Business Insight Zone

Catching up on some reading the other day, I came across this Wall Street Journal article (subscription required) about how Berkshire Hathaway chief Warren Buffett has been taking advantage of the current swoon in the credit markets. There’s a predictable flow of sentiments from the financial world toward Buffett: against a background of constant respect, Buffett is regarded as overly staid during market booms, but then he’s seen as even more of a financial wizard when the markets go to pot.

This happened during the Internet bubble of the late 1990s, when Buffett eschewed ownership of online or high-tech companies because he claimed he simply didn’t understand those lines of business. Buffett is disciplined enough that, if he doesn’t know how to assign an accurate value to an asset, he doesn’t buy it. In the case of the Internet bubble, this meant that he avoided fallout from the spectacular collapses of Pets.com and the rest; meanwhile, his old-line assets like Acme Brick and building-supplies maker Johns Manville just kept chugging along, boringly posting profits year after year. In the past couple of years there has been some noise for Berkshire to disperse its extra cash as dividends, but Buffett has resisted these payouts because he believes that Berkshire can make more money for its investors in the long run by having cash available to invest on their behalf when markets are favorable.

Which brings us to today. During this round of market suffering, Buffett is sitting on a pile of cash — nearly $50 billion — that he can use to buy discounted assets, whether that means stocks, bonds, or whole businesses. Bargains are available because the credit crunch now underway has tightened banks’ willingness to lend money to the usual buyers of the past few years, including hedge funds and private equity shops. That means that Buffett is now running one of the best games in town for asset owners looking to sell. All of this makes Buffett happy because he loves bargains.

As the WSJ article points out in passing, Buffett’s standing also provides a luxury for Berkshire that many other buyers don’t enjoy: the company “doesn’t participate in auctions.” This means that Buffett need never suffer the “winner’s curse” common to auctions — that is, he never ends up “winning” an auction by agreeing to pay more than an asset is worth.

The Journal article touches upon one more thing that has marked Buffett’s business approach for decades: when the time is right, the Wizard of Omaha is able to move billions of dollars at a moment’s notice. The fact that Berkshire doesn’t do a lot of rapid buying and selling is one more testament to the discipline of Buffett, his business partner Charles Munger, and their lieutenants. But it does not mean that the company can’t pull the trigger quickly when conditions dictate.

Expect much more trigger-pulling from Berkshire in the months to come. Warren Buffett is ready to do business at a reasonable price any time, but he absolutely loves a buyer’s market.

Here’s the operative question for Cerberus Capital Management this week [i.e. the second week of August]: “Now that we own it, what do we do with it?” “It,” of course, is Chrysler, which — in case you’ve been traveling deep in the Amazon for the past few months — Cerberus just bought from Daimler. Although it had a few successes along the way, overall the #3 US car maker stagnated under Daimler’s ownership, and the corporate marriage never delivered the synergistic results envisioned by Daimler’s erstwhile CEO, Juergen Schrempp, back in the late 1990s. So now, after what seems like a fairly amicable divorce, the two car makers will go their separate ways. (Daimler has retained a minority stake in Chrysler.)

Mind you, negotiating this divorce wasn’t all fun and games for Cerberus. The investment firm has done plenty of big deals before, including buyouts of auto parts makers and other manufacturing firms. But it had never experienced anything like the limelight it received once it announced the Chrysler deal. This is a key reason that former Treasury secretary John Snow has served as the face of Cerberus during this process; besides his financial and commercial acumen, he’s used to facing the cameras.

Yet Cerberus could predict the media scrutiny. What it couldn’t have known when it announced the Chrysler buyout months ago was that worldwide credit markets would go haywire between that announcement and the consummation of the deal. In the past few weeks, there was even talk that Cerberus might not line up enough funding to pull it off. In the end, though, the deal went through, and questions about financing dropped away when Chrysler made the surprise announcement that ousted Home Depot CEO Bob Nardelli would take the reins. And now comes the hard part: how to make Chrysler relevant again in the automotive world.

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* This article first appeared on the Company of the Day page on 9 August 2007.

Y’all be sure to keep me honest when I blow a prediction, but on this one, I’m claiming victory. Having beat the anticompetitive rap that the FTC tried to pin on it in court, Whole Foods has completed its acquisiton of Wild Oats.

Whole Foods Closes Wild Oats Deal

What I wrote about this in June:

My opinion is that in this case Whole Foods is right, the feds are wrong, and it’s not even close. I’m willing to cite my own experience, unscientific though it is, in support of this view: I sometimes buy groceries at Whole Foods, as well as a Wild Oats-owned Sun Harvest Market around the corner from my house, but I also regularly shop at H-E-B and Randall’s, which is owned by Safeway. Here in Austin — the hometown of Whole Foods, remember — the primary competition for Whole Foods’ mega-flagship store downtown isn’t the little Sun Harvest in my neighborhood, but the large and exquisitely capitalized Central Market stores owned by H-E-B.

That’s why I’m claiming victory now. Of course, I’ve also come down on the side of the FTC, more or less, in the Rambus case, so let’s see how that one works out . . .

Today’s Company of the Day is Royal Dutch Shell.

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So far, 2007 has been a mixed year for the world’s top oil companies. Overall they continue to make piles of money, yet BP and Exxon Mobil each reported declines in earnings for the past quarter. Meanwhile, Royal Dutch Shell’s profits rose nearly 20%, even in the face of continued civil strife around its oil holdings in Nigeria. The improved earnings are a happy turn of events for Shell, which has suffered some real setbacks in recent years. One of the worst came in 2006, when Shell lost control of a $20 billion oil and gas project on the Russian island of Sakhalin — a project that the Kremlin basically took from Shell and handed to Gazprom. Worse, this externally imposed setback came in the wake of an internally driven scandal in which some Shell executives systematically misreported the company’s oil reserves.

With these events now safely in the past, it will be interesting to see what Shell does going forward. Like its peer BP (and unlike Exxon Mobil), Shell has invested heavily in alternative energy. But perhaps more so than any of its rivals, Shell has staked its future success on improved use of technology, which helps to explain why Nokia’s well-regarded former CEO Jorma Ollila is now Shell’s chairman. While the move may not be as historic as bringing in Boeing veteran Alan Mulally to run Ford (or GE and Home Depot veteran Bob Nardelli to run Chrysler), the oil industry is like the auto industry in its tendency to be insular. But since Ollila has such a hand in shaping the company’s strategy, it seems clear that Shell wants to be a technology-driven energy company rather than “merely” one of the world’s largest oil producers.

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The bidding on that question starts at “Really, really smart” and goes up from there, but it will be interesting to see how the hedge-fund wizard will be regarded if his Sears Holdings keeps performing like it has been.

Sears Holdings profit falls 40 percent

Mind you, this is only one facet of the company’s performance, because Lampert doesn’t run the holding company of Sears and Kmart like most retailers run their operations. He’s still a financier at heart, and throughout the time he’s owned the retail chains, he’s used them as cash-generating machines that provide him with ample coin for further investment. Nat Worden of TheStreet.com offers a detailed analysis here:

Lampert’s Sears Strategy Could Pay Off

. . . At $140, the company is trading at approximately 10 times its annual cash flow after taxes. That means that by buying back shares, Lampert is essentially investing his money at a 10% cash return — a good deal considering that 10-year Treasury bonds are yielding less than 5%.

The cheaper the stock goes, the higher his return. Meanwhile, public shareholders who bought the stock at $150 are banking that the market won’t let Lampert get his 10% return for long. Eventually, the value of Sears Holdings’ cash generation will have to be recognized in its market price, as long as the cash flows hold up.

With its sales declines showing signs of digging into its bottom line, Sears Holdings could soon find its cash flows dwindling rapidly — especially in a consumer-led economic slowdown. In that worst-case scenario, some consumers may turn to discount retailers for their shopping needs, but as they build stores, retail titans like Wal-Mart, Target, and Costco are in a much better position to win that business.

The key issue: somewhere down the line, Sears Holdings still must succeed as an actual retailer. Right? Right? That’s the question its non-Lampert shareholders are asking; the answer to that question in, say, two more years will help us to answer the question of just how smart Eddie Lampert is.

A month ago I gave my view on what might/could/should come next for Yahoo as its co-founder and now-CEO Jerry Yang tries to get it back on track. Today’s news brings a flurry of stories assessing the executive moves that Yahoo! has just announced.

Hey Kids! Let’s Put On a Yahoo Reorg!
by Kara Swisher at AllThingsD

… as reported by Valleywag, Greg Coleman is out as its head of global sales and his duties shift over to Hilary Schneider, a fast-rising former Knight Ridder exec who is a favorite of Yahoo President Sue Decker.

[Schneider will] ride herd over all ad sales and also relationships with publishers. [...]

Also, because [Schneider] is not as experienced in the ad sales arena as one might want from, well, the head of ad sales at a company whose principal business model is advertising, Yahoo might also be hiring another still unnamed top exec who will report to Decker and will focus on innovative ad solutions and products.

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Decker rings the changes at Yahoo!
by Rhys Blakely at Times Online

Susan Decker, the president of Yahoo!, has stamped her authority on the struggling internet group, creating a new division that will generate the lion’s share of revenue and will be headed by a close ally.

The new Global Partner Division will include Yahoo!’s sales operations and will oversee all advertising business — including search, display, mobile and video. It will also take “responsibility for all of our ‘partners’ — advertisers, agencies, resellers, publishers, ad networks, developers, or others,” Ms Decker wrote in a memo to staff.

The short version: Decker, who was already the #2 in the company when Yang took over from Terry Semel as CEO earlier this summer, is holding the reins of the company (under Yang’s watchful eye, one would assume), and it will fall to Decker to get Yahoo back to where Yang and Yahoo’s investors want it to be.

Russian industry underwent a major upheaval after the Soviet Union fell in the early 1990s. Out of this process, which was often marked by corruption and cronyism, a number of giant Russian companies emerged — none of them larger than Gazprom, the former Soviet natural gas ministry that is now the world’s largest gas producer. Gazprom enjoys near-monopoly control of Russian gas, and the Kremlin enjoys effective control of Gazprom. In the words of Hoover’s petroleum industry editor Stuart Hampton, this arrangement allows “the Russian leadership [to use] Gazprom as a blunt instrument of foreign policy.”

Last week’s [i.e. the last week of July's] headlines offered a case in point: Gazprom threatened to halve gas supplies to Russia’s neighbor Belarus, citing the smaller country’s failure to pay $460 million worth of its gas bill. Besides angering Belarus, the threat spooked European countries further to the west, which rely on Gazprom gas that flows to them through pipelines laid across Belarus. This is only the latest round in this fight. At the end of 2006, in the depths of the Belarusian winter, Gazprom threatened to cut off Belarus’s gas supply unless the country paid much higher rates going forward. The outcome was the same in both cases: the Belarus government gave in, largely because it had no viable choice.

Gazprom reaps big rewards for its closeness to the Kremlin. Last year the Russian government squeezed Royal Dutch Shell out of its lead role in a $22 billion oil and gas project on the Russian island of Sakhalin, then handed the reins of the project to Gazprom. Last week, as the Belarus dispute unfolded, the Russian energy ministry indicated that another big partner in the Sakhalin project, Exxon Mobil, might be forced to ship gas from the project to Russian customers rather than markets abroad — another move in Gazprom’s favor.

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For more thoughts on Gazprom, see these earlier posts.

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* This article originally ran on our Company of the Day page on 6 August 2007.

Former Treasury Secretary and Harvard president Lawrence Summers has a perceptive column at the Financial Times, which includes this pithy summary of market blow-ups:

First there is a period of overconfidence, rising asset values and growing leverage as investors increase their faith in strategies that have enjoyed a long run of success. Second, there is a surprise that leads investors to seek greater safety. In the current case it was the discovery of huge problems in the subprime sector and the resulting loss of confidence in the ratings agencies. Third, as investors rush for the exits, the focus of risk analysis shifts from fundamentals to investor behaviour. As some investors liquidate their assets, prices fall; others are in turn forced to liquidate, further driving prices down. The anticipation of cascading liquidations leads to more liquidations creating price movements that seemed inconceivable only a few weeks before. The reduced availability of credit then has a negative effect on the real economy. Eventually - sometimes in a few months as in the US in 1987 and 1998; sometimes over a decade, as in Japan during the 1990s - there is enough price adjustment that extraordinary fear gives way to ordinary greed and the process of repair begins.

I found the Summers column via Megan McArdle’s blog. She has a variety of smart things to say about who should get the blame for the current mess and who should be made to pay for it under the rubric of “They deserve it.”

On another front, Andrew Leonard of Slate wonders whether the credit-card industry isn’t due for a wave of defaults as a follow-on effect of the mortgage meltdown. Americans are typically overleveraged (what I would call overleveraged, anyway), often through the mechanism of credit-card debt. It would be sour news indeed for the consumer-sensitive portions of the economy if personal defaults went way up.

Though I’m verrrrry much an amateur at it, behavioral economics has been a fascination of mine for a little while. Here are two current stories, one by the eminent behavioral economist Robert Shiller of Yale, the other overtly about the prevailing logic of poor people, but with a distinct behavioral-economics bent.

First, Shiller in the New York Times:

A Psychology Lesson From the Markets

. . . Classical economics cannot explain this cycle, because underlying these booms is popular reaction to the price increases themselves. Rising prices encourage investors to expect more price increases, and their optimism feeds back into even more increases, again and again in a vicious circle. As the boom continues, there is less fear of borrowing heavily, or of lending heavily. In this situation, lower lending standards seem perfectly appropriate — and even a fair way to permit everyone to prosper.

. . .

People worry that they must increase their wealth to fend for themselves. One might think that this lack of trust would promote much precautionary saving, but world savings rates are not high over all. It has generally fit in better with popular perceptions of the booms to be smart investors, not great savers.

. . .

Many people feel that they have discovered their true inner genius as investors and have relished the new self-expression and excitement. Investors across the world have been thinking that they are winners — not recognizing that much of their success is only a result of a boom. Declines in asset prices endanger this very self-esteem.

This article isn’t the best thing Shiller has ever written, and it doesn’t make for a great primer in behavioral economics. But it is useful for pointing out some of the steps of (il)logic that people use to drive their actions in unusual market environments — or in ordinary market environments that are misperceived.

Next we turn to a Steven Pearlstein from the Washington Post:

On Poverty, Maybe We’re All Wrong

. . . The reason the poor are poor is that they are more likely to not finish school, not work, not save, and get hooked on drugs and alcohol and run afoul of the law. Liberals tend to blame it on history (slavery) or lack of opportunity (poor schools, discrimination), while conservatives blame government (welfare) and personal failings (lack of discipline), but both sides agree that these behaviors are so contrary to self-interest that they must be irrational.

After all, the reason we study, work, save and generally behave ourselves is that these behaviors allow us to earn more money, and more money will improve our lives. And, by logic, that must be particularly true of the poor, for whom each extra dollar to be earned or saved for a rainy day is surely more valuable than it is for, say, Bill Gates.

In economics, this insight — that the fifth ice cream sundae is less valuable than the first one — is enshrined in the law of diminishing marginal utility.

But what if this iron law of economics is wrong? What if it doesn’t apply at every point along the income scale? If you and everyone around you are desperately poor, maybe it’s perfectly rational to think that an extra dollar or two won’t make much of a difference in reducing your misery. Or that you won’t be able to “study” your way out of the ghetto. Or that if you find a $100 bill on the street, maybe it’s logical to blow it on one great night on the town rather than portion it out a dollar a day for 100 days.

On the other hand, maybe the point at which people are most willing to work hard, save and play by the rules isn’t when they are very poor, or very rich, but in the neighborhoods on either side of the point you might call economic sufficiency — a motivational sweet spot that, in statistical terms, might be defined as between 50 percent ($24,000) and 200 percent ($96,000) of median household income.

As Pearlstein himself points out, this is just one theory for what is happening with poverty in the US. But it seems to comport with my own observations, not about financial markets, but about people. We do seemingly irrational things all the time, based on elements of logic that don’t (always) reduce to numerical considerations of money. Any classical economist would admit this off the record, but it is the behavioral economists who have made it their business to figure out what these other considerations are.

In my view of the world, all of this ties back into our perceptions of which phenomena are the (transient) “weather” of our lives and which are the (durable) “landscape.” Our sometimes “illogical” mindsets on these issues lead to the sort of broad miscalculations that we are now seeing play out in the subprime mortgage market.

Today’s Company of the Day is Mattel.

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These days, Mattel would surely love it if consumers focused on Barbie’s platinum hair rather than on the lead that has been found in some Mattel toys. The bad news has come in waves for the world’s top toy maker in recent weeks. The company recalled one million toys from its Fisher-Price brand after it discovered that the toys may contain lead paint. It later recalled nearly half a million toys related to the movie Cars, but that was nothing compared to the 18 million toys — including Barbie, Polly Pocket, and Batman figures — that it recalled over worries about potentially dangerous small magnets. Plaintiffs have filed a class action suit over the recalls, but the bigger problem stands to be with parents’ trust. Most US parents hold to the highest possible standards for protecting their children, and it will be bad news indeed for Mattel if those parents decide that its safety record is unreliable.

The recalls are part of a larger trend of product safety problems for goods manufactured in China. The issue arose earlier this year when pet food made in China poisoned some dogs and cats in the US, and it has only grown worse since the Mattel recalls. The fallout has included executions of, and suicides by, implicated officials in China, along with a growing tide of unease among Americans about the quality of goods made in China. Yet China also turns out some of the finest manufactured goods in the world, everything from electronics to luxury furniture, for companies based elsewhere. But as James Fallows of The Atlantic has pointed out, most Chinese manufacturers achieve this standard only when they are held to it by their customers abroad. Whether Mattel will bear all the blame for its product recalls, or whether some of it will be fixed permanently on Chinese factories, remains to be seen.

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P.S. — If you’re interested to read more of what James Fallows has written on this, start here.