Sunday, February 22, 2015

Pignataro, Mergers, Acquisitions, Divestitures, and Other Restructurings

Paul Pignataro is a master at explaining complicated financial concepts. Earlier I reviewed his work on Financial Modeling and Valuation and Leveraged Buyouts. Now comes his third book in as many years: Mergers, Acquisitions, Divestitures, and Other Restructurings (Wiley, 2015).

Pignataro, the founder and CEO of the New York School of Finance, draws on both his teaching skills and his extensive experience in investment banking and private equity. As in his previous books, he first sets forth some general principles and then takes the reader step by step through a case study. He assumes no prior knowledge, not even of basic Excel coding. By the way, according to standard investment banking modeling etiquette, “all hardcoded numbers and assumption drivers should be entered in blue font” and “all formulas should be entered in black font.” (p. 58) (My own spreadsheets follow this etiquette insofar as they distinguish between hardcoded and formula-generated numbers, but my color choice, which I always considered tasteful, is outright garish by Wall Street standards. Oh well, I guess that’s what happens when you code in a flannel shirt and sweat pants instead of accepted Street attire. But I digress, something Pignataro is careful not to do.)

The case study for this book is the 2013 all-stock merger of equals transaction between OfficeMax and Office Depot, a consolidation in which OfficeMax became a wholly-owned subsidiary of Office Depot. This is a particularly timely case study since Staples has recently made a play for the merged company.

How would an analyst go about determining whether the OfficeMax-Office Depot merger makes sense? He would, Pignataro suggests, build a full-scale model consisting of eight parts: assumptions (purchase price, sources, and uses), income statement, cash flow statement, balance sheet adjustments, depreciation schedule, operating working capital schedule, balance sheet projections, and debt schedule. (The template for the model can be found on the book’s companion website, accessible through the url that appears at the end of the book.)

Pignataro holds the reader’s hand every step of the way. It’s impossible to get lost in this book. Ideas follow one upon another—if not inexorably, at least logically. And painstakingly described Excel keystrokes capture numbers critical to financial analysis. By the end of the book the reader has a full-scale model, a model he can use as a template for his own future work.

Sunday, February 8, 2015

Browder, Red Notice

Bill Browder has written a book that is by turns gripping, chilling, and moving—a book that impels a reviewer to pile one outraged adjective upon another. Red Notice: A True Story of High Finance, Murder, and One Man’s Fight for Justice (Simon & Schuster, 2015) is a scathing indictment of Putin’s brutal kleptocracy, which Browder and the people connected to his firm, Hermitage Capital, experienced firsthand.

Browder, the grandson of Earl Browder, head of the American Communist Party who ran for president twice on the Communist ticket, rebelled and became a capitalist, though he still felt the pull of Eastern Europe. His first major deal was for his employer, Salomon Brothers: buying $25 million worth of Russian privatization certificates that were then exchanged for shares in undervalued Russian companies. In a short time the portfolio was worth $125 million, and the 29-year-old Browder became a hero at Salomon.

Soon enough, he decided to go out on his own. With considerable difficulty he launched his firm, based in Moscow, in 1996. A year later his investors were amply rewarded: the fund was ranked the best-performing fund in the world, up 235 percent for the year and 718 percent from inception. Started with assets of $25 million, the firm now had AUM of more than $1 billion. In 1998, hit by the Russian currency crisis, it dropped a whopping 90 percent, but by the end of 2003 it had managed to climb out of its hole, and then some. It had rallied more than 1,200 percent from the bottom of the market.

Its spectacular recovery was the result of a joint, though uncoordinated effort. Hermitage Capital exposed corruption in Russian companies owned by oligarchs who posed, early on, a challenge to Vladimir Putin’s power. Putin was only too happy to use Hermitage’s research to his own ends. His intervention reined in some of the oligarchs and led to increased corporate profits. Putin won, Hermitage won.

In October 2003, however, Putin upped the ante: Mikhail Khodorkovsky, the CEO of Yukos and Russia’s richest man, was arrested. In June of the next year he was sentenced to nine years in prison. His fellow oligarchs got the message. What could they do to avoid ending up in that cage? Browder speculates that Putin’s response was “50 percent.” “Not 50 percent to the government or 50 percent to the presidential administration, but 50 percent to Vladimir Putin. I don’t know this for sure. It could have been 30 percent or 70 percent or some other arrangement. What I do know for sure was that after Khodorkovsky’s conviction, my interests and Putin’s were no longer aligned. He had made the oligarchs his ‘bitches,’ consolidated his power, and, by many estimates, become the richest man in the world.” (p. 164)

Browder, unaware that he and Putin were on a collision course, continued to name and shame Russian oligarchs. “There was a difference this time, though. Now, instead of going after Putin’s enemies, I was going after Putin’s own economic interests.” (p. 165)

This would not do. In 2005 Browder was expelled from Russia, and things would only get worse from there. As Browder’s lawyer Sergei Magnitsky told him, and as his own imprisonment and subsequent murder would make manifest, “Russian stories never have happy endings.” And in Putin’s Russia stories are a pack of lies, justice is a joke, endings are final.

Sunday, February 1, 2015

Kogon, Merrill, & Rinne, The 5 Choices

Are you familiar with Stephen R. Covey’s book The 7 Habits of Highly Effective People, which has sold more than 25 million copies since it was published in 1989? And perhaps the sequel, The 8th Habit: From Effectiveness to Greatness? Okay, here’s a bit of corporate history that probably passed you by but that’s nonetheless important to the story: Franklin Quest, the company best known for its planners, bought the Covey Leadership Center in 1997 to form FranklinCovey. FranklinCovey is today a publicly listed (NYSE: FC) global professional services firm and specialty retailer selling training and productivity tools to individuals and organizations. Its clients have included 90% of the Fortune 100 and more than 75% of the Fortune 500. It holds the copyright to this book.

The three authors—Kory Kogon, Adam Merrill, and Leena Rinne—are all affiliated with FranklinCovey. Kogon, the company’s Global Practice Leader for Productivity, has already co-authored two other FranklinCovey books. Advanced praise for the book, blazoned on the cover of the uncorrected proofs, comes from New York Times bestselling author Sean Covey. As you should begin to understand by now, The 5 Choices: The Path to Extraordinary Productivity, published by Simon & Schuster (who also published Stephen Covey’s books), was written in-house as part of the firm’s productivity suite.

So, after all this background, what does the book actually promise? Its claim is straightforward: to achieve extraordinary productivity you need to make the correct five choices in three areas: decision management, attention management, and energy management. When making a decision, act on the important and go for the extraordinary, don’t react to the urgent or settle for the ordinary. With respect to attention, schedule the big rocks, don’t sort gravel, and rule your technology, don’t let it rule you. As for energy, fuel your fire, don’t burn out. The combination of high-value decisions, focused attention, and high energy will yield extraordinary productivity.

If these principles sound familiar, it may be because they “are anchored in the timeless principles of human productivity that we and others have taught at FranklinCovey for over thirty years.” (p. 20)

The authors describe the Time Matrix, which is divided into four quadrants. Q1 is necessity, and includes crises, emergency meetings, last-minute deadlines, pressing problems, and unforeseen events. Q2 is extraordinary productivity, with proactive work, high-impact goals, creative thinking, planning, preventing, relationship building, and learning and renewal. Q3 is distraction: needless interruptions, unnecessary reports, irrelevant meetings, other people’s minor issues, unimportant email, tasks, phone calls, status posts, etc. Q4 is waste: trivial work, avoidance activities, excessive relaxation (television, gaming, Internet), time-wasters, gossip.

If you’re like most people, you’re spending only 60% of your time on important things and 40% on things that aren’t important to you. (Actually, the self-reported 60% figure sounds high to me.) You wouldn’t be satisfied if your car only worked a little more than half the time or if only half of the players on your favorite team showed up for a championship game. So, the authors ask, “why settle for less when it comes to your time?”

To be extraordinarily productive, you not only have to use your time wisely, you have to make wise decisions. And, the authors explain, “high-value decisions don’t come in a predictable order. They are nonlinear opportunities. If we are not aware, we might miss them entirely, or only address them in a rushed, low-quality way. A linear approach in a nonlinear reality is a recipe for failure.”

Consider the gap between the least and most productive performers in low-complexity, medium-complexity, and high-complexity jobs. In the first case (for instance, a worker in a fast-food restaurant) the most productive workers are three times more productive than the least productive; in the second (like a production worker in a high-tech factory), top performers are twelve times more productive. “However,” the authors write, “in high-complexity jobs, where the right decisions make all the difference (like software engineer or an associate in an investment banking firm), the differences between the top and the bottom performers were so profound they were unmeasurable.”

Well, that should make you put down the potato chips, stop mindlessly surfing the web, get up off the sofa, and take notice.

Wednesday, January 28, 2015

Sunstein, Choosing Not to Choose

Cass R. Sunstein, a law professor at Harvard and bestselling author of Nudge, continues his exploration of choice in his latest book, Choosing Not to Choose: Understanding the Value of Choice (Oxford University Press, 2015).

When it comes to choosing, we essentially have three options: impersonal default rules, active choosing, and personalized default rules. Sunstein lays down some guiding principles about which option is preferable in what circumstances. Among them, “impersonal default rules should generally be preferred to active choosing when (1) the context is confusing, technical, and unfamiliar, (2) people would prefer not to choose, (3) learning is not important, and (4) the population is not heterogeneous along any relevant dimension. … [A]ctive choosing should generally be preferred to impersonal default rules when (1) choice architects are biased or lack important information, (2) the context is familiar or nontechnical, (3) people would actually prefer to choose …, (4) learning matters, and (5) there is relevant heterogeneity. To favor active choosing, it is not necessary that all five conditions be met. … [P]ersonalized default rules should generally be preferred to impersonal ones in the face of relevant heterogeneity. “ (pp. 18-19)

Increasingly, as information accumulates about people’s actual choices, personalized default rules will be available, something Sunstein considers to be on balance a plus. I’m going to skip straight to his discussion of this option since it is an obvious follow-up to my piece on The Black Box Society.

Sunstein admits that the idea of personalized default rules raises serious concerns. “Some of these involve narrowing our horizons; others involve the exercise of autonomy; others involve identification and authenticity; still others involve personal privacy.” Even so, in many cases such default rules, he maintains, “can make life not only simpler and more fun but also longer and healthier.” (p. 159)

In an extreme case, we could have a political system with personalized voting defaults, so that people are automatically defaulted into voting for the candidate or party suggested by their previous votes (subject of course to opt-out). But, Sunstein notes, there is a devastating problem with such a voting system, “the internal morality of voting. The very act of voting is supposed to represent an active choice, in which voters are engaged, thinking, participating, and selecting among particular candidates. Of course this is an ideal, and far from a reality for everyone. … But the aspiration is important.” (p. 164)

What about shopping? So far retailers don’t offer default rules, simply annoying (at least to me) recommendations. If you bought a book by a certain author, they suggest, you’ll probably like books by another author who is somehow “similar.” But what if sellers knew, “with perfect or near-perfect certainty,” what people wanted to buy even before they themselves did? (This is creepy big data in full swing.)

Sunstein conducted some surveys to ascertain whether people would approve or disapprove of a scheme where a seller sends you books that it knows you will purchase, and bills you (though you can send the books back if you don’t want them). In a nationwide survey respondents didn’t buy into automatic enrollment—71% disapproved; even if you could voluntarily sign up for such a program, 59% said they would decline to do so. Why wouldn’t everybody opt in? Some may distrust the incentives of the seller, others might view searching for a book as a benefit instead of a cost, and of course people’s preferences change. How many James Patterson books do you really want to buy? “Even if the algorithms are extraordinarily good, they must extrapolate from the past, and the extrapolation might be hazardous if people do not like in the future what they liked in the past, or if they like in the future what they did not like in the past.” (p. 182)

Perhaps, Sunstein suggests, we should distinguish among types of purchases. He offers a two-by-two matrix: easy or automatic, difficult and time-consuming on the x-axis, not fun or pleasurable and fun or pleasurable on the y-axis. In the upper left quadrant we have impulse purchases, where there is little reason for predictive shopping. The upper right quadrant—books, vacations, cars—is again not the obvious place for predictive shopping because for a lot of people such shopping is fun. The lower left quadrant (not fun or pleasurable but easy or automatic) includes household staples. Here the costs of choice are low, so there is no urgent need for automaticity. The lower right quadrant is the one where there would be real value in automaticity. This quadrant includes retirement plans and health insurance. Since for most people the choice of a retirement plan or health insurance is difficult and time-consuming and not fun, “if predictive shopping could be made accurate and easy, there would be a good argument for automatic purchases.” (p. 186)

But beware the slippery slope.

Sunday, January 25, 2015

Pasquale, The Black Box Society

For some time I believed my life was pretty much an open book and therefore, like Scott McNealy (“You have zero privacy anyway. Get over it.”), had a casual attitude toward privacy. As for secrecy and obfuscation, I must confess I didn’t think much about them. I walked in the light, or so I thought, and prided myself on clarifying the confused or confusing. But even as I, like most people, eschewed the worlds of shadows and darkness, governments and businesses embraced them as sources of power and profits.

Frank Pasquale, a law professor, takes us deep into these dark, often creepy worlds in The Black Box Society: The Secret Algorithms That Control Money and Information (Harvard University Press, 2015). And offers some ways out, “toward an intelligible society.”

To understand the problem of dark money, data brokers, proprietary methods, supercookies, trade secrecy, and the like, Pasquale uses the metaphor of the black box. It is particularly apt, “given its own dual meaning. It can refer to a recording device, like the data-monitoring systems in planes, trains, and cars. Or it can mean a system whose workings are mysterious; we can observe its inputs and outputs, but we cannot tell how one becomes the other. We face these two meanings daily: tracked ever more closely by firms and government, we have no clear idea of just how far much of this information can travel, how it is used, or its consequences.” (p. 3)

We are constantly being profiled, and targeted. “It’s a cinch,” the author writes, “for companies to compile lists of chronic dieters, or people with hay fever.” The vice president of a company in the health sector went even further: “Based on your credit-card history, and whether you drive an American automobile and several other lifestyle factors, we can get a very, very close bead on whether or not you have the disease state we’re looking at.” (p. 30) Are you going to marriage counseling? Well, at least one credit card company pays attention to this fact. Counseling is a tip-off that “marital discord may be about to spill over into financial distress” and you thereby become less creditworthy. “Once one piece of software has inferred that a person is a bad credit risk, a shirking worker, or a marginal consumer, that attribute may appear with decision-making clout in other systems all over the economy.” (p. 32) On the other side of the financial spectrum, splurge on a pair of headphones and you can see higher prices on sneakers in a later online search.

Black box scoring misapplies natural science methods to the social realm. “A civil engineer might use data from a thousand bridges to estimate which one might next collapse; now financial engineers scrutinize millions of transactions to predict consumer defaults. But unlike the engineer, whose studies do nothing to the bridges she examines, a credit scoring system increases the chance of a consumer defaulting once it labels him a risk and prices a loan accordingly. Moreover, the ‘science’ of secret scoring does not adopt a key safeguard of the scientific method: publicly testable generalizations and observations. As long as the analytics are secret, they will remain an opaque and troubling form of social sorting.” (p. 41)

And then there are the big banks, which exploit “two levels of black box finance: obfuscation in the service of illegality, and opacity resulting from complexity.” (p. 103) Pasquale focuses on risk modeling in the subprime crisis, another misapplication of natural science methods, and high frequency trading. In the former case, to cite but a single problem, “the models had to assume the stability of certain kinds of human behavior, which could change in response to widespread adoption of the models themselves.” (p. 114)

The Black Box Society is a frightening portrait of the ever more powerful shadowy world that blocks light from reaching our everyday lives. It is also a call to action, with a range of suggestions that inevitably pale in comparison to the gargantuan task at hand. But small steps sometimes have outsize consequences. Just ask the folks who control what we see, influence what we buy, and determine whether we can pay for it.

Wednesday, January 14, 2015

Kelly, The 3% Signal

Jason Kelly, author of The Neatest Little Guide to Stock Market Investing, now in its fifth edition, writes for the retail investor who doesn’t want to spend a lot of time managing his money. His latest book, The 3% Signal: The Investing Technique That Will Change Your Life (forthcoming in February, Penguin / Plume), lays out a system that, he claims, will enable the investor to outperform without being a soothsayer or a market timer.

Kelly starts with the assumption that the stock market is a zero-validity environment, what is commonly known as a random walk. Outcomes are unpredictable, and both expert and amateur stock pickers are wrong about half the time. Market timers face even tougher odds. In a 1975 study William Sharpe found that “timers need a 74 percent accuracy rate to beat a passive portfolio taking on the same amount of risk.” (p. 25)

Is there any way to beat the market? Yes, the author claims. His solution is the 3% signal. It has six components: “the growth vehicle where we keep most of our capital during our working years; the safety vehicle where we keep a smaller portion of our capital; the target allocation of capital between the growth and safety vehicles; the safety vehicle allocation at which a rebalance back to its target is triggered; the timing of our growth signal; and the growth target.” (p. 37) Although the investor can define his own permutations of these components, the default plan is “a small-company stock fund as the growth vehicle; a bond fund as the safety vehicle; an 80/20 target allocation between the stock and bond funds; a 30 percent bond allocation threshold that triggers rebalancing back to 80/20; a quarterly timing schedule; and a 3 percent growth target.” (p. 38)

As you may gather, what sets this system apart from and makes it superior to most rebalancing plans is the 3% signal. At the end of each quarter you rebalance based on how much your stock fund grew or didn’t—more than 3%, sell the extra profits and put them into your bond fund; less than 3%, use bond proceeds to bring your stock fund up to its target 3% quarterly growth rate.

The author’s research indicates that 3% per quarter is the outperformance sweet spot. This quarterly performance yields an annual return of 12.6%, 26% better than the market’s annual performance of 10% over the past ninety years. (p. 56) And we know how that extra performance compounds.

Kelly carefully describes how investors can put this outline of a plan into action—what kinds of funds they might use, how they might opt to adjust the default allocation as they age, how they can survive market crashes. He even follows three hypothetical investors as they try to navigate the stock market from December 2000 to June 2013. It should come as no surprise that the one who used the 3% signal fared best.

We often hear, and have come to believe, that models beat experts. Kelly offers the individual investor a simple, mechanical model that instills discipline, removes a lot of self-sabotaging emotion, and has a good track record. Will it continue to outperform? Actually, it just might.

Monday, January 12, 2015

Wilkinson, The Creator’s Code

Amy Wilkinson has written an inspiring book about dreamers who do. The Creator’s Code: The Six Essential Skills of Extraordinary Entrepreneurs (forthcoming, Simon & Schuster) is based on interviews with 200 visionaries who started companies that generate more than $100 million in annual revenue or social enterprises that serve more than 100,000 people. These entrepreneurs, she found, share six skills—skills that can be “learned, practiced, and passed on.” (p. 20) They are: find the gap, drive for daylight, fly the OODA loop, fail wisely, network minds, and gift small goods.

I’m going to touch on three of these skills: drive for daylight, fly the OODA loop, and fail wisely.

The “drive for daylight” concept is borrowed from race-car drivers who say that “the trick to managing speed at 200 miles per hour is to drive for daylight. They go too fast to navigate by the lines on the pavement or the position of their fellow drivers. Instead, they focus on the horizon and, at high speeds, their hands follow their eyes.” Similarly, creators “navigate around immediate obstacles by keeping their long-term mission in mind. … creators don’t benchmark themselves against the competition or focus on industry norms. … they set their sights on the horizon, scan the edges, and avoid nostalgia.” (p. 49)

Integral to the “drive for daylight” mindset is a “to-go” way of thinking. That is, a person doesn’t focus on how far he’s already come but on what remains to be done. “To-go” thinking, researchers have found, accelerates momentum. “Motivating yourself by thinking about how much of the marathon remains before you cross the finish line can inspire you to run harder, faster, more competitively, and with greater enthusiasm.” (p. 55)

The notion of the OODA loop comes from John Boyd, an Air Force fighter pilot who “crafted a framework for making rapid decisions that would ensure success in fast-changing environments. Boyd’s ‘OODA loop’—observe, orient, decide, and act—is as pertinent to business [and to trading] as it is to aerial combat.” (p. 68) Since there’s a fairly extensive literature on the OODA loop, I’ll not say more about it here.

Finally, let’s look at the failure ratio. We’ve all read the advice to fail early and often, but how much failure is acceptable? The author found that “a surprising number of creators decide that ratio ahead of time. They aim not for perfection but to ensure that they take enough risk.” (p. 94) This is, I think, an important metric to consider. Entrepreneurs worry if they experience too few failures. As LinkedIn cofounder Reid Hoffman said, “Frankly, if you tune it so that you have zero chance of failure, you usually also have zero chance of success.” (p. 96) Just think of that beautifully over-optimized trading system that crashes in real time.

Traders focus on minimizing their risk by setting stops or keeping their position size small. But the other side of the equation is equally important. Their portfolio can grow only if the risk they assume is large enough. Institutions have metrics to look at both sides of the equation. Individual traders rarely do, and then they wonder why they come up short.