April 2005

Happy Earth day! Friday, April 22, 2005:

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Investment, Finance & V. C.

In April, there seemed to be rather more dire predictions of economic troubles ahead than normal.  The stability of the US economy has been of concern for some time.  Some benchmarks that put us in the frame.  Americans are borrowing at more than 6% of GDP each year, the US savings rate is the lowest for 70 years, the deficit has ballooned, pensions and healthcare need rejuvenation.  There are significant challenges to be addressed.

The US economy expanded at its slowest pace in two years in the first three months of 2005, official figures show. Gross domestic product (GDP) grew at an annual rate of 3.1%, as consumers and businesses tightened their belts in the wake of rising energy prices, the slowest since the first quarter of 2003. The weaker-than-expected growth figures knocked more than 1% off the major US stock indexes on the day of announcement. Many analysts had expected a more robust figure of 3.6% for the first three months of 2005, and the data revealed a sharp slowdown since the final quarter of 2004, when GDP grew by 3.8%. Housing starts also reflected a slowdown: While house prices rose by 11.2% in 2004, the rate of increase slowed markedly in the fourth quarter, to only 1.7%. At the end of April, the Commerce Department announced that housing starts fell by 17.6% in March, the sharpest monthly decline since 1991.

Japan is to press ahead with the sell-off of the multi-trillion dollar postal savings system. Prime Minister Junichiro Koizumi has signed off on a programme starting in 2007 and lasting a decade. Reform of the system will revitalise the Japanese economy, though the plan has been watered down in the hope of calming ardent opposition from his own MPs, who fear mass lay-offs. The system's 350 trillion yen ($3.2 trillion) in assets have provided a source of spare cash for politicians' pet projects. The system has also been popular with Japanese savers, accustomed to rock-bottom rates of interest and suiting the Japanese culture of homogeneous social behaviour, but it has kept savings away from the private sector where they are more efficiently applied.

While the German economy continues to be under pressure we are still optimistic about its outlook. Playing to our bias we note that German unemployment has unexpectedly dropped in April, falling below the five million mark, as warmer weather prompted companies to hire more people. This drop in unemployment cuts the rate to 11.8% from 12%. German unemployment hit a post-war high in March after cold weather deterred many firms from hiring workers. Job creation has become a key political issue as Chancellor Gerhard Schroeder prepares to fight state elections, and he is balancing this against labour law reform which is needed to open opportunities across the economic spectrum.

More fuel was added to the "long term bear" fire by Crestmont Research which published more data and analysis supporting the view that stock markets are in a long term stagnant/downward cycle.  It also suggested that the decline in volatility over the last couple of years is an indicator that the short term outlook is for decline.  The analysis is principally technical and investors selecting companies based on fundamentals will continue to find value.

Many of us find ourselves inundated with information: data overload.  What we need is help choosing!  A reference to the utility of increasing amounts of data in the analysis of economic predictions pointed to a CIA research paper on the subject. Key findings suggest that more data means more careful discretion is required, which is not regularly applied. The findings were:

• Once an experienced analyst has the minimum information necessary to make an informed judgment, obtaining additional information generally does not improve the accuracy of his or her estimates. Additional information does, however, lead the analyst to become more confident in the judgment, to the point of overconfidence.

• Experienced analysts have an imperfect understanding of what information they actually use in making judgments. They are unaware of the extent to which their judgments are determined by a few dominant factors, rather than by the systematic integration of all available information. Analysts actually use much less of the available information than they think they do.

This warning against over-confidence by experienced practitioners is well put by Dr Pratchett in his book Pyramids. In response to a question on "who are the enemies which dog our steps and for whom we are ill-prepared", the protagonist answers: "Ill-preparedness. Carelessness. Lack of concentration. Poor maintenance of tools. Oh, and over-confidence, sir."

Also on this subject, a current recommended read (by The Ecologist as well as The Economist) is "Blink" by Malcolm Gladwell which discusses our snap judgment decision making process. It has a great zen sub-title: "the power of thinking without thinking"!

The concept of consumer as king has been bandied about for several years now. The consumer will of course never be king per se - "king"'s choices are not limited by availability, price etc - but the power of consumers to influence companies and markets has been a principal trend watched by us.  The Economist concludes in its survey of Consumer Power on 2 April that the weight of power does now rest with consumers - information, pricing, distribution chain logistics, product development, market research, advertising are all now being impacted in significant ways by the net.  It appears that this is more so in some markets, like South Korea, thank others.  Certainly any internet development policy of governments should be encouraged if the analysis in the survey is anything to go by.

In a recent paper John Mauldin discussed big changes in the next 40 years.  His principal view is that there are three things that over the next 40 years are not going to change.

1. The innovation cycle is not going to change - it will be with us as it is simply part of our human progression, although it is going to increase in intensity and frequency.

2. The Business Cycle and its cousins, Secular Bull and Bear markets, will not change. As long as the business cycle remains in place, and Congress has yet to find a way to repeal it, this tendency to go from over-valued to under-valued markets, that started when the Medes were trading with the Persians, will persist.

3. Human psychology is not going to change. Human psychology is the reason we get these cycles and the reason we get busts and booms.

This is striking because I agree with much of his other analysis, but not this.   While the main premise is sound, there is a growing body of evidence that human psychology is making a quantum leap from exclusive models to inclusive models (integral systems) which in turn has a profound effect on economics which certainly will remodel business cycles and possibly innovation cycles too.  The likelihood of the change taking place in 40 years is low, but increasing.  And given the rate of natural destruction, necessary.

Responsible Investing

In March we heard of Hank Greenberg stepping back from CEO duties at AIG.  While many fiduciaries felt confident to allow Greenberg wide latitude in his style of management, the risk of inadequate governance has been shown to be worth billions of dollars in enterprise value. In early April it was shown that Greenberg, gave his wife more than $2bn (£1.2bn) of his shares in the company days before stepping down. And this recent quote gives colour to the style of control that allowed Greenberg to run AIG for four decades: "This board is being run by a bunch of lawyers who can't spell the word 'insurance'.  If you get rid of me, you will destroy this company!".  Ahhh, the sound of the City!

New York State Attorney General Eliot Spitzer, championing the role of outside regulation said "A key lesson from the recent scandals is that the checks on the system simply have not worked. The honor code among CEOs didn't work. Board oversight didn't work. Self-regulation was a complete failure. But one thing has worked: law enforcement." .  That of course is not the whole story because AIG had evidently been lapsing in its duties for many years without detection.  Nevertheless, the likelihood of effective enforcement is making the insurance industry, and others, more efficient.

The Economist, the venerable and sober newspaper, covered its front page on April 21 with concerns about the environment.  The cover story lamented the lack of rigorous analysis and tools being applied in this area of management and this article deftly explains the economics of environmental investment and shows how valuable the benefits are.  At the end of the 1990s WRI estimated ecosystem services at twice global GDP (~ $ 33 trillion).  The World Bank sponsored study from October 2004 "How Much is an Ecosystem Worth?" offers a comprehensive analysis.

Venture Capital

A most interesting ripple from the investigations in to AIG and the departure of Hank Greenberg has been the termination of the two heads of AIG Capital Partners, CEO Peter Yu and managing director Bill Jarosz.  A spinoff of the private equity group had been discussed, but this appears unlikely now.  Although the departure of the two bosses was ham-handed - they were marched out of the office by security, it is unlikely to affect the performance of investments to date and may improve the governance profile of the group if their departure is a reflection of collusion, which is likely given the track record of AIG and the nature of infrastructure investment and similar private equity deals in Asia where much of AIG Capital Partners' capital is employed.

US VC disbursements dropped in the first quarter.  Figures  released by MoneyTree (PricewaterhouseCoopers, the National Venture Capital Association and Thomson Venture Economics) show just 674 U.S.-based companies raising approximately $4.63 billion. That represents a 14% deal volume and 15% investment volume decrease from the $5.44 billion raised by 776 U.S.-based companies in Q4 2004. The number of deals was a bit higher than during the first quarter of 2004 (674 vs. 665), while disbursement volume was significantly lower ($4.63 billion vs. $5.03 billion).  Dan Primack of PE Week suggest that this is partly because of the increase in investment in Europe by US VCs.  However, some managers are beginning to turn away new money because they are concerned about deal price inflation fuelled by excess liquidity in the market.  Institutional investors are funding VC because they are seeking higher returns which are not being yielded by public market portfolios.  Their eagerness is exacerbated by the need to fund obligations contracted during more optimistic times.

Uplift Equity, a newly formed team that focuses on wellness private equity deals, has invested in Organic To Go a Seattle food retailer and caterer.

Interest Rates and Currencies

The US Fed funds rate is expected to hit 3% in early May.  The rate of tightening, while still needed, is now complicated by signs of inflation. Greenspan warned that unless lawmakers come to grips with spiraling U.S. deficits, the economy was at risk of stagnation 'or worse.' 'Under existing tax rates and reasonable assumptions about other spending ... projections make clear that the federal budget is on an unsustainable path, in which large deficits result in rising interest rates and ever-growing interest payments that augment deficits in future years,' Greenspan said in prepared testimony.

The tensions in currency markets continues.  The US$ weakens as its deficit continues to grow. The Chinese Remnimbi's devaluation would help alot of China's trading partners, but this is not persuasive rationale for China.

Trade and FDI

Trade advocates will enjoy the findings of a recent paper in the Journal of Economic Behaviour and Organisation which shows that trade is a principal characteristics distinguishing Homo sapiens from H. neaderthalensis.

Lifting of quotas has resulted in ballooning of Chinese textile trade.  The EU trade commissioner is planning to investigate the change.  The US government has also accepted a request from the US textile industry to investigate the sharp increase in imports of textiles from China. While it was expected that Chinese trade would increase because they are the low cost producer, there are concerns about environment and social/employment conditions.  If pressure is applied by regulators or consumers it is likely that costs will increase but that China will remain the low cost producer.  The EU's trade commissioner has made a plea for Westerners to avoid protectionist thinking. In contrast to his pronouncements Friends of The Earth invite skepticism of Mandelson's integrity:  Play the Mandy game here.

Supachai Panitchpakdi, head of the WTO is concerned that the current round of talks has stagnated again.  The website for the next Ministerial conference is http://www.wtomc6.gov.hk/.

An illustration of the opportunity to level the playing field through open trade policies is in these numbers by the PPI: U.S. sugar subsidies: $1.2 billion a year.  GDP of Nicaragua, 2003: $3.6 billion  World sugar subsidies, 2003*: $7 billion  (* OECD estimate)

A recent analysis of employment costs indicated that the total employee cost is about $ 90,000 in the UK, $ 70,000 in the US and under $ 30,000 in China.  This indicates a simple correlation with efficiency, productivity and also social equity.

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