Krugman's economics, cumbaya and pseudo-science

The man started screaming at the store's clerk. Shocked and scared, I fixated on his long hair and bear. He had clearly not showered for many years and seemed very thin. Truly angry, the guy used more obscenities than I had ever heard from any one person. I was seven years old.
After the man stormed out of the store, the clerk, a store owner's daughter who was left shaken, told us that the store had been giving money to the homeless man for many years. It turns that that day she had not gone to the bank to change the big bills yet. This was the first time that the store had not given him any money.
This is how I learned that giving someone money would not solve their problems but would instead create an obligation for the giver. I also learned that having good intentions was not enough.
Over the years, I resisted giving money to the many people who beg the streets of Mexico, where I grew up. I was therefore called heartless by many friends whose opinion I valued. It did not matter that I had supported many projects aimed at helping people learn to do better by themselves instead. It was difficult to follow my convictions with so much pressure but it was a matter of integrity; I had to do it!.

End This Depression Now

Paul Krugman, on the other hand, seems to be willing to bend his beliefs so long as everybody likes him better. Of course that I don't know the man. This is just the impression that I was left with after reading his book, End This Depression Now! In it, he claims that Economics should not be driven by morality, yet makes many economic arguments based on moral principles. It seemed convenient to take both sides. Often, he would build credibility on one idea only to claim to believe on an opposite one without clarifying what the connection between the dual positions was.
I was therefore turned off by his seeming lack of integrity and a deep emotional insecurity expressed through an obvious desire to be liked by everyone. I rather prefer personal character and a strong conviction, even when I may disagree with the ideas.
As someone with background in engineering and scientific research, I have very little tolerance for those who claim to have mathematical or scientific evidence but who have not applied sufficient rigor to their process. In such cases, I would be much happier if the claims were described as a thesis instead. For example, Mr. Krugman builds his position that government spending will get us out of the recession on a very small sample of correlated data. Just like the Quants who developed the mathematical models that could not see risk in housing derivatives because of only using recent data, Mr. Krugman did not address any of the historic evidence for or against his ideas from before the 1900's; no Rome or Spain. Against claims that promoting business activity would be equal or more effective than government spending, he offered thin arguments. He focused on a single aspect of business incentives: lower taxes. He completely ignored the universe of other possibilities. Moreover, he never described extreme historic examples of too much or no government spending during recessions.
I should probably mention that any true scientific test must include evaluations of opposite or inverse scenarios. Here again, he omitted describing how government spending by the USSR's leadership failed to lift the union's economic collapse during the eighties. A sound evaluation would had then compared the USSR's investments during the 80's with that of China's during the last decade. It would had served as a good variable-canceling pair since both were centrally managed. In such case, the difference was that China promoted private business activity while the USSR did not.

There was one great concept that Mr. Krugman offered in his book; the idea of a Liquidity Trap. A Liquidity Trap happens when additional injections of capital into the financial markets by central banks betray traditional expectations by failing to stimulate the economy. This seems to only take place during deep recessions. It is clear from the way that this phenomenon is defined that it is happening right now and that it offers a better explanation than those from the many economists who have failed to predict results since 2009.

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Unfortunately, there is no explanation of how a Liquidity Trap transitions back to normal under the weight of so much stimulus. A graph with an approximation of the slope would have been helpful. We are thus left with the possibility that high economic stimulus would continue to work until the moment it doesn't. In other words, the graph would show an elbow with a sudden change from deflation to utter inflation. Yes, Mr. Krugman opposes the idea that there would be any inflation at all during the Liquidity Trap, but what he does not address is what happens when such Liquidity Trap ends. He seems to take the position that the graph would show a gradual change in slope; yet he fails to provide evidence behind such conclusion.
On the other hand, the idea of a Liquidity Trap could just as well support the ideas put forth by Edward Conard in Unintended Consequences. Mr. Conard describes how capital can act in either of two fashions: risk-averse or patient. The idea that excess risk-adverse capital is inappropriate when trying to fundamentally rebuild the economy could easily fit the concept of a Liquidity Trap if the excess liquidity happens to be risk adverse. It would also contradict Krugman's suggestion that investment by governments is the only alternative; lowering economic risk expectations could promote deployment of patient capital by business. Even Mr. Krugman had a hard time arguing in his book that government investments were effective enough to merit consideration. He had to rely on correlations; something that earlier he discredited.
In a nut shell, if you do read the book, focus on the concept of Liquidity Trap. Do let me warn you, though, that the road there is paved with lots of religious rhetoric. So you may better spend your time and money studying the concept of Liquidity Trap through other sources. On my part, I was so frustrated with the cumbaya that I almost dropped the book right in the middle of reading it. In my opinion, it could have been better written as a brochure on the concept of Liquidity Trap rather than a book on Krugman's religious beliefs on economics.

Book Title: End This Depression Now! 
Author: Paul Krugman
Publisher: W. W. Norton & Company
ISBN: 978-0393345087

Stocks push higher not on dividends; traces of risk aversion

Did you miss it? The stock market has been stretching higher and higher each day. Now that if your investment portfolio has not participated on the current push through historic highs, you are not be alone. There is definitely something driving stock prices higher, but it does not seem to be money from the average investor. Who is behind all the buying is more important than the fact that new records are getting destroyed almost daily.
The media argues that the floods of capital landing on our shores are seeking yield. They claim that, since Treasuries do not pay investors enough, these funds are goblin dividend paying stocks.
Low interest rates set by the Federal Reserve and their Quantitative Easing program are no doubt creating an environment where bond buyers are getting pushed away from Treasuries and towards other assets. But is yield what these bond holders are looking for? I argue that it isn't; at least not exclusively.

Normal behavior (2009 to present)

Under normal circumstances, stocks or sectors experiencing greater economic expansions would command a higher price than those with inferior potential growth performance. To see this normal behavior, look at the comparison chart of the FTSE Colombia 20 Index, with ticker symbol GXG, and the US Utilities Sector SPDR, with ticker symbol XLU. Because Colombia is going through the economic renaissance that's witnessing the formation of strong balance sheets by former debtor nations in Latin American, it has enjoyed great price appreciation since 2009. On the other hand, the US Utilities Sector's price performance during the same period has been as expected: boring. Normally, not one investor would brag to his mates about owning Utilities. It is like watching paint dry; there is no excitement at all.

Similar Dividends, Diverging Performance (2013 YTD)

But the story has reversed since the beginning of the year. Normal market rules have not applied. Economic success stories Peru (EPU) and Colombia (GXG) have lost about 10% of their value despite their great fundamentals. Contrasting this performance, US Utilities (XLU) and US Consumer Staples (XLP), sectors that would other wise stay flat, have gained between 17% and 20% in value in just four and a half months. These are incredible gains. The gap between exciting and boring assets has grown to about 27% in favor of the boring. Incredible!
Looking at the unusual divergence in pricing, one would be tempted to believe that the push for dividend income is what's creating the gap. The problem here is that all four assets in the chart offer great dividends. In fact, Peru's ETF (EPU) pays 3.63% while the US consumer staples SPDR pays only 2.71%. The other two fall in between. With similar dividend levels, there has to be a different reason behind the difference in price performance.
Risk seems to be the culprit. Money that would otherwise be invested in Treasuries, is now pushing boring sectors higher because these sectors normally experience lower levels of volatility. While dividends matter, perceived safety carries a much larger premium at this time of economic uncertainty. It should be clear that markets are thus pricing risk as if there was a great probability of trouble ahead.
Now that for all those not in the market, there are potential repercussion within the real economy. We have already experienced one economic slow down with all its associated problems in the ability to borrow or to find willing customers. A second swing lower would be most destructive for many businesses now residing at the margin.
I believe that the money that has driven the stock market higher has the characteristics of risk intolerant capital. I therefore think that a correction larger than three to four percent, the dividend being paid, would create a rush for the exits; leaving us all wondering what happened.

Wealth Redistribution House

I think that the present administration and its misguided ideals of wealth redistribution have created an air of uncertainty within the businesses environment. The result has been a complete unwillingness to invest in long term projects and of hiring new employees on the part of business owners. As a result, the economy has not improved despite a massive Federal Reserve intervention. This has created large pools of capital that have been looking for where to get some kind of return while keeping risk low. These funds demands a high degree of liquidity from their investments; a liquidity that would allow them to immediately exit positions in the event of drops in value. Not a great thing during jittery markets.
I certainly would prefer to see a robust recovery, but the signs do not support beliefs of a sound come back. If things were well, money would chase growth potential rather than safety. But as discussed, risk aversion is the call of the day.

Bank loans not for start-ups

Starting up? Do you have a great idea that could be launched and transformed into a successful business? Let me guess. You need funding.
For many entrepreneurs a bank is the first place where they think to look. Unfortunately my experience has shown that even in normal times, which we are far from experiencing now, banks are quite risk adverse. Therefore, I would definitely not suggest for you to waste your time with one. Don't take me wrong. You could try as a way to learn from the experience. But doing the search with the hope of actually getting money will, in my opinion, be wasteful; especially when there are many other things that you need to get done to make your dream a reality. To understand why I am being so direct, think of loan opportunities in terms of what will you use to repay the loan.

• Past sales - You can pay a loan with the money that you already have earned. The collateral is the money already in a bank. This carries the lowest risk for banks. As a result, they love them so long as the company has a good credit record. In reality, these loans are for businesses that have already succeeded and somehow found a need for cash. No, it is not impossible. Apple and its massive balance sheet in foreign accounts needed to borrow to pay dividends in the US without incurring taxes from importing its foreign cash, for example. But since you are starting up, you have no sales and have yet to earn any money yet. You must therefore be excluded from this type. 
• Present sales - You can pay the loan when you get paid for sales that you are making right now. These could usually be Purchase Order (PO) loans or Factored orders. The collateral is the invoices being raised. In many cases, banks seek other collateral. The risk is now higher since invoices may not get paid for many reasons. Buyers could complain about the invoiced amount, the product quality, the method of delivery and many other things. Thus, many retail banks will not take on these loans, leaving you with having to seek commercial banks. Be ready, at this level, interests are not what make loans expensive. Fees can turn seemingly low interest loans into expensive monsters that will end up costing you an equivalent to 20% more in annualized interest. Here again, this may not for the typical start up. You do not even have the the inventory needed to attract the kind of buyers or the volume in business that would allow you to explore these loans.
• Future sales - In this case, you would pay the loan after monetizing or selling the inventory that you have at hand. In other words, there are no sales yet and you are trying to use the inventory as the collateral. You are now far from most bank's risk profile. The answer you will most likely hear from bankers if you ask for these loans is: "if you can't sell you inventory, what makes you think that we can?" Obviously if you had prior success selling the inventory already, you would have no need for a loan, have the cash to back up a different loan or at least have the invoices from present sales. Start up or not, you are out of luck. 
• Way-in-the-future sales - As in after I build a team and get a place to work from and get my idea turned into a great success and get CNBC to talk about it during Squawk Box. In other words, the idea and your enthusiasm, become the collateral. Good luck. The only banks that would touch these are those that issue unsecured loans: credit cards.

Now that you do not have to take my word for it. I found a great article titled How Entrepreneurs Qualify for Funding from Banks by Martin Zwilling that will surely prove helpful to you if you happen to the in the 0.1% of entrepreneurs. If nothing else, he does a great job describing the characteristics that will help you with all other sources of funds.

To me, the fact that banks are risk adverse means that they are a poor match for risk seeking entrepreneurs. Neither side is wrong; they are both just seeking different things. Banks are happy picking up pennies in front of a slow moving steam roller. Entrepreneurs want to swing for the fences even if it means striking time and time again. 

Financing is always risky; the difference lies in how risky it is. At the core of this distinction resides the separation between the patient capital that builds infrastructure and the risk-intolerant capital that rushes out of a country's financial markets at the first sign of trouble. These differences help explain why bank financing is far from normal today. The economy is flush with risk-adverse capital and lacks equity-underwriting patient capital. As a result, consumers and small businesses will have to pay large premiums for loans, if they can get loans at all. We should also expect to see many more flash crashes, where capital rushes out of the US towards other markets as was the case during the hacked AP Twitter account crash. To compound the issue, banks borrow money short-term and lend long-term. So the pervasive uncertainty about the nation's future does not help banking models. Perhaps one day in the future, when the country can find White House leadership that promotes a normal business environment while supporting entrepreneurship as opposed to punishing success, will banks begin offering real opportunities for new businesses. Until then, don't hold your breath and find other ways to fund your great ideas.

Hoax offers taste of nearing capital rush from risk

A hacked Associated Press Tweet drove jittery capital back to Asia

Without warning, all financial market prices crashed precipitously. Within two minutes, the Dow Jones Industrial Average collapsed close to 150 points. Then, just as quickly, the Dow erased most of the losses. Was this a sign of what may yet come? That all financial markets are interconnected became clearly evident on Tuesday the 23rd. At 1:08 PM.

Launch AP Twitter

Apparently, a hoax by hackers commandeering the Associated Press' official Twitter account had spooked the markets. The fake Tweet alerted of two explosions inside the White House and that the President had been hurt. In an instant, every financial instrument crashed. Futures, Options, Equities and Bonds delivered pain to their investors; all markets but one. Interestingly, currencies responded in a distinctive and insightful way.

When capital moves between two countries, currency prices show the flow's intensity and direction. After the Euro remained absolutely stable during the crash while the Japanese Yen skyrocketed, there was no doubt of the unusually large capital flows escaping our market. The US Dollar chart graphs price fluctuations from the instant US markets were crashing. As capital exited towards Japan, demand for the Yen increased and Yen prices moved higher. The relative difference between the Yen and all other currencies was not subtle, highlighting the impact of this currency. A second chart of the Japanese Yen further shows the strong gravitational force that this currency exerted over many global currencies. Flows back to Japan were just huge.

After the crash, the media debated the impact that black boxes had on price swings. High frequency traders had left their finger prints all over the now familiar flash-crash. But perhaps the question shouldn't be who was behind the trading but what were they trading with? I am referring to the type of capital being deployed. Where does it come from? Is it patient or risk intolerant?

In his fantastic book Unintended Consequences, Edward Conard makes a compelling argument about the difference between two types of capital. There is risk-tolerant equity that does a great job underwriting risk. Then there is risk-adverse capital which demands instant liquidity at the first sign of risk.

Edward Conard

If Mr. Conard is right, intolerant capital entering US markets would first inflate low-risk asset prices. Johnson and Johnson's stock would move higher, for example. Finally, any sign of risk would trigger rapid liquidation as intolerant capital flees the US. Yes, the coincidences are eerie.

Treasury Bills would see unusual demand, no matter how dysfunctional our government may be. Then, as the Federal Reserve crowds out bond buyers through quantitative easing, intolerant capital would be forced to migrate to riskier assets. There would be robust demand for high-dividend stable company stocks;

To prevent such capital flights, the Fed needs to reconsider quantitative easing. The cost/benefit analysis of the situation seems asymmetrical. There is close to a trillion dollars of unused money parked at the Federal Reserve. Long term capital investment has never recovered from the recession's collapse. Quantitative easing is simply not doing too well. On the other hand, it is forcing intolerant capital to underwrite risk; driving stock and bond prices higher without a corresponding increase in patient equity. This is unsustainable.

I may not be into debating haute économie with the scholars at the Fed. Nonetheless, I can easily see that there is jittery capital being deployed. I agree with Mr. Conard that in order to ensure full economic potential, we need to create the equity that can underwrite the risk that intolerant capital can't.
This is at the core of the transformation that will make us a great nation for the next hundred years. Government as well as the whole nation need to unite once again behind entrepreneurs and those willing to take risks. We have gone too far with our drive to force people to contribute their "fair share". It is coming across as punishment for success and it is hurting our future. 

Sell your Business, Keep the Growth

Is it really possible to sell a part of your business as a way to get more from it? In short: yes.
Let business be the place where this sort of thing can happen. I can already imagine sparking protests from Wall-street-occupies everywhere about how business always wins at the expense of everybody else. Unfortunately for all proponents of an anti-business world, we are not talking about taking away from anyone. On the contrary, this is about sharing wealth with others. Let me explain.

I recently read Anna Vital's great How Funding Works – Splitting The Equity Pie With Investors article. It nicely describes the various stages of capital funding a company can go through. The article reminded me about a misconception many business owners have. Often, business owners evade the idea of one day selling their business. They think that the day they sell will be the day they quit building wealth; that selling means no more income. It is almost equivalent to becoming old and irrelevant. A real tragedy for someone who has grown accustomed to constantly finding ways to make things better. As a result, owners everywhere refuse to plan an exit strategy. And who could blame them. Who would want to become irrelevant?
Rather than seeing it as part of an exit strategy that'll allow them to take some money off the table while diversifying what they have built, their thinking leads them to believe that selling part of their business is similar to selling an asset like a car. When you sell a car, you stop getting transportation. But selling a business does not stop the benefits. Selling to the right people who will invest in the business will make it grow; making the owner's leftover shares worth much more in the end.

If you do sell, make sure that the new partners have much more fire power than you did. From access to cash, to access to professionals, to access to strategic partners and access to better customers, anything that they can bring to the table will increase the value of your diminishing share of the business.
As a result of the growth after each sale, the founder's unsold share can in fact grow to be much bigger than it was at the time of the first sale. How much bigger? Well, much, much bigger. In the case illustrated in Vital's article, the 17.6% portion of the company that the founder kept all the way to the  IPO became worth more than $450 million. Not a bad chunk of cash for an owner who originally sold half of the business for nothing.

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From zero, his share of the business turned into $12K, then $310K, then $760K and finally $450 million; all while it went down from 100%, to 50%, to 37.5%, to 31.2%, and finally to 17.6%. Clearly, it is much better to sell to the right buyers to give the business a better chance to rapidly grow. Remember the Walton's? Sam Walton's family members are many times wealthier now than before taking Walmart public in 1970 at $16.50 per share. Forbes has Christy Walton pegged at $28.2 billion, Jim Walton at $26.7 billion, Alice Walton at $26.3 billion and Robson Walton at $26.1 billion, for a total of $107.3 billion for their inherited share of a company selling half a trillion dollars in stuff. In 1985, Sam Walton's 20% share of Walmart was worth just $2.8 billion in comparison.
I strongly believe that this tendency to take advantage of what equity markets offer represents a clear advantage for American company owners over their European counterparts. Europeans usually keep their business ownership for much longer than Americans. Case in point, giant furniture retailer IKEA continues to be privately held. Ingvar Kamprad, its founder, has a 100% stake in the company that in 2011 was estimated at $23 billion by Forbes. Because it is impossible to test the counter-factual, we can not argue that Kamprad's shares would be worth more if his company was publicly traded. But what we can surely prove is how people like Microsoft's Bill Gates and Facebook's Mark Zuckerberg are worth a gazillionth each despite having sold most of their businesses. Zuckerberg's share is estimated at $13.3 billion by Forbes after selling 71% of Facebook. Gates' is estimated at $67 billion after selling a whopping 95% of Microsoft.

I will leave you with at least the curiosity to explore a partial capitalization of your business. It can be done to help bring in new skills and energy to the company's management while infusing needed growth capital. It should help you safeguard part of what you have built while allowing the remaining part to grow much larger. A partial sale of your business does not need to be the end. On the contrary, it may be when you start building "real" wealth for your family.

Strangle Options: gaining from success, protecting from failures

What will you do with your investment in a company that soon could face failure as easily as it could soar? What if it's structured as a tax pass-through entity and it continues to borrow to fund operations?
Whether you are an Angel investor or just someone who helped a friend fund her company, you need to be aware that a business failure while holding unpaid debt will create a tax liability to its share holders if structured as a tax pass through.
I recently gave advise to a friend who faced such scenario. Excited for its potential, he had decided to invest in a company. In exchange, he received 25% of the shares. He originally found the opportunity as the company's landlord. When the business failed to make an on-time rent payment, the business founder explained the fact that he had to bootstrap operations to keep the company and its great potential alive. The business was part of an industry with a growing trend, so the upside was great. Furthermore, the founder was a highly enthusiastic and all around great guy who had the deep technological knowledge needed to succeed in its industry. The investment seemed both emotionally and fundamentally warranted.
When the company continued to have poor cash flows, evidenced by the repeated failures to pay rent, my friend turned down a requests to provide additional funding out of fear of ending up too deeply invested in a potential failure. While not ideal, he was somewhat fine losing his initial investment but did not want to risk any more. Nonetheless, he felt that the upside potential demanded that he help the business find individual lenders to help keep the momentum going. Without much to show in the form of success, the company had to pay a premium for borrowed money. Unfortunately, paying such premium made it more difficult to make the company break out of its base. The outcome potential became purely binary. Either things would eventually make everybody lots of money or the business would soon collapse due to the weight of its business debt.
The obvious problem for my friend was that he was stuck with an investment that made it difficult to sleep at night. On the one hand, a failure would result in an unexpected tax bill for any unpaid loans, due to the business' pass through status. If a $100K loan went unpaid, for example, he could suddenly owe around $8K in taxes. On the other hand, if the business flourished, he would not be able to participate beyond his 25% stake despite having given the business free rent on multiple occasions. He needed to find a way to manage his position. So I suggested what is called an Option Strangle. Yes, this is a real financial solution despite it sounding more like a bad horror movie.

Launch the Options Industry Council's website

An Option Strangle has two parts: a Long Put Option and a Long Call Option. Long is geek speak for bought, as in having to buy instead of selling the two Options in order to set up the strategy. A Strangle is designed to profit when prices of an underlying investment move outside of the present range. An Option Strangle is designed to protect against downside risks while increasing exposure to upside gains. It is a great strategy when there are increasing probabilities of an asset moving either down or up within a given period of time. If the asset value does not change within such time, the premiums paid for the two Options would be lost. In my opinion, the cost of the insurance is very much worth the protection; especially considering the circumstances.
To buy a Put Option, my friend simply had to pay the premium price to the company's founder. Of course that there is the need for a Put Option contract to record the transaction and make everyone's responsibilities clear. There are many Put Option contract samples online. A Put Option grants my friend the right, but not the obligation, to sell his 25% of the company to the founder at a pre-agreed price before the Option's expiration date. To make sure the deal happened, I suggested that the pre-agreed price, also known as the strike price, be low; perhaps a dollar. The goal was not to sell the shares at a value higher than their market price right before collapse. Instead, the intention was to accumulate capital losses from his bad investment to reduce other tax liabilities while eliminating the ownership share that could end up creating a surprise tax bill because of any unpaid debt. Remember that a Put gave him the right to sell, which means that the company founder had the obligation to buy the shares.
The rights from owning an Option can be exercised at any time before the Option's expiration date; a date that could be as far into the future as necessary. In any case, it is also possible to close one Option and then buy another one to extend the protection period if the expiration date ends up happening too soon. Think of the fact that car insurance expires at the end of one year and must be bought again and again every year. In fact, Options are insurance devices where the price paid is in essence the premium of the insurance policy.

The second part of the Option Strangle requires the purchase of a Call Option from a company stock owner. In my friend's case, he needed to write an Call Option contract with the founder. A Call Option gives the right, but not the obligation, to buy additional shares at a pre-agreed price. Here, the founder would have to sell the shares to my friend upon my friend's request. If, on the other hand, my friend did not want any more shares, he could simply let the Option expire without exercising his right. The reason behind the Call Option was to convert unpaid rent into company equity in the future if things improved. I suggested that the pre-agreed price, the strike price, be defined by the present share price minus the amount of the free rent. Consider the fact that the Call Option contract must specify how many shares are available and at what strike price. 

I further suggested that my friend use part of the free rent he already gave the company as payment for both Option premiums. This would allow him to protect his position against a downturn while gaining from any upside at no additional cost. 

Remember that you must first check with your CPA on all tax related matters. I am not a tax specialist nor am I offering tax advice. I am also not legal counsel. My goal is to simply highlight the fact that there is the need to be better informed about these issues and that there are powerful solutions that could help you in case you find yourself in the same position.

I know well that the strategies I cover here are much more sophisticated than what is the norm for most business people. But you should learn them nonetheless. These are instruments that have wide use throughout the financial markets. I find that there are great possibilities for investors who are willing to break out of the proverbial box. To me, success in business is all about an open mind and an insatiable desire to solve challenges. Feel free to share your challenges with me. Together we may come up with solutions that will surely help many business owners and investors.

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Wealth-redistributionists shiver - groundbreaking ideas

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A problem I have with many economists, including the Nobel kind, is that they seem to be more interested in religious consensus rather than scientific learning. They seem to peddle their ideas with such drive that they obviously think that consensus will suffice to validate them. Much of the bases for their logic is intuitive, which would normally seem to be a good thing. But we live in a world where many great concepts defy common sense and pop-logic. Einstein's Theory of Relativity baffled the world's scientists because it did not follow common sense. People who forge innovative ideas must start not viewing problems through culturally colored glasses but through clear ones. Edward Conard, author of Unintended Consequences, certainly comes across as someone who did not start trying to prove his expected answer but with curious exploration over a blank canvas.

Unintended Consequences

Unintended Consequences is the BEST economics book I have ever read; and I have read many. Although it is certainly not a beginners' read, the book is easy to follow thanks to Mr. Conard's well structured and detailed case buildup. There are two main ideas within this spectacular book. First is the idea that risk taking must be nourished. Mr. Conard argues that wealth redistribution ideologists take wealth from investors while reducing payoff incentives for risk takers, which then results in lower risk taking and a slower economy. The second idea is about the characteristics of capital. He explains how all capital is not equal. There is short-term-biased capital that's  very risk-adverse. When it's deployed on riskier ventures, it shortens its time bias; getting very jumpy at the first sign of volatility. At the other end, there is patient capital, which is ideal as the equity needed to underwrite business. Unfortunately we do not have enough of this capital and the present administration seems to like depleting it.

Launch Fed - Ben Bernanke

Mr. Conard argues that it was the misallocation of risk-adverse capital in the form of down payment collateral for real state loans that caused the economic collapse. Although patient capital would have done a much better job, it seems that it was the abundance of risk-adverse capital that pushed its way to riskier uses after it run out of safer investments to fund. This reminds me that Bernanke and the Fed are pushing money away from treasuries and into equities as a result of their quantitative easing program. If Mr. Conard is right, watch out below. Any sign of volatility in the equity markets may send capital rushing out of bonds and equities and back to Asia. Wait, it already happened during the recent Fake-Tweet Crash. God help us!
As I previously warned, it is not intuitive. I can't say enough good things about this book and its author.

Book Title: Unintended consequences
Book Subtitle: Why everything you've been told about the economy is wrong
Author: Edward Conard
Publisher: Portfolio Hardcover
ISBN: 978-1591845508

Secret double-life - Warren Buffet spices things up with leverage

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What does this book tittle tell you: Warren Buffett and the Art of Stock Arbitrage: Proven Strategies for Arbitrage and Other Special Investment Situations?
Another book about the Oracle of Omaha? More close your eyes and buy advice? How about the Arbitrage word? Why such long title and subtitle?
Let me tell you, what the book does contain are awesomely and incredibly interesting insights! None of the boring buy-Coca-Cola Buffett stuff. This book is certainly not about buying something and not worrying about the market closing for five years. No sir; Warren Buffett is sort of coming out of the closet here. It turns out that he does use leverage after all. Moreover, he uses it with gusto! So much so that his otherwise lower performance is super charged thanks to his being a naughty boy.

Warren Buffett and the Art of Stock Arbitrage

That these facts came as a surprise to me is an understatement. Who knows what else we will learn next. Maybe we will uncover his disdain for taxes on a future book about him. We will have to wait and see.
For now, the Warren Buffett and the art of arbitrage book is easy to read and short; yet it comes packed with everything from Graham math to various arbitrage techniques for outstanding returns. If you dare to self-direct your investments and are comfortable with looking deeper than the surface, I strongly suggest this book; not because it is about Warren, but because the content is racy in an investment-geek sort of way.







Book Title: Warren Buffett and the Art of Stock Arbitrage
Book Subtitle: Proven Strategies for Arbitrage and Other Special Investment Situations
Author: Mary Buffett
Author: David Clark
ISBN: B004UBL79S

Unusually real reality on TV - business turnaround case-studies

Do you ever have any time for TV? I know I don't. As much as I love football, I don't even watch sports. If I get free time, I watch financial news on CNBC; but that's it.
Recently, things changed a little bit. A couple of Sunday's ago, I was doing home chores when I turned the TV on as background noise. I flipped between channels landing on Spike. What? Spike? I don't even know what the channel stands for. Are they like a new version of MTV? I couldn't tell you. The name of the channel does not help either.

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What came next was very interesting. A show called Bar Rescue where business expert Jon Taffer helps bar owners turn their money losing businesses around. Unlike most reality shows that have a light weight and shallow essence, this one actually shows real life challenges that could be transposed to any other business type. From low skill disengaged employees, to leaders with poor managerial know-how, to bad products and services, the show could serve as a collection of case studies on rapid turnarounds. I found it incredible to think of trying to make businesses change from money losers to money makers in just three to five days. To accomplish just that, Jon laser-focuses on key specific problems and solves them with tailored strategies.
The formula for the show starts with an introduction to the business and the problems. Jon sends in spies and studies the business through video surveillance. He then enters the business creating a shock wave that both wakes everybody up and makes the audience hate him. Many online reviews dislike that he gets on peoples' faces without getting to know them first. Next, he does quick reviews of employee performance and makes a few suggestions. He always brings in experts to teach employees how to prepare the right products and deliver the best service. Then, the bar goes through a stress test. A crowd larger than the team's capacity hits the business from many angles. Weak performers, whether managers or employees, become clearly evident after the stress test pushes the team to its limits. This humbles even the biggest of hard-heads and makes it easy for everybody to buy the idea of change. From customer flow, to capital equipment, standards are raised. After two days of remodeling and offsite training, the business re-opens to a large crowd eager to experience the changes. The team does its best pushing its new image, products and services. The revived business looks and feels great. After Jon exits as the triumphant knight, there is an update of the progress or reversion after Jon and his experts left.
While Jon is aggressive in approach, we all know that that is exactly what it takes to ignite performance changes in many teams. His loud and demanding approach also allows him to stay natural while giving good TV. Then the fact that the businesses are bars helps add audience to the otherwise dry subject of fixing a business.
I definitely get why he uses shock as his first technique. Owners are generally in denial of their predicament, employees are disorderly and/or uncommitted, many employees are inexperienced and immature and there is no time for a slower turnaround. I love his energy and focus. Besides, I often have found that being nice all the time sends the wrong message. Somehow people assume that one is either weak or stupid. So, one must push buttons from time to time.

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Filling the bar beyond team capacity is a great idea as I strongly believe that the best way to get employees to be satisfied professionally is by turning them into great business athletes. When you push them hard, they accomplish remarkable things that make them proud. The trick is just to recognize their achievements in order to help them build confidence.
From product choices to marketing to equipment selection, Jon solves problems differently depending on the nature of the business. All his changes provide great insight into what a bar business needs to succeed. Jon uses real industry knowledge to create answers to real constraints.
If you are a business owner, perhaps the most important aspect of what Jon does is that he makes multiple key changes concurrently. Most business owners plan one change or improvement at a time. Moreover, even when they plan multiple improvements, most owners deploy them in a linear way: first one and then the next. This dilutes progress and minimizes the perceived improvements needed to keep the employees motivated and engaged. There is nothing like feeling that there is real progress to get everybody to push the extra mile; which is much more probable when multiple improvements happen at the same time. This is because improvements that come from changes in marketing and operations, for example, do not add up together; they multiply. More potential customers through the door directly impacts sales. Remember that it is a numbers game where being exposed to more potential customers results in more converted customers (all else being equal). Then, the reduced costs thanks to better operational efficiency, will make each additional sale more profitable.
Multiple concurrent changes are paramount. Jon changes the POS system for better operations, the name for higher potential customer traffic, the service and products for better retention and larger transactions, etc. Also relevant is that he never drives the changes through the existing team of employees. He brings in experts to design the strategic changes. The existing team is in charge of the execution only. This seemingly small detail is important because many business owners refuse to admit that they need expert help with their business. Also, many owners think that the only way to bring in new knowledge and skills is by buying it; by hiring the knowledge expert. But as the show highlights, it is much better to just rent then while change happens and then let them go. In this way, the business spends the least possible for the new knowledge.
Unfortunately it does require for someone from the team (usually the owner or a manager) to manage the temporary experts. This is usually very difficult for the existing leaders since they often only know how to manage through the use of their title and not through leadership. You see, the title means very little to a temporary expert. Leadership, though, is something that always works with anyone; rented or bought.
Needless to say, I like the show and wanted to share it with you. Not to make you watch TV, but to make learning about the potential pitfalls within your business in a way that does not feel so academic.
By the way, I still don't like other reality TV shows.

Bifurcation in consumer spending drives retail opportunities

Right before you pull the trigger and launch new strategic initiatives for your business, are you aware of the fact that you are at the point of maximum uncertainty? From that moment on, the results from all your best efforts will become progressively clearer. Failure or success will become evident. Time, after all, is brutally honest about separating right from wrong choices. Looking back and letting time give its verdict is something I find interesting. So, as I came across an old article I wrote back in June 22, 2011 for a trade publication, I thought of sharing it with the readers of this blog. This article should show whether I was able to gain a clear perspective of the market conditions at the time or not. Enjoy!


Article originally published on 06/22/11

Bifurcation in consumer spending drives retail opportunities

What would you say if I told you that you are missing high end sales? Every retailer wants to know where the sales activity is taking place, but the noisy nature of the market makes this search difficult at best. So, I would like to share recent data with the hope of shedding some light on the issue.

But before we get to the core issues, we must address a few key points. It is said that in the short term the stock market is a popularity gauge. Meanwhile, it is also a long-term-value metric. Despite its daily ups and downs, the stock market serves as a great indicator of earnings health over time.

Over time, there are only two ways to get sustainable earnings improvements. A company's bottom line can continue to increase thanks to progressively better pricing power; also referred to as the ability to extract higher margins from the same customer base. Likewise, profits can sustainably improve when a company's consumer population grows.  Next, value investors like Warren Buffet reward companies offering sustainable profit improvements with higher stock valuations over time. Subsequently, the stock market can serve as an illustration of the fundamental changes taking place within an industry or sector.

The sector in focus for this article is retail and the companies being evaluated are Nordstrom, Dollar Tree and Target.  Nordstrom will show the behavior of the affluent consumer while Target represents the middle and Dollar Tree shows the low end. Although Dollar Tree has the smaller foot print in the group, other Dollar stores have mimicked the performance of Dollar Tree, thus making Dollar Tree a valid sample for our evaluation.

The chart below shows the relative stock price performance of these three companies over the last four years. It should be clear that after the recession, a radical changed took place. The group's historical correlation suddenly breaks after the recession with Target failing far behind the pack.

Stock Price Chart of Nordstrom, Target and Dollar Tree

It should be noted that, despite the current feeling of an almost perpetual recession, US retail sales as reported by the Federal Government have already exceeded their pre-recession peak. In fact both Grocery and General Merchandise sectors of the retail report have experienced robust increases in post-recession sales.

US Retail Sales - all sectors

So if sales are good across the US, how could Target fall behind the market as its relative stock valuation seems to suggest; especially when its large scale should make it tightly correlated with the overall market? How can Nordstrom and Dollar Tree be ahead of Target by such a large margin?

The evidence seems to suggest that the mid-price consumer is taking a hard look at the prices they pay and is thus no longer fully supporting their usual product suppliers. For these often referred to as Aspirational Consumers, due to their tendency to spend beyond their income level, the equation has shifted from style towards price.

Meanwhile, the low end consumer is overwhelmed by fuel costs. It has shifted to lower cost and more conveniently located retailers. While Target is usually considered a low cost supplier, Dollar Tree generally reaches further down and has the added benefit of being located closer to lower income areas; saving on transportation costs as a result.

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A shift towards lower prices and higher convenience has also helped internet sales, which despite not being represented in this study are reported as having experienced substantial recent growth by the Federal Government's Retail report.

The affluent consumer, on the other hand, continues to buy. With wealth that originates from recent outperformers like corporate profits or investment portfolios, the rich continue to buy from the likes of Tiffany and Nordstrom.

These two scenarios create what has been referred to as the barbell effect; businesses tending to the needs of either the wealthy or the poor are doing well while those focused on the middle are not. Since the fundamental pressures causing the barbell effect promise to stick around for a while longer, what should business owners do?

Launch www.Target.com

Many companies have already focused on lower cost products and services. In fact, commoditization seems almost rampant in some product offerings thanks to a departure from all-copper wiring and towards aluminum or even steel cables, for example. In these cases, the retailers are targeting the lower price points rather than the products' performance. While I can't say that I blame them since customers seem to be willing to pay less and less for products, I would like to offer the non intuitive alternative.

Who would have thought that high priced products or services would sell after a recession? This takes us back to reputation building, which is where most businesses started. By focusing on the premium side, owners are sure to further increase the value of their brand equity while also locking in great profits as evidenced by Nordstrom's relative stock value.

Also remember that Nordstrom is far from being a niche supplier. Their size demonstrates that there are plenty of consumers willing to pay more so long as they get superior service and quality. Nordstrom is legendary for their sales-agent tracking metrics and service methodology. Customer satisfaction is the key value behind everything they do; something that seems to be paying off.

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Recent conversations with a few installers seem to corroborate Nordstrom's results. Choosing a few good quality premium products and selling to discerning customers who value exceptional service seems to be having great results in their stores. Besides, there is nothing wrong with making Service the focus of a business' value proposition.

Companies that believe that low prices are the only game in town should seriously reconsider their position in light of the evidence presented here. Even when low price alternatives offer great promises, a race to zero may be the last thing a business with long term aspirations may need. The fact is that the premium buyer is still out there and willing to reward businesses who offer quality services and high performance as part of a well rounded package. Set your business apart by catering to these premium consumers. 

Think independently - legendary investor advice

A Gift to My Children

Legendary Investor Jim Rogers found so much success in the financial markets that he retired at 37. He even partnered with sage George Soros to create the Quantum Fund.
Many stock market prognosticators have their fair share of detractors; but I just can't see Jim Rogers having any. After all, it is difficult to argue with real-life success. Once he made enough money as to never have to worry about it again, he traveled all around the world, once on a bike and another time on a modified Mercedes Benz in the company of his second wife.
With nothing else to achieve, he focused on what is the most important aspect of life: the creation of a loving and closely knit family. Yes, Mr. Rogers made it to fatherhood a little past the time when most other men do it.
His latest book, A gift to my children, was written by the man who has seen it all (literally), as advice to his daughters. The book is short and easy to read.
I had previously read another one of his books, A Bull in China, which exclusively dealt with economics and markets. Mr. Rogers has also authored four more books: Investment Biker, Adventure Capitalist, Hot Commodities, and Street Smarts.

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A gift to my children, different to his other economics books, barely covers any of his trading experience. What the book does is to drive concepts such as perseverance  thinking independently, doing extensive research (learning), speaking at least another language, not trusting boys and keeping an open mind. That he cares deeply for his daughters is evident from the book. It left me wishing that one day my daughters will too read this book.



Book Title: A Gift to My Children
Book Subtitle: A Father's Lessons for Life and Investing
Author: Jim Rogers
Publisher: Random House
ISBN: 978-1400067541

Money wasted - Consultants clueless on ROI meaning

I don't know about you, but I certainly have a hard time keeping a straight face when dealing with most consultants. It just seems as if we speak different languages.

As a member of various CEO groups in LinkedIn, I often receive e-mails from consulting firms seeking to establish a relationship. These emails usually offer a free link to one of their articles. Always looking for better professional insight, I like to scan these articles looking for something of value. Unfortunately, it doesn't take long to be disappointed. After a couple of sentences, the shallow nature of the information becomes evident. It is frustrating even when the information is free.

Case in point (yes, I am picking on these guys), I recently read the Watch out for these EmployeeMisbehaviors article. In a flash, the platitude meter spiked. The problem is that, in the world of business, performance is the only metric. Beautiful verbiage does nothing to turn information valuable. Even the best of intentions can't be monetized. Only execution has a chance to deliver the goods.

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The article starts by establishing that managers deal with poor employees. Really? Then, it quickly describes generally-accepted reprimand techniques. Finally, it lists seven types of employee misbehavior, followed by corresponding explanations. Do you mean to tell me that a manager needs en explanation of what procrastination is? Incredible! The article seems to assume that managers were not previously aware that tardiness, temper tantrums, negative body language and others were types of employee misbehavior. Au contraire, a manager who hasn't already dealt with such misbehavior has a bigger problem than just a couple of bad employees. He or she has been sleeping all this time.

All employee problems starts with poor hiring. A good manager will immediately and clearly establish metrics and ambitious goals for the new hire from day one. Any deviation from the expected performance should be immediately addressed. As Reagan said, "trust, but verify". No surprises. In fact, trouble employees usually show their true nature fairly quickly as personal behavior tends to regress-to-the-mean.

But if consultants are such lightweights when it comes to delivering value, how is it that they stay in business? Well, because people like you or I spend too much on their services. But it must stop.

The article mentioned above made me remember one occasion at a trade show when a consultant attempted to sell me on the many services they offered. Within his pitch, he used the ROI acronym at least a dozen times. So, I stopped him. I asked him to explain what Return on Investment (ROI) meant to him. Nervously, as if I was the first person to ask ever, he fumbled as he tried to describe cost savings. To this, I asked why would he assume that I would spend any money? "If I spend nothing", I said, "there are no savings". Talk about hitting a concrete wall; the guy looked horrified. It was clear that they would not be able to bring value to us.

Perhaps the problem begins with the fact that consultants face zero accountability. All they have to do is make a beautifully bound presentation of their opinion. Anything beyond an opinion will depend on you or I. So you end up exchanging money for a custom made book. That is it; execution and performance are not part of the deal.

Don't settle for just an opinion. Demand Performance instead. Any service (or opinion) that can't pay for itself should be discarded. Often, you will even hear the common adage "in order to make money you have to spend money". I suggest you throw a yellow flag. You too can ask: "how about spending less money to make more money? Have you heard of that?" By the way, even your own employees may fall for such falsehoods. These types of phrases tend to make people who can't manage their own checkbooks at home sound capable of making investment decisions for you. As you can tell, I do not buy any of it. You shouldn't either. Demand real quantifiable ROI's, not just the marketing types. If you find consultants who can both project and deliver real returns, keep them. They are rare!