Big Data Analytics – The McKinsey Mash – Part Two

In Big Data Analytics – The McKinsey Mash – Part One we discussed the potential for “Big Data” to heighten our organization’s competitiveness, enhance competitive advantage, create valuable assets, and improve efficiency and effectiveness of our operations.

This was based on a series of McKinsey articles (and the synthesis thereof which I’m calling a “mash” - that and it’s Halloween in the US, when the "Monster Mash" song is popular), the links for which appear at the bottom of this posting.

How will we be able to bring the benefits of the above to fruition? We will need to focus on our:

·         Business model,

·         Management practices,

·         Human capital practices

A Business Model is a Terrible Thing to Waste

From a business model perspective, Big Data represents “radical transparency”, in which case “companies with proprietary data will be threatened”. If we rely on a model where we have access to lots of information and only share it begrudgingly when the price is right, we could have problems.

This reminds me of an adage I ran across in the social media world – “content wants to be free”. We can see the impact of this already in the recording industry. It seems to me that consultants rely on their knowledge and expertise as a means to secure engagements.

I remember being part of a project where the consultants claimed to have a “best practices database” (though an alum from that institution told me that it was a bunch of hooey - most of their engagements were based on a variant of 5 slide decks).

We are already beginning to experience the personalization of marketing due to data. This is a central ingredient of Google’s model. As an example, I could place on this blog “AdSense” (which is a Google product) that essentially determines why you came to this (awesome!) blog post and place relevant ads (relevant being determined by data - your recent search criteria, web activity, Google plus profile, etc.) in a box to the side.

According to McKinsey, “you need to make a commitment to conceiving of data as a competitive advantage.”, and, somewhat ominously (from a status quo perspective), “…future competitive benefits may accrue to companies that can not only capture more and better data but also use that data effectively at scale”

No Room for Old School

From a management perspective, Big Data is likely to bring about major changes.

Due to sheer granularity, we will be able to test all of our decisions prior to making them, or use “controlled experiments…[to] distinguish causation from correlation”. Big Data may even be able to replace management elements, because it “expands the universe for application of algorithms and machine-mediated analysis”.

In prior posts we have discussed incentives of entrenched power-holders, and how these contribute to less use of hard facts. Big Data may disrupt some of that tendency - “Our research has found a shift from using intuition toward using data and analytics in making decisions.”

Though not without cost. “You have to have a different kind of confidence to be willing to let the data speak…One CEO told me that when he pushed this attitude, he had to change over 50% of his senior-management team because they just didn’t get it.” Uh…later on, dudes!

The message to the rest of us blokes? Get with the program (hmm…pun intended?)!

Is a Data Scientist Born, or Made?

The question of human talent and abilities might very well be the gate-keeper for Big Data. McKinsey says “the harder thing is to get the set of skills”.

What skills, exactly? Among the ones mentioned:

·         “analytical”

·         “a set of attitudes and an understanding of the business”

·         “more to do with sampling methodologies, designing experiments, and working these very, very large data sets without becoming overwhelmed”

·         “creative in seeing patterns and for people who can be entrepreneurial in creating new business opportunities that take advantage of these patterns”

These skills may be very hard to find: “People realize that there is a gap between the current role of statistician or data analyst or business analyst and what they actually want. They are grappling with the set of tools and the set of skills that they need. Across the whole research cycle, it’s a combination of skills that social scientists understand, plus additional programming skills, plus the ability to do aggressive prioritization. And, of course, a good grounding in statistics and machine learning. That collection of skills is difficult to find.”

Based on what has been presented above, I suppose it doesn’t really matter whether you were born with it or you developed it, so long as you got it!

Key Treasury Café Takeaways

Big Data, so long as we are able to obtain or retain a relevant set of capabilities, talents, and mindset amongst our employees, can make a difference in our competitive abilities, though we must be willing to change our management practices in order to utilize.

Questions

What percentage of employees will need to be devoted to Big Data in order for the effort to ‘bear fruit’?

How many do you have vs. how many do you need?

Are you able to envision a scenario where competitive advantage in your industry accrues to those able to utilize ‘big data’?

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McKinsey Article Links:

http://www.mckinseyquarterly.com/Are_you_ready_for_the_era_of_big_data_2864
http://www.mckinseyquarterly.com/Competing_through_data_Three_experts_offer_their_game_plans_2868
http://www.mckinseyquarterly.com/Seizing_the_potential_of_big_data_2870

Big Data Analytics – The McKinsey Mash – Part One

Not ONE…

Not TWO…

THREE!...separate McKinsey articles released this month about Big Data (links are below), a topic we chatted about early last month here at Treasury Café.

Big Data in Brief

To quickly refresh, Big Data is in one sense just what it would seem – really, really large amounts of data. In the Wikipedia definition the sets have become so large they “become awkward to work with using on-hand database management tools”. Analytics software vendors, such as SAS, promote tools that can handle these things anyway.

According to some sources, the total amount of data is increasing at a rate somewhere between doubling every two years to ten times in the next five years (see “Big Data in the House” for links).

They are measuring data in terabytes now (I could have sworn these were extinct millions of years ago!). So the bottom line is we ain’t seen nothin’ yet.

So What?

Why should a finance and treasury organization care about this? As discussed earlier this week, finance and treasury is one of the preeminent analysis centers within an organization. It may be the most able to work with analytical processes and information in some outfits. They will be working with Big Data.

Even when they are not the strongest producer, they will be one of the strongest customers of Big Data. The output of the analytics process, when done correctly, will enhance the quality and degree of knowledge with respect to critical finance and treasury’s processes – cash flow forecasts, financing contingencies, organizational strategy and scenario analysis, and risk management (interest rate, forex, commodity prices).

McKinsey argues that Big Data is a “game changer”, and for this reason interest should be piqued at the very top of the organizational pyramid. In its Trusted Advisor role, finance and treasury have a stake in the game.

Let’s Take It from the Top

Given its potential impact, McKinsey recommends that the CEO ask 4 questions: “What’s the Prize?”, “How Do I Build a Skill Base?”, “How Do I Get the Organization Behind Me?”, and “How Do I Scale This Up?”.

As a trusted advisor from the field of finance, the answers are: “We can help you figure that out”, “It resides here and leave the rest to us”, “We are already behind you”, and “We can help plan for that and execute it”.

So What, Exactly, is the Prize?

The answer to this question lies in the realm of competitiveness, strategic assets, and organizational transformation.

Big Data changes competitive dynamics. A “sizable US retailer” woke up to find a “different, far nimbler” type of competitor, “seemingly out of the blue”, due to that competitor’s “investments in its ability to collect, integrate, and analyze data”.

In addition, “…big data may well become a new type of corporate asset that will cut across business units and function much as a powerful brand does, representing a key basis for competition.”

Finally, Big Data will change competition “by transforming processes, altering corporate ecosystems and facilitating innovation”

Key Takeaway

Big Data, while somewhat confusing, is an element of the organizational landscape that must be addressed. Undertakings in this area can lead to:

1)      Heightened competitiveness,

2)      Competitive advantage,

3)      Value-generating assets, and

4)      More effective/efficient organizational operations.

Who can be against that?

Questions

·         Is Big Data real or just a passing fad?

·         Is competitiveness important to your organization? Can Big Data help?

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Add to the discussion with your thoughts, comments, questions and feedback! Please share Treasury Café with others. Thank you!

Mckinsey Links:

http://www.mckinseyquarterly.com/Are_you_ready_for_the_era_of_big_data_2864

http://www.mckinseyquarterly.com/Competing_through_data_Three_experts_offer_their_game_plans_2868

http://www.mckinseyquarterly.com/Seizing_the_potential_of_big_data_2870

Analytics – Get A Seat at the Table

Analytics are not a new topic for Treasury Café because they are critically important for a finance and treasury organization to think about. Why is that?

Leverage Talent

Finance professionals know how to work with numbers and data. It is a large part of the educational curriculum for one very good reason – it is also a large part of the job! The finance professional is working with mathematical and statistical concepts from the first day of their career to their last.

Depending on their level, this extends into statistical methodologies, models, concepts, and processes. Financial options may be priced based on the statistical properties of a normal or lognormal distribution. In other circumstances, they are priced using Monte-Carlo simulation models, representing any number and variety of statistical distributions.

Often times, statistical analysis of financial market data is required in order to develop the models and the parameters under which the simulation is performed. Alternatively, the finance person is directing others (such as banking or consulting partners) who are performing this analysis.

In either case, they know enough in order to accomplish the mission at hand. In some companies, and in some industries, the finance group may be the strongest when it comes to these analytical capabilities.

Data Utilization

The finance group is generally the one that is producing forecasts and simulations for the organization’s future. If we want to know the answer to a question such as “what is the range of cash flows we are going to generate 5 years from now?” it is likely someone in the finance group knows what this is. They will also be able to tell you the balance sheet and income statement impacts as well.

Newton’s law says that something at rest remains at rest, unless something with enough force changes the inertia. In financial forecasting, we call those forces value drivers. Modeling value drivers is often the critical piece of the puzzle, and this usually entails statistical analyses, testing, and development.

A Pumpkin Tale

For example, last weekend I took my kids to the pumpkin farm since it is Halloween time here in the US. At these places we buy pumpkins, jump on “magic pillows” or “bouncy houses”, watch pig races, find our way out of corn-field mazes, ride ponies and camels, go on hayrides, and other similar activities.

From the pumpkin patch operator’s perspective, the majority of their revenue occurs during a 6-week period of the year, and the bulk of that on weekend days. For those who don’t know, this 6-week Fall period in the Midwest US can be 30 degrees Fahrenheit or 90 degrees. It can be sunny, or it can snow. It can be summer-breezy or bone-chilling Artic-galey. For the pumpkin patch business, weather during these 12 days is a value-driver!

In order to analyze our possible future as pumpkin-patch operators, we would look at weather patterns over a long enough period of time in order to be confident (from a statistical viewpoint) that we have captured the full range of potential weather environments. We would then develop a model out of this data in order to predict a range and probability of different future outcomes of the weather, and its subsequent impact on pumpkin patch attendance and buying behavior. The ability to do this lies in the finance staff’s statistical abilities.

A Seat at the Table

Finance has native talents in the analytics arena, and it certainly has a strong interest in the outcome of analytic efforts. Therefore, it is critically important for finance to have a major voice in the process.

The location of analytics talent will vary by company and by industry. As an example, in some companies or industries marketing rules the roost, and in these situations it likely that the marketing support group has analytics prowess, and they are busy linking web traffic, twitter word counts, in-store visits to income level, area of residence, interest and other data-base elements to arrive at a revenue forecast.

That is fine - the more analytics the better - but if the capability resides in that area then it must be shared with finance and treasury. If not, we run into the silo problem, which we touched on in “The Matrix”.

This is the problem we want to avoid. We want to be a part of the process so that we may leverage the talents and knowledge for the good of the overall organization, and to provide the finance and treasury team enough opportunity to grow and develop.

As the era of Big Data continues, this will become more and more necessary.

Questions

·         Can finance and treasury safely ignore the Big Data phenomenon? Why?

·         Will Big Data significantly impact the way your organization runs its business?

·         What are the finance and treasury staff’s analytic, statistical, and technology capabilities in your organization?

·         Where is the “natural home” for your organization’s Big Data capability?

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Simply Character

Sam Mogannum, the owner of Bi-Rite Market, was recently profiled in San Francisco online in a feature entitled “Cornering the Market”. As I read the article, I had an introspective moment where I asked myself “why do I find this appealing, and why would others?” So I decided to read it again (and again and again) to try and figure that out.

Human and Humble

Sam Mogannum is the owner of a company. He is part of the ethos of the American Dream. As an owner and entrepreneur, he has earned the right to the privileges – status, deference, a corner office, etc. – so frequently associated with this status.

Yet, “he cooks harvest dinners for his staff and serves them”. This is not a man who is pulling rank or putting on airs.

His office is only “a few feet away” from the “market’s cramped prep kitchen…[where] one cook mixes a batch of chipotle-lime mayo and another stuffs sausages”. Apparently, Sam Mogannum did not get the memo about his corner office entitlement.

He also does real work around the store, referring to himself as “the maintenance guy” and performing “hands-on grooming of the deli case”. This is a man who would make Tom Peters proud - he is Managing By Wandering Around.

Community Member

Mogannum’s also a put-your-money-where-your-mouth-is type of guy when it comes to his community. “He likes to support neighborhood businesses, so he heads to Faye’s Video & Espresso Bar for his daily soy café au lait.”

Many of the store’s products are sourced in the community, such as its fish, fruit and vegetables.

In addition, he practices the art of paying-it-forward: “Mogannum takes a personal interest in his vendors, supporting their causes and, if necessary, bailing them out when times get tough”

The sense of community also extends to his profession: “Rivals can go to great lengths to guard their ideas and keep the completion out of their stores, yet Mogannum regularly welcomes other grocers to Bi-Rite”

Contributing to the Greater Good

People are often advised by gurus to “do what you love” and “follow your dreams”. Mogannum illustrates the greater good transcendence, stating “I like to do things that make a difference. Money is secondary. It’s always been secondary…”

The man finds meaning in his work: “Stores like ours are like an heirloom vegetable…we’re a thing of the past, but there’s been a resurgence to bring small markets back, because they have meaning. They have a story, they have history.”

Definitely not the typical growth-at-all-costs CEO.

A Treasury Café Conclusion

The first thing that strikes me about Mr. Mogannum’s attributes (as reported by San Francisco online and as summarized by me) is the similarity to the advice one hears about social media activities - promote yourself no more than 5% of the time, consistently ask how we can help others and lift them up, become a member of the community before all else.

The second thing is that while this on-line community can be great, it is still merely digital. Unlike this nascent wikiworld, the Bi-Rite story is one of these idealistic traits occurring in real life, able to be seen, touched, heard and sensed. We can experience it in 360 degrees, up-close and personal.
And finally, the best part is that it might all be as close as our neighborhood market!

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Triangulating Steve Jobs

Full disclosure - I did not know Steve Jobs. I did not know anyone who did know him. I am not a lifelong Apple fan - ownership of my first Apple product occurred less than 1 year ago (iPad last November).

As is often the case when I seek to learn something, I try to get my hands on several pieces of information and attempt to triangulate to what is important or identify some set of factors that might serve as a common denominator. For those not familiar, triangulation is a process where you take one perspective, and then a different one, and from that we can begin to get a full 3-D representation rather than a one dimensional viewpoint.

Call it the curse of being analytical.

So in order to understand what Steve Jobs might have truly represented, as opposed to being named the next Saint, I read a lot of articles. For the purposes of this post, we will consider four:

 “What Makes Apple Apple” – Gary Hamel

“Steve Jobs: Seven Lesson from Apple’s founder” – Frederic Filloux, The Guardian

“How Apple Works: Inside the world’s biggest startup” – Adam Lashinsky, CNN Money 

“What I Learned From Steve Jobs” – Guy Kawasaki

We All Agree

Creativity and Design – all 4 authors identified this factor as one of Jobs’ contributions in one form or another. Lashinsky discussed the few management meetings Apple held, the fact that they said no to many things, and that a group of two wrote the entire Safari browser code. Hamel touched on this principle in his “Be Unreasonable” trait, where he discusses moving from either/or to both/and as being a hallmark of achieving the “impossible”. Filloux notes that Jobs could "connect aesthetics with function".

Most of Us Agree

Marketing – three of the four articles discussed marketing, but even further than that one particular element. Lashinsky: “People don’t know what they want until you show them”. Kawasaki: “customers cannot tell you what they want”. Hamel:  “Be Unreasonable… Aim to Surprise”. Hamel further notes that Jobs sought to “produce the same sort of gee-whiz delight that a parent aims for on Christmas morning”.

Accountability – all but Hamel mentioned a culture of accountability as an Jobs legacy, though this is putting it nicely. Kawasaki stated “I lived in fear that Steve would tell me that I, or my work, was crap”.  Lashinsky discusses the concept of the “DRI”, or Directly Responsible Individual, and also discusses a “brutal” atmosphere, “dictatorship” leadership, and long lasting “fear of retributions”. Filloux quotes Jobs’ statement that there are “zero” committees at Apple.

Be Different – Lashinsky discusses several aspects to this trait, discussing that Apple seeks to operate “like a start-up” despite its size, and that it “thumbs its nose at modern corporate conventions”.  Kawasaki said that Jobs would “Jump to the next curve”, noting that “big wins happen when you go beyond better sameness”. He also notes that “experts are clueless”, and for that reason Jobs followed the beat of his own drum. Hamel discusses that Apple “sets itself the challenge to radically redefine the status quo”.

These 4 factors, Creativity/Design, Marketing, Accountability, and Being Different, are the ones mentioned by over half of the authors. This list is obviously not exhaustive of what others believe Steve Jobs represented. It is not intended to be. But based on these articles, these are the factors that come closest to a consensus.

When I re-read this list, there appears to be hints of a common thread  - "go beyond sameness", "customers cannot tell you what they want",  create "unreasonable" products. This theme is evocotive of a willingness to step out as an individual, resisting the reversion to the collective mean. It means following our own inner light, and listening to the muse within.

So perhaps we can ultimately conclude:

Steve Jobs was Steve Jobs, and nobody else...and that was exactly the way he liked it. 

I would love to hear your thoughts about Steve Jobs or your stories on this topic if you have them.

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The Best Thing to Bring to Work Today? A Box of Pins!

Ever feel like your boss is not listening to you? Do you sometimes get the sense that your input does not really impact your organization in any meaningful way?

Well, guess what – you’re right!

Strategy + Business just released information about recent research that will be published in a forthcoming edition of Organizational Behavior and Human Decision Processes. The study examined those who held power, and the impact of this on their ability and willingness to accept advice or outside views.

The main take away – the more power someone holds the less they seek out advice or others’ opinions before making judgments, assessments and decisions.

Let’s Think About This

Now that we know this – let’s ask some questions:

Given a group of five people on the factory floor, or the warehouse, or the front of the shop, what will be their level of collaboration versus five people attending a senior executive retreat? According to the research, the front-line folks are more likely to seek out, listen to, and respect each other’s opinions or recommendations. In other words, the level of collaboration will occur near the front-line, not in the leadership ranks.

What is the likely usefulness of the proverbial “open door” policy that many organizations promote? Based on the research conclusions, while people may be free to come and go, the open door policy does not necessarily translate to an “open between the ears” policy!

Given the research, what level of credence can we give to the CEO’s statement that the executive team works really well together?

It All Becomes Clear

In past blogs I have made a point of discussing the organizational silo issue. There always seems to be somebody who is not communicating with somebody else. This research confirms some of those perceptions. Why does Supply Chain not consult with Treasury, or Marketing with R&D? Because they think they know better - they don’t need those other people!

At least the folks at the top are thinking that.

In the Big Data post, we discussed the situation where folks do not avail themselves of data and analytic tools even when they are available. Again, according to the research, this makes sense. Why let facts interfere with what we already know?!!

We Must Be Human Without Being Human

The antidote to this is simple – don’t let power go to our head. However, this is the human tendency, and it is not easy to correct, though there are some things we can do:

Cultivate an Attitude of Servant Leadership – believing that our leadership’s purpose is to serve those who are working for us will cause us to listen openly to our staff and other’s in the organization.

Actively Practice Humility – one of the great steps in the 12-step programs is coming to believe in a power greater than yourself. Just holding on to this belief makes us more open to ideas and people outside our realm of comfort.

Make Advice Seeking and Research a Requirement – if the organization can embed some process of information gathering and analysis as part of the decision process, this can help counteract some of the tendencies discussed above. This was mentioned in the S+B article.

Beef Up The Data Capabilities – the ability to analyze data, convert it into information and transform it to knowledge is a great antidote, and one that will be increasingly available if we learn how to use it.

Walk the Talk – if we want to be open, transparent, honest, then we need to be. We cannot say it, we cannot point it out, we have to do it!

Taking these steps can help us to correct the natural tendency to turn inwards into ourselves as we progress through our lives and careers.

What if all that fails? We can always use one of those pins to pop a hole in our inflated egos!

 I would love to hear your thoughts about how power affects us as leaders or your stories on this topic if you have them.

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The Face Behind the Brand

I wrote on my Technorati post about Pan Am and the fact that the image of the brand may diverge sharply from the reality of it.

In today’s web-connected, socially-networked world the issue of brand’s and their meaning are popular topics. Have a bricks and mortar company - what is your social-media brand? Looking for a job – what does your on-line persona reveal about your personal brand? Looking for an entrepreneurial opportunity – what niches are still wide-open to a strong brand presence? How can we enhance our brand using Facebook? LinkedIn? Google+?

Once Upon a Time...

There was a local phone company who would try and cross-sell on every call made to them. “I didn’t get my bill this month…we’re sorry sir, we’ll send that right out, and would you like to use our voicemail service?”  “The repairman didn’t show up…we’re sorry sir, would you like to use our long-distance plan?”

My wife had the misfortune of talking to them once, and they said that based on an analysis of our phone bill we would save money by going to Calling Plan X. So we did, and it cost us 50% more for the next two months! Switching back over led to another cross-sell, and they refused to refund the extra cash they snookered out of us through their bogus “analysis”.

They Got What Was Coming To Them

Local phone service opened up for competitive providers, and needless to say we jumped at the chance to switch from Bait-and-Switch Telephone Co. And for an idyllic period of time we lived in a world without cross-selling, self-serving “analysis”, and phone company evils of all sorts.

In addition, the service we were using was from a company with a great brand going back a long-way. The Pan Am of phone companies. What a glorious world we live in!

But Who Gets The Last Laugh?

Meanwhile, back on the ranch, everything is fine until…Evil Bait and Switch buys Pan Am Phone – and takes their name and logo!

To this very day, I sometimes need to recite in my head when I catch myself seeing Pan Am Phone’s name and logo:

“they are not Pan Am Phones, they are Evil Bait and Switch”

“they are not Pan Am Phones, they are Evil Bait and Switch”

“they are not Pan Am Phones, they are Evil Bait and Switch”

Perform Brand Due Diligence – Vigilantly, Regularly, Faithfully

Brand image is powerful. Madison Avenue has lasted as long as it has because brands can invoke positive feelings, imagery, associations, and other valuable reactions within us.

But when the brands are sold on the auction block, we must be very wary. They will tell us, as Oz did to Dorothy and her entourage, “do not pay attention to that man behind the curtain”, but we must ignore that and pay very careful attention. Very, very careful attention indeed.

The brand we love may no longer be what we believe it to be. It may have lost its soul. It may have been traded for a quick buck. As consumers, we are loyal to brands. But every so often we need to make a dispassionate assessment though the lens of clarity to decide whether they are still worthy of us.

Each of us is special. Each of us is unique. The brands we choose to identify with, promote, honor, and cherish need to be just as worthy.

We cannot afford to compromise our integrity for those who believe they can buy us on the auction block, or trick us through cheap magic.

I would love to hear your thoughts about the Face Behind the Brand or your stories on this topic if you have them.

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Term Limits 3D

Imagine the situation where our CEO approaches us and says “why don’t we issue short-term debt so we can pick up some earnings per share this coming year?”

What factors need to be considered in order to assess this proposition properly and provide an appropriate recommendation? Roughly speaking there are three dimensions:

Risk

Refinancing – if the debt comes due at inopportune moments, when supply and demand are out of balance, the organization can face significantly higher funding costs.

Cash Flow Volatility – if our firm is subject to cash flow volatility, the choice of short-term or long-term debt can exacerbate this, depending on what factors cause the volatility and the correlation of the volatility to interest rates.

Investor Diversification – short-term debt investors and long-term investors can differ, so in aggregate it may be beneficial to diversify to capture the lower portions of each segments supply and demand curves.

View of the Future

Signaling Effect – if we are aware of information or opportunities that will positively impact the organization over the coming period of time, we may issue short-term debt now so that we can refinance later at better rates when these opportunities have come to pass and the information is public.

Funding Cost Strategy – short-term debt rates are usually (though not always!) lower than long-term debt rates, so by issuing short-term debt consistently our financing costs will be lower than if we financed at longer tenors.

Market Timing – if we have a view that rates are near their “bottom”, or are likely to rise, then we may execute longer term debt issuances in order to “lock in” the more favorable rates.

Flexibility – long-term debt may make the organization less likely to exploit future growth opportunities, since a portion of the value of these opportunities will go to existing debt investors.

Current Market and Financial Situation

Current Interest Rate Environment – short-term vs. long-term interest rates may be very different or very similar.

Current Credit Environment – short-term vs. long-term credit spreads may be very different or very similar.

Current Debt Structure – depending on our existing debt structure, such as existing “maturity buckets” and short-term vs. long-term mix, we may need to use an upcoming issuance to balance the debt from an aggregate viewpoint.

Current Asset-Liability Duration – the duration of the company’s liabilities to its assets may create a need to balance from this perspective. 

This list of factors is long. Different elements will be more important than others at any given time, and therefore we will see situations where two different companies execute completely opposite financing activities, or two people in the same company may have opposite opinions about which way to go. This is to be expected – this is not a decision that can emanate from a black box.

I would love to hear your thoughts about term structure of debt or your stories on this topic if you have them.

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Let’s Move On

The stock market has been on a roller coaster the past couple of weeks, and much of the news centers on the latest developments in the Greek debt crisis as the cause.

Really?

Greek debt was downgraded to below investment grade status by Standard and Poor’s in April of 2010.  That was 18 months ago! If they defaulted tomorrow, would that really be such a surprise to anyone at this point?

Any bank holding Greek debt has to have done something by now - write it down, boost reserves, raise capital, or sell. All the governments have run numerous scenarios and developed contingency plans within contingency plans.

Will the financial system topple because of something we have seen coming for the past year and a half?

My understanding is that Lehman caused an issue in large part because it was unexpected, in at least two ways - the extent of their problems, and the decision by the US government to let them fail.

We are not surprised by Greece’s debt problems at this point. Perhaps there is still a lingering expectation that governments will step in to prevent a failure, but that cannot conceivably be a 100% expectation, can it?

If it’s something else we need to be concerned about (and that could very well be), let’s start focusing on that rather than hiding behind an 18 month issue.

It’s time we moved on.

I would love to hear your thoughts about Greek debt or your stories on this topic if you have them.

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Investors: [Do Not] Yield to Oncoming Analysts!

Investors have a difficult task. There are thousands and thousands of stocks to choose from, many bonds to consider, futures and options related to these and other things, commodities, etc. In order to derive a true understanding requires a lot of research.

In order to assist, and market, “sell-side” analysts arose to do some of this work for the investor, and communicate succinctly the critical and important information while discarding the rest.

There was a sell-side analyst report I ran across the other day which touted as an investment benefit the high dividend yield of the stock compared to its peer group.

Wait a sec – is that right?

Pros

On the positive side, a higher dividend yielding stock does offer some “downside” protection. As long as the dividend is considered relatively safe, then there should be value attributed to it, and thus the stock price has some kind of floor related to it due to this dividend.

Cons

On the downside, dividend yield is usually correlated with interest rates, so as they move the price of the stock can move against you even if everything else remains the same.

But even more darkly, what if we believe the economic theory (covered in earlier posts) that the market price of a security does in fact reflect the best information available to all investors? If we believe this, then the dividend has a higher yield for a reason. And a good one.

Valuation

The price of a stock using the Dividend Discount Model, in its simplest format (there are more complicated representations), is:

Simply stated, the price of the stock (P) is equal to the dividend of the stock (D), discounted by an appropriate cost of capital (k) less growth expectations of the dividend (g).

Rearranged to reflect dividend yield, this equation becomes:

The dividend yield therefore reflects the cost of capital in relation to the growth prospects of the stock.

In a situation where we consider two stocks, one with a yield of 6% and one with a yield of 3%, the difference between the two is due to k-g. This means, at the two extremes, either:

a)      the cost of capital for the higher yielding stock is higher by 3%, which means the risk inherent with that stock is greater than the other.

b)      The growth expectation of the higher yielding stock is lower by 3% than the other.

Of course, it could be a blend of the two anywhere between a and b.

The point here is that the higher yield is due to a combination of greater risk and/or lower growth. Last time I checked neither of these are attractive situations, sell-side analysts notwithstanding.

So how can a higher yielding stock be a good idea?

Consider the Possibilities

If we take the position that the market might not reflect the true possibilities (a heresy to my alma mater!), then it might be possible we are taking on less risk than we are being compensated for. Using a casino analogy, under normal conditions the odds are in the houses favor, but if we end up at a blackjack table that pays 5:1 for a 21 then it might be advantageous to play.

Alternatively, we might be getting growth “for free”. Not a bad deal.

However, this ultimately means that even the sell-side analyst reports cannot just be consumed or acted upon… as investors we need to make sure the investment makes sense according to ourselves and our work.

So, in some respects we are back to square one – we as investors need to evaluate the merits and prospects of our investable universe. An analyst report might be one facet of information, but only we, and we alone, can decide the merits of its content.

I would love to hear your thoughts about investment valuations or your stories on this topic if you have them.

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