investiledysfunction

The November 3, 2008 issue of Newsweek contained a letter from Mayor Michael Bloomberg to the President-Elect (and now Barack Obama).  This blog is strictly non-political and will remain that way, but Mr. Bloomberg offers a great commercial for portfolio management applied at the public sector level.

In his letter to the president, Bloomberg writes,

“In exchange for legislation creating an infrastructure bank that funds projects based strictly on merit, agree to invest more money on the infrastructure our country needs most.  And you should also demand more from the states and cities that get federal money: hold them accountable for building on time and on budget.  Call it a “New New Deal”: investing more, more wisely and getting bigger returns.”

I’m not sure there has been a better encapsulation of what portfolio management is all about.  I am pretty sure that government and citizens ultimately would benefit significantly from the approach Mayor Bloomberg is advocating.  Competition for funding and holding people accountable for results always yields good results.

Josh Kopelman of First Round Capital put up a great quick website promoting the idea that technical talent (meaing those who know computer stuff) may want to consider a startup given the mess the banks and financial services are in.  The site’s master of the obvious title is Leave Wall Street - Join a Startup.  I’ve posted his points below which make a lot of sense and which would help ‘diversify’ NYC’s economy a bit although this would take many many years.  I remember the days of Silicon Alley (upto year 2000) as I worked at Kozmo.com.  Unfortunately, no significant businesses emerged from that as far as I can gather.  But here’s to hoping a Google can emerge out of NYC.

Financial services will always be huge in NYC, but introducing some other types of economy into the mix would only be healthy.  Remember, diversification is good.  The politicos seem to agree as well having recently started NYC Seed - an angel investment fund giving $200k to worthy business plans.

For those who aren’t familiar with Kopelman, he is best known for starting Half.com and selling it to eBay for $350 million.

Those who visit the site will also see Kopelman has posted positions at some of First Round Capital’s portfolio companies as well.  So besides making some good arguments, Kopelman has also found a good way to promote his companies and his interests in them.  This is very smart.

Here’s to the new NYC startup scene.   Kopelman’s comments are below:

For years, one of the biggest challenges facing New York city based startup companies has been the competition for technical talent.   It was very difficult for a venture-backed startup to compete with the compensation packages offered by the big investment banks.  Stock options had a hard-time overcoming oversized cash bonuses.

While no one is happy with the turmoil we’re seeing facing the financial services sector, and no one is happy to see mass layoffs, this does represent an opportunity for startup companies to attract seasoned, technical talent.  With Bear Stearns laying off over 7,000 employees, Lehman Brothers rumored to layoff over 20,000 employees, and Merrill Lynch expected to layoff thousands after their sale to Bank of America, we’re on track to see over 150,000 people lose their jobs this year.

If you are one of those 150,000 employees, you might want to consider joining a startup.  These days, startups are more stable than Wall Street (seriously).  And while a startup probably won’t offer the creature comforts of a job in the financial services industry, startups offer different benefits.  You get to participate in the creation of something new.  Your work makes a direct (and clear) impact on the success or failure of the company.  No more politics, endless meetings, or multi-layered organization structures.  Plus, you’ll likely get stock options to share the upside.

If interested in taking the plunge to the world of startups but you’re not in NYC, you can also search for startup opportunities in your country or city, check out ChubbyBrain’s advanced search feature here where you can specify your criteria.

I’m a big fan of P2P lending as my prior post on the topic will demonstrate and so I keep abreast of developments in this arena especially as I believe that this business has some very disruptive possibilities.  The last couple of weeks have seen some interesting developments, notably:

1. The entry of newcomer, Loanio, to the space.  Their pitch doesn’t all that different than Prosper, but I haven’t done much diligence on them so may be I’ll get around to that.  Their website is clean, but browsing a couple of posts, they seem to have a handful of loan requests but not a ton of bidders to this point willing to fund those initiatives.
2. The bigger news of the week is the departure of Zopa from the US market to focus on the UK, Japan and Italy.  While my first instinct was that they chose to avoid the crazy credit markets of the US, it seems they ran into regulatory roadblocks that prevented them from ever getting started.  This is surprising given they seem to have a much more seasoned team and more money than Prosper and Loanio, but I guess stuff happens.

If regulatory reasons were the impediment to them getting started in the USA, it is a shame.  With credit markets tighter now, there may have been an interesting opportunity for players like Prosper, Loanio, Zopa and LendingClub to step up and fill a void as many consumers and small businesses may be finding it difficult to get credit given tightening conditions.

If Zopa is leaving because they couldn’t take the heat in the US “credit kitchen” as some have suggested, this indicates the company has little faith in its risk modeling capabilities.  If you’re only willing to play in a market when you perceive times to be good, that is not much of a business.

Let’s hope it was just regulatory issues.  I hope the rest of the guys will make some inroads during this time and begin to put P2P lending on the map.

I’ve been reading about how Silicon Valley is adjusting to the downturn as it’s a popular topic in many blogs.  Many prominent VCs have issued memos to the CEOs of their portfolio companies telling them to raise more money, control expenses and focus on profitability because things are going to be rough for the foreseeable future.  This is all pretty good advice.  Of course, the sinister, conspiracy theorists amongst those I’ve read feel this is an easy way to instill fear and get better valuations for VCs.  I’m not so skeptical so as to believe this.

But the outcome from this recession/downturn from an entrepreneurship and innovation perspective is going to be positive in my view for 2 reasons:

Reason 1 - As I mentioned in my Part 1 post, there are going to be a lot of unemployed or disillusioned people who say “I’m going to invest in myself instead of getting a job or investing in the stock market”.  These people will pursue new ideas, develop new technologies and will start new companies.  Out of this might emerge a few great companies and many more which will employ people and inspire even more entrepreneurs.

Reason 2 - This shakeout is going to get rid of a lot of crap ideas and companies.  There is no other way to say this.  Many of the “me too”  social networks or “iPhone/Facebook app” developers hoping to generate a userbase that they’d one day magically figure out how to ‘monetize’ may not make it.  They won’t make it not because they don’t have a cool idea that is fun and even potentially useful, but because many of these businesses were “built to flip” as a friend of mine at a prominent Sand Hill Road VC once commented.  And so they were never predicated on a real business model that could bring in more revenue than the dollars they spend.  This is a risky proposition and unfortunately, and such businesses don’t allow you to make it up in volume.

And while some of these ideas were marginally useful or fun as I mentioned, I also don’t know if they were solving real problems, e.g., building stuff that people really needed or finding a better way to do something that enough people cared about.

So what we’ll see in my estimation is the bar will get raised and better ideas will emerge and a new crop of more well-conceived startups will come forward.  With VC funding tightening up, entrepreneurs will need to do this.  Things that solve really big problems and that are built with an eye towards becoming sustainable businesses which are lean, mean and profitable are what will come into vogue.  A dollar and a dream may not be enough but a dollar, a dream and some serious discipline will be required.

In essence, for every Facebook, there will be many others that don’t have the backing to make it through the next several years.  And honestly, even if they did, being the social network for ex-convicts was never going to be that big (sorry guys).  I do think that many of these smart people who don’t make it out of this cycle will come back with better, tighter, more refined ideas the next time around, and this type of cycle is healthy.  Of course, this all only holds until the next bubble.

I had dinner with a good friend who works at a hedge fund this past week, and after we discussed the markets and our views on where things are going (sorry we didn’t come up with an answer), he made an interesting comment that struck me.  He felt that this downturn may be a good thing for the US economy for the long-term.  His logic was pretty simple.

• A lot of very smart people over the last many many years moved into careers in finance because it was lucrative and was seen as a path to quick riches.
• Back in the day, there was a similar belief about becoming a doctor for instance but it was not a “quick path” but one that existed for the best and brightest after many years of hard work.
• With this being a potentially protracted downturn, some of the current and many more from the next generation of smart people may go back to pursuing careers which in his words “are not just about trading paper”.  This means more innovation, entrepreneurship, etc from smart people trying to solve real problems.

I found this perspective quite interesting coming from someone in the hedge fund world - especially someone who is successful at it.  I also agree with him. Finance companies (banks, hedge funds, etc) have had a voracious appetite for PhDs and smart people in general who’ve helped them build complex derivatives and the like.  This downturn/recession may mean less of these people are inclined to go into or stay in finance and if this happens, they may look elsewhere, e.g., in science and math disciplines either with employers or in research organizations (mainly universities).  This is a good thing as it can lead to ideas and innovations that drive the next great wave.

I’ve seen this migration to finance firsthand.  I graduated from the Jerome Fisher Program in Management & Technology (M&T) at the University of Pennsylvania which is a dual degree program between Wharton and Penn’s Engineering school.  As I’ve met alumni from the program over the years, it has become apparent that fewer and fewer of us went down the engineering route in our careers (I’m guilty on this count).  The early graduates of the program were more likely to have worked in engineering fields for at least some time while with the more recent grads, most have sought to go down the business (especially finance) with a belief that their training from engineering would always be valuable.

It’s obvious that these types of attitudinal and structural shifts don’t happen overnight, but if some small segment of the smart people who previously pursued careers in the world of finance move towards entrepreneurship and innovation, this is a good thing for us in America as well as globally.

This doesn’t mean the finance types go away nor should they.  Someone will have to extend credit and funding to these entrepreneurs, right?

I talked recently about why I don’t think the Red Mango & PinkBerry thing will end very well (see my recent post here).  Today’s AM New York had a similar article with a lengthy title - Pinkberry, Red Mango ignite new frozen yogur craze with a tart spin, but will it last?.

While many of our viewpoints are similar, there were a couple of choice quotes which I thought were useful/interesting or which added to the case for why this might not end well.

1st quote

“The question is, are you going to just be a niche player or will you be a national chain,” said Harry Balzer, vice president of NPD Group, a consumer marketing research firm that tracks how Americans eat. “They clearly are getting a nice buzz within the population. But we often mistake our willingness to try new things as a trend.”

2nd quote

“Still, this could be a fad that comes and goes like the last, something that Heidi Miller knows about. In 1981, the former bodybuilder opened Heidi’s Frogen Yozurt in a cramped storefront tucked into a shopping center in Irvine, Calif. She built the company to 120 locations before cashing out by selling an 86 percent stake in the company in 1989. The chain is no longer in operation.”

Heidi’s Frozen Yogurt which I never heard of could definitely be the trajectory of these guys.  The point that I raised in my earlier post still holds true here.  Similar to Heidi, the founders of Red Mango, Pinkberry and the early investors may (and will likely) do quite well.  It’s the later guys who will get burned as that is when the fad or the growth runway will end.

Yesterday’s NY Times Dealbook contained information about a $12 million Series A round raised by Red Mango “led by a former chief executive of Blockbuster and the Dallas-based private equity firm CIC Partners. The announcement came 10 months after Pinkberry unveiled a $27.5 million round last October, spearheaded by Maveron, a venture capital firm co-founded by Starbucks chief executive Howard Schultz.”

versus

For those who don’t know about Red Mango or PinkBerry, they are hot new retail concepts hawking high-end frozen yogurt.  Uber-cool hipsters in NYC and LA love PinkBerry and paying really high prices for ‘tangy’ yogurt.  I must admit it’s pretty tasty.

Taste and naming unoriginality aside (color + fruit), here is why this won’t end well.  I’m not talking about this not ending well for series A investors who may be rewarded for their early stage risk taking, but I’m talking more about late stage investors - the series C/D guys or even the public stockholders if they ever IPO.

Why?

Primarily because one hit wonders have a pretty terrible track record in the market (see chart at end of this post).  While people point to Starbucks as an example, there will never be a need for ubiquity amongst frozen yogurt shops no matter how tasty.  Let’s remember some of the much hyped and now struggling, dead or soon to be dead brethren of Red Mango and PinkBerry.

• Cold Stone Creamery - Poor franchising
• SmoothieKing - the original JambaJuice
• JambaJuice - the new SmoothieKing
• TCBY - Anyone remember them?
• The Cheesecake Factory - Limited market for 4000 calorie meals
• Pizzeria Uno’s - Today’s Wall Street Journal talked about impending bankruptcy

A friend of mine knows the PinkBerry folks and per him, their desire is to stay exclusive and grow in high-end locales (places like Dubai, NYC, Vegas, Paris, etc I’d imagine).  If they can do that, PinkBerry could turn into a very solid, profitable business.  The problem is the $27.5 million venture capital round they raised.  With that money comes expectations of growth and lots of it, e.g., there are strings attached.  And that means aggressive over-expansion unfortunately.  And the uber-cool won’t like PinkBerry so much when the local mall has it and your uncool aunt and uncle are talking about it.

Starbucks which has been lauded as a growth company did the same thing.  The thing Starbucks had going for it, however, was a massive and growing appetite for coffee so the ceiling at which growth would stall was very high.  But nevertheless, they hit the ceiling.  To keep up with Street expectations of growth, they kept expanding.  Instead of saying to the Street, “we’re going to slow down our growth and as a result, you should lower your view of us from a growth company to a value or GARP (growth at a reasonable price) company”, they said “we’ll just keep growing.”  Nothing grows indefinitely.  Never happened - never will.  PinkBerry and Red Mango will have the same expectations of them and this will lead to bad things at some point.  I’m not smart enough to know when but it will.

The one hit wonder concept isn’t just in food retailing.  Think of Crocs (you know - the horribly ugly shoe things) or American Apparel (remember CEO, Dov Charney, who called his CFO an idiot). Lots of hype, great stock prices for a while and then plop!  You can make money if you get out at the right time, but if you ever find yourself saying “They could be the next McDonalds”, it’s apparent you’re drinking the Kool-Aid and probably a good sign that it may be time to exit.

Consumer tastes are fickle.  Red Mango and PinkBerry still have lots of runway to grow so this is not to say they’ll flame out tomorrow, but it will happen.  Plus not being a frozen yogurt afficionado, is there really room for 2 similar players in the premium markets they’ll target?

Here’s a look at the 5 year chart for some of the publicly traded one-hit wonders (Starbucks, American Apparel, Cheesecake Factory, Crocs) I referenced above.  (note:  not all have been public for 5 years)

Perhaps there is a shorting strategy here?

The popular blog on all things technology, TechCrunch, recently had a post on something you don’t typically see on the blog - organic growth.  The entry entitled “Does Google Have an Organic Growth Problem” - discusses an analysis by Citi equity research analyst who argues that Google’s organic growth is decelerating.

It was an interesting post and something we were glad to see given our work on organic growth.  Below are our thoughts on the post and the findings about Google.  We’ve benchmarked and analyzed the entire S&P 500 (of which Google is a member) on organic revenue generation and efficiency over the period from 2003-2007, and our #s reveal a similar story, but the picture still is very positive.

We would agree with Citi’s analysis that the organic revenue as a % of total revenue for Google as well as a % of total revenue growth is declining over the longer period we studied.  As compared to Yahoo (the closest comparable to Google if there is one), we have seen that Google is destroying their peer from an organic revenue perspective.Our analysis goes beyond just organic revenue and looks at the efficiency of generating this organic growth, e.g., how much are companies like Google, Yahoo, etc spending to achieve organic revenue growth.  We call this efficiency ratio the Organic Growth Multiplier (OGM).  The logic behind the OGM is that if one company can spend $1 to get $3 of revenue and another can spend $1 to get $5 of revenue, the latter company is healthier and has more momentum in its business.

When we look at the OGM of Google versus Yahoo and versus the larger S&P500 tech financials category, the picture is actually quite pretty for Google.  They’re tops as it relates to OGM which means a dollar of investment into their core business generates more revenue than the average tech sector company.  They also outshine Yahoo on this count as well.

The indexed OGM for Yahoo and Google over the period from 2003-2007 are 50.9 and 312.84, respectively.  Without getting into the quantitative models that underlie this, the point is that Google’s organic revenue efficiency is far superior to Yahoo.

Most importantly from all this work is that we’ve seen that higher OGM and total shareholder return are positively correlated.  So having the ability to generate organic growth efficiently is a good indicator of shareholder returns.

While the assertion that their organic revenue is declining does remain true, the news is not as dire as I’ve been reading elsewhere from those who’ve picked up on this TechCrunch entry.  Yes, if they can turn one of their acquisitions into a money maker, this will obviously supplement some of the organic revenue deceleration that might be evident in their historical core business, but on the whole Google is still a star when it comes to organic revenue generation and efficiency.  The fact that Citi retains its buy rating despite the organic picture is testament to this.

A bit on the methodology.

There are some notable differences from the Citi analysis which despite the similar conclusions do make our analysis more robust.

1.  We’ve looked at a more extensive time period (2003-2007)
2. We strip out market growth for each company.  In essence, if the market is growing at 10% and your company grows at 10%, we don’t give you credit for this.  This is rising tide growth and is not due to management’s actions and investments in the core business.   Organic revenue, therefore, in our models is only the growth we can attribute to management’s prowess (or lack thereof).
3. In our Organic Growth Multiplier, we also look at the efficiency of generating organic revenue by determining how much is spent by each company to achieve its organic revenue.  This gives a truer sense for the efficiency of the company’s organic revenue capabilities.

We do lots of work in the financial services industry and so we tend to look at what the sell side is saying about public companies we work with.

From past lives, we even know some of the guys on a social basis and will occassionally shoot the breeze with them.  Overall, they tend to be smart, driven and very good with Excel.  These are all essential ingredients for a good time.

But like the internet days when we had superstar analysts (Henry Blodget anyone?), we now have the new market guru of the financials arena in Meredith Whitney of Oppenheimer & Co.

She’s undoubtedly made some prescient calls and hasn’t been shy in making them aggressively and in an outspoken manner, but the question really is whether Meredith Whitney is more sizzle than steak?

When you look at her performance as reported in the August 18, 2008 issue of Fortune, you get some perspective into this.  They write:

“Whitney’s insights haven’t always translated into lucrative investment picks. Based on the performance of her buy and sell recommendations relative to her industry peer group - what analyst tracker Starmine refers to as an analyst’s “industry excess return” - Whitney’s stock picking ranked 1,205th out of 1,919 equity analysts last year and 919th out of 1,917 through the first half of 2008. That said, evaluating Whitney solely on the timing of her buys and sells misses the point. It’s not just that she’s bearish on the entire banking industry. What makes Whitney so interesting is the brutality of her arguments and the evidence she summons in making them.”

Based on the statistics aka something we call the facts, Meredith Whitney isn’t that great a stockpicker.  And if I’m a client or investor, I’m guessing that the correctness of stock picks is what makes me money and not the “brutality of her arguments and the evidence she summons in making them.”  Looking at her stock picks as a metric for measurement doesn’t “miss the point”.  It is the point.

However, the media love a story and Meredith Whitney provides it.  She is married to a WWE wrestler (JBL for those like me who are former WWE fans.  And no I’m not ashamed to admit that.  Okay, I kind of am).  And more importantly, she makes swing for the fences calls which attract attention.  If she was wrong, she’d have faded into obscurity.  But because she has been right on some of these big, hairy prognostications, she’s been appointed a guru and CEOs and CFOs spend time with her (most recently Ken Lewis, CEO of Bank of America, CFO Nelson Chai of Merrilly Lynch and CEO Ken Chenault of American Express).

Unfortunately, it seems the frequency of being right which I presume the folks who are ranked highly in the equity analyst crowd are is being drowned out by the magnitude of correctness no matter how frequent.

Let’s remember the primary objective of an equity analyst should be to make good calls that inform clients’ investment actions and enable their success.  As a result of this, they should be rewarded.  Somehow, being 919 out of 1917 equity analysts doesn’t seem worthy of much praise, but once again, style sells.

The question now is if Meredith Whitney’s stock picking skills don’t improve, how long will the hype last?