid and student loans I was able to get a great education at a reasonable price.

When I started college in 1995 the estimated in-state annual cost of attendance was around $4,900 for tuition, fees, room, board, books, and supplies.  By 2011 the number has increased to $18,493, a staggering 8.7% annual growth rate.  In 2001, I continued my education at the Carlson School of Management at the University of Minnesota –Twin Cities.  Tuition per credit at Carlson was $475 my first semester in 2001 and has risen to $1,090 by Fall 2010, an even higher growth rate of 9.7% (Carlson hasn’t posted their 2011-2012 tuition rates yet due to the state shutdown).

Unfortunately, this trend is happening throughout higher education and it is having disastrous effects on family finances.  The median number of years college students attend undergraduate studies has grown to over 5 years.  Consider if parents want to fully fund a 5 year college education for a 5 year old attending a public college costing $20K per year today would take a monthly investment of $836 assuming the costs are only growing at 6% (lower than the most recent 10 years) and the investments returned 7% (higher than the most recent 10 years).  Factor in 2 or more children attending college and for many families it is like having a second mortgage.  If the kids plan on attending private universities, it is a good rule of thumb to at least double, if not triple, these numbers.

I have been a financial advisor for over 4 years and can speak with experience that this issue weighs heavily on the minds of parents.  After calculating the monthly savings needed to fund their children’s educations they say something to the effect: “I can’t afford that, aren’t we going to get some financial aid?”  That question gnawed at me, my own professional success was due, in part, to accessibility to higher education.  With costs exploding the way they are, the math that enabled me to pay for my own education with no prior savings no longer works.

For the better part of a year I studied the college financial aid system to understand the complexity and how aid eligibility is determined and how aid is allocated at various institutions.  What I found shocked me.  The financial aid process is similar to tax planning with finite formulas for determining things like “Expected Family Contribution” and “Remaining Need”.  The most surprising thing was that almost nobody outside of aid officers knows how the system works.  Unlike tax planning, there isn’t a large group of knowledgeable and objective tax professionals to help.  Many of the ways families are saving for college actually decreases the amount of aid they will receive.

This lack of knowledge can literally costs families thousands of dollars per year in college costs.  The aid officers themselves have no incentive to show families how to get more aid as much of the aid comes directly out of the endowment of the institution that employs them (talk about a conflict of interest).

When I shared the details of the college financial aid system as well as some strategies to decrease the cost of college, the Walkers suggested I share the information.  Unfortunately, the need is great and few know that a potential solution even exists.

I spend much of my time nowadays educating parents of college-bound students on the financial aid system and helping them build strategies to save ON the cost of college instead of just for college.  Parents do not have to leave their current advisor to receive an in-depth college plan as my business model allows me to charge hourly for specific planning services.  To learn more about the college financial aid system, your best resources are my website www.CollegeBuyersGuide.com or meet me for coffee.

1) By accident of birth, you will be at the mercy of timing your whole life,

2) Not only is good timing possible, it is necessary,

3) It is no longer the sole province of big business:  we have been bringing the tools to small firms for a decade and more.

Below is a summary presentation from our salon last winter on timing.

The Successful Entrepreneur, part 3: TIMING

Our first work was to help Bill develop a business plan.  Not every owner has his own idea of what his firm should be or a deep view of how things should be done.  Bill did.  The business plan was created—realized is maybe a better word—to reflect his view.  For him the process was like a light turned on in the dark cave of convention.

Bill’s first move was to change his approach to spending on feed.  Industry wisdom said you adjust the ration to minimize cost (corn, hay, & sundries being highly volatile commodities).  His own view was contrary.  He believed that every change put cows off their feed until they re-acclimated and substantially shortened their milking life.

The first thing that happened was feed costs exploded.  But Bill didn’t cut, he spent—he stayed on his idea.  This was a problem for others.  As a true entrepreneur, Bill’s deep knowledge was not explicable by his education or training.  His spending ran against the “facts.”  What to him was reason to others was purely subjective.  His action and results were contrary to expert opinion and industry standards.

The first thing that happened was feed costs increased, a lot.  The second thing that happened was that milk production improved dramatically.  And a year or so later, the third thing that happened was the cows’ productive life increased by 40%.  In 10 years Bill’s net worth grew from $150,000 to $1,500,000.

His success would not quiet opposition; as with all others who achieve good results unconventionally, it would heighten it.  I’ll take up the reasons for that in a later session.

Go here for part 1 and here for part 2 of the full story told at my last salon.

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Bill’s is a good story.  He did what he thought made sense.  He did what fit him.  He worked through the reasoning.  And time proved him right.

Now I want to tell you why it worked.

The Bill story and this season’s series depend on understanding three things:

• The successful entrepreneur is guided by and acts today on his own opinion about the future.
• The economic basis for small business is efficiency of innovation, not efficiency of costs–the model of large business.
• The principles and tools of management were developed for large business.

It worked because the action was based on his opinion about the future.  He was not guided by convention, how things are done.  He arranged things based on his own reasoning.  It may have seemed daring but he carefully set and tracked his course.

As a small firm his was not likely to succeed by applying the customary management techniques appropriated from large firms.  His change was an innovation, not an exercise in cost-cutting.  I have to say I especially liked what Bill did.  He demonstrated amazing possibilities even in commodity-based, capital-intensive industries.

He made a hard distinction adopting the tools of management while rejecting the principles of management.  More commonly, firms buy into the principles while rather incompletely adopting the tools.  They see immediate but temporary success from cost cutting; Bill saw success by dramatically increased value in the future.

Bill is one case of hundreds in my experience.  This happened almost 20 years ago.  His financial results are impressive.  He gave us the credit.  But we owe him.  Through him we came to understand what we are sure of today.  His mind and courage remain an inspiration.

Click below to download the presentation.

The Road Ahead – Part 4

Maybe the jagged line that describes the stock markets is also the jagged line for business investment and prices.  Up, up, and up, then off a cliff; and then, slowly starting back up again.  If you draw a jagged line that reflects the market and then draw a straight line below the peaks and above the bottoms, you get a trend line.  The line shows upward trend.

So stay the course, they say.  Let us assume—and this assumption is often untrue in reality—that you have both the capital and the stomach for the jagged ride:  the capital, so you won’t run out of money before the market turns, and the stomach, so you won’t panic and forget that the trend is up even as the direction is temporarily down.  Even so, do we have to ride out the line?  That cliff does damage; confidence is broken, liquidity dries up, and asset values crash beyond all reason.  A strong stomach does not cure running out of money.

Returning to the jagged line, the question isn’t perfection of foresight.  If you get out in time, it must always be before you reach the cliff.  Getting back in will always is never comforting at the time.  Even those who get out in time find their stomach tested just the same when they buy back in.  When you buy toward a market bottom, you buy when the consensus is that stuff is broken.  Reasoned foresight doesn’t change the feeling in the pit of your stomach, it just helps you remember that it is a sensation of a problem, not an actual problem—unlike just riding that jagged line, which is an actual problem and the sensation always comes too late.

This jagged line is inevitable.  It is inevitability is made more extreme by the [arguably] well-intentioned hand of the government.  It is also inevitable that you will face a storm of criticism for profits forgone–profits that continue to pile up until the top.  But the criticism pales compared to the ire you will draw from some quarter for seeing and acting.  Many people’s dogma says there is something unfair about knowing something others could but didn’t,  and something even more than hateful about those who act on what they knew when others declare they too saw but were not in position to act.

At our meeting I drew that jagged line on the board.  It is intriguing to begin to construct the thinking, the math, and model for foresight. It was great fun.

Know this: the nature of foresight is to be always wrong (get out too soon, get back in not quite at the bottom), but wrong on the right side of the cliff.  Let me say, correct side of the cliff:  think of the jagged line, the right side is where it’s too late, the left side is where you’re wrong but a fraction as wrong as everyone else winds up being.

What bugs me, and has always bugged me, is the years of hard work that get tossed by riding off the cliff; years of work that because of the loss now will have to be followed by year more of hard work.

More on this next time.

My first-hand observation is that one can gain as well as lose in downturns.  This marks the beginning of my obsession with the effects of economics on business.

In 1971 Nixon devalued the dollar.  At first US exports scarcely kept pace with inflation.  Then in 1974 exports jumped, quadrupling by the end of the decade.   Net food and grain exports rose a whopping 1700%.  The mark and the yen rose 2 and 3 times the dollar, respectively.  The presumed trade imbalance was “fixed.”

GDP increased 150%, too.

Inflation was good in the 70’s.  Producers could raise prices with little resistance.  People expected to pay more.  Even as costs for companies started to increase, inflation still worked in their favor.  Their big investments in plant, property and equipment were in old dollars.  They were fixed.  The increases in other costs were easily passed along.

Company P&L’s looked good.  Profits, sales, and even margins were up.  Foreign competition from imports was restrained by our weak dollar.

People came to understand that higher interest rates were actually low.  Interest rates less inflation made the “true” cost of money cheap.  Loans could be paid with depreciated dollars.  It is true that property and equipment cost more, but the view was that it would be even more expensive later.

Besides, business was good.  People thought profits would continue to rise.  If you didn’t invest, you missed the chance for higher sales and profits.

Inflation cured higher costs, proving the view that real estate and property were a sound inflation hedge.  The rate of investment in 1979 was triple that of 1970.

No one (at least not many) argued otherwise.  Business was good.  Accounting reports proved it.

The decade ended with Chrysler needing a bailout.

The economy crashed.  Business failure rates tripled.  Accounting profits were proven to be what they were–vapor.   Our dollar couldn’t fall forever.  Inflation couldn’t continue to rise.  So interest rates popped up, way up, taming inflation and re-valuing [strengthening] the dollar.  Inflation no longer padded banks’ loan collateral, so borrowing got tougher and tougher.  Climbing sales prices no longer covered rising costs.  People who invested heavily in those last days got burned.

Reality is everything going on outside your business.   Knowing what is going on inside your business is a function of good management, and I freely admit it is often enough in ordinary times.  But when it isn’t enough, it really isn’t enough, and inside information will never warn you when.  When the economy gets extreme, what we can judge by looking inside is at least misleading and often dangerous.

Is there another lesson–make that another useful, practical, critical lesson–from what we are going through now?

For me, I wasn’t going be nailed again.  I wasn’t about to have clients nailed simply because they didn’t look.  Or nailed because I was too busy or too unwilling to ask unpopular questions.

Here it is then.  In good times think about bad events; in bad times plan for good.  A redux of the 70’s?  It is for me.

Business is cutting costs, drawing back, tightening controls, holding cash, and guarding capital.  That tactic will have the same result in this decade as 40 years ago: it ain’t good.  All that is missing is high interest and inflation, but not for long.

Our specialized insights serve best those unreasonable owners [they don’t think or act like others] who make things, who are in old, established, and capital-intensive industries.

I started my business in a recession.   Four years on, I found myself in another and finished the decade in a third.  It was disruptive for me, and highly advantageous.  Two of my most successful acquisitions and startups occurred in the face of 20% prime and a chorus of doom.  Those two clients had too little capital–so I was told.  They had no management training, almost no experience.  I found that they had something better.

If you make things, the weak dollar will bring inflation, but not to your assets.  Weak dollar and inflation will bring a bubbling of opportunity.  Knowing what it means helps you seize and keep the advantage.

I said we like companies that make things.   Such industries are usually established—they have histories, traditions.  They have proven ways of how things are done.  They will be stuck in the past and present and blind to change.  Our kind of owner, often called unreasonable, is not stuck.  With our economic foresight, that person is never blind.

Doubt economic foresight is possible?  Think about this: If the causes of a crash are knowable afterward, they are also observable before.  Still, observation beyond the common field of sight is hard.  But that is what we do, and do exceptionally well with an “unreasonable” owner.

I also said that we like capital-intensive industries.  It is fair to say most will take a hit in these times.  Later on, high interest rates will devastate profits earned by industry convention.  Inflation will hide the damage until it is too late.  It is the opposite side of this we major in.

We got this work doing turnarounds and workouts during the 70’s and 80’s.  From that experience I began to doubt the conventional criticism of small business:  that it was poorly managed and under capitalized.  I knew more than a few smart owners who nonetheless lost large amounts of money.  These owners had sought advice.  It wasn’t bad advice for the time.  The experts had done their homework:  the decision was good.  Only later after the decision fell apart was the owner accused of being a hip-shooter and poor one at that.

The 70’s were the era of Nixon-Carter:  a time defined by those two very smart people.  High inflation, ABM, higher interest rates, energy prices, devalued dollar, export explosion, high unemployment.  Our only certainty was that times would never be good again.

It is easy to say now it wasn’t that way.  But then the prevailing wisdom featured population disaster — Paul Erlich.  Conference of Rome in1974 declared we were running out of everything, the environment was destroyed — all downhill from here.  A decade framed by Vietnam and Iranian hostages.  But Erlich didn’t foresee Norman Borlaug’s short wheat; Rome did not foresee the Reagan-Clinton boom.  The doomsayers were wrong.

You see, sticking to the facts is not the same as seeing what comes next.  Even when we see the present reality accurately, it may be said the pressure of present reality creates an opposite reality.  The best minds in business quickly forget that the future is never reliably a mere extension of the present.

It took me a while to figure out how smart money can be so reliably wrong.  It has taken just as long to find how to fix it.  But by the late 80’s, at the height of the S&L crisis, not only could we avoid disaster, we knew how to profit from its anticipation.

Peter Drucker wrote about the 1997 Asian crisis.  He said it was clearly foreseeable a year in advance, and had warned of its imminence.  A year is enough time to duck and enough time to profit.

Predictions are entertaining.  We don’t do prediction.  We do foresight.  Predictions are entertaining generalizations.  Foresight is the hard work of making sense of risk and opportunity achieved through pragmatism and humility.

So how come we don’t see?  Too busy?  Too many problems?  Dumb?  I don’t believe it.  Greedy?  Too easy to say, who doesn’t want more!  We miss things in part because we view management as the highest function in business.  Therefore, we misunderstand management.

Simply put (as simply as I can get it): managing is gathering, analyzing, and deciding the facts.  This very process is necessary but shortsighted.

Foresight is about the future.  The future has no facts.

Drucker described management as inherently (not necessarily) introverted.  Drucker believed that outside data was the key to foresight.  Managers overwhelmingly relied (and still do, in my experience) on inside data, much of it purely financial.  Drucker urged the big guys to look outside; his advice was mostly ignored.  You and I couldn’t take the advice.  We couldn’t afford the computers in 1970 or the data entry costs, and we didn’t have the tools to interpret what we saw.

Two things happened in the Nixon-Carter era that would change it in time: the Intel 4030 and the internet.  By the turn of the millennium computing was cheap and a world of data was available at ones fingertips.    My son and I finished the third piece — knowing what to look for and how to handle it.

You see the compelling lesson of the 70’s & 80’s, and the source of my obsession, was that most crises that led to the workouts and turnarounds I effected did not have to happen in the first place.  The prevailing expert advice lacked foresight.  Being factually- (not future-) based, it is the advice that tends to prevail.  But of all those involved in a major decision, only the owner has to live with what is NEXT, what is beyond today’s facts.

Is that clear?  You, the owner, bear far and away the greatest cost of being right about the present and absolutely wrong about the future.

This is my experience:  data interpreted by economic theory make us see what is yet out of sight; seeing past today’s facts wins.

Foresight is seen as having no factual support, as lacking management credibility.  And as Larry Bossidy, retired Honeywell CEO, said, facts are the highest form of management.  As it happens, I think he is inadvertently right about facts and management.  I doubt he intended it this way, as he makes management a bit player.

But a bit player it is.  There are no plans without change, and no foresight without purpose:  these are the province of the entrepreneur.

Though not a rare experience in my career, Jim’s* case stands out as representative of the conflict between what I call the business model and economic theory. It is a story of an expansion, a doubling in productive capacity, which followed a dozen years of profitable operations that had increased the capital base 8 times over. The business model won. The business lost.

The noise surrounding this case was loud, as usual. What I mean is that Jim, my client, was surrounded by people who were enthusiastic to double the firm in size. They were employees, family, and lenders–also as usual. Economic times were good: stable growth was apparent everywhere.

In a previous entry I had critiqued the business model as a means of making major decisions. Stated simply, that model is based on profitability, facts, and proof. This seems rational enough, and used properly, has its merits. But it leaves important questions unasked, let alone answered, and is a recipe for disaster.

Economic theory begins with these basic theories:

• Price and value never match.
• When price exceeds value, it is a time to sell or at least not buy. Value is calculated (a funny word because value is subjective) by measuring return on assets.
• When value exceeds prices, it is time to buy or at least not to sell. Another way to say this is sell high, buy low. In practice, in times of high excitement, we have a strong tendency to do the opposite.
• Prices are greatly affected by credit supply, its cost and availability. Government is the major manager of credit supply. The effect on credit, and hence asset prices? Predictably disastrous.

The apparent relevance of this theory depends on our view of the future. Much of the time the future turns out just like the present. The relationship between price and value one day is pretty much true the next day. But sometimes it changes.

Jim’s expansion was forecasted to show higher, much higher, profit than before. That number had everyone’s attention, and was all the argument they needed. What they didn’t want to see was the return on assets. This was much lower than historic performance, the performance that increased wealth eight times in the preceding dozen years. It predicted dangers. It is always just a matter of time before the price/value pendulum swings back, and ruins all sorts of calculations, especially those that are limited to nominal profits.

I don’t like winning arguments this way: everyone loses. As return on assets made clear to me, when the price/value relationship shifted, the return on assets on the entire business plummeted, and the promise of higher profits dried up.

I had not been clear … enough. The case was so difficult that it was instrumental in my taking 3 years to review, research, and write Oddballs and Misfits: the entrepreneur’s war with himself and corporatism.

For Jim to combat the business model meant he had to disagree with everybody. He had to stick to his own opinion about the future and not be guided by everyone else’s view. As an oddball entrepreneur, it was how he did things up to this point.

Jim knew that by personality if everybody took one side I would take the opposite. Maybe it is a personality trait. In my defense, it is also how I find the chink in the armor–either my client’s, before an adversary finds it, or in my client’s adversary’s, so he can exploit it.

Perhaps Jim heard my personality and not my argument from economic theory. Prices were greater than value at this time. They had been for sometime. Inevitably, the inequality would reverse and that added to the ordinary challenges of a major expansion were too much to overcome.

Today, the inequality is on the other side of the pendulum’s arc. Value is becoming higher than price. The opportunity is great, and resistance to seizing it will be high.

* For obvious reasons, not his real name

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Next salon will be Thursday, April 23, 4.30 p.m.

Subject: Economic Volatility: part 5, “Only Action Matters”

This is the final of the series.