SOPHISTICATED FINANCE

Diaspora Management

I have spent the last two days in Jamaica, including some time at a convention devoted to the 4-5 million Jamaicans that live outside the country. Currently Jamaica has a local population of 2.3 million. The Jamaican Government call this overseas population the Diaspora. The Government went to Israel to study how that country manages their diaspora or overseas population of religious followers. There are even academics who have developed a set of five best practices for diaspora management. They are all so obvious that I will not repeat them.

As near as I can tell, diaspora management is designed to guilt the overseas population into investing in the homeland as a means to foster economic development. Economic development theory has baffled me for years, despite quite a bit of study of the subject. As this previous post on economic development makes clear, the subject is overly complicated and therefore much of the theory appears to have limited applicability.

Diaspora management appears to me to be another part of economic development theory that is overly complicated. If you want to attract foreign investment, regardless of the source, you need to satisfy four conditions:

1. Free movement of capital across borders
2. A legal system that protects investor rights at the level of developed countries
3. An economic performance that has sufficient stability and growth to attract investors 
4. Market rates of return for the perceived level of risk that are attractive compared to alternative investments (in other countries)

Jamaica is making progress on the necessary conditions outlined above. Personally I think diaspora management is a distraction that will have limited effect on economic development. Increased efforts to build an economy that attracts more foreign investors would be my strategy for Jamaica.

Areas that look particularly attractive to me for investment in Jamaica are agriculture and alternative energy, which are also key industries in the government twenty year plan (in addition to tourism and logistics). Interestingly, Jamaica is trying to build an enormous transhipping facility to take advantage of the expanded Panama Canal in 2014. Project is in the early stages but foreign investors are showing interest. Miami beware!!

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Excel Competition--ModelOff 2013

The most popular posts at Sophisticated Finance over the years have been some posts I did on Excel modeling, which are in the link at left called "Excel Models and Tips". All the posts related to Excel are here.

Some folks sent me the announcement for a world championship of Excel Modeling called Modeloff 2013. This is a cash prize competition to find the best young modeler in the world. Competitors are required to have a knowledge of finance and Excel but statistics also looks helpful.

One of the sample questions from the 2012 competition is here. It is a list of 50 tasks in Excel and the competitors had to identify the Excel command. Also a nice review of advanced Excel commands if anyone wants to improve their skills.

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More Excel Tips

Presenting Financial Information

Suppose your boss asks you to send him the year-to-date six month P&L. What would you send? There are probably three alternatives:

1. Send the cumulative six month results
2. Send quarters 1 and 2 summed to a six month total
3. Send each of six months individually summed to a six month total

The proper answer is number 3. This approach has several benefits:

1. Makes it easier for the recipient to spot check accuracy by looking at values for six individual months
2. Makes it possible to do trend analysis over six months of data
3. Allows any seasonality to be obvious

Note: Unless you are a publicly traded company, I can see no reason to ever report financial information by quarter.

 

 

Another Look at ROI

I have done finance for almost 40 years and I have done it in almost all its forms--capital raising, trading securities and funding operations. Whenever I am involved in an operating company people always ask me what ROI do we need to reach to justify an investment. In routine, repetitive investments (such as opening another retail store) I almost always have a quantatative target and it tends to be much, much higher than the cost of capital. I have seen several CFOs who use the same technique of setting very high ROI targets. If you use such a technique in routine, repetitive investments you generally get people focused on the efficiency of capital, which is a good thing. Given the high hurdle rate for ROI you also get people focused on customers and revenue. These are equally good results.

However, in other situations I never use ROI. These investments are for strategic reasons or to build comparative advantage against the competition. Until today I had never found anybody who shared this view--ignore ROI for strategic investments that build the foundation for the company future.

In a post today on company sustainability, the AVC blog shared the same view.

"ROI is not the right framework for companies to evaluate investments. ROI is for the wall street folks. They will use it to decide if they want to invest in your company. But when you make investment decisions in your company, don't use the tools that wall street uses. Use the tools that animals use. Survival instincts. What will it take to ensure that your company is around in ten years, fifty years, 100 years? That's how to think if you want to stay in business."

I always say that I specialize at the intersection of finance and strategy and almost always strategy is more important than finance!

Another Benefit of Women

Fast Company has a great post today on some research by Credit Suisse. Key findings:

1. "Only 41% of companies on the MSCI World Index, a collection of global stocks, had any women on their boards at the end of 2005. By the end of 2011, it had increased to 59%."
2. "Between 2005 and 2007, when economic growth was relatively robust, there was little difference in share price performance between companies with or without women on the board."
3. "From 2008 onwards, as volatility increased, the companies with female board members outperformed the others."

So when times get tough in the business, look to women...which you should have learned from your mother at about age 3. Credit Suisse's conclusion: "More women in the group signaled a greater collective intelligence."

 

Black Swans Explained

Nassin Taleb's bestseller "The Black Swan" popularized the notion of statistically improbable outliers. Benoit Mandelbrot's "The Misbehavior of Markets" explained the math behind black swans and took away the mystery.

Studies have shown that the more often we succeed in risky behavior the more likely we are to repeat it. "For ego protection reasons, we like to assume that past events are a product of what we controlled rather than chance", according to Georgetown business professor Catherine Tinsley (Wired Aug 2012). Effectively, success encourages a tendency to ignore the black swan event(s). However, neuroscience may explain this irrational behavior.

In John Coates new book, "The Hour between Dog and Wolf: Risk Taking, Gut Feelings and the Biology of Boom and Bust", the "irrational" exhuberance of financial traders is explained. "The euphoria, overconfidence and heightened appetite for risk that grip traders during a bull market may result from a phenomenon known in biology as the ‘winner effect.’" The winner effect is brought on by an increased flow of testosterone. Effectively human biology may take precedence over the more rational analysis Mandelbrot made possible.

Image credit: Wikipedia

The Role of Shareholders

One of the foundations of capitalism is that the for-profit company is owned by shareholders. However, in the most fundamental sense, little has been written about the nature of shareholders. In a new article in HBR Justin Fox and Professor Jay W. Lorsch (HBS) argue that shareholders are more like "renters" than owners. Shareholders have limited rights rather than the full rights of ownership. The authors argument can be summarized as follows:

1. The average holding period for a stock has declined from 7 years in 1950 to 6 months today.
2. In 1950 90 percent of shares were held by households but today as much as 65-70 percent are owned by institutions; portfolio management approaches in many institutions reduce the focus on individual company performance. 
3. The nature of shareholder voting rights favor management and the board of directors rather than shareholders, which dilutes the benefits of ownership for shareholders.

What brought about most of these changes were the intended or unintended consequences of a government lead initiative to lower brokerage commissions on common stock transactions. Lower transaction costs facilitated more trading and made it cheaper to trade in and out of a stock position, thereby creating shorter holding periods (and more price volatility) and the accumulation of stock positions by institutions.

So what is an individual investor to do? Fox and Lorsch's conclusion was very theoretical and not particularly helpful. My conclusions are:

1. Invest in hedge funds who specialize in short term trading strategies
2. Invest in companies where there is a large shareholder (in percentage ownership terms) because these companies tend to generate better returns for all shareholders due to greater control of management self-interest

The entire article "What Good Are Shareholders", which is well worth reading, is here.

 

 

Facebook Stock Price Slides

Facebook is now trading at 24% below the IPO price. This is a significant price adjustment for a new stock (or any stock) and suggests that the bankers overpriced the stock at the IPO. Aswath Damodaran, the legendary NYU finance professor, explains where the bankers went wrong in this excerpt from Business Insider:

"I think the investment bankers priced the offering based on how shares of Facebook were trading in the private market and their assessments of institutional demand. I don't think that revenue growth, margins, risk or any other fundamentals played much of a role in the pricing. I don't fault them for playing the momentum game, but they played it badly."

Most stocks do not have a large active private market prior to their IPO. Facebook established their private market partly as a means to provide liquidity to the founders and perhaps to provide some support for an aggressive valuation at the IPO. 

As crowd funding grows as a means to fund startups and other private markets in pre-IPO stock emerge, perhaps one should be cautious about these markets as a basis to price IPOs. 

 

Financial Modeling Workshop Miami May 11

I will be doing a workshop for the FIU Pino Entrepreneurship Center on May 11. The workshop focuses on how to build financial models, including an introduction to some advanced Excel commands that make building models easier. This workshop begins where my workshop on business concept development and growth drivers ends. There is an exercise that develops the logic of model building, a digital handout of a linked income statement, balance sheet and cash flow model and a handout of the advanced excel commands.

More details on the workshop are here. Proceeds go to the Pino Center at FIU. If you would like to see a previous presentation, look here. Very practical, little theory, informal style.

Disclosure: I am a member of the Board of Directors of the Pino Entrepreneurship Center.

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A Thought on Facebook's IPO

Image via CrunchBase

Everyone knows that Wednesday Facebook filed an S-1 with the SEC for an IPO, initial public offering. Tech Crunch covered the story and included a public letter from Mark Zuckerberg, the CEO of Facebook. In the letter Zuckerberg states:

 "Facebook aspires to build the services that give people the power to share and help them once again transform many of our core institutions and industries.”

Tech Crunch interprets this quote to mean:

 "Zuckerberg compares Facebook to transformative technologies like the printing press and the television".

First we should recognize that every big IPO has a fair share of hyperbole. Hyperbole often helps people to understand the larger but more complex part of the investment thesis. However, hyperbole works best when solidly grounded in fact. I do not agree that Facebook is a "transformative technology" comparable to the printing press, the telephone, the automobile or even Google.

All of these technologies or business concepts launched a new phase of the industrial revolution. Each of these concepts lead to multiple, large valuable derivative industries. For example, printing presses made possible magazines and newspapers, the telephone launched remote customer service and Google made possible You Tube and Wolfram Alpha. While Google may prove to be a catalyst comparable to the automobile, it is too early to tell. The automobile launched innumerable major industries, such as taxis, car leasing, parking lots, gas stations, car repair and even fast food restaurants.

My concern in comparing Facebook to these major innovations is that I do not think it will produce derivative industries. Facebook is a closed garden that companies pay to access. I think that Facebook is more like the phonebook was to the telephone. The phonebook was a great idea but few businesses were derived from the phonebook. The phonebook did not take the industrial revolution to a new more productive level.

While I do question the hyperbole in the Facebook IPO, I think Facebook will be a successful transaction. Hopefully it will launch a strong IPO market for tech companies over the following twelve months.

 

 

Related articles

• Facebook IPO Summary (ecademy.com)
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Miami-Pino Spring Entrepreneurship Workshop Series

The Pino Entrepreneurship Center at FIU has released its schedule of workshops for March through May. These workshops are open to the south Florida business community as well as students. I will be giving two workshops:

1. "Developing a Killer Business Plan" which focuses on how to develop a business concept and a business model and also provides a checklist for how to write a business plan. March 2.
2. "Financial Modeling" which deals with the logic, design and construction of an Excel model for a business or business plan. More on my philosophy of business models is here. This is the first time in about two years that I have offered this workshop so you may want to save the date May 11.

John Fleming (LinkedIn profile) will present a workshop, "Marketing Strategy and Social Media for Entrepreneurs" on April 13. John does a great job on some complex but important subjects for every entrepreneur.

Registration, location and pricing for my workshop March 2 is here. Proceeds go to the Pino Center.

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Two Good Finance Articles on Returns and Valuation

A little finance never hurts and two articles on equities caught my attention. The first article comes from Bloomberg, where they cite some research by Wharton Professor Jeremy Siegel. The professor's research shows that for the first time since 1861, the thirty year return on bonds exceeds that of equity. You will remember from introductory finance class that equity returns should exceed bond returns given the higher risk in being an equityholder. A few possible explanations for this rare phenomena:

1. Equities are undervalued
2. We are in some sort of "war" market akin to the U.S. Civil War
3. Demand for bonds is disproportionately high, driving up prices and returns, in response to various global uncertainties (the other side of point 1.)

The other article cites some high level mathematical analysis from Cornell Professor Robert Jarrow  and Columbia Professor Phillip Protter to identify bubbles, or overvaluation, in different asset classes including equities. For example, the methodology correctly identified the dot.com era and the price runup after the LinkedIn IPO as bubbles. Also interesting, the methodology shows that current gold prices are not a bubble. Of course trading on such math should correct for the bubble in a given stock. Question I have is whether the professors have applied their methodology to whole asset classes such as bonds or equities to see if they give us any insight into the current existence of bubbles. If bonds showed "bubble" behavior, that might explain Siegel's findings.

I found at least one of these articles on FinanceProfessor.com.

 

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UBS CEO Resigns

The New York Times is reporting that the CEO of UBS, Oswald Grubel, is resigning due to losses of $2.3 billion from a fraudulent trading scheme. Mr. Grubel had assumed the position in 2009 after the bank replaced the former CEO for losses in trading sub-prime mortgages. 

UBS appears to have a record of holding the CEO accountable for poor performance, particularly when it is attributable to control weaknesses. I think that this approach is fair, although I would expect that every manager between the rogue trader and Mr. Grubel should be relieved of their position.

Related articles

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HP Spins Off Computer Division

Image via CrunchBase

It’s always nice to have your predictions confirmed and the sooner the better. Yesterday’s post said that in five years the only surviving brands in consumer IT would be Apple and Amazon. Today’s announcement that HP is spinning off its computer division seems to support my prediction. Sale of the division would be the next logical step.

The new HP focus on business services also looks like a good decision. However, I would point out that this market is becoming more complicated by executive personal device selections, which now have a much greater effect on corporate decisions.

HP also announced that they are dropping further development of webOS. Based on this week's Google Motorola transaction, maybe someone in Asia like Samsung will buy it. In fact, maybe Samsung should buy HP's computer division. That would be an interesting development.

 

Related articles

• H-P Earnings Clouded By PC Spin-Off and Possible M&A Rumors (HPQ, SAP, DELL, AAPL, IBM, MSFT, INTC, RIMM, GOOG) (247wallst.com)
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Accounting and Finance Workshop

Image via Wikipedia

I just presented a two day workshop called "Accounting and Finance for Non-financial Managers" for a large international company. The workshop focuses on theoretical concepts in micro-economics, finance and accounting and the practical application of the concepts to business management and decision making.

The client wanted the workshop to focus on the analysis of new projects using the discounted cash flow methodology. What was particularly interesting is that the company shared their own discounted cash flow template for project analysis. Every CFO makes adjustments to such a template to achieve certain strategic or risk management objectives. When I was CFO of the Indonesian company I added seven percent to the actual weighted average cost of capital discount factor to reflect the uncertainty of the operating environment. The differences between the client template and the theoretical model for discounted cash flow gave me quite a lot of insight into the strategy of the company. I would like to illustrate this point more fully but I would be violating my non-disclosure agreement with the client. One point worth noting is that the next time you do due diligence on a large acquisition ask to see their capital expenditure evaluation template. May give you some real insights into how they think about the business.

If you are interested in refreshing your knowledge of theoretical finance and valuation, Aswath Damodaran, a professor at the Stern School at NYU, has a terrific website here. What could be more fun on this 4th of July weekend than reading about beta and weighted average cost of capital. Enjoy the weekend even if you don't do any finance.

 

Peru, Colombia and Chile Merge Stock Markets

As reported in Big Think, South America's most centrist governments are merging their stock markets. Peru, Colombia and Chile have announced the merger of their stock markets to improve market liquidity and access to capital for local companies. In the run up to the Peruvian presidential elections, this announcement and its timing raises interesting issues for front runner Ollanta Humala. Humala is backed by former President Lugo of Brazil and President Chavez of Venezuela and would be expected to be against such a pro-business merger. Comments against the merger would increase concerns in the business community and abroad about a future Humala government. My guess is that Humala will remain silent on the issue until after the elections.

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Finance Term--Civets

For years I have been trying to introduce into common English usage the word "bozette". A bozette is a female "bozo". I have had little success but never the less I carry on. Now to "Civets".

Civets are the group of six emerging market countries just below the BRIC countries in terms of economic attractiveness. The countries include Colombia, Indonesia, Vietnam, Egypt, Turkey and South Africa. According to this story in the FT, the term "Civets" was coined by Michael Geoghegan, former chief executive of HSBC, to define an investment product for this country grouping.

 

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Bond Rating Agencies--China vs the U.S.

Traditionally bonds for corporates, banks and sovereigns have been rated by Moody's, Standard & Poor and Fitch. All three of these rating agencies are based in the U.S. It is not surprising given the size of the U.S. bond market and the large institutional investor base here. Of course the size of U.S. debt markets may call in to question the objectivity of U.S.-based rating agencies. These were the same rating agencies who missed the problems in real estate loans and derivatives in 2008.

As reported in this post, capital markets are increasingly becoming influenced by Asia and the capital being accumulated there. So it comes perhaps as no surprise that China has developed their own rating agencies. The leading rating agency is Degong Global. Degong downgraded the U.S. credit rating from AAA to AA+ in 2010. Some might speculate that the downgrade was politically motivated. Hard to believe that Degong, based in the most politicized capital market in the world--China, has much likelihood of being taken seriously.

Might be a good new business idea to start a rating agency based in Singapore or Switzerland where political interference would be minimal, no allegations of vested interest are likely and home country debt is not significant enough to affect ratings.

I found this story on Big Think, who found it on Mail.

 

Africa Looks Promising

Everyone is watching China and those of us in Miami are always focused on Latin America. With my work for OLPC I have been following Africa for the first time in my career. In the next 10-20 years I think that Africa could emerge as the new darling in emerging markets. My logic is in part based on these facts:

• Angola is the fastest growing economy in the world at over 10 percent per annum
• Demand for natural resources will increase dramatically over the next 10-20 years, which will benefit the resource rich continent of Africa
• China is investing large amounts of foreign aid in infrastructure in Africa
• Sources of capital are starting to focus on Africa, as evidenced by the FT report that Carlyle is setting up a private equity fund for the continent

Keys to the success of Africa will be whether it can develop its human resources and a middle class. Education and health services will be the important requirements to achieve these two objectives.

Interesting fact: Africa is a larger land area than China, the U.S. and Europe combined.

Image credit

Pitching a Deal

The Gong Show has an interesting article on a different style of presenting an investment to an investor. After the introductions and small talk, start the presentation by highlighting the reasons not to do the deal. In other words, present the key assumptions or risks in the deal. By getting these issues out of the way, the presentation can focus on the reasons to do the deal.

This is perhaps an extreme approach to pitching but it has several advantages that should be in every first pitch:

1. It conveys honesty
2. It shows a more profound understanding of the business concept
3. It focuses the pitch on the key issues for the investor
4. It weeds out the uninterested investor more quickly, saving you time

Suffice it to say, you are supposed to have mitigants for the risks identified and these are further developed in the presentation.

If you are going to use this up front style I would make one exception. At the end of the presentation I would briefly mention felony convictions, tax liens, personal bankruptcies or Attorney General or SEC investigations. Up front these issues might consume all the alloted time or turn off the people before you get to describe the business concept, but you mention such items in the first meeting.

Sophisticated investors are very methodical in risk analysis and they are going to discover the issues eventually. The key is to have the honesty and experience to correctly identify the major risks. I have used this type of approach for thirty years and it works effectively worldwide regardless of culture with sophisticated investors. 

Note: This approach is for pitching sophisticated people, which would be my preferred source of capital every time. I have never pitched friends and family but honesty is still the best policy if you want a chance to be invited back to Thanksgiving dinner after the company fails.