I was talking with a friend of mine the other day about the global economic crisis.
Alarmed by the doomsday prognostications of so-called experts, he raised the specter of things really falling off a cliff.
Serendipitously, that same morning I was watching an interview with Nassim Taleb (of Black Swan fame), and he told the story of a group of travelers lost in the Alps.
Against all odds, with no food, limited supplies and in snowy conditions, the lost travelers somehow found their way back to safe ground.
Asked how they did it, the leader of the group, said, “Thank God, we had this map. It enabled us to find our way back.”
But, the map was not a map of the Alps. It was a map of the Pyrenees! A member in the audience felt compelled to point out the obvious. Nonplussed, the team leader said, “At least we had a map.”
Taleb’s point in telling the story is two-fold. One is that we are sitting at a place in time when legions of so-called experts are armed with a map of the Pyrenees, when the situation at hand desperately requires a map of the Alps.
Given same, how can we possibly trust what comes out of the experts’ mouths?
His second point is more subtle; namely, that the nature of western thought is such that we feel compelled to “do something,” regardless of whether it’s well thought out, we have the right information at hand or not.
Needless to say, ignorance and a propensity to take action for action’s sake does not inspire confidence.
So is the sky falling, never to rise again, as my friend wonders?
Perhaps if your industry is predicated on financial engineering, if growth is dependent upon easy credit and deep leverage, or if your business plan amounts to flipping (versus building) a business, then yes, you are in a world of trouble.
And of course, if you are one of Wall Street’s financial wizards, those $10M annual bonuses probably won’t be returning anytime soon, so for many of you it is a doomsday moment. You will have to learn to live like the rest of us. :-)
But let’s not confuse the death screams of the pimps and profiteers of the Age of Easy Money with the great cataclysm, for this storm shall pass. It always does.
There is No Free Lunch
Don’t get me wrong. I am not suggesting pain-free times. A global deleveraging of balance sheets leveraged at 30 to 1 is not easy or pretty, particularly when everyone is doing it at the same time (as Andy Kessler puts it).
Believe me, I have the canker sores to prove this point, but I take heart in the conversations I have with REALLY smart people, who look at the current situation, their portfolio losses, the Madoff scam, et al, and FINALLY get it.
With incredulity, and a sense of pained knowing, they own up:
“I wondered how so many titans of finance, entertainment, charity, etc. got fooled by this Madoff guy, failed to ask questions, get backup documentation.”
“But, then I remember all of the times over the past decade when I listened to some wizard rattle off terms that I couldn’t understand, but who promised incredible returns, often citing a brilliant track record of doing same.”
“Candidly, I felt like too much of a nebbish to raise my hand, and say, ‘I have no idea what the fuck you are talking about.’ Well, now I get it.”
“Keeping me confused, intimidating me into silence, and bullying me with a dizzying array of numbers and name customers was meant to shield the fact that a lot of this was financial chicanery, supported by quid pro quo market manipulation and conflicts of interest up the wazoo.”
Ignorance is bliss, no more. Less obvious is what happens when that ignorance is replaced by knowledge and hard-earned experience.
Do we step up, get real and grow a pair? Or melt in the heating sun? Whether we like it or not, we are in the process of finding out.
The New Arbitrage
Arbitrage is the practice of taking advantage of a price differential between two or more markets.
Sticking with the Alps and Pyrenees analogy, we have markets that ascribe value based on different financial execution time horizons, credit availability assumptions and primary asset usage goals, and there is money to be made as the “definition of the situation” shifts from the old model (the Pyrenees Map) to the new one (the Alps Map).
Specifically, I see three long-term trends playing out over the coming months and next 3-5 years:
- A Return to Long Term Planning: Whereas value in the public sector has disproportionably been weighted around short term quarterly performance cycles, often to paralyzing effect, I expect that value weighting will become more focused on earnings durability over a longer-term horizon, a weighting which rewards consistency of execution around clear operational vectors, like product differentiation, diversity of revenue sources, quality of management team, product pipeline, operating margins, cash flow, balance sheet strength. It’s all part of the 'Get Real' logic that will drive us moving forward.
- Cash is King Again: A departure from the days of easy credit means two things. One is that liquidity, the very ability to access credit, is much tougher to come by. Two is that even when credit is available, the relative percentage loan to value will be much smaller (i.e., less leverage for your dollar). Needless to say, this constrains the types of deals that can be done and the underlying values of the assets themselves.
- Shift from Asset Flipping to Asset Management: The days of flipping assets at crazy multiples or building shiny revenue-free baubles on the premise of selling your asset based on ‘new metrics’ are mostly behind us. This necessitates building properties with a discriminating eye to revenues, cashflow and operating leverage, shifting from flipper to owner/builder/operator. Hallelujah!
How to Play the New Arbitrage
So how do you make money from this shift away from short-term focus, credit based underwriting and a prodigious M&A environment and towards long-term asset value creation built around cash flow generation?
For one, recognize that in the current maelstrom countless companies are stuck in the old model psychologically, fiscally and in terms of their talent pool, and this will lead them to sell good assets at stupid prices, even if it requires them partially financing the deal to make it happen.
Why? Because, as cited earlier, they are driven by a need to “do something,” and fundamentally, they are holding the wrong map.
Now more then ever, upper management feels compelled to “focus on strategic lines of business,” and the emphasis on short term quarterly results will lead them to throw the baby out with the bath water – i.e., sell at a serious discount to cash flow – all in the name of working capital preservation.
Depending on how you are positioned, this can translate into three fundamentally different outcomes.
One, play this arbitrage shift to buy assets on the cheap, and push the seller (or originating lender on certain types of assets) to finance it.
Two, is watch your competitors disappear – encourage and entice them if you can, as they de-focus on what may be non-strategic for them but core and central for you.
Three, is be forewarned that a flooding of cheap assets in your market can create noise, confusion and downward pricing pressure while customers figure out how they can exploit the current conditions for their advantage. Know where you sit in the food chain, and position accordingly. You will look like a visionary as you tell customers/prospects/partners what is playing out, and why you are the beacon of focus and stability in turbulent times.
I saw this one play out first hand during both the S&L Crisis (circa 1989) and to a lesser extent, post-tech bubble (2001-2), and those with liquidity and intestinal fortitude acquired cheap assets at serious fire sale prices, and emerged as industry leaders as the storm subsided.
Getting Real: It’s About Who; Then What
The most basic truth in all of this is that ultimately the key strategic decisions are less about the industry, the products, the pricing, the message, the sales channel or even the technology, and MOSTLY about the people.
It’s the proverbial “who, then what” dynamic at play.
As such, this is a time to define your ideals, establish your culture, document your vision, strategy and tactics, and commit to actually living it.
Hire builders who think like owners, who operate with strong values, who are long-term thinkers, data-driven, and who want to build stuff that matters (not just make money).
Creative destruction along the lines of what we are going through is difficult but it is also a time to improve the DNA within your company, and build for the long haul.
UPDATE 1: Both Fred Wilson of AVC (see 'When Greed is Good') and my friend Kevin Saxe felt a bit of a disconnect between the Alps/Pyrenees story as used in the post, and how it applies to the present day economy. Their interpretation of the story is one more of ‘blind faith’ and the fact that when put in a dire situation, having faith that a map will get you out is sometimes all you need, since sometimes inaction = death. As Kevin notes, “The map was not correct, yet the people survived the trek thinking that it was the one thing they needed to get down the mountain. The map helped them make the right decisions (or lucky one’s) and was the ‘rock’ that they held on to so they could continue.” My take: I don’t disagree with that logic at all. If anything, I believe that it is more important to do the ‘right things’ than have to do everything ‘perfectly right.’ That said, Taleb’s point is more systemic; namely that we have come out of a period of time where there is blind faith to a map that has lead people off a cliff and now is a time to re-think what the right map is, and where embracing same can open up arbitrages capitalizing on value asymmetries relative to people stuck in the old model. One thing that I am realizing in watching this crisis play out is that while doing the same thing over and over is a recipe for insanity, a lot of the holders of old maps have such antibodies against embracing new perspectives that they will fight tooth and nail against real change even if the net-net is that they create a vicious cycle, and prove out the doom and gloom. I would argue that the scariest thing is group psychology; namely, that there is a large constituency that holds the “NO CHANGE” map, will fight with all of their being to prevent a new map from taking hold, and that that is completely independent from the other map analogy which is "Sometimes when armed with incomplete data, we need simply to move forward."
UPDATE 2: Great article in Forbes, where Paul Johnson nails the obfuscation issue. 'In Business, Simplicity is Golden' he sums it up succinctly, saying, "Here are some pointers: Trust what is simple and can be understood
at a glance. Anything more elaborate, investigate carefully and
thoroughly; if it's too convoluted for you to grasp, pull back.
Remember, in financial matters the object of complexity is all too
often to conceal the truth, to deceive. All this is obvious. Odd that we should have to reiterate it. Meanwhile, the wealth of the world has been halved."
UPDATE 3: Great primer that explains the financial crisis, debunks assertions that it was caused by the Fed's easy money policies (as opposed to rampant greed and lack of proactive oversight by SEC). In 'How We Were Ruined & What We Can Do,' Jeff Madrick shows how a core part of what set this thing in motion was the emergence of a "shadow" banking system of hedge funds and other unregulated investors as a major force in lending. Unlike commercial banks, which have
reserve and capital requirements legally imposed upon them for
activities on their balance sheets, and are also subject to Federal
Reserve scrutiny, the shadow banking system's capacity to borrow was by and large unrestricted and without oversight. How much of a disruption was this in terms of flow of dollars though the economy? By 2006, 80 percent of all lending occurred in unregulated sectors of the economy, compared to only 25 percent in the mid-1980s. That is a shocking number.
Related Posts:
- Thought Streams – Rape of Europa, Fundamental Asset Re-Pricing & The Movie Marketer’s Playbook
- The Restaurant: On Partnering and Purpose
- Black Swans and Bank Runs: Why the financial crisis was predictable
- Engine Failure: When Financial Markets Fail - good primer on crisis
