Strategic Framing

I’ve received a few inquiries about layoffs and future financial performance.  Several years ago I did research in this area and my general findings were that layoffs tended to have more negative than positive results.  The real driver of a link between layoffs and future firm performance is found in management reaction to the layoffs as well as in the way in which the layoffs are implemented.  My general rule was to avoid investing in companies which layoff more than 5% of their workforce in a given year.   Such large scale layoffs introduce a complex array of firm level risk.  It is often wise to wait and see how well executives manage that risk before jumping in as an investor.  In today’s recessionary environment, I would consider shifting that rule of thumb up to 10% of the workforce but I’d still be wary of any large scale layoffs.

In a study of Fortune 500 firms, Peter Chalos & Charles Chen (Journal of Business Finance & Accounting, 2002) found evidence that different types of downsizing strategies have different performance implications. Layoffs related to plant closing led to slightly negative market reactions, layoffs related to cost cutting (renengineering processes, aligning cost structures with market realities, etc.) did not show a significant market reaction, while layoffs related to revenue refocusing (dropping underperforming or unrelated product lines) led to positive market reactions.

Most public announcements of layoffs (and discussions in 10-K footnotes) state one of these 3 reasons for the layoffs. This research suggests that you can use this information as a preliminary guide when assessing impact of the layoffs on future performance.  Most recently announced layoffs fit the second type of layoff, aligning cost structures with market realities.  These types of layoffs are frequently industry wide events and do not reveal much firm-specific information valuable to outside investors.

In a forthcoming post, I’ll outline some ways companies can use layoffs as a springboard for strategic change.

What do you do when financial market modeling based on past performance does not work because the market is acting in a fundamentally different way?

An article in today’s Wall Street Journal explains how one Philadelphia money-management firm, Glenmede Trust, turned to scenario planning.  As someone who works with scenario planning on a daily basis, this does not surprise me.  Scenario planning is an excellent choice when facing a highly uncertain future.  When you feel past trends will not continue into the future, scenario planning offers a disciplined way to set strategy.

Using scenario planning as an investment tool is not a totally new idea.  See the 2005 article in The Journal of Wealth Management by Anne Shumadine.

At DSI, we have a team of scenario planning experts with experience in the financial services industry.  If you have more questions about how this process could work for your company, please contact me.

There is an excellent article at skeptic.com that ties in to my previous post about how cognitive biases contributed to the Madoff investment fraud.

Stephen Greenspan, author of the new book Annals of Gullibility, describes how he was taken in by Madoff.  He describes four factors which contribute to gullible action: situation, cognition, personality, and emotion.

The article is a wonderful read and nicely links these four factors to the author’s personal Madoff experience.  I’ve spent much time focusing on the connections between cognition and situation and enjoyed Greenspan’s discussion of the important roles of personality and emotion.  His arguments are persuasive and have inspired me to dig deeper into the research on the emotional factors.

I’ve also been inspired to buy his book so I guess I am one data point to demonstrate the effectiveness of articles as marketing for books.

Well played Mr. Greenspan!

Ah New Years!  A time for predictions.

Predicting pop culture trends, new technologies, political changes….and of course, the economy.

Am I the only one who feels these predictions are particularly quaint this year?  I get the sense journalists and columnists are just going through the motions.  They know as well as we that 2009 is fraught with uncertainty. No one has a clue.  Once you realize that no one has a clue, the television pundits become particularly entertaining because it seems on TV you need to pretend you actually know something that other people don’t know.  Nevertheless, the ‘2009 Predictions’ stories are fun holiday reads.

In the best of times, we are notoriously bad at predicting the future.  Here at the start of 2009 we face an inflection point.  A moment when the recent past does little to help us predict the future. At such moments, rather than trying to predict the future we can focus attention on identifying the boundaries of our uncertainty.  Let’s figure out precisely what we don’t know rather than trying to look into the crystal ball and fool ourselves into believing we can see the future.  Once we identify the range of our future uncertainty, we can begin to monitor the areas of uncertainty to spot weak signals and we can design flexible strategies that enable us to thrive regardless of how the future unfolds.

This whole ‘embrace uncertainty’ thing not for you?  No worries!  I’ll be glad to refer you to an excellent pyschic who will tell you exactly what will happen next year.

One aspect of international travel that I truly enjoy is reading about the business world from a different perspective.  On my trip to Sydney, Australia earlier this month, I dug through local papers and The Australian Financial Review to get a sense of how the current economic challenges where being felt and understood in Australia.  I look forward to getting a different perspective next month when I head to South Africa.

I found in interesting article in an insert magazine in The Financial Review.  The insert magazine is rather amusingly called Boss.  In the article, Mike Hanley did a wonderful job explaining the limits of the efficient markets logic.  A key limitation is that markets consist of human beings and human perception of risk is predictably irrational.  These pervasive cognitive biases were revealed in the research of Nobel Prize winners Daniel Kahneman and Amos Tversky.  Kahneman and Tversky demonstrated how we can be easily manipulated to become risk-seeking or risk-averse, how we over value confirming data and discount disconfirming data, and how we are overconfident in our knowledge and decisions.

I find it interesting to consider the implications of Kahneman and Tversky’s work for the financial markets.  Because these biases are so ingrained and pervasive, we cannot rely on the ‘wisdom of the crowd’ to save us.  A majority of the crowd will suffer from these same biases and it is folly to simply hope these biases will counteract each other.  Rather, what is needed is a system designed to offset these human cognitive tendencies.  I certainly do not pretend to have the answer of what that system would look like.  However, it would surely include mechanisms to limit considerations of sunk costs, counteract confirmation biases and reveal limitations of investor information.

No worries eh?

The potential $50 billion loss is mindblowing.  Even if the losses from the Madoff Investment fraud comes in below this number it is still going to be a fraud of historic proportions.

To put it in perspective, the trading scandal that brought SocGen to its knees and rocked the markets in January 2008 was on the order of aproximately $7.1 billion.  If the sky was falling then, what’s falling now? (side note: If you are stressed and need to relax, close your eyes and try to answer that question.  What can be greater than the sky?  The question has a certain perverse zen like quality to it)

Now the conversation turns to the question: Why did so many people not see the warning signs?  We’ve learned that there were signs of something fishy at Madoff Investments.  The biggest one may be the low probability that any firm can continually generate such predictable returns  in variable markets.  Another warning sign was raised about the feasibility of Madoff’s reported investing strategy for a fund of such a size.

No doubt there are many answers to the question of missed warning signs.  Let me add the role of human psychology.  We depend upon social valuation to judge others in complex environments and we seek information that confirms our initial judgments.  Both these cognitive tendencies came into play in this case.

Madoff relied upon his reputation to bring in new investors.  His legitimacy as a financial professional came from his reputation.  His reputation was built up over such a long time that to spend time investigating Madoff’s expertise is easily dismissed as a waste of effort.   To use the political term in vogue these days,Madoff had been vetted and new investors could comfortably accept that.

Combine such strong reputational legitimacy with our natural bias towards confirming evidence and you have a receipe for fraud.  Our overweighting of data that supports our decisions and underweighting of data that disconfirms our decisions is well documented.  This is the same dynamic that causes politically conservative Americans to watch Fox News and politically liberal Americans to read Salon.com.  It is also the dynamic that prompts investors to discount negative analysis of companies in which they have invested.  Investors may claim the analyst is biased, missed a key point, or just doesn’t get it.  It is easy to rationalize why information is useless once you’ve decided the information is useless.  Madoff invested had $17 billion reasons to rationalize away warning signs.  They’d already made the decision to invest in Madoff.  That was the hard decision.  Seeing evidence to reinforce the correctness of that decision after the fact is easy…and natural.

For years, economists have been wringing their hands about the US consumer’s low savings rate and dependence on credit to support their lifestyle.  I recall numerous articles during the late 80’s imploring us all to be more like the Japanese consumer and save more.  Then Japanese savings rates plunged and we were urged to be more like the Germans and French.

On Thursday, The Federal Reserve reported that consumer household debt declined for the first time in 50 years of record keeping during the 3rd Quarter.

This news was met with…intense hand wringing.

Once again we can see the wonderful prisoners dillemma structure of our national economy.  What is best and rational for the individual consumer is not what is best for the economy as a whole.  For years, we’ve been told to save for our future.  Yet our economy was built to support the lifestyle of a nation of debtors.  Production capacity in the world economy is scaled to support an economy based on massive household leverage.

Now, with household investments and job prospects uncertain, the logical action for the individual is to pull back consumption and build a savings nest egg.  Of course, less credit card spending means less buying..means less sales…means less productions…means fewer jobs…means cats and dogs sleeping together.

It’s kind of disheartening to know that the health of our economic system is dependent upon the willingness of the individual household toact against their best economic interests.

There is an interesting side story to the surprisingly deep and rapid drop in demand for new cars.  Part of the blame for the drop can be attributed to the impressively successful marketing work within the auto industry over the past thirty years.

You will often hear analysts or commentators note that cars are necessities given that our entire way of living (where we live, how we buy, etc.) is based on a car culture.  It is true that most of us in the United States depend upon our car to get through our daily lives.  However, that fact no longer translates into car purchase decisions being approached as necessities.

For a large portion of the population, a new car is a luxury not a neccesity. There are two primary reasons for this shift.

1. Increase in cars per family.  In 1970, there was an average of 1.25 cars per family.   By 2005, the average was 2.3.  During this time we’ve seen a significant shift towards two income families so we would expect the need for cars to increase along with the two income trend.  However, the shift to two cars has increased family flexibility.  If a car breaks down in a one car family, options to get to work are limited and the family will likely be forced to purchase a car.  In a two car family, even with two working adults, family members can shift schedules to manage on one car for an extended time.  I speak from recent experience here, thanks to the actions of an over-eager deer on a local highway,

2. Misalignment of marketing demand and product lifespan.  This is the primary reason new cars are now luxuries.  According to a study by R.L. Polk, the median age of passenger cars in 2006 was 9.2 years.

Over the past 30 years, auto manufacturers have poured marketing efforts into getting Americans to trade in their cars every 2-3 years.    The average car age at trade in in the US is aproximately 6 years (I’ve found different statistics on this but the range is from 5.8-6.6 years).   It is deceptive to focus on the average though.  A significant minority of new car buyers routinely trade in their automobiles every three years.  For these consumers, a new car purchase is a luxury and a big one at that.

This story is one of an incredible marketing success.   Savy marketing increased demand for new cars.  In good economic times, this has driven demand well above “car as neccessity” demand.  Now we can see the dark side of this success.  Because product marketing is not aligned with product lifespan, few people actually need to purchase a new car at any given time.   Add in the glut of available used cars, due to supply based on the luxury product model, and you have the current situation of a deep and shockingly rapid plummet in new car demand.

The interesting question rattling around my head is what other industries have been successful in creating this misalignment of marketing demand and product lifespan?  Housing comes to mind immediately.  Anyone have others?

Each day brings new layoff announcements.  In the past week, we’ve learned that the layoffs in the banking and financial services sector are not limited to North America and Europe as banks pare their staff in Asia.   In recent days, media companies (AP, New York Times), law firms, manufacturers (Boeing), bottlers (Pepsi), and tech companies (HP, Sun) have announced layoffs.

So are all layoffs bad news from an organizational performance perspective?

The short answer is yes.  The long answer is some types of layoffs are much more difficult to overcome than others.  In addition, every layoff action, no matter how small, has the potential to do long-term damage to a company if not managed properly.

Start by assuming layoffs are a bad sign. Layoffs mean management made bad decisions in the past, demand for the company’s products and services are declining, revenues will be dropping, and the company is going to lose some key personnel in the near future. Now cut management some slack if layoffs are industry-wide, seasonal, or clearly due to a unique and unforeseeable event. 

Some have argued that current events were foreseeable but I think we can all agree the extent of the economic damage was not anticipated. 

As for the industry-wide excuse, the need for layoffs may be unavoidable (as is the case in most financial service firms right now) but the way in which the layoffs are managed is entirely at the discretion of management.  Seven years ago, the telecom equipment industry was devastated by a sudden drop in demand.  Each company suffered but for some companies the suffering was made worse due to self-inflicted wounds from poor management of layoffs.  Layoffs dragged on, strong employees were recruited away, employee morale plummeted.   One company, Cisco, seemed to manage the process better than its competitors.  Cisco announced its layoffs in one big action and committed to ensuring the company was strategic about how the layoffs were implemented and which parts of the organization were effected.  By making one large layoff announcement rather than slowly bleeding employees on a quarterly basis, Cisco reduced the length of the internal post-layoff recovery period.  This is one example of turning an industry-wide slump into a competitive advantage.

The Bottom Line: Layoffs are an admission that the company made poor decisions in the past. They are not a sign of strong management. They can get a company back on track but they will not make a company great. Companies do not cut costs to become industry leaders, they innovate.  However, skillful managing of the layoff process can enable a company to recover from an industry slump before its competitors.

Weak signals is a collection of news stories highlighting “surprise” data or activities that could indicate qualitative changes in the business environment.  Weak signals are the early warning signs that a company’s environment may be changing in unanticipated ways.  Weak signals need to be monitored for further development and strategies need to be adjusted accordingly.

In today’s Wall Street Journal comes a report that household energy usage has dropped at a greater rate than would be expected based on weather and economic reasons.   This weak signal may suggest a qualitative shift in consumer energy use.  Perhaps energy saving device adoption has reached a tipping point.  Household energy usage has been fairly stable and predictable.  A shift in household energy patterns will impact numerous energy industry model assumptions.

Surprise Drop in Power Use Delivers Jolt to Utilities