Monday, March 22, 2010

Communism is Dead, but State Capitalism Thrives

Ian Bremmer, founder of the Eurasia Group, is a political risk expert. Investors all over the world pay big bucks to hear his views on what various governments might or might not do. At the moment, he is in Japan--just one stop on a tour visiting clients. Bremmer says "Everywhere I turn on this Asia trip, folks have been pressing me with their concerns about the deterioration of the U.S.-China relationship...and what it means for them."

Indeed, the relationship between these two key countries appears to be deteriorating rapidly. I've written before about the looming trade war brewing between the U.S. and China. America is pressing China to revalue its currency and Google is threatening to leave China entirely. But the Chinese are also flexing their muscles against other nations. They have detained an Australian businessman who works for Rio Tinto, accusing him of taking bribes.

Bremmer is the author of several books. Three years ago, he wrote the "The J Curve: A New Way to Understand How Nations Rise and Fall." A year ago, he wrote "The Fat Tail: The Power of Political Knowledge for Strategic Investing." His newest book, which comes out in May, sports a title that is anything but subtle. It's called "The End of the Free Market: Who Wins the War Between States and Corporations?" No doubt, you can make a good guess at the answer to that question.

In the Introduction to his newest book, Bremmer begins with another question--one posed by a Chinese diplomat during a meeting that took place in the midst of the global financial crisis. The diplomat asked Bremmer, "Now that the free market has failed, what do you think is the proper role for the state in the economy?"

There is no denying that in almost every country, government is exploiting the recent crisis by assuming a bigger role in the economy. This is true even in the U.S.--once considered a bastion of free market capitalism. The U.S. government now owns substantial equity stakes in formerly blue chip companies, and it is getting involved in everything from strategic managerial decision making to executive compensation.

However, as Bremmer explains, the free market has not failed and we are not witnessing a resurgence of communism. Instead, what we are seeing is a new system called state capitalism. It is a system in which governments use capitalism and free markets to advance their own power and interests.

Bremmer's book does not focus on China or the U.S. alone. In fact, it provides an excellent around-the-world tour of almost every country that has an economy of any meaningful size. All investors, professional or novice, who are looking for global diversification, will benefit from a careful read of the insights provided in this book. Nonetheless, the most interesting and fascinating portions of the book focus on the world's largest and fastest growing economies.

That includes China. The book does an excellent job of explaining how the Chinese government uses state-controlled companies to advance its policies. It uses its power to make sure these companies have every possible advantage. In this way, the government is literally engineering China's development.

As communist governments collapsed all over the world, communists in China maintained power through brute force, best exemplified by the quashing of the Tiananmen Square protests. Yet China's communists also understood that command economies could not effectively compete against free markets. The trick, as far as they were concerned, was to grow the economy while maintaining political control. Their solution was state capitalism, an ideal that has spread around the globe--even to the U.S.

Friday, March 19, 2010

More Info Needed on Pay for Performance

James Reda, founder of James F. Reda & Associates, is a leading executive compensation expert. His firm just released a study of pay and performance metrics for senior executives at the 200 largest companies in the S&P 500 Index. The study is based on information submitted by corporations during the 2009 proxy season.

Of course, executive compensation has long been a hot button issue for corporate watchdogs. Investors often complain about compensation that appears excessive, especially compensation at the CEO level. This is a particularly serious problem when performance results are poor.

In addition to paying a salary, most large companies reward their top executives through short term and long term incentive plans. Short term plans are usually based on pre-determined fixed targets such as EPS or net income. Long term plans rely on relative performance measures such as total shareholder return relative to the average return for other companies in the same industry. The SEC requires corporations to disclose their compensation policies and performance targets for both short term and long term incentive performance measures.

Unfortunately, Reda concludes, "Reporting of performance metrics and related payouts has not improved at the largest companies in the U.S. In fact, the numbers have deteriorated over the last year." To a large extent, investors are not getting the information the SEC says corporations must give them. Reda says this is because companies believe that disclosing specific targets could result in competitive harm. They also do not want to be held to specific published targets. They would rather keep their performance goals flexible, adjusting them as they see fit.

When share prices are going up, stockholders do not get worked up about compensation issues. After all, they usually do not have a problem with the CEO and other executives making lots of money if they, too, are making good money. However, shareholders get very upset when the CEO rakes in millions of dollars of compensation when the company is reporting net losses and the share price is sinking. Pay for performance makes a lot of sense. However, as Reda's study shows, existing plans and practices leave a lot to be desired.

Wednesday, March 17, 2010

The Looming Trade War With China

In recent weeks, Chinese leaders have stepped up the verbal assault on the West by attacking U.S. policy as well as U.S. and European corporations.

Due to the global recession and falling demand, some Chinese factories had to lay off workers and close their doors. While there has been some talk of finding ways to boost domestic consumption, that's a tough sell with China's leaders. After all, consumption still has a bitter taste on a communist tongue. Chinese leaders would prefer instead to see the export ball rolling once again. Furthermore, they blame free market capitalism for the worldwide financial crisis and recession. They don't take kindly to U.S. politicians lecturing them about a weak currency. On the contrary, they say America is the one that is purposely debasing the value of its currency in order to boost its exports and raise the cost of China's goods for American consumers. For good measure, they have even complained about U.S. arms sales to Taiwan and President Obama's temerity for meeting with the Dalai Lama.

The Chinese have also gone on the offensive against Google, putting the company in a rather awkward position. Google executives are asking themselves if they should compromise their values and censor searches (especially searches on political speech) in order to maximize shareholder wealth, or if instead they should live up to the company's code of conduct, 'don't be evil,' even if doing so results in the loss of an estimated $600 million (according to JP Morgan) in revenue this year alone.

It seems that values are winning this debate. Now that Google appears set to pull out of China, its advertising partners are up in arms. They say Google's decision will put them out of business. They want compensation for their losses. Are lawsuits far behind?

Not long ago, Google and a number of other American companies were targeted by computer hackers who were operating from within China. Some experts suspect the Chinese government was actually behind those attacks.

On top of all this, Chinese officials are suddenly claiming that Western luxury goods makers are selling shoddy products in China. This seems like a thinly veiled attempt to urge Chinese consumers to buy only Chinese made goods.

The bottom line is that corporations are finding it much more difficult and costly to make a buck in China. Others may follow Google's lead and leave the country entirely. Or, they may complain to their governments to apply diplomatic pressure. The end result could be an ugly trade war, which would hurt all parties involved. That's an outcome that will make the Great Recession even greater.

Tuesday, March 16, 2010

Financial Engines is a Sharpe IPO

As an academic, William Sharpe was one of the most brilliant and prolific financial researchers. MBA students are familiar with his work on portfolio analysis and the capital asset pricing model. Portfolio managers often use the eponymous Sharpe ratio to determine how much excess return they are producing per unit of risk. Dr. Sharpe has received innumerable honors. In 1990 he was even named a co-recipient of the Nobel Prize in Economics.

This man, however, is no ivory-tower academic. His theories are used every day in the world of finance. Dr. Sharpe is also an entrepreneur. In 1998, he founded what is now Financial Engines (FNGN). The idea was to use the power of the Internet to deliver independent financial advice to investors.

Well, Financial Engines just went public. The company issued 10.6 million shares at $12 per share. That was above the indicated offering range of $9-11 per share. Since the underwriters, Goldman Sachs and UBS, have a 15% over-allotment option, the offering will raise about $146 million before fees. A little less than half the net proceeds is going to selling shareholders.

The stock immediately rallied higher as soon as it became available on the secondary market. At last look, it was trading around $17 per share. That's 42% above the offering price. That gives the company a $675 million market capitalization. FNGN is now selling for 7.9 times sales and more than 100 times trailing earnings. The stock ain't cheap.

Jay Ritter, another respected academician, is best known for his work on IPOs. According to Professor Ritter's work, IPOs tend to underperform the market over a rather long period of time. His research suggests that it would make little sense to buy into an IPO unless you can get it at the offering price and sell it soon after it runs up on the secondary market.

I gave Professor Ritter a call to ask what he thought about the Financial Engines IPO. He said he isn't too concerned about long-run underperformance in this case. He said, "Long-run underperformance is concentrated among companies with less than $50 million in sales in the year before going public." Because Financial Engines generated $85 million in revenues in 2009, it does not fall into that category. As a result, Professor Ritter isn't worried about Financial Engines being a long-run underperformer.

As a former academic myself, I am tempted to buy a few shares just to keep a close eye on the stock. However, I will probably wait until the stock falls back a bit before I get in. Of course, that was my plan with Google when it went public at $85 per share in 2004. I'm still waiting for my buy order to execute on that one.

Thursday, March 11, 2010

Get Rich by Investing Like The Rich

Every year at this time, we at Forbes magazine publish a list of the world's billionaires. This year, Carlos Slim of Mexico took the top honors, marking the first time in 16 years that the richest person in the world is not an American. In fact, there are only three Americans in the top 10 this year. The top 10 also include two Indians, a Brazilian, and three Europeans.

Those who made the list have demonstrated an uncanny ability to invest well, which brings up an interesting question. Can you, too, get rich by investing like the rich? The results of a research study out of Babson College suggest you can.

In a yet unpublished paper, Professor Joel Shulman examines the holdings of 1,125 entrepreneurs who made the Forbes billionaires list during the period April 1996 to March 2009. He identifies 495 publicly traded companies that represent major investments for these ultra-rich individuals. He was able to secure reliable data on 200 companies that trade on 41 different exchanges across 22 countries. His conclusion? Investing in these 200 companies during the period studied would have generated an annualized return of just over 20%. That compares to only a 1-2% annual return for relevant benchmarks.

Of course, what worked in the past may not work in the future. Yet entire hedge funds have been created to implement strategies based on much flimsier evidence. This one certainly seems worth a try.

Tuesday, March 09, 2010

Who Has the Greatest Propensity to Spend Tax Rebates?

Economists sometimes argue that tax rebates can spur economic growth. Furthermore, they say that in order to get the biggest bang for the buck, the money should go to those most likely to spend it. According to conventional wisdom, that would be the poor.

Some argue that giving tax dollars to people who haven't actually paid taxes should not be called a tax rebate. Yet even they would agree that lower wealth, lower income individuals are more likely to put this money back into the economy by spending it. Richer people who don't really need the money would probably just end up saving it. That wouldn't do the economy much good in the short term.

Well, now there is a study that turns this conventional wisdom on its head. In "Household Spending Response to the 2008 Tax Rebate," authors Claudia R. Sahm, Matthew D. Shapiro, and Joel B. Slemrod argue that the $96 billion tax rebate resulted in only $32 billion of extra consumer spending. The majority of recipients either saved the extra money or used it to pay down debt.

What is even more startling is that the propensity to spend the money increased as one's age, wealth, and income increased. In other words, of those who were eligible to receive the payments, the ones who were older, wealthier, and had more income were the most likely to put the money back into the economy in the form of consumer spending. This result is completely contrary to the accepted wisdom.

If you are interested, you can get a copy of the paper from the National Bureau of Economic Research.