Sunday, January 27, 2008

Cutthroat competition

I just read “The Running of the Bulls – Inside the cutthroat race from Wharton to Wall Street”. It is a fascinating book by Nicole Ridgway (now Senior Editor of SmartMoney) – that describes the life of an undergraduate at Wharton (arguably the best undergrad program in the US for finance). It outlines the intense competition, drive and hunger of the students in their 4 years at the school. The book takes us through the experiences of 6 students – as they go thru brutal interviews for the 10 week summer internship. Students work 100-120 hours seven days a week at firms like Goldman Sachs, Lazard Feres, Citigroup, McKinsey, General Mills, etc – just to keep up. The author then takes us into the interview process (case studies, quantitative technical questions, situational interviews, etc) with the jobs they land after graduation.

The author has selected the 6 students with enough diversity that their stories do not seem monotonous. One of them is Shreevar Kheruka (whose family owns Borosil group) - from my hometown, Bombay. It is an easy read that is sure to take you back to your school/college days.

The book also mentions Kellogg alum and the superstar of Lazard Feres - Gary Parr (Deputy Chairman). It outlines Gary mentoring one of the 6 students. Gary helped broker the $58 billion transaction that merged JP Morgan Chase with Bank One.

Friday, January 18, 2008

What does a Chief Strategy Officer do?

Recently, my friend Rohit Shyam joined Accelrys as their Chief Strategy Officer (CSO). This is a newer C-level title that is catching up in many companies. Traditionally, the CEO is responsible for strategy and company direction while the COO is in charge of operations. So, what does the CSO do?

From the title, one would think that the CSO is responsible for formulating strategy. That would be a very incomplete and misleading definition. In a recent issue of the Harvard Business Review, authors R. Timothy S. Breene, Paul F. Nunes, Walter E. Shill outline the CSO role in greater detail. For starters, the CSO role is not just a “(strategy) thinking” job. In fact execution is an integral part of this role. Typically, the CEO is bogged down by the ever growing complexity of the global business environment – political, regulatory, economic, shareholder and other stakeholder challenges. Add to that the pressure to deliver results at an ever increasing pace. Clearly, with all this pressure, it becomes tough for a CEO to ensure strategy refinement and execution.

That is the reason more and more CEO’s are hiring CSO’s – to help them with refinement and execution of strategy. The CSO typically reports to the CEO. The CSO is tasked with creating, communicating, executing, and sustaining a company's strategic initiatives. The CSO is not just a thinking/dreaming strategist; in fact they consider themselves as doers.

They help set and refine the strategy. Furthermore, they ensure that different departments/organizations within the company understand their role in the strategic plan and how it connects with the overall objectives. They also drive change across the company – to ensure the different arms of the organization march in tandem. Finally, the CSO validates the decisions made by the various departments to ensure alignment with company strategy. CSO’s help steer the top team away from groupthink and from focusing too much on past practices and accomplishments.

CSO’s are seasoned executives who have held P&L responsibilities and have had significant operational experience. Most importantly, a good CSO candidate should be: deeply trusted by the CEO, a master of multitasking and a jack of all trades, a star player, and a doer, not just a thinker. The CSO role is an apt successor to the CEO – since they get involved in almost all parts of the business. Having a CSO is no longer a luxury for a CEO – it is becoming mandatory to have a strong CSO in order for CEO’s to perform their job well. The COO role does not go away. They are still critical but their focus is on day-to-day tactics and operations.

I am very thankful to Rohit for clarifying the role of the CSO. I wish him only the very best in this new venture.

Sunday, January 13, 2008

Technology spending in 2008

Analysts across the board are predicting lower technology spending in 2008 compared to the previous year. IDC expects technology spending in the US to grow by 3-4% (softer than 6.6% in 2007). Gartner projects US technology spending to grow by 5.7 % (compared to 6.1%).Forrester expects the U.S. market to grow 4.6 percent, down from 5.4 percent last year.

Other than the different specific numbers, the consensus is that technology spending in 2008 will be lower than 2007. The credit crisis, subprime ripple effects and rising oil prices have not helped matters. When credit tightens, the first thing that takes a hit is capital spending and technology spending. Star (technology research) analyst - Laura Conigliaro at Goldman Sachs advised her clients that IT spending is less than comforting.

However, there is consensus that vendors that focus on developing economies in 2008 will reap benefits. IT purchases among countries in the Asia-Pacific region is expect to hit $535 billion next year, up 14%, following a 19% rise in 2007, says Forrester. The United States remains the biggest buyer of IT by far, at a projected $533 billion this year. China, which spent $117 billion this year, will surpass Japan, which spent $173 billion, as the second-biggest consumer of IT within a few years, Forrester predicts.

The major areas that firms will spend money - maintenance and upgrades. Since spending is going to be softer, cost saving initiatives will be looked at positively. We could see increased outsourcing contracts based on cost reductions and strong ROI models. Server Virtualization (VMWare,etc) will be another area that companies will look to spend money – to run their data centers effectively.

There is debate on the impact on SaaS firms. SaaS firms argue that since they do not require massive capex, it should be popular in a soft economy. On the other hand, MGI Research states that SaaS vendors will be hit harder if the economy heads downward than vendors licensing software in the traditional mode. SaaS vendors have more infrastructure costs to bear, and businesses will lower the number of subscribed employees if a poor economy stretches beyond nine months, MGI predicts.

MGI states that in a declining economy, SaaS companies may take a triple hit as they will see their initial transaction sizes trimmed, upsell opportunities reduced or eliminated, and then there is a possibility that users will aim to reduce the number of subscribed seats. Not that on-premise software vendors have it easy. SaaS vendors have challenges due to the heavy infrastructure burden. Also, in an enterprise model, the user provides first level of support, but in a SaaS model, most (if not all) support is provided by the SaaS vendor.

Net/net – Technology spending will be lower in 2008. Whether it is an on-premise software or SaaS, both will face its own set of challenges. Vendors will need to be creative to make the most of the soft spending. Emerging areas like SOA and virtualization are good bets. There will be a lot of focus on cost savings (read outsourcing). Upgrades are another prime area. Firms would do well to look (expand) overseas instead of just looking within the United States. Expanding into growing economies like China and India would be beneficial (see my blog on the Chinese currency appreciation at

Sunday, January 6, 2008

Do price limits behave like magnets?

I was reading a paper that was published by my friend Purnendu Nath (PhD Finance - London Business School). The paper is titled “Do price limits behave like magnets?”

Many major stock and commodities exchanges have instituted procedures to limit mass selling in times of serious market declines or irrational bull runs in a single day. These mechanisms include Circuit Breakers, the Collar Rule, and Price Limits. Circuit Breakers establish whether trading will be halted temporarily or stopped entirely. The Collar Rule and Price Limits affect the way trading takes place. In price limits, the exchange places restrictions on upper and lower limits (e.g. plus or minus 10% of the previous day’s closing price). Trading does not stop when the price limit is reached, however trades must take place within the specific range. The main reason for price limits is to ensure prices do not drop or increase dramatically in a single day.

For his paper, Purnendu collected tick data from the National Stock Exchange of India (NSE) – over 110 million trades in a 14 month period. He proves using empirical analysis that price limit does not suck in prices in its neighborhood. In other words, the price varies across the band and is not necessarily attracted to the upper/lower limit.

He also shows that price limits do not always cause acceleration in trading. Using regression and statistical analysis, he shows that for upper price limits there seems to be a reduction in trading activity as a stock approaches its limit price. For lower price limits, there is acceleration as a stock approaches the limit. However, it cannot be concluded that the existence of a lower price limit causes the acceleration in trading. That falling prices evoke fear and induce panic related trading is a possibility that is also confirmed by examining the extent of trading at the limit prices.

Price limits do have benefits. They do prevent stock market overreaction and do not necessarily cause it.

In the United States, the SEC has institutionalized price limits in the “futures” market.

Nice work, Purnendu!!!!

Friday, January 4, 2008

Goldman Sachs – How they did it?

Goldman in comparison with its peers
Wall Street firms like Citigroup, Bear Stearns, Morgan Stanley, Merrill Lynch and others are struggling and bleeding – due to the drastic impact of the recent subprime and credit problems. The top executives lost their jobs and were kicked out in despair by their Boards and investor.

Now, consider this in contrast – On Dec 18 2007, Goldman Sachs reported excellent positive results. It is the only major investment bank in the United States that has emerged as yet unscathed from this debacle. Goldman's annual profits were up 22% to $11.6bn. The bank's 30,000 staff will share a compensation pool of $20.1bn - amounting to $600,000 each if it was divided up equally (which, obviously, it won't be). Goldman CEO Lloyd Blankfein will take home approx $70 million this year compared to $54 million last year.

Wow – incredible!!!! How did they do it?
How did Goldman manage to avoid the downslide?
Goldman has avoided the worst of the mortgage mayhem in the US by making an inspired bet that there would be a huge rise in loan defaults among higher-risk homebuyers in the US. Last year, when the mortgage markets were still riding high, they decided to reduce their holdings and take out hedges against losses, going directly against most of their rivals, who continued to fill their boots.

According to The Wall Street Journal, taking that position generated nearly $4 billion of profits during the year ended Nov. 30. This decision did not necessarily come from the top. Instead, it came from 2 traders of a very small division (superstar traders Michael Swenson and Josh Birnbaum) of the bank. Michael and Josh pushed their belief and convinced senior management to take this strategy.

Is that the complete story?
But wait – this is not the complete story. On the one hand, they took a short position. But on the other hand, Goldman Sachs took part in issuing, packaging, slicing, and selling bundles of asset-backed debt during the past several years, charging multimillion-dollar fees to its clients (who lost a bunch of money).

Critics accuse Goldman of not being careful with their clients’ money and not advising clients to take the same bets they (Goldman) made. I do not think that this was a planned conspiracy as it looks in hindsight. They hedged their bets wisely – and made commissions out of an instrument that was in high demand. Yes – they had a double whammy – they made money on commissions as well as by shorting. Goldman has once again proved – why it is the “crème de la crème” of investment banking.

Some notable Goldman alumni – Jim Cramer (Mad Money), Eddie Lampert (K-Mart, Sears), Robert Rubin (Chairman of Citigroup), Joshua Bolten (White House Chief of Staff).

This story certainly depicts the impact of contrarian thinking. I am sure Michael and Josh got a very nice bonus check and a lot of thank you notes from their bosses!!!!! What are they up to next?

Tuesday, January 1, 2008

Can we predict the future (Deming, Taleb & The Law of Karma)?

Dr William Edwards Deming
Dr William Edwards Deming is known as the father of the Japanese post-war industrial revival and was regarded by many as the leading quality guru in the United States. He was invited to Japan at the end of World War II by Japanese industrial leaders and engineers. They asked Dr. Deming how long it would take to shift the perception of the world from the existing paradigm that Japan produced cheap, shoddy imitations to one of producing innovative quality products.

Dr. Deming told the group that if they would follow his directions, they could achieve the desired outcome in five years. Few of the leaders believed him. But they were ashamed to say so and would be embarrassed if they failed to follow his suggestions. As Dr. Deming mentioned, "They surprised me and did it in four years". For his efforts he was awarded the Second Order of the Sacred Treasure by the former Emperor Hirohito.

Dr Deming used to say “The most important things are unknown or unknowable". The factors that have the greatest impact, long term, can be quite surprising. Analogous to an earthquake that disrupts service, other "earth-shattering" events that most affect an organization will be unknown or unknowable, in advance. Other examples of important things would be: a drastic change in technology, or new investment capital.

The Black Swan – Nassim Taleb
Nassim Taleb is the author of the book "Black Swan" that discusses the massive and pervasive impact of highly improbable event. Taleb was a pioneer of complex financial derivatives and was a senior trader at Wall Street. Taleb regards many scientific discoveries as black swans—"undirected" and unpredicted. He gives the September 11, 2001 attacks as an example of a Black Swan event. For hundreds of years, it was accepted that the color of swans was white. However, in the 17th century, swans with black color were discovered in Australia - thus the name "Black Swan" - that denotes an improbable event that no one had predicted but came to pass.

Taleb claims that almost all consequential events in history come from the unexpected - while humans convince themselves that these events are explainable in hindsight. He argues that forecasting methods (statistics, fractals, power law, etc) have not been able to predict major events. By just focusing on past events (to predict the future), we tend to ignore other possibilities.
A black swan is an outlier, an event that lies beyond the realm of normal expectations. How would an understanding of the world on June 27, 1914, have helped anyone guess what was to happen next? The rise of Hitler, the demise of the Soviet bloc, the spread of Islamic fundamentalism, the Internet bubble, 9/11: not only were these events unpredictable, but anyone who correctly forecast any of them would have been deemed a lunatic (indeed, some were).

Law of Karma
In contrast to the randomness that Taleb talks about, the Hindus subscribe to the “Law of Karma”. The effects of all deeds actively create past, present and future experiences, thus making one responsible for one's own life, and the pain and joy it brings to others. Karma extends through past life, this lifetime and future lives. The net effect is that you sow what you reap (except that there is a time-lag (that sometimes spans lifetimes) between action and result).

In Conclusion
Hence, the recommendation for us is to keep an open mind and be open to idea that you may not be always able to forecast correctly. The "Black Swan" may be right under your nose and you might miss it completely!!!! In that sense, Deming and Taleb are saying the same thing - be open to the impossible and do not necessarily look to history to predict the future. The past does not necessarily equal or point to the future.

Tough times for Private Equity & LBO funds

In financial markets there is something known as the Bigger (Greater) Fool Theory. It means that “buy a stock and you'll make money as long as some other fool is willing to buy the stock from you at a higher price in order to sell it to an even bigger fool at an even higher price." (Crash, Arbel & Kaff). Unfortunately, speculative bubbles always burst eventually, leading to a rapid depreciation in price due to the selloff.

The Bigger Fool Theory might be in play with respect to the Private Equity and LBO funds. The Blackstone Group, the private-equity powerhouse lead by Stephen Schwarzman, has lost a quarter of its value since it went public in June. Fortress Investment Group, a diversified alternative asset management company, and Och-Ziff Capital Management, a hedge fund run by Daniel Och, a former Goldman Sachs trader, have also stumbled following initial public offerings.

The tightening credit squeeze has sent the buyout industry into a funk and left some hedge funds with steep losses. Kohlberg Kravis Roberts (KKR), which invented the modern buyout industry, is now struggling to get its own IPO off the ground. AQR Capital Management, a $38 billion hedge fund, has put its plans for an offering on hold. Citigroup, which helped take Och-Ziff public in November, recently warned that the firm was likely to face headwinds for the foreseeable future.

The ongoing issues with the financial markets is certainly hurting Private Equity and LBO funds. However, like everything else, it will bounce back. Will a bigger fool come and save the day?