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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

***

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.

(Summary, January 13^th Salon)

Economic volatility is common (see Chart: the Volatile Economy in the prior post for set of examples). So are its effects– common like the common cold sapping one’s energy. But it is not reliably common; when we look at failures which are caused by, or at least happen concurrently with, extreme volatility, we can easily see why we are blindsided and often don’t know what hit us.

I believed Drucker in 1998 when he that the Asian collapse–one of the most severe economic events of that decade–was clearly foreseeable a year in advance. So for me this mortgage/housing collapse was clearly foreseeable. I sold my house in 2004 and largely cleared out of the stock market in 2007.

Drucker could foresee collapse. Others foresaw the mortgage collapse; stocks, too, although they were the extreme minority. But if I could successfully anticipate both, then what happened to Bear, Lehman, Merrill, Wachovia and others who made losses of such size as to wipe out their profits, indeed their companies?

I know the standard reaction to acting to economic foresight. In 40 years of involvement in turnarounds, startups, and workout, I can say that almost all happened because people failed to look, failed to see, or failing to act accordingly.

Drucker’s assertion did not alter the actions of these firms. Who and what stood in the way, antagonists to his insight?

Take no comfort in the charge that this disaster was caused by greed, stupidity, or insufficient regulation. (As early as 2001 Congress was warned of this developing disaster and warned many times after. They did not act other than to ridicule the testimony.) These companies employ the smartest, best-educated, and most experienced men and women. When they made the argument for getting in and staying, it was on the basis of reported profits, marshaling the facts, and delivering proof.

These are irrefutable, it seems.

Contrary arguments are met with skepticism, ridicule, and cloture. And why not? Who can dispute the need and duty for profits or successfully argue that less profit is better? And since contradiction depends on seeing the future, it fails on the test of facts. There are no facts about the future. And if proof is offered; there is none that is contrary. Those who take a contrary position prudently hide what they are doing — not for advantage but for the avoidance of criticism. Finally, then since proof is what others are doing, try to explain how your lower profits, compared to competition, should make shareholders and employees feel good about lower stock prices and reduced compensation.

Larry Bossidy, former CEO of Honeywell, declared there is no higher form of management than facts. I agree.

If facts are management, then the burst of these bubbles time will happen again, just as they’ve happened again and again in history. “Don’t be greedy or stupid, regulation is watching” will not work because it will not see. But if the solution is leadership–acting on what is clearly foreseeable–not management, what we need is cover for the leader.

I won’t bother to go through what the experts did say. To be sure it was impressive in content, detailed in analysis, and grounded in hard reality. But I will tell you what has been said by owners confronted by the same choice of present reality versus future uncertainty:

- You can’t time these things.

- Things have changed. They are different now – a paradigm shift.

- What we are doing works and will work.

- It won’t happen again.

- There is no evidence.

- You can’t run a business on speculation about the future.

- I can’t do anything about it anyway.

- It won’t affect us.

- I can’t ignore what my competition is doing.

Greenspan said in testimony before Congress, “I made a mistake in presuming that self-interests of organizations, specifically banks and others were such as that they were best capable of protecting their own shareholders and their equity in the firms.” His statement is enough to make the wise and humble lay awake at night wondering what they are missing.

To this I add: In decisions made according to the “highest form of management” the hard calculus of current profits will censor the softer, intellectual argument of future uncertainty. However, the antagonists are refutable; their model is flawed and incomplete, and the recent evidence is buried in the wreckage of the mortgage crisis. Like gold, it is hard work and worth digging out.

***

Our next salon continuing the theme of Economic Volatility will offer the means of cover for the owner who is a leader. Though there is much to commend the continued use of the business model, I will point to where it falls short.

I’ve spent more than 3 decades pondering a mystery: the difficulty owners have in grasping economics. In the early years I thought I had it figured out. In those days my advice was based on so-called economic theory.

The theory applied to credit and prices seemed so obvious. Credit supply at the extremes of shortage or excess drove prices. Stupid prices always came from excess supply. Too cheap prices came from extreme shortage. It was never hard to tell when either extreme was the case. But it only reached the owner’s conscious when the extremes stuck them down the rush of black hole. Then it was no longer theory. But this sudden recognition was not a real conversion, it was just a foxhole conversion.

There is nothing like the near-death experience of a workout, turnaround, bankruptcy, or other disaster to enliven the desire to learn and understand. But these things are passing events, and most people return to old habits as soon as possible. Amongst large companies, less than 7% were better off just 2 years after major cost cutting. So what I thought were conversions–I had advised many through these things–were just passing sobriety.

About two decades ago we began to able to add hard data to economic theory. I was sure that with the facts, the theory would be undeniable. And it wasn’t, for some. Others didn’t bother to deny, and neither did they act. Still, I had fun pulling, crunching, and displaying data. It was fun because it confirmed my theory. It was even more fun for the refinement it what could happen and when led to advantages for our friends that didn’t require an overwhelming surge of unbridled uncertainty.

Even results don’t convert. I had not found a compelling argument in theory, facts, nor results.

The evidence, though anecdotal, piled up over the decades: almost all major crises were a bad decision or a failure to see a decision was needed a few years before. Fixing these things kept me busy, but the results were mixed for the owner. What makes more sense: planning to avoid a beating, or working to heal after the beating?

Providentially one company triggered my interest and led to an insight that is good enough to call an answer: Porsche.

Coming into to this century, Porsche hedged the dollar. It protected their ability to hold market share and margins at the same time. I liked it. It is my kind of thinking.

I should have seen it before. I bought commercial real estate in early 90’s. I bought First Bank after they turned a smart hedge into a stupid speculation. My friends lost their jobs, and I lost the bank that financed me in 1969 on that one (although I made money on the stock). I sold my house in 2004, half my stocks in 2006, and another third in 2007. That was merely on two economic theories: the affect of excess credit supply on prices and the necessary relationship between price and income. (I admit I listened to some others and didn’t sell everything. Holding oil worked. The rest, not so much.)

I should have known. I should have seen HOW one actual acts on economic volatility. Because for me, despite my assurance of what I knew and had advised for decades, I doubt I would have sold but for one thing. I was about to resign from all our retainers and begin to write a book, a 3 year proposition with an uncertain outcome.

I sold for a powerful reason. I did not want the distraction of mind, dilution of time, or financial peril to deflect me from my intended purpose. I was sure that what I was about to do was something much better and would prove to be worthwhile. There was to me only one risk, disruption. (The hard slog of reviewing my cases, 40-year career, research, dozens of outlines, bibliography, footnotes, and writing was more than hard enough.)

Well back to Porsche.

This isn’t the first time Porsche had to deal with currency exchanges rates. The last time was in the 80’s and it nearly ended them.

Porsche was founded on Ferry Porsche’s dream of a rear engine sports car you could drive every day. He started in the 40’s. Even a little knowledge of history reveals the incredible obstacles he faced. By the 80’s Porsche was moving rapidly away from rear engine. They were phasing out the 911. It had developed engine problems that were expensive to repair. Fixing it needed some straightforward engineering. They didn’t do it, but sold highly profitable repair kits instead.

Ferry Porsche’s dream was gone — rear engine, drive every day (which, among other things, means reliability).

The dream was restored under Peter Schutz. Schutz was CEO from 1981-1987. Accounting was next door to Schutz’ office. Ferry was in an outbuilding. Schutz moved accounting out, and Ferry in. Every morning over rolls and coffee, he would talk with Ferry. The dream was back. By 1996 there were no more front engine Porsche sports cars.

What was good enough to start Porsche in extraordinarily difficult times was good enough to bring it back. Imagine sipping coffee and searching to find the dream to bring about turnaround.

I was not surprised that the turnaround worked. Ferry Porsche’s dream was something he thought others would share. That made it a promise to himself and to others. Who were the others? Customers-to-be.

Having reset the firm from the outside, looking outside was possible–otherwise economic surprises would break the [renewed] promise.

At one time, if the matter of predictability was a matter of intellect, training, tools, data, statistics, and budget, then only large institutions could get it right. Now Lehman, Bear, Merrill and the House Banking Committee (Frank and Waters were warned two years beforehand) but they didn’t get it right. They made no promise? They broke a promise made?

It takes tools, training, data, and statistics. We offer all that. It takes a promise made and kept.

Next salon in January is Winning by Default, part 3, Antagonists to Entrepreneur.

P.S. Holger Haerter Porsche’s CFO, who designed the hedges, is an economist.

Prediction is about avoiding the unacceptable when the unacceptable is not readily foreseeable from the opinion of others or from personal experience.

How did you know?”

“I looked.”

“But why did you look?”

“Because I knew you wouldn’t.”

“But how did that make you right?”

“I didn’t have to be right, just more right than you.”

Peter Drucker said in a 1998 article[i] that the then on-going collapse of Asian markets was predictable a year in advance. You could see it clearly in various financial measures and statistics, he wrote, all of them widely available. In spite of this, most large companies were caught completely unawares.

What this business giant wrote wasn’t news to me. It was confirmation so I shouted with delight. I had 30 years in the trenches of workouts and turnarounds. I knew most were avoidable. To me Drucker confirmed:

That uneasiness of economic prediction, which depends on outside the firm data, is better than the relative certainty of decisions based on accepted opinion, memory and business experience. Know the times; get timing right.

“Yeah, but everybody knows you can’t time.”

“You mean we don’t take time.”

“The big guys missed it.”

“Then you feel better because you have company?”

“Well they can afford it. I can’t, don’t have time, don’t understand. It’s economics, statistics. You can get whatever answer you want. It’s speculation. I won’t do it anyway. How would I explain it? It will reduce profits. I got real problems to deal with ….”

“But?”

“What?”

“What are you going to do?”

Economic prediction isn’t a theoretical exercise by which management draws out a universal on the whole economy. Economic prediction is specific to a single company, to look at those things outside the firm capable of upsetting or accelerating its future results. The objective and the outcome is to make things a little easier and happen faster with better results.