Rough Numbers

When Elephants Dance

2011-02-22T23:40:00.000-08:00

In the tech sector, there's an old saying, "When elephants dance, the mice get trampled." Lately, however, it seems the elephants may be doing more damage to each other-- and their stock prices -- than anything else.

Two weeks ago, Cisco announced weak results and disappointed the market with an uninspiring forecast for the coming quarter.

Perhaps most notably, Cisco's gross margins compressed by 4.3 percentage points from the prior year, suggesting increased competitive pressure in its core networking business plus the impact of lower-margins from some of its acquisitions in set-top boxes (Scientific-Atlanta) and consumer electronics (Flip Video). The market responded by taking Cisco down 15%

Tonight, after the market close, Hewlett-Packard reported earnings that beat expectations but on weaker-than-expected sales. In addition, the company's guidance for the coming quarter and full year was clearly below expectations, and the stock promptly sold off by 10-12% in after-market trading.

HP's problems were largely related to soft sales of consumer PCs (as opposed to enterprise sales, which propelled Dell to better than expected results last week) and its services business. In servers, networking and storage, where it increasingly competes with Cisco, HP enjoyed a boost in both sales and operating profit.

Despite optimistic forecasts for IT spending in 2011, the latest results are highly idiosyncratic, suggesting that a robust and widespread recovery in tech spending may remain elusive for awhile.

SOS! MayDay! Send the Life Rafts!!!

2011-02-14T17:22:00.000-08:00

P.S. Bring cash.

Source: WSJ

Source: Geek.com

Nokia's Burning Man

2011-02-09T11:22:00.000-08:00

In an unusually vivid and candid internal memo, recently installed Nokia CEO, Stephen Elop scolded his colleagues for Nokia's rapid descent from the world's leading supplier to mobile phones to also-ran status in high-end smartphones.

In what may prove to be an unfortunate metaphor*, he compares Nokia's plight to the choice faced by workers on BP's Deepwater Horizon drilling rig who jumped 100 feet into the pitch black Gulf of Mexico rather than burn to death.

"The State of our Company"
Photo credit, US Coast Guard

Summarizing the situation, Elop writes:

For example, there is intense heat coming from our competitors, more rapidly than we ever expected. Apple disrupted the market by redefining the smartphone and attracting developers to a closed, but very powerful ecosystem.
In 2008, Apple’s market share in the $300+ price range was 25 percent; by 2010 it escalated to 61 percent. They are enjoying a tremendous growth trajectory with a 78 percent earnings growth year over year in Q4 2010. Apple demonstrated that if designed well, consumers would buy a high-priced phone with a great experience and developers would build applications. They changed the game, and today, Apple owns the high-end range.
And then, there is Android. In about two years, Android created a platform that attracts application developers, service providers and hardware manufacturers. Android came in at the high-end, they are now winning the mid-range, and quickly they are going downstream to phones under €100. Google has become a gravitational force, drawing much of the industry’s innovation to its core.
Let’s not forget about the low-end price range. In 2008, MediaTek supplied complete reference designs for phone chipsets, which enabled manufacturers in the Shenzhen region of China to produce phones at an unbelievable pace. By some accounts, this ecosystem now produces more than one third of the phones sold globally - taking share from us in emerging markets.
While competitors poured flames on our market share, what happened at Nokia? We fell behind, we missed big trends, and we lost time. At that time, we thought we were making the right decisions; but, with the benefit of hindsight, we now find ourselves years behind.

Many observers expect Nokia to announce on Friday a partnership with Microsoft to use the Windows Mobile 7 operating system on Nokia smartphones. By my count, this will leave Nokia supporting three different operating systems: MeeGo, Symbian and WM7, which will hardly streamline their product development pipeline.

And doesn't that passage above -- "We fell behind, we missed big trends, and we lost time" -- pretty well describe the recent history of Windows Mobile?

* No doubt Mr. Elop's goal was to set the stage for some radical change at Nokia and I suspect the memo was leaked intentionally to create a "point of no return" to squelch continued internal debate or back-sliding on the issue. The memo clearly states that Nokia's executives must make decisions they would never consider under less dire circumstances. At a deeper level, however, if Nokia announces its intent to develop Windows-based phones, Mr. Elop's metaphor suggests that's a plunge a rational company would take only when the alternative is imminent death by immolation... hardly a resounding vote of confidence in one's new partner.

The engineering team might print up some "I'd rather develop a Windows phone... than burn to death." tee shirts.

Update February 11, 2001
As expected, Nokia announced a "broad strategic partnership" with Microsoft. under which Nokia would adopt Windows Phone as its smartphone platform. Curiously, the following disclaimer appears on the Nokia press release:

DISCLAIMER Nokia and Microsoft have entered into a non-binding term sheet. The planned partnership remains subject to negotiations and execution of the definitive agreements by the parties and there can be no assurances that the definitive agreements would be entered into.

In my experience, it is unusual for Microsoft to participate in an announcement based on a non-binding term sheet. This has the feel of a hurried deal, which may explain why Nokia's stock traded down nearly 15% today.

AOL Acquires Leading Media Company(2011 Version)

2011-02-08T23:05:00.000-08:00

This post was updated February 14, 2011 with a different version of the graph below. The scaling on the graph has been changed as well as the value for Twitter as explained below. The original version of this post is available at Seeking Alpha.

Last Sunday, AOL announced the acquisition of the Huffington Post for $315 million. The acquisition is right in line with the strategy Armstrong has articulated for AOL, and the management team deserves credit for its focus and decisiveness. Time will tell if they overpaid; it's notable that the HuffPo's shareholders took 95% of the purchase consideration in cash even as AOL's stock price is bumping around its all-time lows.

The ensuing press coverage is way out of line with the importance of the deal, probably because $315 million seems like such a big number for a five-year old, controversial and unconventional news site.

But most remarkable about this deal is how "conventional" it really is. AOL is simply amassing a stable of media titles under one umbrella, with the hope that it can figure out some scale economies before the cash flow from its dying ISP business runs dry. Michael Wolff has a pithy column on this topic here.

AOL is unabashedly becoming a content farm, much like the recently IPO'ed Demand Media. But with HuffPo and some of its other brands, AOL seems to think it can slap a brand name on its product (think "Chiquita" or "Sunkist") and get a small premium compared to generic produce. This may be a survival strategy, but it lacks the scalability to make it a big winner online.

After all, there are other brand name content providers on the internet, and this strategy hasn't really worked for them either. The websites of most metro newspapers in the US offer some pretty high caliber content, but revenue and a profitable business model remain elusive. The problem is not solved by replacing so-called "high priced" talent -- go ask a journalist how well she gets paid -- with low-cost freelancers generating search-engine optimized ad bait, because that's not the problem.

The problem is that, on the internet, there's a lot less value to the curation and aggregation of content (and ads) than there was in the pre-internet days when your local newspaper had a quasi-monopoly on the process. (See related post here). The value created by "organizing the internet" is captured by search sites like Google and social media sites like Facebook and Twitter that direct users to relevant content.

Take a look at the following graph, which plots "enterprise value" (the value of all of a company's stock, plus its net debt) against revenue for various companies.

(Click on chart to enlarge)

At the top, there are three highly scalable businesses: Google (GOOG), Facebook (FB) and Twitter, whose business models are based (currently and mostly) on the sale of advertising against content supplied by others. For Facebook I have assumed $1.8 billion in revenue and based on recent report, $50 billion of enterprise value. For Twitter, $45 million in revenue, $6 billion in enterprise value, halfway between the $4 billion value in its last financing and the $8 billion being rumored in a possible sale to Google or Facebook.

Then there are some traditional newspaper companies, the New York Times (NYT) and McClatchy (MNI). These two publicly listed companies are mostly "pure play" newsgathering companies working through the transition to the online world. Clustered among them are Demand Media (DMD), AOL and HuffPo, online media companies pursuing a distinctly conventional approach to curating and aggregating content.

Finally, I have added Yahoo! (YHOO), which is a bit of a tweener and the company AOL probably aspires to be... or to be acquired by. (see Note 1.)

Note that the axes are logarithmic scales. Adjusted for company size (since valuation is highly dependent on expected growth and hyper-growth gets harder as a company gets larger) market valuations are roughly 10x greater for the scalable businesses than for the content aggregation businesses. This is not surprising, since the scale economies in these businesses provide meaningful growth opportunities at enviable profit margins, something that investors used to say about newspapers.

I expect AOL will continue to acquire as its bank account and stock price permit and a merger with Demand Media would be a way to add acreage to the content farm, while eliminating the temptation for both companies to over-produce and drive down the value of their ad inventory. One can even imagine AOL merging with a traditional media company so long as the merger partner could suffer the inevitable comparisons with the ill-fated AOL-Time Warner merger a decade ago.

(Note 1. I have reduced YHOO"s enterprise value by approximately $7.5 billion, my estimate of the after-tax value of YHOO's passive investments in Alibaba and Yahoo! Japan in order to show a "pure play" value for the company.)

AOL Gives Itself a Swirly

2011-02-04T00:02:00.000-08:00

Business Insider has posted an internal AOL document, The AOL Way, on its website. It's a detailed 58-page slide show (ugh!) that provides a fascinating look at AOL's content strategy.

But I couldn't help noticing the image on the cover page. Is that the AOL logo circling the drain?

Curb Your Wheels

2011-01-21T14:34:00.000-08:00

A little while back, the San Francisco MTA issued me a parking ticket because my wheels were "insufficiently" turned to the curb. In actuality, my wheels were touching the curb, which meets the requirement that the curb act as a "check" to a potential runaway vehicle on any street with a slope exceeding three degrees.

I asked an MTA enforcement agent the next day (I'm pretty sure it was the guy who issued the ticket) whether it could be appealed and he basically replied, "You won't win, because you can't prove the enforcement agent made a mistake." He further explained that the MTA has a "performance requirement" which compels agents to issue tickets for sidewalk parking and wheel infractions so that lazy enforcement agents don't simply follow the street-cleaners and issue tickets for street-cleaning violations.

As I thanked him for his time, I couldn't help but notice the front wheel on his unattended vehicle.

Does MySpace Really Need to Ask This Question?

2011-01-21T09:17:00.000-08:00

MySpace misses me...

I'll file this under "Unintended and Painful Irony." Meanwhile here's a re-link to one of the funniest videos on the web, which foreshadowed this email by a year or two. And here's my take on the social networking wars.

Gotta hop... someone signed my guestbook at Classmates.com!

Thanks, Google Labs! - Books nGram Viewer

2010-12-17T16:11:00.000-08:00

(Updated January 24, 2011)
Google Labs has quietly introduced a new tool for linguists, historians, trend-followers and literary dilettantes with the ungainly name, "Books nGram Viewer."

The tool allows a user to plot the frequency of words (or phrases) in Google's vast archive of scanned books from 1800 through 2008. The left axis plots the frequency of occurrence of each word or "n-gram" (a two-word phrase is a "2-gram" a three-word phrase is a 3-gram and so on) as a percent of all the n-grams in the corpus.

Here is a plot (click to enlarge) of some of the most important media technologies in the last 150 years, smoothed with a 3-year moving average, restricted to books published in English. The graph nicely illustrates the typical S-curve diffusion of technologies, or more accurately, the general awareness of technologies. Interestingly, the fastest ascending curves are those for "radio," "computer," and "Internet."

It's also interesting that "computer" seems to have peaked, while "Internet" is approaching the popularity of "television."

(Click image to enlarge)

Click here to view in Google n-Gram Viewer

As useful and fun as this tool is, it currently has some important limitations, which one must consider before drawing conclusions about its output. For starters, Google's book-scanning project is a work in progress, hence some "trends" may reflect the types of books that have been predominantly scanned for one period or another. So if the proportion of science books that have been scanned varies widely from one decade to another, the frequency of technical terms and scientific subjects might appear to be changing.

Another limitation is that the n-gram search tool is case specific, so "Internet" and "internet" return vastly different results. It's a good idea to check both forms of capitalization. In addition, the tool does not yet support wild cards or stem searching. If I want to track the diffusion of the concept of the telephone, ideally I would want a search term like "telephon*," which would identify occurrences of "telephone," "telephones," "telephony" etc.

The tool also lacks the ability to group synonyms. The above graph would be more interesting if I could combine synonyms such as "wireless" and "radio" or "television" and "TV". (Indeed, the decline in "telephone" is mirrored by a similar increase in "phone" beginning in the 1940's and accelerating after 1960). One hopes that Google will add this feature, or allow users to download the data underlying the graphs to further manipulate the data. (Note 1). Until this feature is added, the utility is most useful for tracking the evolution of synonyms over time, or for comparing the use of precise, technically defined terms.

So in true Beavis & Butt-head tradition, I feel compelled to offer this plot below of "penis", "vagina" and "clitoris."

This one took me partially by surprise. I expected that the clitoris might have received relatively scant attention compared to the primary sex organs, but I'm struck by the 80-year surge in relative popularity enjoyed by "vagina" in the mid-nineteenth century.

Any scholars of Victorian erotica out there who can shed some light on this one?

Update (January 14, 2011)

The Victorians are absolved. Further analysis shows that the relative popularity of the vagina in the English language corpus is almost entirely a colonial affair.

Here are the separate plots for British English and American English.

British

American

The scaling on the two graphs is very nearly the same (another feature request: user-defined scaling, please!) so clearly the higher frequency of "vagina" occurs mostly in the collection of U.S. English titles. Interestingly, there is a noticeable, sharp spike in the relative frequency of "vagina" in the British corpus that begins almost immediately after Queen Victoria's death in 1901.

Note 1.

Google does make the entire dataset available for download, but it does not currently allow one to download the raw data associated with a specific search request.

Incumbents Beware

2010-10-14T22:31:00.000-07:00

Percent of Labor Force Unemployed for 27 weeks or more

This November will be an especially challenging time to be an incumbent with long-term unemployment at a post-war high. With those unemployed for more than 27 weeks representing 4% of the workforce, we are in uncharted territory when it comes to voter dissatisfaction with the status quo. There will be lots of commentary about Democrats vs. Republicans vs. Tea Party extremists, but the overriding theme will be "throw the bums out."

It's well-known that recessions are generally not kind to incumbents; and according to the NBER, the recession officially ended in July 2009. But a quick glance at the chart above shows that rising levels of the long-term unemployed were associated with the incumbent party losing the White House in 1960, 1980 and 1992.

Incumbents can take some comfort from the slight tick down in the long-term unemployment rate over the past few months, but with the absolute level nearly double the '80 - '81 peak, November 2 promises to be a bitter night for incumbents from both parties.

Source: St Louis Federal Reserve

AXA's Asteroid

2010-04-29T11:27:00.000-07:00

Gizmodo has published a wonderful photo of asteroid P/2010-A2 taken by the Hubble telescope that shows a striking similarity to AXA's corporate logo.

Maybe readers can help here. Didn't AXA previously use a logo of a stylized archer that looked even more like asteroid P/2010-A2?

Or am I remembering someone else's logo?

Google Image Search has been of no use identifying the logo I seem to recall.

Keeping up with the News Cycle

2010-03-19T00:13:00.000-07:00

More than a week has passed since the release of the "Report of the Examiner in the Chapter 11 proceedings of Lehman Brothers Holdings Inc" so naturally coverage of the report is moving beyond reaction to reflection.

I have a few thoughts on the report -- and the reporting on the report -- that I'll write up in separate posts as they're of interest to different audiences. This post offers my thoughts on the "reporting of the report" and the changing media landscape.

It remains popular within the mainstream media to dismiss the blogging community as mostly commentators rather than reporters. What's more, according to the MSM types, most of the fodder for the blogosphere's ruminations comes from reporting in the mainstream media.

The clear implication is that without the mainstream media to painstakingly investigate, write, edit and publish the news in the first place, the blogosphere would be reduced to self-indulgent opinionating and bloviating, like, for example the content you'd expect to find on MySpace.

Even worse, according to the extreme form of the argument, the lack of professional standards and good editing in the blogosphere can lead to reckless "reporting" with potentially costly consequences.

So I was puzzled last weekend when the NYT's editorial page asserted that Lehman Brothers, in the last quarters prior to its September 2008 bankruptcy filing, engaged in repo transactions that removed "troubled assets" from its balance sheet.

My surprise arose not from Lehman's conduct (although the Times professed to being "dumbstruck" and "blindsided") but from the fact that I quite specifically recalled the report, right on page 796 saying:

...the vast majority of securities Lehman utilized in Repo 105 transactions were investment grade, with all but a few of the securities falling within the A to AAA range.

Curious how the Times editors were so perfectly misled on this point, I went back to the paper's original story on the Lehman report, only to find the following correction.

Correction: March 13, 2010

An article on Friday about an examiner’s report detailing accounting maneuvers used by Lehman Brothers to conceal its perilous finances described incorrectly in some editions the assets that were temporarily shuffled off its books. They were mostly high-quality securities that could be easily accepted by other banks, according to the examiner’s report; they were not “troubled” and “mostly illiquid real estate holdings...”

So here we have a Times story, written under deadline, that gets a key fact exactly wrong, followed by a correction. Okay, stuff happens. But what must be especially embarassing to the Times is that the newsroom appears to have noticed and corrected its error before the editorial page went to bed with the wrong fact 24 hours later... kinda like a blogger spouting off his opinion about something he read online, without checking the veracity of the story.

Even worse, a week later (March 17) the New York Post, which apparently gets its facts from old copies of the Times, publishes this:

Among Valukas' findings is that Lehman used an esoteric accounting practice known as 'Repo 105,' which allowed the firm to move toxic mortgage assets off its books in order to make it seem healthier. (emphasis mine)

Update, March 22:

And Wiliam D. Cohan, who apparently has annotated the Examiner's Report, asserts in a March 18 NYT column:

...we now know that one executive after another at the firm signed off on the now infamous “Repo 105” trick in order to move some $50 billion of squirrelly assets off Lehman’s balance sheet at key moments. (emphasis mine)

Don't these guys have time to read the financial blogs?

No doubt the authors of these stories are bright and industrious and take pride in their work. Which makes me think the underlying issue is structural. When it comes to reporting complex news stories, the mainstream media's reporting conventions may leave it competitively disadvantaged versus the blogosphere.

For example, the "inverted pyramid" approach to a traditional news article gives short shrift to second- and third-level details, which may be summarily discarded if the 'news hole' that day is too small. At the margin, this may act as a disincentive to fully vet details that may not get printed.

The need to present both sides of the story "objectively" requires time-consuming phone and email contacts for "On the one hand... on the other hand..." quotes from so-called expert sources who likely possess less knowledge about fast-breaking news than the reporter himself. (Michael Kinsley has written and Kara Swisher has spoken (a little past the 10:00 minute mark) far more eloquently about this issue, so I'll refer you to them.)

Finally, for print journalists, the need for a "static" version of a story to meet the circadian publishing cycle creates constraints that a living story on a blog doesn't face.

Not so long ago, a "Report of the Examiner in the Chapter 11 proceedings of Lehman Brothers Holdings Inc" would have been released in a small press conference in New York City, where a smattering of lawyers and business journalists would lug their 2200-page copies back to the office to research potential lawsuits or the news angle. But the public at large would not have had convenient access to the source materials until they arrived at the local library, if at all. So journalists of yesteryear enjoyed quasi-monopolistic access to much of the source material for the important stories of the day.

A recent Pew Research Center study of news dissemination in Baltimore found that 63% of news stories originated with government entities. News organizations originated 14% and the remainder were largely from interest groups. This suggests that 86% of the "news" is originated (that is to say, "published") by government and private non-journalistic organizations. Increasingly, these stories are being published online, where they're immediately available to all interested readers. And for a story of any complexity, the party most qualified to comment may in fact be some guy (a former Lehman repo trader, perhaps) posting in his pajamas from his basement office.

If you've read this far, you deserve a reward, so I'll give the last word on the subject to the writing team on NBC's hit comedy,"30 Rock," who nail the topic with brutally efficient satire. ~~Currently, No longer,~~ Once again available, on Hulu (4:30 into the show).

In the scene, Avery Jessup a fictional, on-air reporter for CNBC (played by the adorable Elizabeth Banks) calls her lover, Jack Donaghy (played by Alec Baldwin) a senior executive at NBC, about a rumored takeover of NBC.

Phone rings in Donaghy's office.

Jack Donaghy: "Hello?"

Avery Jessup: "Answering your own phone on the first ring... It's all hands on deck over there, huh?"

Jack Donaghy: "Whaddya mean?"

Avery Jessup: "C'mon the NBC buyout... what's happening today?"

Jack Donaghy: (Increduously) "I'm sorry... You're calling me as a source? How are you going to explain your unnamed executive to your producer."

Avery Jessup: "I'll tell him it's a guy I'm having sex with... It's a 24-hour news cycle here, Jack. We really don't have time to do it right any more."

Anton R. Valukas, Speed Reader

2010-03-18T16:54:00.000-07:00

Anton Valukas is not only the Chairman of Jenner & Block and author of the recently released report on the failure of Lehman Brothers, but he may be the world's fastest reader.

According to the New York Times, in preparing his Lehman report, Mr. Valukas " ...reviewed by his own estimate about 34 million pages of email."

Since the the appointment of Mr. Valukas was mandated on January 16, 2009 and the report itself is dated March 11, 2010, it appears Mr. Valukas had exactly 419 days to prepare his report.

419 days

x 24 hours per day

x 60 minutes per hour

x 60 seconds per minute

= 36,201,600 seconds, or about 1.065 seconds per page.

I don't question Mr Valukas' stamina or work ethic, but I assume he must've taken some time to sleep and eat and run his law firm during the past year, so we're using the word "review" pretty liberally when we're discussing 34 million pages.

It's unlikely that Mr. Valukas had any time to chuckle at the occasional joke, admire a well-turned phrase or marvel at some prescient prediction that he uncovered in his reading.

Sadly, the Times article fails to reveal whether the 34 million pages were delivered to Mr. Valukas electronically or on paper. If it was on 20 pound paper, Mr. Valukas's pile of "evening reading" would've been 3,060 meters high, roughly seven times taller than the Sears Tower in Mr. Valukas's hometown of Chicago, and it would've weighed about 170 tons.

If he carried it home in equal parts each night, his briefcase would've weighed 800 pounds.

Addendum: The Lehman report is exceedingly well-researched and written. Give Mr. Valukas's team credit for reading the mountain of emails more thoroughly than a number of journalists read the final report. See my related post.

(The first version of this post missed a decimal point and claimed Mr. Valukas reading assignment would've been merely 306 meters high. The math is 9 cm per 1000 pages x 34,000 / 100 = 3,060 meters. And I know the Sears Tower has been renamed the Willis Tower, but call me old-fashioned. I still call the MetLife building in NYC the "Pan Am Building" and nobody is confused.)

Apple Introduces the iPad iPod Classic

2010-01-29T10:20:00.000-08:00

Are Newstands Hazardous to Newspapers?

2010-01-21T08:20:00.000-08:00

International Business Times reports on an Outsell study with the headline, "Nearly half of Google News users just skim headlines.

According to the IBT article, "The findings give further ammunition to publishers who insist that Google and other news aggregators are linking to their stories without paying any advertising revenue."

I'm not entirely sure why publishers need "further ammunition" to establish a stipulated fact. Yes, Google links to news stories. And no, Google generally does not pay for linking to news stories, just as it does not pay me to link to this blog. But the conclusion above is a non sequitur teetering on a counter-factual.

What would indeed be interesting and relevant is understanding whether Google is generating significant ad revenue from the 44% of users who scan headlines without clicking through to the underlying stories.

Here's an "above the fold" screenshot I just took of Google News (click to enlarge). If I come to this page to skim the news, it's hard to imagine there's much revenue associated with my visit. In fact, I'm at a loss to find a revenue-generating ad element on this page at all.

"But wait," claim the publishers, "If Google wasn't aggregating these links, then headline-skimming readers would come directly to our websites, where we'd make money by loading our landing page with display ads that these readers rarely notice." Well, maybe... but that's an easy experiment for any publisher to conduct; and if it were demonstrably true, publishers would be opting out of Google's indexing service in droves.

There's an alternative experiment that anyone can conduct. Stand next to a newsstand in a busy office building or subway station. Count the number of passers-by who glance at the papers ("stealing the headlines" as it were) as they pass. Exclude paying customers. At the end of the day, calculate the ratio of headline-glancers to newspaper buyers. Is it higher than 44%?

Extra credit: Calculate the revenue from the non-paying commuters who skim the headlines as they pass using two different methodologies:

(1) How much did they actually pay?

(2) How much additional revenue would you make if every one of them bought a newspaper?

If your answer to question (2) is greater than your answer to question (1) do you believe you can sell more newspapers by putting them in brown wrappers that hide the front page?

Alternatively, do you believe newspaper circulation would increase if newstands were abolished?

Was Wall Street Deriving While Impaired?

2010-01-14T08:07:00.000-08:00

In the aftermath of the 2008 global financial crisis (at least I hope we're in the aftermath) observers of the financial markets continue to debate its underlying causes. Some point to executive compensation, which supposedly encouraged excessive risk-taking. Others blame excessive leverage (the most basic form of risk-taking) and finger the Federal Reserve for maintaining artificially low interest rates from 2002 to 2005. Other critics believe that a surge in esoteric and poorly-modeled derivatives allowed banks to pretend that a substantial increase in risk and systemic co-dependence was safely hedged.

But an article in "Science Translational Medicine" offers a simpler hypothesis consistent with lowered inhibitions, excessive risk-taking and impaired judgment: Wall Street was three (spread)sheets to the wind.

Now I'm not suggesting that investment bankers were drinking at work... at least not more than usual. But 100-hour workweeks are not uncommon on Wall Street, and as Bloomberg quotes the study, "Staying awake for 24 hours straight equals having a blood alcohol concentration of 0.10 percent, beyond the 0.08 percent legal limit for driving in the U.S."

You wouldn't give your car keys to a sleep-deprived, cognitively-impaired twenty-two year old, but bet a billion dollars (levered 10:1) on the AAA-rated tranche of a 30-layer, collateralized debt security that he modeled at four in the morning? No problem.

Memo to AT&T: Help Me Help You

2009-12-18T14:35:00.001-08:00

This summer I wrote about AOL and how widespread service failure can actually be a bullish signal for a company, if the company responds correctly.

This week, AT&T Mobility Chief Executive Ralph de la Vega disclosed that AT&T was considering "incentives" to encourage customers, especially data-guzzling iPhone users, to reduce the amount of wireless bandwidth they consume. To which, Dan Lyons, in the persona of Fake Steve Jobs, responded in a typically humorous and profanity-laced post:

"So let’s talk traffic. We’ve got people who love this goddamn phone so much that they’re living on it. Yes, that’s crushing your network. Yes, 3% of your users are taking up 40% of your bandwidth. You see this as a bad thing. It’s not. It’s a good thing. It’s a blessing. It’s an indication that people love what we’re doing, which means you now have a reason to go out and double or triple or quadruple your damn network capacity. Jesus! I can’t believe I’m explaining this to you. You’re in the business of selling bandwidth. That pipe is what you sell. Right now what the market is telling you is that you can sell even more! Lots more! Good Lord. The world is changing, and you’re right in the sweet spot."

This is the "America Offline" problem all over again. Consumers on a flat-rate bandwidth plan with a choice of 100,000 apps to run on their iPhones want to take advantage of all the cool stuff they can do with what is essentially a pocket-sized computer. When it faced a similar problem, AOL responded by aggressively adding bandwidth and signing up 27 million households at its peak. True, things eventually went south for AOL... but come to think of it, if AOL had figured out how to offer even more bandwidth by offering its customers a migration path from dial-up to broadband, it might not be the shrunken colossus it is today.

It's been a rough week for AT&T. Mr. de la Vega's disclosure of AT&T's thinking absent any specific proposals led to a groundswell of online suspicion, complaints and rants about AT&T's wireless service at a time when Verizon is aggressively attacking AT&T's 3G wireless coverage in a series of pointed and amusing ads. What's worse, when Dan Lyons (half?) jokingly suggested that subscribers should engineer a "chokehold" on the AT&T network by using bandwidth-intensive applications at a coordinated time, the meme spread via Twitter and Facebook and was picked up by the mainstream media, ensuring that by the end of the week, every sentient American was aware, at a minimum, that lots of other people thought AT&T's wireless service sucks.

The Verizon marketing guys are undoubtedly enjoying an extra round of drinks at happy hour this evening.

AT&T, here's what I'm willing to do to help.

Send me one of those 3G Microcell devices you've announced but seem to be testing only in Charlotte, North Carolina. I'll hook it up to my home network and it'll route my iPhone calls from my home over my DSL service instead of your wireless network.

Admittedly, this isn't going to free up much existing bandwidth on your wireless network, because -- ahem -- I don't make too many calls from the one window on the third floor where I can actually get two bars of service. But at least my cell phone will work in my house and you won't have to put up another tower in the vicinity, so we'll both be ahead.

Oh, and when the 3G Microcell arrives, I don't want to pay $150 for it, nor do I want to pay an additional $19.99 or even $9.99 per month to use it on top of the $100 per month I already pay for my cell phone service. After this week, do you really want to deal with the PR implications of that pricing model? "Unhappy with your cell-phone service? Now you can pay more!" Trust me, you really don't want to go there.

But I'm a reasonable guy, so let me know what your marginal cost is for the millionth unit you manufacture, and I'll pay that.

Now comes the good part. If you build appropriate security into the device, I'll let strangers in my neighborhood route their calls through it too! That will free up bandwidth on your network, provide more coverage and save you money. Even better, you could offer the same deal to my neighbors and pretty soon, you might not see any wireless traffic on your network at all in this neck of the woods. Hell, if y'all want to have some real fun, pay me to switch to Comcast high-speed internet and together we'll route your traffic over their network. This net neutrality stuff is delicious with irony if you just work at it a little.

Admittedly, I didn't think this up all by myself; engineers and entrepreneurs have been talking about wi-fi mesh networks for awhile, but now you have an economic incentive, a user base and a compelling business reason to make it happen.

Rarely in business do you get an opportunity to see the future so clearly because the past provides such a compelling example of how to act.

Let's make this happen, whaddya say?

Can Newspaper Ad Revenue Recover in 2010?

2009-12-17T13:49:00.000-08:00

This is a short excerpt of a longer post I am preparing on newspaper print advertising trends, but a post today by Alan Mutter encouraged me to publish this small excerpt.

Mutter expresses skepticism about the rosy advertising scenario presented by U.S. newspaper executives in a survey conducted by Kubas Consultants. As this table from the Kubas report shows, newspaper executives are hoping for flat advertising revenue in 2010, with a 15% increase in online (approximately 10% of 2009 revenue) offsetting small declines in every print category.

I am particularly curious about the poll's findings regarding retail advertising, which after the steep declines in classified advertising over the past few years, will account for just over 50% of total print ad revenues in 2009, making it the biggest driver of the overall results.

The following graph (click to enlarge) plots retail ad revenue per subscriber against per capita personal consumption expenditures (PCE) for 1952 - 2009. Both the ad revenue and PCE data have been adjusted to constant 2008 dollars using the consumer price index (CPI-U).

Presumably there is a relationship between the amount of goods and services companies sell to consumers each year (represented by PCE) and the amount those companies are willing to spend to reach each consumer or household by advertising in newspapers.

And indeed there is a relationship, or more accurately, several relationships. From 1952 through 1990, newspapers sold retail advertising equal to about 1.76% of personal consumption expenditures on a predictable basis. Coming out of the 1990 recession, however, there was a clear downward shift in the relationship and for the next decade, retail ad sales ran at about 1.52% of personal consumption. (see note 1).

After the 2001 recession, there was another shift down in the relationship between ad spending and personal consumption; and for the next five years, retail ad spending in newspapers was basically flat in real terms. It's worth noting that in real terms, retail ad spend actually peaked in 2000.

Finally, since 2006, real retail ad revenue has plummeted as the recession took hold (in December 2007) and consumers abandoned their free-spending ways.

Recessions often act as antidotes to inertia by making households and companies (link added 04/15/10) reassess how and where they spend their money. Advertisers almost certainly used the past two recessions to reassess their spending in newspapers, and it's a fair bet they'll do the same as the current recovery unfolds.

A slavish reading of the most recent trend suggests that retail ad spending will simply continue to plummet like a rock falling off a cliff. This could happen, but I doubt it. Ad spending, even in newspapers, should respond to an eventual recovery. But making economic predictions around recessions and recoveries is notoriously difficult since prior recessions and recoveries provide limited relevant precedent. To paraphrase Tolstoy, if periods of prosperity are all alike, every recession unfolds in its own way.

But I'll take a stab at it. In a related analysis, I have compared changes in retail ad spending to changes in PCE on a quarterly basis. This analysis suggests that it will take real growth of 3.2% in per capita PCE just to keep retail ad spending per subscriber flat. It would take a sharp "V-shaped" recovery to reach that level of growth, but the WSJ has published a consensus estimate of 3.8% for GDP growth for 2010.

If GDP does grow at 3.8% and per capita PCE matches this growth, retail ad spend per subscriber could come in at +1.5% in real terms. Add 2.0% for inflation if you believe that newspapers will have any pricing power, then subtract 3% for subscriber attrition and you get 0.5% growth.

More pessimistically, if you assume GDP growth (and PCE) come in at 1.7% (the average from the 1992 and 2002 recoveries), retail ad spend per subscriber could come in at minus 4.0%. Assume no pricing power and subscriber attrition of 5% and overall retail ad spending would shrink by 9%

The precision of the numbers should not mislead about the confidence of the forecaster, but for my money, I think a range of flat to down 10% for newspaper print advertising feels about right.

note 1. A more precise, but likely less clear statement about the relationship would say, "From 1952 to 1990, for every $1,000 increase in real consumption expenditures per capita, spending on retail ads (per subscriber) in newspapers increased by 1.76% of this amount, or $17.60." For each of the regression lines, the intercept terms are small enough to make me comfortable with statement in the text.

note on data sources. Annual retail ad spend and paid circulation data comes from the Newspaper Association of America website. Personal Consumption Expenditure data, Consumer Price Index - All Urban and Population data are from the St Louis Federal Reserve Bank's FRED database.

Murdoch's Sun Encourages File-Sharing, Deep Linking

2009-12-04T16:24:00.000-08:00

The theme's been done before, but News Corp's tabloid, The Sun is running an advert touting the paper as "The UK's Best Handheld for 40 Years."

The spot is cute, if a bit predictable; but what struck me was the message, "This is how easy it is to share content with friends" (at the 0:38 mark).

Newspaper Circulation

2009-11-03T10:54:00.001-08:00

The Audit Bureau of Circulation's report last month showed daily newspaper circulation plunging 10.6% from year-ago levels, a dramatically steeper decline than the historical trend. Not surprisingly, many commentators see the accelerating decline as the end (or at least the terminal stage) of the newspaper format. And they'll be right in less than a decade if circulation continues to drop by the current pace of 4-5 million subscribers per year. On the other hand, Daniel Gross over at Slate is not so sure and he recommends that we all just "chillax". In Gross's view, the recent decline may be largely explained by general economic conditions.

"... there's nothing ipso facto shocking about a decline in patronage of 10 percent in six months... In case anybody has forgotten, we've had a deep, long recession, a huge spike in unemployment, and a credit crunch. Consumers have cut back sharply on all sorts of expenditures.... Many other components of consumer discretionary spending—hotels, restaurants, air travel—have fallen off significantly. Do we draw a line from trends over the last few years and declare that in 15 years there will be only a handful of hotels? I'm not sure why we would expect consumption of a purely discretionary item that costs a few hundred dollars per year not to fall in the type of macroeconomic climate we've had."

Gross also reminds us that many publishers took steps that predictably reduced circulation, including raising prices and discontinuing home delivery to outlying suburban areas that could no longer be served economically.

Extrapolating from two data points is a highly uncertain business so Gross is right to recommend caution, especially when current cyclical factors may greatly exaggerate secular trends. For his part, Gross declares, "At some point in the future, newspapers may disappear. But count me in the later rather than sooner camp." But a peek at longer-term trends suggests that difference between "sooner" and "later" may be shorter than one might think. The chart below plots total daily circulation from 1940 through 2009 (the shaded areas indicate recessions).

(click chart to enlarge)

These circulation numbers come from the Newspaper Association of America (spreadsheet available here). For 2009, I have reduced the NAA's 2008 statistic by the Audit Bureau of Circulation's estimate that April-September 2009 average circulation was down 10.6% from the prior year period, resulting in an average daily circulation estimate of 43.4 million for 2009. (Over at his Newsosaur blog, the estimable Alan Mutter extrapolates a 2009 estimate of 39.1 million, but without his underlying data, I cannot reconcile that number to the NAA historical estimates, which are probably counted differently from the ABC numbers anyway).

The long-run trend is unmistakable. Circulation peaked 36 years ago, in 1973 but remained relatively stable until the 1990's when it began a steady downward trend, which accelerated in 2003, and appears to have accelerated even more in 2009.

The data provide some support to Gross's thesis: in the 1974 slowdown and the 1980-82 "double-dip" recession, circulation declined temporarily, but rebounded with economic recovery. By my calculations, those recessions caused circulation to decline about 2.2% vs. the trend from the five years preceding the recession.

More recently, during the two relatively mild recessions of 1990 and 2001, if the recessions caused any decline in circulation, there was no subsequent recovery. In fact, the decline in circulation accelerated as the economy emerged from those two recessions. So I suspect Gross is right that the current recession has accounted for some of the circulation decline; but if past recessions are any guide, the measured 10.6% decline reported by the ABC might be only 8.0-8.5% in a healthy economy. This is hardly reassuring news for the industry and recent history argues against a significant post-recession rebound. Even ignoring the recent plunge, if the trend from the past five years (excluding 2009) were to continue, total daily newspaper circulation would fall to 33 million by 2020, which seems optimistic in light of the manifest challenges faced by the industry.

It's also useful to consider newspaper circulation per household. By this measure, newspaper circulation has been declining steadily since World War II with most of the decline coming from the near-extinction of the afternoon daily. Over half a century, circulation per household has declined by 1.4 percentage points per year with remarkable consistency.

(Click chart to enlarge)

No doubt the introduction of evening newscasts on television 50 years ago reduced the perceived value of the afternoon paper, but even in 1980, the year CNN was launched, afternoon circulation actually exceeded morning circulation. Since then, afternoon circulation has all but disappeared. Morning circulation, which trended up in the 1980's (presumably as afternoon subscribers switched) and was relatively flat during the 1990's, has been dropping steadily since 2000, around the time that household penetration of high-speed internet access began in earnest.

(Click chart to enlarge)

As with the raw data, extrapolating the current year's trend suggests that newspapers would cease to exist by 2017. This is the "breathless" conclusion Gross warns us against, and his caution is warranted because (if for no other reason) as marginal subscribers quit, the remaining subscriber base is, by definition, the most loyal to the medium.

Still, longer-term trendlines based on the full data set and the period since 1999 yield very similar predictions, namely that circulation will fall to about 20% of U.S. households by 2020 (I'm ignoring the fact that some households may take multiple papers). Against the backdrop of the long-term trend, and with the internet acting as an obvious catalyst for further declines, this prediction seems entirely plausible.

But even if a loyal subset of households want their morning newspaper, the bigger question is whether the business model will continue to work at decreasing scale. As I have argued elsewhere, the newspaper industry historically enjoyed enviable returns to scale. As the industry shrinks, it may fall through a threshold level of scale (call it the "Tripping Point") below which the model is irretrievably broken and the publishers themselves pull the plugs on the presses.

Where might this threshold be? The approximately 40% decline in advertising revenue over the past 18 months put many papers through a near-death experience. Even if ad spending returns to pre-recession levels, a 40% reduction in circulation from today's levels (which would occur in 2018 according to the long-term trend) might be unsustainable if it implies a corresponding 40% reduction in ad revenue.

Further, if only two out of ten households take the morning paper at some point in the next decade, can home delivery continue to be justified? At some point, route density starts to work against the industry and the paper-boy may go the way of the milkman.

Chicago Trib to AP: "Cancel my subscription"

2009-11-03T07:51:00.000-08:00

The Chicago Tribune is testing whether it can live without Associated Press content.

Is Virtual Farming Bigger than Actual Farming?

2009-10-29T00:45:00.000-07:00

The NYT has an article today that claims 62 million people have signed up to play Farmville on Facebook.

I am not one of these 62 million, so you'll have to read the NYT article (or ask any random 5 people in the U.S., one of them is likely a Farmville player) how the game actually works. But I am fascinated by the economic effort expended on Farmville.

According to the Bureau of Economic Analysis (see page 9) the total economic contribution from U.S. farming in 2007 was $137.3 billion. Dividing $137.3 by 62 million Farmville registrants equals $2,215 per user per year. Divide $2,215 by the current minimum wage ($7.25 per hour) and you get 305 hours. Divide 305 hours by 52 weeks and you get roughly six hours per week.

If Farmville players are spending six hours per week on this game, the opportunity cost of the Farmville economy may be larger than the actual U.S. agricultural sector.

And, no, I will not adopt your lost cow.

Monkeys, Typewriters and The Odds of the Governor's Hidden Message

2009-10-28T11:42:00.001-07:00

Everyone's heard the theory that with enough chimpanzees, typewriters and time, you'd eventually produce "Hamlet."

Shakespeare it's not, but California Governor Arnold Schwarzenegger's office today released a letter to the California State Assembly vetoing Assembly Bill 1176. A number of commentators have noticed a sub-textual message composed by the first letter of each line. The governor's office has called it "unintentional" and a "weird coincidence."

How weird? What are the odds that seven lines of a note could just happen to spell out this particular message? Would you believe less than one in 2.7 billion?

The math is surprisingly simple. Assume that each of the seven important lines of the letter have to start with a word (no hyphenation) that itself begins with a specific letter. The odds of randomly coming up with the Governor's message is then the product of the odds of each of the seven letters occurring as the first letter of all the words in the English language.

Surprisingly, a quick scan of the web didn't uncover a complete list of beginning-of-word letter frequency for English (how 'bout some help here, Google?) but I did find this top ten list.

Letter	Frequency
T	0.1594
A	0.1550
I	0.0823
S	0.0775
O	0.0712
C	0.0597
M	0.0426
F	0.0408
P	0.0400
W	0.0382

Source: Top 10 Beginning of Word Letters

So here's the math (using < 0.0382 for "u", "k" and "y" which don't make the top ten.

f = .0408 x
u < .0382 x
c = .0597 x
k < .0382 x

y < .0382 x
o = .0712 x
u < .0382

<= 3.693 x 10^(-10) or approximately one in 2.7 billion.

Some coincidence... the governor may have some especially talented chimps on his staff.

Really?

2009-10-27T08:52:00.000-07:00

Gotta get me a set of vegan snow tires.

Does Barry Diller Watch "The Office"?

2009-10-08T22:06:00.000-07:00

Barry Diller, a very smart guy and CEO of IAC/Interactive Corp, once famously dissed "user-generated content" (a progressively meaningless phrase) by suggesting that there's a limited audience for videos of "... a cat throwing up on your grandmother."

A few minutes ago, I finished watching NBC's one-hour episode of "The Office" featuring Pam and Jim's wedding, ~~now, no longer,~~ again available at www.hulu.com. It was, as always, charming and brilliantly executed. But most notable was the closing five minute sequence which was a lovely homage (fair use?) to "Jill and Kevin's Big Day" on YouTube, which features Chris Brown's song, "Forever".

Here's "The Office" version.

Art and reality reflect each other in infinite recursion. And tonight's episode of "The Office" may cause Mr. Diller to re-think his cat vomit thesis. Somewhere out there in UGC-land, Jill and Kevin had an inspired idea, arguably violated Sony BMG's copyright, choreographed five very special minutes of their lives, posted it on the internet, and created a sensation (28 million views!) Now that NBC has picked up the theme (in a show that ironically poses as documentary) it will probably drive another 50,000 iTune downloads for a guy currently serving six months of community service in Virginia.

Is this a great country, or what?

P.S. Even if you don't usually watch the show, check out the opening 1:45 below. For a more ham-fisted use of the vomit theme, check out Microsoft's online ad (since pulled) for Internet Explorer 8.

Lost in Transition?

2009-09-15T10:48:00.000-07:00

The WSJ website has a nice interactive on the anniversary of Lehman Brother's bankruptcy, which displays the WSJ front pages from that momentous week. For those of us who followed the markets and the story, the series of images captures the urgency and drama of the Lehman collapse and its aftershocks in the financial markets.

But for me, what is most striking about these headlines is that until yesterday, I had never seen them. I'm a regular reader and have been a WSJ subscriber for twenty-five years, but gave up the print edition several years ago. Consequently, I consume my WSJ one story at a time and unless I see the print edition at a newsstand or on someone's desk, I generally don't see the front page the way the editors pasted it up.

One thing that newspapers do well (that Google hasn't automated... yet) is to make editorial decisions about how the day's most important or interesting stories are laid out, with subtle emphasis conveyed by position, allocation of space and type size. So it's somewhat surprising that as newspapers wrestle with the transition from print to online, their websites (well at least the WSJ, New York Times and San Francisco Chronicle) don't feature the front page more prominently on their home page.

As readers inevitably gravitate to the web, it would be a shame if we lose the shared recognition of those iconic front pages that mark the major news events of our lives.

What Hath Tech Wrought?

2009-07-30T10:44:00.000-07:00

Here's a paragraph from today's WSJ that neatly captures some of the themes I've been exploring about technology's impact on business models, corporate life-cycles and investment horizons.

"Kodak spent $3.4 billion from 2004 through 2007 converting the bulk of its 129-year-old business from high-margin film to more competitive electronic technology. It is in the midst of cutting 3,500 to 4,500 jobs, which could reduce its work force to a 1930s-era low of 19,900 from a 1988 peak of 145,300."

It's worth noting that the enterprise value (equity value plus net debt) of EK is a little under a billion dollars today (at roughly $3.00 per share.) Including pension liabilities of $2.4 billion in the net debt calculation increases the enterprise value to roughly $3.4 billion, equal to the amount Kodak invested over four years to convert from a film-based to an electronic imaging company.

Under the most generous interpretation, the market is valuing Kodak's 129-year history at zero right now, despite it's highly recognized brand and long tradition of technological innovation.

AOL - R.I.P.?

2009-07-25T09:39:00.000-07:00

(updated July 30 to include note 2.)

Saul Hansell has put together an illuminating timeline of AOL's sad decline over the past decade at his New York Times blog.

As Tim Armstrong, who recently took the helm at AOL, attempts to revive the company, I am reminded of one of Warren Buffet's most popular aphorisms: "When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is usually the reputation of the business that remains intact."

To be fair, AOL is not completely dead yet. According to press reports, the company was valued at around $5 billion based on Time-Warner's recent buyback of Google's 5% interest in AOL, but the real valuation is likely half to two-thirds that much (see notes 1 and 2). In the quarter ended June 30, 2009 AOL reported operating income of $271 million on revenue of $804 million (see page 19 of filing). At quarter's end, AOL still counted 5.8 million paying subscribers for internet access, but lost 500,000 subs in the quarter. At it's peak, AOL claimed 27 million subs and was the world's most visited website. Today, acording to Alexa, AOL.com is the 35th most popular site, only two places behind Google's Italian search site and a distant 33 places behind Yahoo. So if AOL is not quite dead, it does look a bit like the guy over John Cleese's shoulder in this classic Monty Python bit.

I have been an AOL skeptic for a long time, going back to the mid- to late-1990's when it's widely publicized service failures gave rise to nicknames like "America Off-line" and "America On Hold".

My skepticism was primarily related to the "walled garden" approach to the internet that made up AOL's content offering. While this "internet-on-training-wheels" offering clearly worked for internet novices, it always seemed fundamentally disadvantaged to me. It just seemed unlikely that a single company could pay its employees and moderators to "summarize the internet" when the internet itself was available for free. And over time, new and improved (and free) internet browsers and portals like Yahoo (also free) and search engines like Google (again, free) made the internet easily navigable, rendering AOL's walled garden of content embarassingly superfluous. At bottom, I always saw AOL as a dial-up internet service provider whose attempts to become a content company were doomed by an infinitely more powerful force that, ironically, AOL itself helped enable.

And writing this in 2009, I feel reasonably sure that my decade-old instincts were correct in the long run.

But there was a period, let's call it 1997 through 1999, during which I was spectacularly wrong about AOL (or at least about it's stock price) and I am grateful for my employer's compliance restrictions that prevented me from shorting the stock.

The AOL saga illustrates some classic themes for technology and growth stock investors.

1) In the long-run, technology matters... a lot. Ultimately, AOL's core business was dial-up internet access. Its inability or failure to develop a competitive broadband offering was an obvious and fundamental weakness that eventually and inevitably eroded its subscriber base. And as I mentioned above, the attempt to develop a content offering to offset that risk faced a powerful, if not invincible force.

2) In the short run, don't underestimate inertia. AOL's subscription model, based on relatively modest charges to a subscriber's credit card, worked for a long time even after broadband internet service became widely available in the U.S. I suspect many subscribers carried the service for several months longer than they needed it because it required a proactive decision (and a not-insignificant investment of time) to cancel the service. True, AOL's customer service operations and policies seemed designed to make it inconvenient, if not downright impossible to quit, a practice for which the company has been widely criticized. Even today, some subscribers are unwilling to part with a long-standing email address, creating some stickiness in the subscriber base. There was also a time -- which seems almost quaint in the Twitter age -- that one's AOL Instant Messenger buddy list was considered a significant barrier to switching.

3) Sometimes, widespread customer service "failure" is really evidence of overwhelming customer demand, hence a bullish signal. When AOL switched from metered billing to flat-rate billing for internet access, it triggered a huge increase in subscribers and usage. AOL's inability to keep up with the demand surge led to its widely publicized service outages. From an investment perspective, this was actually positive, at least in the short run. Indeed, the surge in subscription revenue allowed AOL to quickly invest in the infrastructure to meet the increased demand. To be clear, widespread customer service failures that are quickly rectified may be bullish signals if they reveal massive consumer demand and a quick response by the company. This investment thesis should not be applied to businesses whose customer service failures seem chronic and institutionalized, like for instance, certain U.S. airlines and cable companies.

4) Adaptation is really hard for successful companies. AOL was not utterly blind to the fact that high-speed access presented a threat to its dial-up subscriber base. The company did experiment with broadband offerings and "Bring Your Own Broadband" discount packages for email and instant messaging. But it does seem that corporate hubris prevented AOL from striking deals that could have blunted the threat from broadband. At its peak, AOL was notoriously high-handed in negotiations with business partners, and it's easy to imagine how AOL (who thought it owned its customers) and cable companies (who thought they owned their customers) might not come to agreement on a business deal. Publicly, AOL dismissed the threat from broadband as in this comment from Bob Pittman (also reported by Saul Hansell) ten years ago.

"''Broadband doesn't sell itself,'' Mr. Pittman said in an interview. ''There is a small group that says 'Yeah, it's faster.' '' But high speeds don't make a difference to the activities that AOL members use most, he added, saying, ''Your E-mail doesn't get any better with broadband.'"

Maybe Pittman actually believed this. Or maybe this was a corporate posturing for the financial markets or for negotiations with cable and phone companies. Maybe it was all three. But when a charismatic corporate leader makes public statements like this, he runs the risk that his employees will believe it and act accordingly.

Absent a broadband strategy, AOL increased its bets on content, culminating in the ill-starred merger with Time Warner, which was a bold attempt to leverage a temporary advantage in dial-up internet access into permanent leadership as a content provider. But sometime this year, that deal will finally be unwound, leaving only bitterness and decimated Time-Warner 401(k) plans behind. More recently, AOL has let go of its paying subscribers (who were leaving in droves anyway) while shifting its emphasis to ad sales. But today AOL.com looks like a smaller and much less popular version of Yahoo. In the current ad recession, Yahoo -- the second most popular destination on the web -- has struggled to regain its former glory. Tim Armstrong faces the same challenge, but from 35th place.

Note 1. Time Warner announced that it repurchased Google's 5% stake on July 8 for $283 million, a price that includes "cash distributions owed to Google". Google made its investment in AOL in December 2005. According to this pre-spin off filing by AOL, net distributions from AOL to Time-Warner in 2006 through 2008 come to $2.85 billion (page F-5). Assuming Google was owed a pro rata interest in these distributions, the "cash distributions owed to Google" may have been as high as $150 million, suggesting that Google is accepting a mere $133 million for its 5% stake in AOL, which would imply a total equity value of $2.66 million, or 2.5x run-rate EBITDA (or OIBDA as AOL prefers it) based on the June quarterly OIBDA of $271 million (see page 19). This extremely low-sounding valuation may be plausible as subscriber revenue, which undoubtedly has a high contribution margin to OIBDA, shrunk by 27% over the prior year quarter. If subscriber revenue is halved from its June quarterly result of $356 million with no corresponding cost reductions, quarterly OIBDA would be just under $100 million, and a $2.66 billion valuation would imply a 6.6x OIBDA multiple.

Note 2. On July 30, Michael Nathanson of Bernstein Research published a report (subscription required) on Time-Warner. Nathanson estimates that "cash distributions owed to Google" made up approximately $100 million of the $283 million Time-Warner paid Google for its 5% stake in AOL. This would imply an equity valuation of $3.66 million for all of AOL.

Steve Jobs' Health is None of My Business

2009-07-08T13:12:00.000-07:00

Bloomberg today reports the non-news that, "...disclosures about Steve Jobs’s health remain under scrutiny by U.S. Securities and Exchange Commission investigators over how his condition went from 'relatively simple' to 'more complex' in nine days" according to an unnamed source.

It must be vacation season if Bloomberg is trotting out a "situation remains the same" news story, which then recycles lots of commentary from legal experts not involved in the situation and doctors not treating Jobs. Predictably, nobody actually involved in the situation provided any on-the-record comment.

For the ultimate phone-it-in vacation season news story, go read this parody by Andy Borowitz. Like Mike Royko's traditional New Year's Day column or the Wall Street Journal's annual Thanksgiving editorial, Borowitz piece deserves to be republished every July 4th and Labor Day weekend.

Back to Steve Jobs' health.

Here's a simple fact that seems to get overlooked by the breathless journalists on this story: Like every other CEO I've ever met, Steve Jobs is mortal. Presumably rational investors in Apple factored this into their investment decisions years ago. Bloomberg is especially aware of this fact, having already published an obituary for Jobs back on August 28, 2008.

Here's another simple and widely reported fact. Steve Jobs announced to Apple employees that he had been diagnosed with islet cell neuroendocrine cancer of the pancreas back in 2004. Investors in Apple who previously overlooked his mortality probably factored this into their investment decisions then.

Now here's a more complex fact. Cancer, in all its forms, remains a complex disease. Nobody, including Steve Jobs and his doctors, knows what tomorrow will bring. As anyone who's had a close friend or relative battling cancer knows, the prognosis can swing from high to low and back again in mere days. Any near-term prediction about the course of someone's cancer is inherently speculative and as likely to mislead as to inform. If this were any other risk factor and any other company, it would suffice to include boilerplate language in the 10-K along the lines of "We maintain key man life insurance on certain of our senior executives but there can be no assurance that recoveries under these policies would fully compensate the Company for the loss of the executive's services."

Surely the SEC staff has better things to investigate, journalists can find more newsworthy stories to report, and we can all just say a silent prayer for Mr. Jobs and his family and leave them alone in this difficult time.

Buzzword Beat -Mark Cuban on "Free"

2009-07-07T08:49:00.000-07:00

Mark Cuban has published a new post on his weblog entitled,

When you succeed with Free, you are going to die by Free.

In the post, Cuban argues,

"Lets look at the rule that eventually KILLS all freemium based content plays:

There will always be a company that replaces you. At some point your BlackSwan competitor will appear and they will kick your ass. Their product will be better or more interesting or just better marketed than yours, and it also will be free. They will be Facebook to your Myspace, or Myspace to your Friendster or Google to your Yahoo. You get the point. Someone out there with a better idea will raise a bunch of money, give it away for free, build scale and charge less to reach the audience. Or will be differentiated enough, and important enough to the audience to maybe even charge more. Who knows. But they will kick your ass and you will be in trouble."

Any thesis in the sphere of economics that includes the words "rule", "kill" and "all" is inherently suspect, and Cuban's post reads like a breezy attempt to join the buzz-fest around the publication of Chris Anderson's new book, "Free, The Future of a Radical Price". The giveaway is Cuban's strained "BlackSwan" reference from Nassem Nicholas Talleb's book of the same name.

(Anderson's book is an expanded version of this Wired magazine article.)

As a number of commentators have already noticed, Cuban's thesis says nothing about "free" or "freemium" business models that is not equally applicable to any business. Yes, business is a hyper-competitive sport, someone will eventually -- no time frame given -- come up with a faster, better, cheaper version of what you do and "kick your ass." A vague and generally agreeable prediction -- hedged by the inclusion of "eventually" so not falsifiable in the abstract or the concrete -- is not worth arguing about.

Here's my take.

"Free" business models like Google's search engine, MySpace and Facebook are predicated on low, arguably zero, marginal costs. Facebook can afford to be the digital bulletin board for 225 million worldwide users only because the marginal cost of storage and bandwidth is very small. Equally important, the capital costs of storage and bandwidth decrease predictably in general accordance with Moore's Law. So even as Facebook's user base explodes, its technology costs (per user) are likely dropping by 15-20% annually.

What Cuban should have said about "free" business models is that the low marginal costs and declining capital costs of these technology-intensive businesses go hand in hand. And if the infrastructure cost of MySpace or Facebook declines by 15% per year, a competitor can replicate that infrastructure four years later at 52% of the original capital cost. With half the capital cost, a new competitor is tempted to compete on price (more, better stuff for "free") and win away the business. Even if the new entrant fails, it will likely compete away some of the incumbent's profits.

In his article Cuban seems to be thinking of social media businesses -- Friendster, MySpace and Facebook-- although he includes Google (which deserves an asterisk if only for its multi-year history of handsome profits). What's economically interesting about these social media businesses, allowing them "to raise a bunch of money" is often explained in terms of "network effects", a popular buzz-phrase for what economists call a positive externality.

According to Wikipedia, the concept of "network effects" was introduced in the early 20th century in the context of emerging telephone systems. The positive network effect (you have a phone, making it more valuable for me to have a phone) helps drive adoption of the new technology. But in the early 20th century, adding those additional phones meant stringing expensive wires to each house or place of business. And after the first entrant incurred that sunk cost, there was little incentive for a competitor to incur the same cost to compete for the same customers with the same service. Even if some of the installation costs declined over time (cabling, electronics, e.g.) the costs of rights-of-way, telephone poles and labor likely increased, allowing the first-mover to build a long-term competitive advantage based on network effects and sunk costs. This is why most telephone systems in 20th century became regulated monopolies.

Facebook's current membership, at 225 million registered users, testifies to the potency of network effects in social media. And with the physical infrastructure of the internet already in place, a network that would have taken decades to build in the last century can arise in mere months today.

That's what's frustrating Rupert Murdoch as Facebook has surpassed MySpace in popularity. It probably keeps Facebook CEO, Mark Zuckerburg, up at night as well. Network-effects businesses on the internet generally don't enjoy the additional competitive advantage of high and rising capital costs to keep new entrants on the sidelines. And the glue that holds the network together and preserves its value may be nothing more than "community," an economic intangible that's as fragile as it is powerful. If a new entrant gains sufficient traction through differentiation or well-funded patience (think Microsoft), it too will eventually enjoy network effects. As users defect from one community to another the winner's positive externality is the loser's negative one. If your friends have stopped updating their MySpace profile in favor of Facebook, you'll probably stop looking for them on MySpace. If your friends start posting their updates on Twitter, you'll spend less time on Facebook. After enough defections the market may reach a "tipping point" (buzz-phrase alert!) as yesterday's market leader becomes tomorrow's also-ran.

Clever entrepreneurs understand the fragility and potentially transitory nature of their competitive advantage if it's based primarily on network effects. Successful ones use their early competitive advantage period to build potentially more durable advantages based on technology and intellectual property. This is an important point where Cuban and I disagree, especially with regard to Google. At December 2008, Google's 20,000 worldwide employees included more than 7,000 engineers. Not a lot of venture capital money is flowing into startups to take on that army of programmers. Google's R&D investment strikes me as a rational strategy while Cuban sees it as a costly act of desperation.

Chris Anderson seems like a smart guy, so maybe he's covered all this in his new book. I'll have something to say about that when it's available at my public library where I'll check it out... for free.

Clueless in Chicago --Unraveling Newspaper Economics

2009-07-01T15:51:00.000-07:00

Major newspaper publishers met last month in Chicago in a not-exactly-secret, but definitely closed-to-the-public meeting to discuss the future of the newspaper business. More specifically, it seems, the meeting was convened to share ideas about how to more effectively monetize newspaper content on the web as traditional print subscription and advertising revenue plummet.

(As an aside, since most newspaper content on the web today is free, "monetize" must mean a price increase. Imagine if any other industry convened a closed meeting to discuss a price increase. What would the press have to say about that?)

As an avid reader (and paying subscriber) of several newspapers, I'm hoping they'll figure out how to survive. Sadly, I think the meeting must've been terribly disappointing.

A copy of "Paid Content - Newspaper Economic Action Plan" produced for the meeting by the American Press Institute (API) has been published on the web in several place including here. A quick read of the document cannot inspire confidence. The action plan recommends that newspaper publishers experiment with micropayments, subscriptions, and more ominously, coordinated industry and maybe government pressure on companies like Google, Yahoo and Microsoft to share search-related ad revenue. This last bit is called the "Fair Share Doctrine" described as "Negotiate for money, a lot more, from Google and online news aggregators for a 'fairer' share of the profits from linking and ad sales."

These ideas are neither novel nor untested. And they haven't worked so far. One gets a vague and uncomfortable sense that when the API recommends, "... [using] technology, news-industry production protocols, influence and public policy to thwart piracy" what they really mean is "maybe some government intervention can help us survive in our current form."

The 31-page API report goes wrong in its second paragraph when it asserts, "The problem is that the online business model does not yet come close to compensating for the steep slide in the print business model that it is replacing."

Guess what, it never will.

For well over a century the newspaper industry has enjoyed handsome returns from the economics of bundling combined with enviably low marginal distribution costs. These returns became even more attractive as many cities (in the U.S. at least) became one-newspaper towns. Bundled pricing, low marginal costs and monopolistic (or at least oligopolistic) market structure is a wonderful way to make a living. It is, however, not a birthright. And the government has no role helping the newspaper industry compensate for its loosening grip on its historical monopoly.

Here's Warren Buffet, whose Berkshire Hathaway has owned the Buffalo Evening News since 1977 and is a major investor in the Washington Post Company, writing in his annual letter 25 years ago:

“The economics of a dominant newspaper are excellent, among the very best in the business world. Owners, naturally, would like to believe that their wonderful profitability is achieved only because they unfailingly turn out a wonderful product. That comfortable theory wilts before an uncomfortable fact. While first-class newspapers make excellent profits, the profits of third-rate papers are as good or better - as long as either class of paper is dominant within its community.” [emphasis added]

Twenty-five years on, Mr. Buffet has changed his view of the newspaper business. During Berkshire Hathaway's latest annual meeting, he said, “For most newspapers in the United states, we would not buy them at any price...They have the possibility of going to just unending losses.”

What's Changed?
The structure of any market in equilibrium is determined by a complex and recursive interplay of technology, economics, inertia (in the form of pre-existing business relationships) and sometimes regulation. In the short term, the last three factors are paramount; in the long-term, technology dominates.

Traditional Newspaper Economics
The Virtuous Circle

Historically, the market structure of the newspaper business enjoyed a virtuous circle as depicted above. Once the sunk cost of the editorial staff is incurred, the printing press paid for, and the distribution system in place (collectively representing yesterday's technology), the incremental cost of including an additional classified ad -- or any other feature -- in the daily newspaper is negligible. Hence, newspapers had incentives to bundle many forms of content in addition to their own editorial content: TV listings, horoscopes, movie schedules, stock listings, comic strips, classified ads, etc. A reader paid for the bundled product even if he used the classified ads maybe once a year, or never read the horoscope or used the TV listings (note 1). The high fixed costs, offset by the surplus economics from bundling and low marginal distribution costs gave rise to something akin to a natural monopoly. And in most U.S. cities, the market leader has seen its competitors fade away in the post-war years (note 2).

Now imagine you're a newspaper subscriber (maybe you still are). If you could disaggregate the horoscopes from the weather from the sports from the local news from the international news from the business news from the TV listings from the almost non-existent stock price listings, how much would you pay for the parts of the paper you actually intend to read? Probably less than the $10-$15 per week it currently costs at the newsstand. Probably less than the $6-8 per week it costs to subscribe.

Probably a lot less.

This is the problem faced by the newspapers. Bundling is a pricing strategy that delivers surplus economics to the supplier by enticing customers to buy more than they would if the bundled products were sold separately. By weight, the majority of your local newspaper (and its website) is information sourced from third parties (ads, stock listings, classifieds, lightly edited excerpts of corporate news releases, etc.) readily available elsewhere on the internet (note 3). By allowing readers to disaggregate the newspaper's traditional bundle of content, the internet may be exposing the market value, or to use the API's term "true value" of the original editorial content produced by the publisher itself.

As publishers experiment with revamped online pricing models they may find that the true value of their original content will give horrifying meaning to the term micro-payment. No newspaper has a monopoly on "the news." It certainly has no monopoly on the third-party information it republishes. The newspaper industry suffers from a notion that it should enjoy monopoly economics on content ("Hey, that's copyrighted!") when in reality its historical monopoly was control of a distribution channel and much of the profit was based on aggregating and organizing other people's content. In the internet age, that distribution monopoly no longer exists and others, like Google, do a pretty good job of aggregating third-party content.

Copyright should be respected. But if a reader can get his daily dose of international news as readily from the Washington Post, the New York Times or a foreign newspaper, copyright on a particular rendition of the news will not give rise to monopoly economics.

Like the music industry before it, the API's view of the newspaper industry confuses the surplus economics arising from bundling and distribution monopolies for the natural economics of their copyrighted content. Copyright does indeed confer a monopoly right to a particular form of expression, but in no way guarantees that consumers will pay handsomely for it, if at all. The music industry has spent the past ten years battling piracy when the larger economic problem has been the unbundling of the album format. It turns out that customers prefer to pay $1.29 for one song they really want rather than $14.99 for the twelve songs the label bundled on a CD album. Losing the additional $13.70 per transaction really hits the music label's revenue line. A twelve-year old kid downloading thousands of songs he can't otherwise afford does not.

If newspapers no longer command a monopoly on distribution and can expect no surplus economics from bundling third-party content -- including ads -- they may find that the ratio of the "true value" of their editorial content to their historical revenue approximates the 20% of the average paper that is made up of original content.

When new technologies completely undermine an industry's market structure, that industry needs to be rebuilt from the ground up. The newspaper industry will fumble along (much like the music industry) if it starts from the premise that its historical economics represent some kind of natural order.

--------------------

Note 1. It should be noted that subscribers to print newspapers generally pay less than the actual cost of writing, editing, printing and delivering the newspaper... often a lot less. What drove newspaper profitability in the past was advertising sales, but that requires the aggregation of a large audience, which requires aggregation of diverse content to appeal to a large, diverse audience to attract the advertisers. Another virtuous circle... or vicious cycle if it starts running in the wrong direction.

Note 2. Noam, Eli M., "Media Ownership and Concentration in America"

Note 3. This morning's complimentary San Francisco Examiner landed on my front porch despite my wife's repeated attempts to discourage them from delivering it; I guess they need the circulation numbers to support their advertising rate base. The paper, including ad inserts, totals 54 pages. A quick inspection shows the content is allocated as follows:

Third-party content
Ads: 34.5 pages
Classifieds 4.0 pages
Movie listings 2.0 pages
Weather 1.0 pages
Games 1.0 pages
subtotal 42.5 pages

This leaves 11.5 pages of news content, but of course the "World", "Nation" and "California" sections (one page apiece) appear to be entirely made up of syndicated pieces by the Associated Press or others. So the actual original content produced by the Examiner comes to about eight pages, or about 15% of the total newspaper.

The Twitter Revolution?

2009-06-18T14:59:00.000-07:00

Changing the world 140 characters at a time. (Click to read)

Where'd You Get That Dress (Video)

2009-06-18T12:54:00.001-07:00

A shout-out to Mr. Danny Montoya, kindergarten teacher extraordinaire and short subject film-maker.

Check out this link to his end-of-year video with my daughter's kindergarten class.

Where'd You Get That Dress?

Made Me Laugh

2009-06-02T08:59:00.000-07:00

For more, click here

Candidate Change, Meet President Perseverance

2009-05-14T09:41:00.000-07:00

The Wall Street Journal reports that President Obama is considering detaining terror suspects indefinitely.

While this continuation of the previous administration's policy may disappoint those who need to believe that every element of the Bush/Cheney foreign policy was evil or incompetent, it's not terribly surprising if you think about it for a clear-headed minute.

Nearly 3,000 civilians were killed in the 9/11 attacks.

Let's say you're the President and your military and intelligence agencies have managed to track down and capture a number of suspected terrorists. Under no duress, these suspects applaud the 9/11 attacks, claim responsibility (perhaps boastfully rather than truthfully) and pledge themselves to commit their lives to the further killing of Americans by any means possible. And just in case there's any doubt, they're all in favor of the extermination of Israel and maybe the overthrow of the kingdom of Saudi Arabia.

As President, would you release such suspects to threaten American citizens again? Remember, the 9/11 attacks on the Twin Towers were the second successful attack in eight years. So what's a President to do? He's sworn to protect, preserve and defend the Constitution, but as Commander in Chief he's also required to protect and defend the citizens. It would be convenient if these suspects could be tried, convicted and thrown in prison for life; but a civilian criminal trial may be a dicey proposition if the specific evidence is primarily confessions that may sound more like boasts.

In an era of rougher justice "...shot while trying to escape" would be one likely end to this awkward predicament. Or perhaps the suspects would be quietly extradited to a country whose legal system makes a specific judicial outcome more certain.

But we live in the current era. Meanwhile President Obama -- unlike candidate Obama -- is privy to the dossiers on these suspects and responsible for the security of the nation. He has a track record of respect for the Constitution and clear-headed, practical thinking. I'm prepared to give him the benefit of the doubt here. From the vantage point of the Oval Office, he seems to be doing the same for his predecessor.

Pruning Facebook

2009-04-21T14:24:00.000-07:00

Interesting post on Fred Wilson's blog.

"... I started visiting Facebook every day and I found it way too busy. I was having a hard time finding the information I cared about inside all the other information there, most of which I was already seeing on Twitter."

Pretty much as I suggested a few months ago.

"Also, social networks in the real world rarely grow indefinitely and infinitely large. Maintaining relationships in the real world requires an expenditure of effort, which puts an upper limit on effective network size. As we move through the paces of our lives, we often prune the outer, less intimate branches of our social networks. On the internet, it's easy to "add a friend" and the maintenance costs (a little storage at pennies per gigabyte) are low and getting lower. But there is almost certainly an inverse relationship between the value of (personal) information shared on a social network and the size of the audience, which ultimately is a negative network effect."

Facebook vs. MySpace (Hilarious!)

2009-03-24T14:02:00.000-07:00

A substantially less funny post by me (link)

Are You Smarter Than a Fifth Grader?Congressional Edition

2009-03-24T11:03:00.000-07:00

From Politico reprinted in its entirety for non-subscribers:

Rep. cries foul over Nets naming rights

"Maybe they should just call it TARP Arena.

Rep. Bill Pascrell Jr. (D-N.J.), wary of taxpayer anger over the AIG bonuses, wants the New Jersey Nets to reconsider selling naming rights to the British bank Barclays for an NBA arena being built in Brooklyn.

Barclays received $8.5 billion in bailout funds from the Treasury Department, and Pascrell believes the $400 million it cost to have the naming rights for the soon-to-be Brooklyn Nets arena should be used, say, for lending to consumers instead. Pascrell was quick to make an exception for the new Citi ballpark the New York Mets are building, because that ball yard was already well under construction under the Citi name before the bailout money was approved.

“I believe that any further payments of taxpayer money, whether through TARP or the Federal Reserve System, be conditioned on the cancellation of any stadium or arena naming-rights agreements that may be in place,” Pascrell said.

It’s worth noting, of course, that Pascrell represents a lot of New Jersey Nets fans quite unhappy about losing their NBA team to Brooklyn."

Actually, Congressman, Barclays did NOT receive any "bailout" funds from the Treasury Department. Nor have they accepted any bailout money from the government of the UK, where they happen to be domiciled. To their credit, they have steadfastly resisted taking money that comes with governmental strings attached; and with each passing day and every congressional comment like yours, the wisdom of their strategy becomes more clear.

True, Barclays received $8.5 billion from AIG, presumably as collateral against or settlement of AIG's contractual obligations under trading arrangements. But to suggest that this is the same as a bailout is just wrong. To further imply that any organization that does business with a recipient of bailout funds is thereby subject to mindless Congressional meddling is either stupid or frightening, depending on how serious you are.

Oh, and Congressman, pretty much all "payments of taxpayer money" are made "through the Federal Reserve System." In fact, when you give a one-dollar tip to the guy who shines your shoes in the Congressional cloak-room, you're using what we in this country call a "Federal Reserve Note". It's actually printed on the top of the dollar bill in capital letters to help you remember.

Perhaps you'd like to regulate what he does with that too?

The Beginning of Wisdom...

2009-03-23T17:35:00.000-07:00

"The beginning of wisdom is to call things by their right names" according to the Chinese proverb.

The chart above (click the chart to enlarge) shows the relative frequency of Google searches for "Troubled Assets" vs. "Toxic Assets" over the past 12 months. As the Treasury introduces "TARP 2.0" today, the change in the vernacular reflects a shift from a market view (or hope, really) that the problem was a temporary impairment of "troubled" assets to the acknowledgment that many of the assets at the center of the financial storm are permanently impaired or "toxic". If this view is widely shared, it may actually speed the recovery process as buyers and seller converge on valuation for the assets.

Contrarians may find a bullish signal in this verbal shift.

If you want to update this chart, click here and enter the search terms "troubled assets" and "toxic assets" separated by a comma.

Great Moments in StatesmanshipH.R. 1586

2009-03-23T10:08:00.001-07:00

Photo credit Stephen Crowley/The New York Times

H.R. 1586The Law of Unintended Consequences

2009-03-20T17:07:00.000-07:00

Well, they did it.

The US House of Representatives, apparently vying for the title of "The World's Greatest Retributive Body" passed HR 1586 - "To impose an additional tax on bonuses received from certain TARP recipients". HR 1586 was designed specifically for the purpose of taxing the bonuses of several dozen employees of AIG, the giant insurance company at the epicenter of the financial crisis.

Look, I'm no fan of AIG. AIG's reckless underwriting of credit default swaps has required a $170 billion injection of government aid to post collateral with counter-parties and extinguish obligations. And I will be surprised if AIG doesn't require more aid before this crisis is over.

So I am as infuriated as any other taxpayer to read that AIG planned to pay out $165 million in bonuses, including bonuses to employees who worked in their Financial Products group, where the credit default swaps were written.

But the speed with which the House has wielded its most powerful weapon -- As Chief Justice John Marshall put it, "The power to tax is the power to destroy" -- is a truly frightening precedent. By levying a confiscatory 90% tax on bonuses paid by firms who have received aid under the Troubled Asset Relief Program, the House has undermined the compensation model of our leading financial institutions, not just AIG. More to the point, it will create a financial hardship for many employees whose banks may not have needed TARP funds, but were persuaded by former Treasury Secretary Hank Paulson to accept them in an act of industry solidarity designed to stabilize the crisis late last year. It will also create financial hardship for many employees who had absolutely nothing to do with mortgage securities, credit default swaps or crazy leverage ratios and who probably earned their bonus. For some, it may mean selling their houses into an inventory-clogged market. For all, it will surely mean a reduction in both their saving and spending, just exactly what we don't need in the current economy.

It was bad enough last month when Deputy Sheriff Barney Fife... I mean House Financial Services Committee Chairman Barney Frank... was chiding Northern Trust for honoring its commitment to sponsor a PGA event in Los Angeles. But HR 1586 is a breathtaking act of power, passion and political pandering that should give pause to any believer in liberal democracy. Look hard enough and you will find federal aid, if only in the form of freedom from federal tax, in almost every nook and cranny of our modern society. Will lesser forms of federal aid be used as a pretext for the House to follow its new precedent of hastily drafted confiscatory taxes to coerce private behavior?

Fortunately, the administration has expressed reservations about the House bill and the public outrage has encouraged some AIG employees to forfeit their bonuses, so cooler heads may yet prevail and this hastily drafted legislation may be rejected or modified.

If you'd like to see how your representative voted, click here.

A Lesson in This Recession?

2009-03-17T08:41:00.000-07:00

During economic booms, certain publications and political parties can be counted on to point out that the growing wealth produced by the expanding economy is being inequitably bestowed upon various segments of the population. This (unsurprising) observation usually leads to journalistic hand-wringing, cynical campaign slogans and calls for a more progressive tax code and redistributionist spending programs.

The breadth and depth of the current recession provides an interesting opportunity to observe the results of an experiment no sane policy-maker would ever intentionally conduct.

Last week, the Federal Reserve released its latest triennial analysis of changes in family income and net worth:

Changes in U.S. Family Finances from 2004 to 2007: Evidence from the Survey of Consumer Finances

Trust me, you probably don't want to read it all (I haven't yet either) but I'll share one of the authors' observations. The report is based on household surveys conducted in 2007 and focuses on changes in household finances since the 2004 survey. In light of the significant changes in housing and equity prices during 2008, the study's authors also make an attempt to estimate the impact of 2008's market meltdowns through October.

A number of assumptions are required, which can be found on pages A10-A12. The authors conclude, "...these assumptions imply large drops in median and mean net worth since the 2007 survey — 17.8 percent and 22.7 percent, respectively."

These numbers feel about right. From January to October 2008, the S&P 500 declined 34.0% and the Case-Shiller 20-city composite house price index declined 14.5%.

Many commentators get tripped up when confronting means and medians, and politicians are probably responsible for statistics being lumped together with lies and damned lies. So here's a little refresher (page A6) on interpreting means and medians that most students should've had by ninth grade.

"Where a comparable median and mean are given, the gain of the mean relative to the median may usually be taken as indicative of relatively greater change at the top of the distribution; for example, when the mean increases more rapidly than the median, it is typically taken to indicate that the values in the top of the distribution rose more rapidly than those in the lower part of the distribution."

This is equally true in reverse, i.e., when the mean decreases at a greater rate than the median, it is typically taken to indicate that the values in the top of the distribution fell more rapidly than those in the lower part of the distribution.

So by certain conventional measures of inequality, the concurrent meltdowns in the financial and housing markets plus the economic recession have increased "fairness" in the United States.

This is not a headline I expect to read soon.

I make this observation not in defense of the well-to-do compared to the less fortunate. To be sure, this recession is hurting every family at every level. And the hardship at the lower end of the income and wealth spectrum is undoubtedly more palpable and immediate. What's more, the magnitude of federal aid being provided to companies like AIG evokes uncomfortable echoes of the "Welfare Queens" who figured in class warfare debates of the '70s and '80s. It seems we all live in a glass house now; so maybe everyone should put down his stone.

But when this economy recovers, as it certainly will, maybe we'll have learned that although prosperity inevitably benefits the prosperous, it's better (for everyone) than the alternative.

Yearning for the Good Old Days When the Glass was 130% Full...

2009-03-16T12:31:00.000-07:00

From today's WSJ (link)

"The rise in the stock market, even if it isn't always a reliable predictor of the direction of the economy, could offer a sorely needed boost to confidence. "What you're trying to do is reverse psychology," said Robert Barbera, an economist at ITG, a research and trading firm. "You're trying to get people to think of the glass as a third full instead of 97% empty. ..."

Are Investment Advisors Worried Enough?

2009-03-06T10:11:00.000-08:00

According to a survey by discount brokerage Charles Schwab summarized here,

Fifty-five percent [of independent financial advisors polled] said it could take as long as three years for portfolios to return to their levels of last September..." (emphasis mine)

Assuming that the "levels of last September" are the Dow's closing price of 10,851 on September 30 and the poll was taken when the Dow was hovering around 7,000, that implies that 55% of the respondents think the Dow will recover 3,851 points in three years. That's a 55% return over the period, or a 15.7% compound annual return.

What are the odds?

The graph above is the distribution of rolling 3-year compound annual price changes for the Dow Jones Industrial Average since 1930, according to Yahoo! Finance. (This captures only the change in the index, not reinvestment of dividends). Based on the past 78 years of market history, the odds of a 3-year return of this magnitude are about 15-16%.

Which makes the following quote pretty hilarious.

“Advisers don’t have a GPS to guide them, but they have the experience and savvy to see that there are still potholes on the road ahead,” said Bernie Clark, senior vice president for Schwab’s adviser services, which supports 5,700 independent investment advisers. “Their long-term view, reasoned outlook and steady approach will serve their clients well in this environment.”

Despite the gloom in the economy and markets these days, sell-side optimism appears undimmed.

Bumper Sticker

2009-03-05T23:24:00.001-08:00

Greenspan-o-Meter - Two Down, One to Go

2009-03-05T15:17:00.000-08:00

On December 5, 1996 Fed Chairman Alan Greenspan famously wondered whether stock prices reflected an "irrational exuberance" on the part of investors. This afternoon, The Nasdaq Composite index joined the S&P 500 by closing below its level on that day more than twelve years ago. For its part, the Dow Jones Industrial Average is a mere 2.4% above its level that day, or about one day's volatility in this choppy market.

As it turns out, Greenspan was perhaps too modest about his abilities to spot a bubble. For earlier posts on the same subject, click here and here.

"We Don't Need No Stinkin' TARP Money" - Northern Trust

2009-03-02T08:57:00.001-08:00

Northern Trust has released a response to Congressman Barney Frank regarding its sponsorship of the Northern Trust Open, a PGA golf tournament. Congressman Frank, Senator John Kerry and a score of political grandees have been publicly harrumphing about Northern Trust's expenditures on the golf tournament while the US Treasury holds preferred stock in Northern Trust under the Capital Purchase Program of the Troubled Assets Relief Program (TARP).

Northern Trust's basic message is "We're happy to give back the money we didn't ask for.... where should we send the check?"

In his letter to the Congressman, Northern Trust CEO, Frederick H. Waddell, gets the nuance right when he says, "As we have stated publicly, the Northern Trust Open and its related activities were in no way reliant upon Capital Purchase Program funds, and would have occurred even had we not received Capital Purchase Program funds."

Click here for my earlier post on the topic.

At the end of the day, congressional meddling in the day-to-day operations of TARP recipients may be the most effective way of getting the funds back quickly. But it will certainly cause investors -- and possibly depositors -- to discriminate between those banks who can and do return the funds and those who can't. When the Treasury took stakes in the various banks late last year, it apparently cajoled some of the stronger financial institutions into accepting the funds. The Treasury's intent was to characterize the financial crisis as a systemic liquidity issue that could be alleviated by a temporary injection of capital from the government. The Treasury specifically tried to avoid singling out banks that needed the money to avoid creating more concerns among their counter-parties and depositors.

As the Treasury Department put it back on October 14,

"Nine large financial institutions already have agreed to participate in this program, moving quickly and collectively to signal the importance of the program for the system. These healthy institutions have voluntarily agreed to participate on the same terms that will be available to small and medium-sized banks and thrifts across the nation."

With Citicorp trading at $1.27 per share at the moment, maybe the Treasury's desire for benign opacity was naive. But if Northern Trust, JP Morgan, Goldman Sachs and a few others rush to repay the TARP money so they can be left alone to run their businesses, it could have a serious impact on those banks who don't.

This is a pretty serious policy reversal to be driven by a golf tournament.

Addendum: Northern Trust's June 17, 2009 press release regarding its repayment of TARP funds.

Working in Media is Its Own Reward...

2009-02-27T22:55:00.001-08:00

In December, the Tribune Co,, publisher of the Chicago Tribune, Los Angeles Times and Baltimore Sun, filed for bankruptcy protection.

In January, the Star-Tribune, publisher of Minneapolis' largest newspaper also filed for Chapter 11 protection.

This week, the Rocky Mountain News announced it was shutting down a few weeks shy of its 150th birthday, the Philadelphia Inquirer filed for Chapter 11 in its 180th year and the Journal-Register, publisher of 20 daily newspapers, also filed for bankruptcy.

Hearst Corp. has threatened to shut down the Chronicle in San Francisco if it cannot get concessions from its employees and has said it will shut down the print edition of the Seattle Post-Intelligencer if it cannot find a buyer within 60 days.

Meanwhile, the New York Times Company, publisher of the New York Times and the Boston Globe, is trying to sell off assets and has suspended its dividend to conserve cash.

So, in the last three months, the publishers of leading newspapers in eight of the biggest 23 markets have entered bankruptcy proceedings or threatened to shut down. I sense a trend.

To be fair, a number of the bankruptcy filings are related to bad capital structures (too much debt) rather than loss-making businesses. (See related article at Ad Age) But the businesses are surely weakening as websites cut into classified advertising and the slow economy reduces ad spending generally. And newspapers have historically relied on local ad spending from the automotive, real estate and retail sectors, all of which struggle with their well-documented challenges.

Today, Ad Age reports that local ad spending may continue to decline through 2013, according to BIA Advisory Services. Could ad spending be declining on a long-term trend beyond the current recession?

It could.

I remember - during the Web 1.0 era as it's now called -- listening politely as budding internet entrepreneurs quoted the line attributed to John Wanamaker, the Philadelphia-based merchandiser who founded the eponymous department store chain. Wanamaker is reputed to have said, "Half the money I spend on advertising is wasted; the trouble is I don't know which half."

The marketing pitch from the internet entrepreneurs was that the targetability and interactivity of internet advertising would make advertising so much more efficient by allowing advertisers to reach their target audience with a high degree of precision.

The question I always posed was, "If interactive capabilities can make advertising twice as effective, won't advertisers be able to cut their budgets in half to eliminate the "wasted" half? The usual answer was... silence.

Nobody's predicting a 50% reduction in local advertising spend just yet, and BIA's forecast does predict continued double-digit annual growth in online spending. But this just makes the picture worse for "traditional" media like newspapers and cable TV as they are expected to bear more than 100% of the overall decline in local ad spending.

The current recession, especially if it is prolonged, may be the catalyst for the profound change in media economics that those internet entrepreneurs predicted a decade ago.

Greenspan-o-Meter - February Update

2009-02-27T15:49:00.000-08:00

On December 5, 1996 Fed Chairman Alan Greenspan famously wondered whether stock prices reflected an "irrational exuberance" on the part of investors. This afternoon, the S&P 500 closed below its level on that day more than twelve years ago. For an earlier post on the same subject, click here.

While We're On the Subject...

2009-02-27T10:33:00.000-08:00

"Representative Barney Frank of Massachusetts, chairman of the House Financial Services Committee, along with 17 Democrats on the committee, demanded Tuesday that Northern Trust repay what it spent on entertainment during the [Northern Trust Open held in Los Angeles] which ended on Sunday."

"And Senator John Kerry of Massachusetts vowed to introduce legislation to end “the extravagant spending practices” of banks that received taxpayer dollars in the federal bailout."
Link to NYT story

Congressman Frank and Senator Kerry:

By my reckoning, the US federal deficit has soared from around $1 trillion when Congressman Frank first entered Congress in 1981 to $10 trillion today and we're on our way to $12 trillion according to the President's recent budget proposal.

Until the federal government pays back this money, there are a few expenditures I'd like to discuss with you.

In the meantime, I trust that you and your honorable colleagues in the House and Senate -- mindful of taxpayer concern over profligate spending -- are currently using the Metro for your daily commute. If not, you should know the Federal Center station is mere 6-minute walk to and from the Capitol. I know the fare-card system can be confusing at first, but my nephew's third-grade class has been studying the Metro and would be happy to organize a field trip to help you and your colleagues learn the ropes.

We look forward to your continuing vigilance on behalf of the tax-payers.

Dumb and Dumber

2009-02-27T08:57:00.000-08:00

I don't know which is sillier.

1) The outrage professed by certain politicians that banks receiving government assistance engage in marketing activities, which might include entertaining clients and fulfilling obligations made months ago to sponsor a golf tournament, or

2) The ridiculous statements made by the PR departments of banks that "... the money for these activities comes from operating profits, not TARP funds."

One expects the grandstanding from politicians, but the bankers really ought to know better. What percent of the population do they think buys the notion that TARP funds are "balance sheet" cash distinct from cash used in operating activities? Please just stop it.

It suffices to say, as Northern Trust recently did, "We came to the conclusion that no public purpose would be served by canceling the Northern Trust Open and related events.” But then they blew it by trotting out the "No TARP funds were used..." defense.

Marketing your business, raising money for charitable purposes and supporting your local community are valid reasons for sponsoring a golf tournament and remain so today. Here's my suggestion. Take away the single malts in the courtesy tent: your customers will gladly drink blended scotch in these parlous times. Make your employees double up in hotel rooms; none of them will WANT to go without a compelling business reason for doing so. Keep it low key, and maybe get the local hospitality and restaurant businesses to highlight the dollars and jobs that are supported by a major golf event.

Then, shut up.

Taxpayers are not stupid. Eventually someone will observe that government assistance is not exactly a novel idea. Farmers receive agricultural subsidies, households receive tax credits, not-for-profits enjoy their tax-free status. If the receipt of a financial benefit from the federal government is sufficient reason for Barney Frank to weigh in on every recipient's every expenditure, then maybe he should personally do the grocery shopping for every family on food stamps.

Finally, I have to reprint comment 8. to the NYT article linked above. I can attribute it only to "Joe", but it bears quoting in its entirety.

"Money is fungible, idiots! Either give them money, or don’t and take them over. This false outrage is really getting tiresome. I say let them golf. But force them to tee off from the blue tees and make Barney Frank go along with them, in bright Madras shorts and cap, to provide oversight and prevent them from taking mulligans. That ought to freak them out a little bit. Then post their scores publicly. Bankers need all the humiliation they can get these days."

Golf PrimerHow to Make Birdies

2009-02-25T22:28:00.000-08:00

"On the next hole, Woods hit his second shot to within four feet of the hole, using a 5-iron from 235 yards."

Quants vs. Suits - Who's to Blame for the Financial Meltdown?

2009-02-25T11:32:00.000-08:00

Eric Falkenstein has posted an exceedingly well-written response to Felix Salmon's recent Wired article, "Recipe for Disaster: The Formula that Killed Wall Street" over on SeekingAlpha. Falkenstein nicely captures the interaction between the "quants" and senior management in financial institutions when he writes,

"The decision makers are rich, powerful, kind of smart, do not feel embarrassed by their lack of knowledge in obscure technical trivia, and surely are not intimidated by it."

In my experience, the best quants are generally quite keen to identify and debate the risks and assumptions in their models, but too rarely encounter non-quant managers who show the patience to comprehend the implications. If you're rich, powerful and kind of smart, it's more comforting to say: "I don't pretend to understand all this greek, but I've hired the smartest guys to do the math" than to say "I've tried to understand it, and frankly it's over my head."

Felix Salmon's Wired article is indeed worth reading, although the headline is a tad melodramatic. In Salmon's view, the adoption of Gaussian copula techniques to model the risk characteristics of mortgage-backed securities mortally wounded Wall Street.

Over at the New York Times, Joe Nocera seems to think it was a Value-at-Risk spreadsheet that killed Wall Street in last month's "Risk Mismanagement" article.

Perhaps Wired magazine will sponsor a debate between Mr. Salmon and Mr. Nocera about whether it was a VaR model or a Gaussian copula model that buried Wall Street. Nassim Taleb might be willing to moderate.

To Mr. Salmon's credit, his article does discuss what is -- in my opinion -- the single biggest source of failure in these risk management models. Namely, the use of CDS price data as a proxy for otherwise hard-to-track correlations among many discrete and illiquid securities. It was the availability of a real-time price series that apparently made the Gaussian copula function "tractable", but the use of CDS price data appears to have led to models that vastly and tragically oversimplified the real world relationships they were meant to simulate. Moreover, as Salmon points out, the limited history of CDS prices meant that the historical data was largely drawn from a period of benign economic data. Finally, the CDS market ultimately became a speculator's market with the notional value of default insurance dwarfing the underling credits supposedly being insured, which undoubtedly raised the noise-to-signal ratio on CDS price movements and correlations.

Salmon's and Nocera's articles are the most prominent examples of a growing "The model made me do it" set of explanations for Wall Street's current predicament. Unfortunately, the journalistic imperative for a catchy headline and strongly themed story tends to gloss over the more complex human, institutional and managerial failings that are more appropriately to blame.

If you've read this far, and you're truly interested in the subject, I highly recommend reading UBS's confessional Shareholder Report on UBS Writedowns (pdf). This remarkable report from April 2008 describes the causes of UBS's losses related to US residential mortgages, which at that time were a mere $18.7 billion.

What you will find in this report is a board-approved "hurry up" strategy to rectify lagging league table performance in global fixed-income markets, which led to an aggressive market entry into the RMBS market as it was peaking. You will find that internal capital charges were not routinely adjusted for the true risks of proprietary positions, leading to "carry trades" and correspondingly high inventories of ultimately risky securities. You will find that "warehoused" securities held-for-sale were not hedged at all. You will find that dubious AAA-rated mortgage backed securities were hedged based on the five-year default histories of the small handful of remaining AAA-rated corporates during period of strong economic growth. And you will find that compensation policies rewarded traders for current year profits, even if the positions they held proved toxic down the road. What you don't find in this document is "Oops, the models broke" types of excuses.

For anyone interested in the subject, I also recommend Suna Reyent's article on SeekingAlpha as well.

The Equity Risk Premium Puzzle-Who are the Long-term Holders?

2009-02-23T06:39:00.001-08:00

One of the unsolved mysteries of modern finance theory is the "Equity Risk Premium" puzzle. In a sentence, the puzzle is why equities have historically outperformed bonds (in real, dividend-adjusted terms) by such a large margin? For an elegant illustration of the concept, see Brad DeLong's 2006 blog post here.

Of course, stocks should deliver a larger return since they are riskier claims than bonds; and the variance of stock returns -- the measure of risk in modern finance theory -- is manifestly greater than the variance of bond returns. But the magnitude of stocks' outperformance is the puzzle, especially in light of the well-known fact that the variance of stock returns can be mitigated by long holding periods. (note 1)

This latter notion is most famously articulated in Jeremy Siegel's "Stocks for the Long Run" and more infamously in Glassman & Hassett's "Dow 36,000".

Barring a quick rebound in the US stock markets, the Equity Risk Premium puzzle is likely to be a hot topic in finance departments over the next few years. And if the US experiences another decade of meandering stock price performance to match the current Japanese experience, it may be decided that there's no puzzle at all. The major Japanese market indices are hovering at the same levels they first reached twenty years ago and are roughly 80% below their all-time highs. The current generation of Japanese investors are probably not scratching their heads over the inexplicably high historical returns of common stocks.

Recent news events may shed some light on the issue as well. Like many universities, Harvard has recently reported that it's endowment shrunk 22%, or $8 billion, in the last half of 2008 and that it may shrink by as much as 30% when illiquid assets such as private equity and venture capital positions are marked to market. Geraldine Fabrikant has covered this story for the New York Times here

"Harvard Endowment Loses 22%"

and here.

"Endowment Director is on Harvard Hot Seat"

What I find interesting in this news is the fact that "Harvard depends on its endowment for about 35 percent of its operating budget..." representing $1.4 billion of endowment income contributed to annual operating expenses according to this letter from Drew Gilpin Faust, the university's president.

"Letter to the Community - February 18, 2009"

Now, $1.4 billion per year equals 3.8% of Harvard's endowment of $36.9 billion as it stood on June 30, 2008. But $1.4 billion per year comes to 5.4% of the $25.8 billion that Harvard's endowment will shrink to if realized losses are in fact 30%. At current prices, I suppose it's possible to construct a diversified portfolio of this size that would generate a pre-tax return of 5.4% without touching the endowment principal; but it wouldn't be easy and, more importantly, the income stream likely would not grow as fast as the operating expenses it funds.

Hence, Harvard is selling off a number of its endowment positions in public and private equity and borrowing in the debt markets to provide short-term cash. On the operating front the university is tightening its belt, suspending some ambitious construction plans and instituting certain pay freezes. The university will undoubtedly be reaching out to the alumni base for increased giving as it celebrates its 373rd anniversary this year.

But if Harvard, whose endowment is managed with a multi-century time horizon, finds its liquidity affected by the current crash in financial asset prices, who exactly are the long-term holders who can ignore the current volatility in stock prices and sit tight for the long term? Insurance companies like, for example, AIG?

There may simply be an insufficient amount of investment capital with a multi-generational investment horizon that is indifferent to market volatility like we're experiencing today. This alone could explain a good bit of the Equity Premium Puzzle. Moreover, the NYT "Hot Seat" article on Jane Mendillo, Harvard's new endowment manager, suggests a related agency issue. Even if Harvard University can take a truly long-term view, ultimately the investment decisions are made by individuals (or committees) whose career horizons are quite a bit shorter than Harvard's. Even if one truly, truly believes that in the long-run stocks will deliver premium risk-adjusted returns, it's no fun to report a 30% decline on your watch.

So for all those young investment bankers who intend to wait out the current recession in business school for the next two years, start reading up on the Equity Risk Premium Puzzle and the Liquidity Preference Function. They should be hot topics for the next couple of years.

**********

Some more comments by RHH on this topic over at Seeking Alpha

Annals of Rank Hubris, Larry Summers Edition

Larry Summers's Billion Dollar Harvard Gamble

(note 1)
Much, though not all, of the data used to analyze the Equity Premium Puzzle comes from US stock returns from the mid-1920's, or in some cases stretching back to the Civil War. This is largely due to data availability and reliability. Some commentators on the Equity Risk Premium Puzzle have noted that returns for US equities over this period may be related to country-specific factors, specifically the evolution of the US from an agrarian, emerging economy into a political and economic super-power. As such, US returns may reflect a "success bias" making them unrepresentative of global equity returns over the same periods. For a good discussion of global equity returns, see "Global Evidence on the Equity Risk Premium" (pdf).

It should also be noted that even 160 years of stock price data represents only eight non-overlapping 20-year observation periods, a relatively small data sample. Likewise, the commonly used U.S. data back to 1925 represents less than five non-overlapping 20-year periods. This means that new, extreme data points can dramatically change our view on the odds of their occurring. This time last year, one could say that a 50% peak-to-trough decline in the S&P 500 had occurred only once in 88 years, and that was associated with the Great Depression. As of today, it's occurred twice.

Working in Media is its Own Reward...

2009-02-12T15:56:00.000-08:00

Spotted on the WSJ Tech page (click image to enlarge)

Alan Greenspan, Market Timer?

2009-02-09T09:45:00.000-08:00

Floyd Norris's piece in the New York Times "A 10-Year Stretch That's Worse Than It Looks" is well worth reading.

Click to read article

According to Norris, the 10-year stretch ended January 31, 2009 represents the worst 10-year return (in real terms, including dividends) since the S&P 500 index was created. The compound annual loss in purchasing power was 5.1%.

Further says Norris, "Taking inflation and dividends into account, an investor who put money into the market any time after the end of 1996, and held on, now has less value than when he or she started."

Here Norris misses the opportunity to trot out Alan Greenspan's infamous "irrational exuberance" quote. Over the years, I have asked many sophisticated investors and financial professionals if they remember when Greenspan made the comment. Most give answers between 1998 and 2000, corresponding to the Nasdaq bubble.

In actuality, Greenspan made the comment on December 5, 1996. Closing prices of the major US indices that day (and on Jan 30) are shown here.

It's worth remembering Greenspan's quote more fully. The Fed chairman was addressing the American Enterprise Institute for Public Policy Research on the topic "The Challenge of Central Banking in a Democratic Society." In a wide-ranging speech that briefly covers the history of the central bank, Greenspan raises the issue whether the Fed's goal of price stability should include not just the prices of those goods and services that make up the inflation indices, but of financial assets as well.

"But where do we draw the line on what prices matter? Certainly prices of goods and services now being produced--our basic measure of inflation--matter. But what about futures prices or more importantly prices of claims on future goods and services, like equities, real estate, or other earning assets? Are stability of these prices essential to the stability of the economy?"

"Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?"

How do we know when? When the Fed chairman starts talking -- however obliquely -- about overheated equity markets, that's when.

Ironically, Greenspan finishes up with the following thoughts:

"Along with our other central bank colleagues, we are always looking for ways to reduce the risks that the failure of a single institution will ricochet around the world, shutting down much of the world payments system, and significantly undermining the world's economies. Accordingly, we are endeavoring to get as close to a real time transaction, clearing, and settlement system as possible. This would sharply reduce financial float and the risk of breakdown."

Oops.

For the full text of Greenspan's speech, click here.

Well, duh...

2009-02-05T07:39:00.000-08:00

"Hands criticises 'pass the parcel' inflation effect" - FT.com

"Guy Hands, one of Europe's top private equity bosses, has criticised "pass the parcel" deals, in which buy-out groups sold companies to each other for ever increasing prices, for inflating the bubble that left investors facing big losses."

"'We saw an increasing number of pass-the-parcel transactions between general partners [in private equity firms], where limited partners [investors] essentially retained the same asset while paying fees and carry each time it changed hands,' he said."

What is most puzzling is why the largest, and presumably most influential, limited partners in private equity funds permitted this to happen. As noted by the esteemed Mr. Hands, many LPs -- who had investments in both the selling and the buying PE firms -- were essentially paying 20% carry for the privilege of moving their investment from their left pocket to their right. Surely there must be some cases where an LP investor actually increased his net investment in a particular company and paid a carry on the step-up in value.

If anyone has an example, please let me know.

Did TARP 1.0 Get it Right?

2009-01-29T10:03:00.001-08:00

Some good comments from Robert Baird (and follow the links to Yves Smith) regarding the emerging view that TARP 1.0 was the right solution.

For those (like Joe Nocera, NYT) "First Bailout Formula Had It Right" who believe that the intent of the original TARP program was nationalization of bad banks -- or at least bad bank loans -- I say let's deconstruct the words. Someone spent more than a few minutes picking "TARP" among the various pronounceable acronyms that could've been created so there must be some subtext worth examining.

"TARP" stands for "Troubled Asset Relief Program". At the time, these assets were thought to be merely "troubled". Not distressed, not underwater; just a little anxious or, like teenage boys, a bit undisciplined and prone to mischief. The thought was that the government could take them into its custody, perhaps let them spend some time at the spa or in rehab and maybe in a few years they would be restored to perfect health with nary a care in the world.

Now, the growing consensus is that maybe some of these assets are more than a little "troubled" and let's face it, "impaired".

If, as widely expected, the Obama administration comes out with a new program next week, they'll need a new acronym. I suggest "Commercial bank Recapitalization and Assistance Program" or CRAP. The assets acquired by the taxpayers will be known, quite sensibly, as the CRAP assets. That should be easy to remember.

****

BTW, Can anyone shed some light on "TARP"?

Was it meant to suggest a tarpaulin, perhaps in the sense of a being spread UNDER the assets as a sort of safety net? Dictionary.com defines "tarpaulin" as "a protective covering of canvas or other material waterproofed with tar, paint, or wax", which reminds me more of the sheet they pull OVER dead bodies at a crime scene.

Maybe the acronym was more apt than its creators intended.

(Comments on) What the Facebook is Going On Here?

2009-01-09T09:50:00.000-08:00

Hilarious article on Facebook by Peter Madden over at AdAge (subscription may be required.)

"What the Facebook is Going on Here? - AdAge.com"

Is there really a fan page for Lysol?

Mostly, I'm surprised by the "Peter, you just don't get it" comments in the subsequent thread. I think Peter gets it perfectly.

Yes, Facebook has proven to be a mobilizing force for good causes. And, holy cow, consumers are out there providing all sorts of information about themselves that may *someday* be useful for marketing purposes. (As an aside, I find the current advertising on Facebook amusing. I am listed as having an MBA degree, yet one-third of the advertising presented to me seems predicated on the notion that I might want to get a second one... I click on them to ensure that stupidity is penalized. Another ad that appears incessantly is an invitation to buy a Spinal Tap-themed tee shirt since that is listed among my favorite movies. Note to 6dollarshirts.com: Thanks, but I have plenty of tee shirts already.)

Facebook, like any form of social interaction, faces the risk that the overall tone of the conversation is dominated by the lowest form of discourse. A steady news feed from your 600 closest "friends" is pretty random and (I imagine) quickly becomes tiresome. An endless stream of requests to join various noble causes is about as welcome as a telephone solicitor at dinner-time. And a conversation consisting of "Peter is getting on a plane in Las Vegas... Brittany is having french toast for breakfast... Gary has the sniffles" is a bore in ANY medium.

We need a neologism for this latter phenomenon. I submit "blackberrhea" but I'm sure the creatives who read AdAge can do better.

Ceci Reading Nursery Rhymes at 2 Years, 10 Months

2008-10-01T14:51:00.000-07:00

Weather Report - Perfectly Stormy

2008-08-05T12:39:00.000-07:00

Lately, the "Perfect Storm" metaphor has returned with gale-like force to explain all manner of business failures. This buzzphrase hasn't enjoyed such popularity since the collapse of the dot.com bubble in 2001-2003. Most recently, WCI Communities (NYSE:WCI) , a developer of luxury homes and towers in southern Florida invoked the meteorological metaphor to explain its bankruptcy filing.

(Read article from NY Times Dealbook)

And WCI is not alone:

(Read article from TheDeal.com)

As I recall it, a perfect storm is a "100-year" storm, a weather event so unusual that one should expect it to occur only once in a (very long) lifetime. Of late, however, every corporation that runs into a patch of rough water seems to blame a perfect storm of economic headwinds for its difficulties.

It's ironic that Wall Street types use such an extraordinary metaphor to describe the utterly predictable. Notwithstanding the dramatic moderation in the cyclicality of the U.S. economy since 1982, the U.S. has suffered a recession roughly every decade since then. We suffered through the savings & loan crisis in the early 1990's and today -- only fifteen years on -- we are in the midst of yet another real-estate related banking crisis. We've had a bubble market and crash in tech stocks and residential real estate in the first decade of this new century alone. These are hardly once-in-a-lifetime events.

Even more ironic, if the Wall Street whiz kids who created (and the credit agencies who rated) AAA-rated CDO securities had actually understood what it means for a borrower to maintain the ability to pay uninterrupted interest and principal notwithstanding predictably improbable adverse economic events, Wall Street would've avoided much of its current mess.

Consider what a "once in a hundred years" event might look like. World War, perhaps? That's happened twice. Besides two World Wars, the last hundred years have witnessed the rise and fall of the Soviet Union, four different governments in Germany, uncontrolled hyper-inflation of the deutschemark, 25% unemployment in the U.S. and exactly one World Series championship by the Chicago Cubs.

Many statistically improbable events actually do occur in a hundred years, and some of them naturally merit the "perfect storm" designation. But residential over-building in Florida, followed by a collapse in housing starts during a period of tight money ain't one of them.

For another well-written article on the topic, see:

(Long-Term Capital: It's a Short-Term Memory)

Facebook vs. MySpace

2008-06-24T12:08:00.000-07:00

Interesting article on PCPro observing that Facebook has just surpassed MySpace in monthly uniques.

(Murdoch Fumes as Facebook Overtakes MySpace)

Perhaps this should be marked as a cross-over point in market structure reminiscent of the "serial monopoly" or "serial oligopoly" that often observed in emerging marketplaces where network effects provide significant value to the network users. Think of instant messaging, search marketing; or for older readers, PC-based word processing or spreadsheet software.

Or maybe its just that online social networks are starting to mirror social networks in that other, real, world. They may eventually consist of a small durable and evolving core of networks (plural) surrounded by a busy swirl of transitory, largely inconsequential interactions whose importance and permanence diminish quickly with distance and time.

Note that I wrote, "...small, durable core of networks". In the real world, most people maintain multiple, distinct social networks. And these may be overlapping or mutually exclusive or something in between. For example, colleagues at a new job vs. college drinking buddies. Facebook and MySpace both operate on the dubious assumption that what I'm willing to share with my college drinking buddies should also be shared with prospective employers, my local pastor and Aunt Millie.

Also, social networks in the real world rarely grow indefinitely and infinitely large. Maintaining relationships in the real world requires an expenditure of effort, which puts an upper limit on effective network size. As we move through the paces of our lives, we often prune the outer, less intimate branches of our social networks. On the internet, it's easy to "add a friend" and the maintenance costs (a little storage at pennies per gigabyte) are low and getting lower. But there is almost certainly an inverse relationship between the value of (personal) information shared on a social network and the size of the audience, which ultimately is a negative network effect. And sometimes it's even more important to prune the most intimate branches of one's social network... that's why ex-boyfriends and girlfriends are rarely invited to weddings.

Before a winner is declared in the social networking arena, a great deal of evolution in the product offering (and of course the business model) will likely occur, and it's probably way, way too early to declare one of the today's leaders the inevitable champion. Also, keep in mind that any discussion of MySpace vs. Facebook will probably sound parochial to tens of millions of social networkers in China.

Many, if not most, observers thought "Internet Search" was over after Yahoo emerged as the dominant portal versus its contemporary challengers -- Excite, Lycos, InfoSeek and AltaVista -- while Google's founders were still working on their doctorates.

In five years, a debate about the dominance of Facebook vs. MySpace may be as quaint as a discussion today about whether Yahoo's home page index of the web was preferable to AltaVista's search engine or whether Multimate or WordPro was the best PC word processing software in 1985.

Updates

2009-12-17 - The Financial Times has a nice epilogue on MySpace

2010-10-17 The NYT has a nice article about dual profiles on Facebook. I love the irony of friends emailing each other (that's so 2005!) to get permission to post vacation photos on Facebook.

What Was Merrill Lynch Thinking?

2007-10-30T15:14:00.001-07:00

According to an October 25, 2007 Wall Street Journal article

(Pioneer Helped Merrill Move Into CDOs - subscription required)

Merrill Lynch underwrote $160 billion of CDOs from 2000 through 2007 year-to-date. Assuming Merrill earned an average underwriting spread of 1.25% on this business, they booked $2.0 billion in underwriting fees over these 7 1/2 years. Those are some pretty good numbers even by investment banking standards. And with investment banking compensation at 45-50% of revenue, you can assume Merrill's CDO desk took home some pretty handsome paychecks over the years.

Now Merrill is taking a nearly $8 billion writedown on CDO inventory that they warehoused and couldn't sell. Some think the number will go even higher in the current quarter ending December. At the moment, it would appear that Merrill's approach to CDO underwriting was driven more by league table bragging rights, quarterly profit targets and perhaps a compensation system that ultimately failed to tax the CDO underwriting group with an appropriate capital charge for the risks they took with the firm's money. Ultimately, Merrill was buying the securities it packaged. This looks less like a failure of risk-management systems than a complete lack of one.

To be fair, the development of CDO's helped provide the abundant liquidity that enabled private-equity firms to buy out companies, which in turn, has helped prop up the equity markets. And Merrill seems to have done quite well in its M&A advisory, brokerage and other underwriting activities. So the CDO underwriting business may have contributed directly and indirectly to Merrill's success in other lines of business, mitigating the pain somewhat. Ironically, Merrill seems to have managed its exposure to leveraged finance commitments remarkably well, making the CDO debacle even more puzzling.

More to come on this one.

1997-08-28T14:00:00.000-07:00

An old article I co-authored with some interesting data on Yahoo, Lycos, Infoseek and Excite

Private Capital and Public Markets