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.

The techniques we use became practical for small companies because of the internet and the pc. The internet provides access to more kinds of data and the means of getting the data into a computer without weeks of data-crunching. The low cost computational power of the PC made it possible to examine the data; advanced mathematics is now available through pc software. The result is usable computer models.

Two other models control computer models (I mean models as in frames: the way we look at things). One of the models is accounting. It some what measures what actually happened in the microscopic scope of a single company. The second is an economic model, which estimates what could have happened on a grander scale.

Where folks have difficulty is that they think of the accounting models as objective, that is, reliable and irrefutable. In reality, it is an approximation that leading investors regard as crude — even for a single company. The accounting model’s true appeal is its familiarity.

Milton Friedman objected to facts without theory. Accounting fails the test because it has no theory. Accounting is a legal convention, not an economic construct.

The second model is economic. In many small businesses, especially those that are led by entrepreneurs, this model estimates much higher returns. The economic model is speculative in the sense that it estimates ROA base on what could, but has not yet, happened.

What we construct in DecLink is a set of facts based on theory. And we start with theory (actually, so does everyone, but I won’t go there).

When we propose DecLink we make a few assumptions for later testing. These assumptions explain the difference between returns achieved and returns possible. The difference is losses. The accounting model does not and cannot calculate these losses, so according to accounting model the losses do not occur. This is why pricing losses are viewed with skepticism; accounting cannot report them.

The assumptions are:

§ Entrepreneurial firms have higher profits than non-entrepreneurial firms.

§ Inside data is not captured to measure customer subjective value.

§ Measurement of internal cost displaces subjective value.

§ Large losses in ROA come from small losses in prices, costs, or investments.

§ Companies do what they have always done and that will be reflected in their data.

They are suppositions that do not pinpoint whether lower ROA is caused by pricing losses. But we start by eliminating things that are not a cause. We use a large array of formulas to compare the firm’s data to outside data.

***

DecLink has its origins is the rough-and-tumble of commodity markets with big low-margin farms. The idea was that there had to be a better way to price. It was here that we applied our skills in the pc modeling and math software–with strong results.

Finding DecLink was something of a happy accident. We were building a model to measure risk and rewards in price, volume, and credit supply volatility because almost all the hundreds of crises and opportunities on which we have advised were long-term in origin. Timing was extremely critical in reading opportunities. And timing was a powerful tool in resolving firm-threatening crises. Our objective was to be able to get a read of economic conditions for improved performance, reduced risk, and persuading doubters of our client’s capacity. In that process, lo and behold, we found a way to read commodity markets.

The application to companies in un-traded markets was immediately obvious to us. We did not see any necessary limitations because of the difference between traded and un-traded. In traded markets prices could be “read” by what worked for the producer’s target ROA. The difference between traded and un-traded is accepting an offered price versus offering an accepted price. The psychological load on a company’s decision makers is about the same.

***

I have a deep distrust of convention. It is fair to say business convention is okay to follow most of the time. But when it is not okay, it is really not okay. The results prove disastrous. But convention is so appealing because the proof is implied since others are doing the same thing.

An entrepreneur brings solutions that are somehow novel. Pricing is one way the application of convention causes common [lower] profits in spite of the uncommon solutions for the customer.

There are only two people who understand the entrepreneur’s idea: the entrepreneur himself/herself; the customer whose problem the entrepreneur solves. I say that because it points to two problems I almost always find with a firm’s data:

§ Under-utilized data including a failure to collect on the subjective aspects critical to implementing the entrepreneur’s idea.

§ Even though the entrepreneur’s idea was conceived before there was a company, and even though there are many who might be, but are not yet, customer, there is little space given to collection of date from outside the company.

It leaves the company and the entrepreneur vulnerable to convention.

***

Conclusion:

Often enough the true entrepreneur does not need convincing, and therefore might not need DecLink. But the entrepreneur forgets that convincing his colleagues requires more than his or her conviction, charisma, enthusiasm, or passing rages. It requires the kind of proof conventional types need before they can act. DecLink provides that proof.

DecLink is a service of Praexis. The techniques used are widely available. The methodology we use is proprietary. In application, DecLink produces astounding improvements in profitability. However, in practice results for some companies are limited. This is because of a general distrust of economics, models, and mathematics. Some companies cannot get past it. In a few cases, results ended when companies believed they could copy the techniques and so save costs on the assumption that economic conditions and conditions within a company remain constant.

Commentaries point resistance to: people’s dislike of thinking; the expert’s presumption / resistance to calibration; a view that the subjective can’t be measured; distrust of accountability; ‘I already knew that’; data availability; character; threat to competence; implied criticism.

The collapse of Bear Stearns makes me uncomfortable. I say that because I saw something they apparently did not. Or if they saw it, they went ahead anyway and I wouldn’t have joined in. In fact, I didn’t, having liquidated any mortgage or real estate holdings, including my own then-overpriced house, because I thought it was clear what was coming.

Not many years ago a client told me of his plan to triple his business. In general economic terms I was opposed because it was an expansion during very good times. Not only was demand high and of course prices, but the price for the capital assets to expand followed suit, and credit supply was easy and cheap.

Tom, Jr. and I made a trip to talk with them face-to-face about the proposal. It was short notice so all we had was the general argument about avoiding capital investment in high times. I hold that position because it is just buying high, which in the best of times is only breaking even by selling even higher. Our visit came with just enough notice so that they were prepared for our disagreement.

The sum and substance of their position was that expansion would be profitable. The client was a good operator his numbers proved it.

I hollered and screamed. What they had built took 10 years. They credited us with their success. We rightly credited them and expressed appreciation for getting to play a part. What they had already done was not easy, not without objections and resistance from others, but they had done it. I feared it was all at risk for virtually no upside potential other than the thin argument of profit.

Why that is almost business sacrilege – that profit is a thin argument. But that is my position.

Profit is not the basis for doing something, it is only a means of continuing to do something.

As you may know Goldman Sachs invested in sub-prime mortgages opposite of others. They shorted. That is they bet on sub-prime becoming a big loser. They were in thin company.

I have long suspected that the fastest way to the highest immediate profits is riding a wave. I have suspected that failing to ride the wave while it was still rising would deliver less profit. I hesitate to write it that way because it sounds like doing nothing is better than doing something. A recent Economist article compared the profits of Bear and others with Goldman. Sure enough, while the wave was cresting Goldman lagged in profits behind the others who rode the sub-prime wave.

Telling somebody that profit is not a reason is a sure way to get ridiculed. Because you can’t get the words out of your mouth fast enough that you’re not proposing as some sort of goal that they would be better off with less profit. Even from an exalted position such as we enjoyed with this hell-bent-on-tripling client, getting it said and offering the reasoning just doesn’t do it. At least I couldn’t persuade them.

I spent years trying to fix things after they went bad. To avoid the problem in the first place is to see something as a problem before it is a problem. This is why I wondered if such things could be foreseen in a useful practical way.

Back in the 80’s I was working on computer-based models with 10-year time horizons. It seemed to me that what hit firms — what was economically relevant — was three things every owner understands: prices, volume, and credit. We finally found outside price data we could afford (far easier today than 15 years ago). I had long dreamed of the day we could afford to get the data into our computers. The internet made that happen. Tom, Jr. was working with the model and the price data. He inadvertently found — that is, he found something even though he was actually looking for something else — a way to read and draw conclusions about when to sell something and at what price. It was for commodities.

We pitched several clients on the idea of developing Tom Jr.’s work and they provided the rest of the front money. It worked. It really worked. But not for all of them, which brings me back to Bear Stearns.

Did Bear Stearns even look? I can’t imagine they didn’t, although very few actually do look. Assuming they looked, did they see? I’ve seen people deny what they plainly see. I can’t imagine that at least someone at Bear Stearns did holler and scream as I did. That’s all speculation on my part. I think it a reasonable speculation.

Bear Stearns won’t make that mistake again…they’re gone.

Do I write to scare? Yes. Almost all the cases I’ve had were like Bear Stearns: people who had something to lose and lost it, or nearly so. Having a great deal to lose shows by results these were people of skill, experience, and judgment. Yet all three failed in an instant.

Therefore, Bear Stearns makes me uncomfortable.

I talk (about 20 minutes) about these things and take questions at our Wine & Cheese Salon Tuesday, April 29, 4:30-5:30. This is the last salon on economic foresight for awhile; I will deal with new topic materials at our May salon. Bring a friend. Registration is limited.

Owners who got into trouble were my motivation. I found it gratifying to get them out of trouble. It seemed to me it would be even better to keep them out of it altogether.

There is an owner’s story I heard much later in my career, but it seems to me the epitome of everything I’ve seen before and since about things that goes wrong. We had become good friends, and so he unfolded his story for me. I could see it happening, I could anticipate what had gone wrong before he confirmed it in his telling. I wish I had been there in time, and said so. He told me we would not have listened.

I find no comfort in being proven right by a disaster. It is been the challenge of my career to make the information I offer compelling to people like my friend before the disaster. It is so much better for both of us if I am vindicated by my client’s success.

***

I want to say this carefully: managing a business is important, but it ranks dead last in the creation of wealth and avoidance of economic loss. In fact its techniques are often contrary to wealth creation, because management is about control, tighter costs, more volume, fewer mistakes, narrow focus, and so on. All these are contrary to true economic gain, which is dependent on innovation. And they miss true economic loss, because they’re not looking outside the firm from where it comes. For management to work, it has to be consciously subject to these two realities that fall outside its function, and indeed its ability to function.

I once that small business was beset by uniquely bad management. I meant no criticism, because I didn’t think the problem was solvable: managers with superior education and training are financially impractical for small companies. However, wise judgment apparently takes something more than education and training. As happens time and again, economic foresight escapes even the best, brightest, and biggest, as the spotlight of publicity has recently shown. Bear Stearns’ shareholders have a front row seat. In 15 months their shares went from $165 to $10.

That is where economics enter.

The field of economics began when some smart people noticed that some decisions that were good in the short term turned out very bad in the long term. In the short term, P=V_u. P, the price of doing something, is about equal to V_u, all the costs of doing it (including a sufficient return on capital, or profit). The problem is this: P never equals V_u for long enough to safely ignore the rest of the formula, whatever our short memories tell us. The whole formula goes like this: P=V_u[(S_y, U),t^{(n-1, n+1)}]. Price = Value modified by Supply and Uncertainty over time; this is discernable historically (n-1) and can be anticipated and prepared for in the future (n+1).

P=V is a rule of thumb; we use it because it’s fast, easy, and familiar. But it assumes that (S_y,U) does not affect the outcome. And it won’t today, and mostly likely won’t next week. Thereafter? N + 1; it certainly will, at an uncertain but insufficiently distant date.

Think about the supply of credit, which is also making some headlines. The availability of money, the conditions of borrowing (collateral, money down, etc.), and interest rate are all parts of it. It is a common and insidious player in terms of its influence on decisions. Abundant credit drives prices up, but those don’t change the economic use value. When the government inflates the supply, always for a good cause of course, it falsifies our simple P=V calculation. It is a sound calculation except it ignores S when the supply inevitably contracts later on (n + 1).

No one is immune. Some owners avoid investment or borrowing when they sense the growing risk of a mature boom. By this they assume they’ve escaped the risks from, to follow our example (I have countless others), a credit-driven distortion. They won’t. Yes, they’ll avoid the collateral erosion and the liquidity crunch by loan call. But when I have diagnosed these ostensibly conservative firms I find them neither established nor conservative. When you under-invest, you become under-competitive. The law of economics dictates the need to adjust again and again. Others don’t stop invention and innovation just because you have. In the failure to invest you also have the loss of an idea, and so the loss of the future. In wisely escaping the most discernable effects of economic volatility, they fall prey to economic change.

***

My friend’s crisis had its roots in the 80s. He was probably right — I would not have persuaded him. Now the tools of my trade are better. The picture of the future can be painted with more than words of wisdom from sound economic reasoning. Data can fill factual gaps that were impractical to crunch 25, even 15 years ago. We have learned, or relearned something as well. Data can hide things that pictures, charts, and graphs, can easily reveal. Benoit Mandelbrot, a mathematician famous for his work on chaos theory, drew pictures of his math for the same reason. Would I have convinced by words, reasoning, data, and pictures? He was well-educated, a man of broad experience and clearly a man of vision (a true entrepreneur). I like to think I would have.

Today I would approach the matter by extending the analysis deep into history, t^(n-1). Unfortunately, business is not known for its interest in history. The other morning I heard an analyst say that he hadn’t seen anything like the current conditions in 25 years. Since he was talking about a combination of high inflation and recession, I thought is history was too short. The 70’s saw plenty of both. Are we so much smarter now that this is ancient history and doesn’t matter?

The business of business is maintaining and increasing profits. Without profit we don’t survive. If we’re profitable today, we can take care of tomorrow…tomorrow. We solve problems, plug leaks, correct the wayward, and tend our networks, and should see some profit.

Like Bear Stearns. They did those things, and brought considerably greater expertise to bear than most of us will ever have at our command. No one can argue the business they were doing was unprofitable. It was different that the business they did before, we all knew. It was new innovative products, we all knew. But different words for the same things and calculations by spreadsheet instead of pencil and napkin do not revoke the laws of economics. Fool with credit supply and soon enough everyone things the future is all up. Uncertainty disappears. It is nice to think the future is always upward, but it is not always so. The ramped up credit supply did not make housing affordable. Finally, the unaffordable reality intruded and pinned the bubble to the floor.

So that you don’t miss the point because of my focus on mortgages, examination of economics runs to the question: Where were the executives at Bear Stearns (and many others, excepting Goldman Sachs)? What is the CEO’s job if not to consider and prepare for the future?

On the other hand, the executive who wrestles with the future will hear rumblings for “neglecting” today’s problems and profits.

How can I say the future is foreseeable? We in small business have tools now that were unimaginable or at least impractical before the last 25 years. Alas, even these are “impractical” for the hardnosed businessman. Tools don’t give answers, they raise hard questions. You will take some hits to the shins because your gaze is ahead, not at your feet. My best advice is to strap on the shinguards and look. For those who need justification for such a “speculative” process, surely the answer is to make good decisions. What decision matters that is not about the future? In fact, when is a decision ever not about the future? And what decision is ever proven right until the future passes?

As it happens, the success of this foresight doesn’t depend on the executive’s being exactly right –- one only needs to be more right than the competition. The potential is not speculative when the competition is locked into fixing the problems of the day. They aren’t even looking.

***

I asked him why he thought he would not have listened. “We were the golden boys. Everybody knew it and said so.”

For a brochure on Turning Points, P=V_u[(S_y, U),t^{(n-1, n+1)}], which shows how we look to the future, call or e-mail us.

Next salon is April 29, 2009 4:30 to 5:30 on this subject.

We are extending another invitation. I polled participants from the first meeting and found their interest largely matched my expectations:

- No one wanted a prescriptive course
- The question is not how, but why
- Diverse participants but shared entrepreneurial characteristics
- Professionally led discussion
- Author participation
- The advantage of early exposure

Personally, I would not have gone to an exchange group. I had no interest in seeing how others would run my business, nor did I have any interest in having someone point out all the ways I fell short. I make my own mistakes. Surely others would not make them. But then the mistakes they make I wouldn’t have made either. They wouldn’t learn from me and I wouldn’t learn from them.

If the exchanges included experts on various subjects, I would not have gone. I could never reach their exalted heights nor plumb the depths of their knowledge. More importantly, I didn’t need to. Telling me how to do something, it seemed to me, was more like telling me what I ought to become–though I still do not doubt that if I could become the person they proposed it would be to my advantage. It wasn’t that I did not, or do not, know of superior qualities and characteristics in others, but that I concluded a long time ago that I was the height I was despite the clear advantages of being taller.

Oddly, I am proposing a contradiction to what I have just written. Contradiction one: form an entrepreneurs’ exchange group. Contradiction two: base it on an experts view — in this case, mine.

In defense, I say that (like everyone else) what I am offering is different, and by implication better, that somehow (as an expert) my expertise is superior because I discovered what every body else missed. I did enough research in 4 years of writing to know that in some respects I do have another take. But it is not a take arising from superiority on my part; rather it is from the providential advantage of having advised several hundred owners (some of whom were entrepreneurs) who were in the midst of trouble. I also had the good fortune (or misfortune) to spend 4 years away from battle to write about what I have learned.

I also say that mine is different, because I deliberately wrote to avoid prescription. I say I deliberately wrote to avoid telling entrepreneurs what to do because I could find no way to tell people what to do without telling them to be something they aren’t. Besides, the evidence shows clearly enough that far and away the dominant factor in a business is the entrepreneur. Place on him or her prescriptions and results fail, sometimes terribly. That used to puzzle me until I realized that the difference. When entrepreneurs conform to expertise, ”best practices” if you will, it fails because expertise serves best when it conforms to the entrepreneur. It is in my book. I’ll talk briefly about it in our meeting.

That is the entrepreneurial dynamic in business without yet defining what kind of entrepreneur. For now I’ll leave the description to another time except to hint that most business owners are not entrepreneurial.

There is another thing I’ll speak of at the meeting, and that is economic volatility. We have written about it on our website. At the risk of repeating ourselves (it is a subject worthy of many repetitions), I will say that second only to misguided attempts to remake the entrepreneur, economic volatility is the major force in business trouble and in business success. Economic volatility is everything outside the business–outside of your control, so to speak. But it hits you here and there with major effect on prices, volume or credit. In fact, in all the crises forced upon a business, it was economic volatility that was the source of my clients’ adversaries’ overreactions. It is so strong that I may say that all the data about your company is accurate, but because of economic volatility it is not relevant when it matters most.

We can think of economic volatility as recessions, though in the last 20 years recessions have been few, short and shallow. But recessions are too narrow a view because it includes bubbles and bursts, and some others things as well. Tom Jr. wrote a journal on a lute [an arcane musical instrument, distant cousin to the modern guitar] purchase that demonstrates by its very smallness the subtlety and the practical reach of economic volatility. Well, in the same way the Internet and powerful PC’s have put you at the world’s doorstep, it has also put practical means of dealing with economic volatility at your doorstep.

The entrepreneurial distinction in business and economic volatility are my two favorite subjects. They run through all 9 chapters of my book. I don’t say that my book or even the impact of entrepreneurs arguing over the book will make an entrepreneur a success. Looking back over 35 years, I can’t say as I made any entrepreneur a success. I can say that my book and discussions with fellow entrepreneurs will make business easier, faster, better and safer.

Go here for information on the time and place and for registration–we only have space for 15.

Years ago I concluded that conventional wisdom and practices were wrong when it mattered most. It was my clients’ efforts, contrary to convention, that were producing prejudicial and scathing criticisms. The antagonists weren’t supporting or improving; they were pre-consciously trying to stop improvement.

Being something of a blockhead, I moved to help my clients prove their ideas to those whose support they needed. I wanted them to know my client was right. It was all a factual battle. About 20 years ago it began to dawn on me, very slowly, that facts produce counter-facts, more facts produce more argument, and so on. What became clear is a problem of risk, perception and nature. This led directly to considering the role of economic adjustments and economic volatility. Economic adjustment is the need to improve, discover, and develop new products and services. Somebody else does even if you don’t. The practical failure to do so on the part of most firms was evident because the model performance benchmarks touted by industry experts was so low that in most years the average firm’s earnings percentage was lower than the cost of borrowed funds. In other words, convention is almost always wrong. This redefined risk. Risk tacitly accepted by doing nothing is much higher than the risk of acting today on the future. This was an important bridge to build because what is behind many objections is myopia and provincialism.

To counter these limitations we spread the data over decades showing that what is high risk in business is avoidance of improvement. A remarkable finding from this work: gradual improvement was even riskier than none.

The bridge had to deal with another risk. This one is real, economic volatility. We narrowed the consideration of broad economic volatility to its basic business impact — credit supply (cost and availability), demand (volume), and prices (paid and received, including modification by foreign exchange). Few know much about economics, but they fully understand credit, volume, and prices. They have felt them. This was more than interesting because with it we could readily punch holes in the assumptions regarding the causes of success for tired old companies, and plug holes if an innovation is being dragged down by external economic matters. It is accurate to say the economy is improving in seven times as many months as it is declining. We forget the good, and have “day-mares” about the bad.

This thinking also opened up two other avenues important to entrepreneurs. (I believe entrepreneurs have a heightened sense of risk and so are more risk averse than others.) The first is the timing of their “adventures”. Economic troughs are always better for starts than the peaks. This tends to time most development with economic peaks–notice the shift. The second is a host of risk mitigation strategies including types of financing, financing covenants, and hedges including commodities and currencies. We don’t do predictions, they are non-sense. Prediction depends on fundamentals but the future depends on human reaction, which is altogether unpredictable–especially in timing. We do odds. This proved to be a very good way of avoiding arguments over facts and predictions from facts. Everybody loves prediction; only a fool believes it.

Together the elements of this bridge help antagonists because it shows respect for their concerns.

The final element is the entrepreneur, the entrepreneur’s story.

I discussed these out of sequence for how we apply them today. The sequence is only how I learned them over the decades.

The story is first. The bridges come second, to demonstrate that the entrepreneur is astute in business terms, or more accurately, in economic terms. Defense is applied after start-up to deal with the inevitable snooping. (To put a good face on snooping, call it the need to demonstrate stewardship).

Finally, as to the entrepreneur. I very much like von Mises’ description:

“What distinguishes the successful entrepreneur is precisely the fact that he does not let himself be guided by what was and is, but arranges his affairs on the ground of his opinion about the future.”

To that statement add his other comments that concern the entrepreneur’s uncertain (that is, not looking positive) future for himself and his family. Add to that my own more homely experience. An entrepreneur is some one who sees that a thing can be done [much] better and that doing so would be worthwhile. It is a combination of improvement and market acceptance.

I recently did some research on the Toyota Industries Corporation—highly regarded and for good reasons. Years ago, the Toyodas (the family name of the founders) fit von Mises’ description. They started with looms, autos were later. I think when they watched how the women in villages did manual weaving they went outside of expert practice (what was, and is). But their observation goes much deeper. It is like Edison looking at the veins of feather as inspiration for the filaments in a light bulb. It is respect. The women earned respect, Toyoda gave it and from that could see improvement. I think something, a great deal, is lost by studying Toyota (or the start-up and growth of any highly-regarded firm) without an even deeper understanding of an essential and deep respect for creation.

Toyoda went from loom to zoom. Wright went from pedal to flight. Porsche, from VW parts to Lemans. What are these but great dreams! And also something else: the compulsion of their story, the very means of their support is their status as the underdog. People love underdogs (even business experts). Toyoda wanted to build a world-class car. Ferry Porsche wanted a sports car you could drive every day. Think of it in their times. The CEO of Porsche asked Ferry in early 80’s what made him think he take VW parts and sell it for 5 times what everyone else did. He replied, “I didn’t listen to anybody. I thought others would share my dream.” For Eijii Toyoda’s renowned stubbornness he was called “the Ox in the darkness.”

When the entrepreneur tells his story–this kind of story–people listen, they follow and they support. Resistance will rise. But it does not matter for people want somebody to follow.

Robert McKee in Story describes the compulsion of a great story as having these elements:

1. the basic conflict – the reality of scarcity in life
2. insight into the gap between reality and expectation
3. life is filled with contradictions, so a healthy suspicion that things are not as they seem
4. the requirement of absolute values
5. and, finally, an Object of Desire

Those are things of Toyodas’ story and every other entrepreneur, renowned or not.

The antagonist is usually expert, and certainly someone who feels threatened. They are not enemies; they are cooperatives in advance. For those who sense their needs, who see the future, the antagonist is merely the means of sharpening sight, selecting supporters, and helping them to be able to help.

I close with a couple of thoughts that are at once disturbing. But if you think about them you will see, as I do, underneath they reveal great possibilities for us. One investment house makes investments overseas because although the business climate is better here, the idea flow is much better there. Peter Drucker said that other than advances in distribution there have been no major discoveries in the U.S. in a century. Twenty-five years ago financial firms accounted for 6% of Dow capitalization’ today it is nearly 30% of capitalization and profits. A South American e-mailed a friend here to explain that what he and his friends were doing is copying what the USA used to do but does no longer.

The book on what is and was is written. We are therefore free to move on, and freedom is a better word for entrepreneur: free to discover. We are therefore also free to respect, for respect is a better understanding of what grounds all invention.

This journal previews a series of entrepreneurial exchanges oriented around my forthcoming book and moderated by Jim Jacobs of Savvy Consortium. Click here to read more, and to register.

Not long thereafter some change in the industry or economy makes it clear that however painful it was to shed that asset, to have owned it during and after the change would have been disastrous.

The owner demands of us: How did you know?

The answer is, strictly speaking, we didn’t. Such events are recurrent in Sr.’s and my combined careers, but our advice is something less than prescience. It is also more than coincidence.

It is very hard to treat this subject without writing a book—-in fact, Tom Sr. is doing just that and is nearly finished. But if I distill our experience into a few broad observations, and deal with the one measurement that exposes the economic strength or weakness of an asset or expansion (any long-term economic commitment fits the bill), I might just get something said in a couple of journals. This one is the first, and the setup.

It seems that the following things hold true:

1) Few firms, however small, can get by without making some long-term and nearly-irrevocable commitments (can’t be reneged without significant and even prohibitive losses). For our convenience here, call them assets.

2) Assets are subject to cyclical fluctuations in value. The timing of these fluctuations is not specifically predictable, although it is possible to broadly assess when they are high, or low, and likely to increase.

3) These fluctuations can make or break individual firms.

4) The vast majority of us find it hard to resist buying when prices are already high; we find buying when prices are low nearly impossible. Chalk it up to human nature, herd instinct, or “irrational exuberance.” I won’t try to explain it. Volatility would be less dramatic without these tendencies.

5) A firm’s financial performance cannot always be accounted solely by internal characteristics. External happenstance can negate excellence or mask weakness, temporarily.

To elaborate on my set of premises: once the process of production is begun it is hard to stop. The only way to recoup the costs plus some return is to see them through the production cycle that was envisioned when they were purchased. The valuation of work-in-process inventory is purely an artifice of accounting. Its market value is almost certain to be far less than the cost of the inputs invested in it. Even assets such as real estate are problematic. A fast sale demands a discount (this apart from general changes in market values).

That asset values fluctuate is readily apparent. Most people with practical knowledge in an industry can quickly assess when the relevant assets are cheap or expensive. They can point to occasions where something was bought too expensively and cite the damage done, or when it was bought cheaply and cite the unusually high speed of payback.

Regarding premise #3: the failure of businesses is conventionally attributed to the failure of the idea, the execution, or the capital. True, many ideas have no viable market. And the execution of a viable idea can fail. But the sufficiency-of-capital question is problematic. Not enough? It kind of begs the question. How much is enough? It is like blaming someone’s lack of success on his or her lack of wealth. However, the capital question does indicate, if vaguely, the impact of externally driven volatility on individual businesses. Consider another scenario:

Let’s assume that the business in this case is demonstrably well run, with a good idea, and has the track record to show it. In fact, execution is so reliable and the idea so popular that an expansion is in order. The firm has to get access to the range of assets to facilitate growth by using other people’s capital. Let’s assume also that this expansion is concurrent with a general rise of activity in this industry. For this reason, the needed additional assets are considerably more money this go-around. No matter; they have done the math, and the math is good.

Expansion is messy, and at some point or another, an expansion will stretch management beyond its immediate capacity, and execution will suffer. This firm in this scenario winds up in just such a situation. Concurrently, the general demand for their product is in a slump. Between the two, sales fall and costs rise. These events are, strictly speaking, not failures; they inevitably attend growth. Given time, this management team will adjust successfully, as they have done in the past.

However, there is no time. The conditions that slowed sales growth for this company hold true for the entire industry. People are canceling plans to expand and shedding idled assets. This has a predictable effect on the price of assets, which predictably weakens the company’s balance sheet and its standing with the bank. Add to that a period of operating losses due to growing pains and the attendant shortage of cash. The bank is demanding a solution now.

This example might read like one of the improbable moral dilemmas that television screenwriters concoct, except that it really happens. This story or any number of variations has been a staple of our careers—helping business owners to avoid, or extricate, or benefit (avoidance and benefit are nicest, but life doesn’t always work that way).

How is it that we see what other miss? The same way everyone else does. I buy into the idea expounded by the great economist Friedrich A. Hayek: all knowledge is local and personal. The beginning of every new business is essentially one person acting on knowledge that no one else will. Knowledge is by nature “asymmetrical,” although that description reads more like a guilty verdict in some circles. Oh well.

The two scenarios contrast a firm that acts in time with one that doesn’t. The second one is not past help, although getting past the crisis is certainly more stressful than avoiding it altogether. Perhaps I can add a sixth observation to the set above:

6) Every successful entrepreneur will experience at least one of each in a career.

There is a financial measure, which is economic, not just financial, in orientation. No other single measure trumps it for predictive value. That measure is return on assets. It is not unfamiliar to many people, but it surprises me how rarely it is used, at least in the realm of private, independently owned firms. Having introduced the concept, I’ll try to fit it to a journal-lengthed discussion next month.

“Wrap it round your head to ward off noxious fumes or avoid the gaze of the Ravenous Bugblatter Beast of Trall (a mind-bogglingly stupid animal, it assumes that if you can’t see it, it can’t see you–daft as a brush, but very very ravenous).”

–Douglas Adams, The Hitchhiker’s Guide to the Galaxy

The whole of Adam’s book is a satire, and a pretty good one, on a range of human foibles played out by a variety of alien species and on a galactic scale. By nature we would prefer it if more of our antagonists hewed to the Bugblatter Beast’s flawed logic. Don’t see them, and they’ll let you alone. The problem with relying on covering our eyes–metaphorically–to get us through the day is that it precludes even the option of judicious inaction as a possible response to danger. I mean, beating a very quiet, very cautious retreat is the recommended course of action when encountering a grizzly bear in the wild; covering your eyes would make both the “quiet” and the “retreat” parts of your response highly problematic.

In real life, ignorance is not bliss. Even the Hitchhiker’s Guide assumes that prior to encountering the Bugblatter Beast, the towel was in fact not wrapped around your head.

Economic happenstance is another sometime-adversary that refuses to ignore you just because you can’t see it. I like simple examples, because they avoid the diversions that complexity causes. All the better if the simple example is a real story.

In a parallel life I play the lute (think of a guitar, but with a round body and more strings). The path that led me to play music of the 16th and 17th century on copies of an archaic instrument is something I won’t try to explain here. Lutenists need lutes, so as few practicing lutenists as there are, there is an even smaller cadre of luthiers who build them. These people are not renaissance-festival types who don their Henry VIII/Anne Boleyn costumes any chance they get, but are like any number of highly skilled artisans, whether they work with wood, metal, food., etc.

They are the epitome of the boutique industry. So far is their remove from what most of us call “business” that their efforts seem to be entirely a non-economic event (that there is actually no such thing is a subject for another journal entry). The profession is often called a “labor of love,” but for most of them, this love still has to pay rent and put food on the table.

One of these people is building an instrument for me. His are amongst the best (I have played them…they are so good it feels like the player hardly needs to show up), and obviously everyone who plays agrees, since his prices are top-dollar and his waiting list 6 years long. (Are they worth it? As someone once said of Porsches, if you have to ask, you won’t understand.)

The financial equation for a luthier is as simple is it gets. The complexity is all in the craft. As to numbers…figure 20% on materials cost and something for the space, although many work out of their homes. The rest is a question of building & selling enough instruments to make a living.

Well, when I spoke to him recently asking the perennial question “Is it done yet?”, he mentioned that the weakness of the dollar against his currency was reducing his gross income 40%. Being a man of his word, he did not look to me to fix his problem, but this was clearly a real problem for his livelihood. I doubt if he checks the currency board periodically; most likely, he makes his bank deposits from checks denominated in the customer’s currency and the bank converts for him. No doubt he watched the early movement with some bemusement, but chalked it up to ordinary fluctuations. But that months-long slide to a 40% discount would cause a sensation closer to panic.

His assumption, probably unspoken, when he set his prices, was that his currency would track the dollar in a sufficiently narrow range to both give him revenues to support the business in the long term and not create damaging variability in the short. That assumption was reasonable in light of his experience. Unfortunately, it is those assumptions that set us up for real trouble.

I am not trying to underline the astonishing naiveté of the craftsman. Anyone who is highly trained in one area will be comparatively unaware of the imminence of opportunity or difficulty in other areas. This is as true of financial and economic professionals as it is of luthiers. Only consider the dramatic example of Long Term Capital’s downfall in 1998, where the juxtaposition of financial genius in one area with demonstrably unwise assumptions (not to be equated with stupidity or crass ignorance, however) in another came uncomfortably close to bringing down the world’s banking system.

When important economic issues are not addressed, the resultant condition is a business engaged in unwitting speculation. My luthier was speculating in currency markets; that it was unintentional and not related to his business only makes it more wrenching. Some people do well speculating, but that is contingent on 1) they mean to and 2) they have the resources. When your business is building the best lutes in the world, you probably have insufficient resources to speculate in currencies, too. In fact, Porsche AG took a similar view with their cars; they hedged currencies on the tacit argument that their business is cars, why accept the complication of currency risk?

The more common view is that hedging a currency (or whatever ever hedgeable significant economic factor) introduces speculation–if you look at the Bugblatter Beast, he will eat you. This view is also common among professionals; it is not just the populist take on economics.

Speculation is a given in human action. We make commitments, set in motion processes which are not easily stopped, and from which the costs cannot be recouped until the end of the production cycle. In the midst of this process, the calculations that made sense at the outset can be embarrassed by changes to key elements. Some are beyond our control. Some can be partly controlled. Studying markets as they relate to the individual firm and where possible, taking positions, is about narrowing our exposure to external risk. It never ceases to amaze me that this action is slapped with the label “speculative.” Wrong! We already were speculating as soon as we committed to production, what we are trying to do is speculate less.

This does not require us to be expert economists, at least in the academic sense. The calculation on which the mitigation of external risks is based begin with the firm, not with the global economy. The individual firm, or firms, is our basic unit for constructing a risk mitigation strategy. This can include, but does not always require nor is it limited to, taking hedge positions in traded markets.

How does someone who is by definition a part-timer compete in broadly traded markets? I mean, won’t an craftsman who takes positions on a currency exchange get his head handed to him by the more experienced? To the first question: he doesn’t compete, so, in answer to the second, no. Someone whose agenda is to remove some externally-driven price or cost risk from their plans is not trying to beat the market when it comes to gains or losses. They are only seeking to insure the prices that work for their business. It works.

What do you do when you have already been hit by volatility? There are no quick fixes, unfortunately. That is why there is such a premium for preparation. Still, it is inevitable that more than once in a career we will find ourselves dealing with the aftermath of unintended and avoidable speculation. Those feeling the pressure on their cash reserves tend to chafe against this deliberative approach, but in this situation a rush to action is almost guaranteed to make things worse.

It is a difficult juxtaposition that in crisis, deliberation and patience are needed where events seem to demand frenetic activity, and that in quieter periods, a certain urgency to meet the unexpected, even unknown, is best. It challenges our instincts, and many people go with instinct, which another reason the rewards from this approach are considerable: so few others do it.

On four occasions I hired marketing firms to put words to what I do. The first three described what I should become. One of them thought I had to present a happy, warm friendly face. Sure, that makes sense when almost all my work was fighting with owners in to prepare to fight successfully for them. There are no happy faces in workouts, turnarounds, splits, expansions, acquisitions, sales and startups. Those come only after you have won.

I hired the fourth firm because I thought they would know. I had advised them on a major crisis—navigated them successfully through it. When it was over one executive told me she had thought hiring me was a mistake. “You’re just an accountant.” She said she was wrong about me: what I did according to her was genius. Gee, l loved that–from class dunce to applause.

Alas, their advice was to take the prospect through “step-wise”–not a single word that reflected insight into what we did in their crisis.

Suppose you do what I do. Wouldn’t you suppose that your client is smart, at least on the argument that the customer is always right? Wouldn’t you suppose the owner has already tried customary form and found it wanting? And, since they are at your door, wouldn’t you look beyond accepted forms for solutions?

In crisis I react to the personal offense coming from a prejudice against small company owners. It took time for skill to be added to my umbrage, years to realize that the problem with what is normal and conventional was that it missed the gaps. What we know, what we are taught, what constitutes the state of present knowledge should not be a limit, but the ground from which what is not known can be found. There is nothing wrong with what is ordinarily true, even in business; there is a lot right. We always check what we see against normal and do so rigorously. But to mark a thing as lowest because it is not normal, not the way it should be done and then assign to some ignoble heap is non-sense. What is different threatens, but so does progress.

It is these gaps that interest me. They suit human curiosity, the driving urge to find out why. They were, I see now, the nature of my grandmother’s contrariness. Why is like a plague, a chronic disease. It keeps posing the question. It led me to a question that in one type of crisis to another kept coming up: why was it that owners and others involved were blindsided by the crisis? Oh, they said they knew, but their assertion is disputed by their inaction.

When small businesses are troubled the accepted wisdom states it is for reasons of deficient capital and management. But I could not see enough difference between those on whom trouble fell and those on whom it didn’t. Maybe it was just a few examples that exposed the gaps in accepted wisdom.

It was in those few examples that I fit another piece of the puzzle. I saw smart, motivated people get blindsided. Years ago First Bank–doing what they knew, very smart, and surely cautious–got blindsided. I know because I happened to have timed an investment in their stock right. It was this combination of blindsiding of smart people and timing that lead me to a conscious recognition of the role economics in my work.

I read quite a lot. Increasingly I read economic theory. It started to fill the gaps for me. It explained why what I had done intuitively had worked. This time the gap was not so much using what is known to find what is not. It was confirming and adding to my own knowledge gap. Economics is a lot of math and models, but I want to shift your mind a bit on economics.

Economics is a branch of social sciences. It deals with, it explores, how people act in economic decisions. Risk, uncertainty, timing, future, status, reputation all play into it. What I saw was like a light shining back into my past.

The study of economics came about when a few very smart people noticed that good short-term decisions were often terrible in the long-term. It became clear that in addition to failing to ask why, following proper form left the decision makers too sensitive to the short-term, setting up a terrible long term. Nobody is sure of the future, and many are all too sure about the present. That leads to things like bubble and bursts. It leads to holding onto what no longer works because it once worked. It leads to good form and bad results.

That gap between what is and what will be is economics. It accounted for people’s being blindsided. But just as fully as unseen gaps create risk, the dead certainty of gaps delivers advantage.

I’ll attempt to tie this all back to education. The problem with education–how it is taken, if not how its taught–is that it becomes the limit of what a person can know rather than the ground from which to reach for what is not yet known. Reaching is the precursor to progress. Those who do not fit the form may be intellectually deficient. Ah, but they may–and I think more likely–are those who see something more, something beyond. And that is the potential, the promise and the possibility of any small business owner.

I can’t resist a metaphor from the Maginot Line. It has been soundly criticized for its failure. It was also the best possible thinking–if you will, form–of its time. The problem was that its achievement was seen as the limit of possibility, when it should have been seen, and could have by the eye of humility, for what it was. It was both opportunity and an unheard warning to look for the gap. The Maginot Line is like best of business management and its inevitable gap in economic knowledge. Economics are unconsciously practiced by the entrepreneur for opportunity. It is so that that the entrepreneur’s economic practices are also limited to their own opinion about a narrow slice of the future.

Alas, I am not a genius.