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February 28, 2007

China crisis: latest

The latest breaking news from China: China could get worse:

A day after shares in China plunged 8.8%, shares on the Shangahi Stock Exchange rebounded, with the index ending the day up 3.9% at 2,881.07.

But investors in Hong Kong say that the worst is still yet to come, and that the outlook for China's market remains overly optimistic. The Hang Seng ended the day down 2.46% at 19,651.51.

"Equities in China are still much more overpriced than people are admitting at the moment," says Sean Darby, head of Asian strategy at Nomura Bank in Hong Kong. "The Chinese pressure cooker is getting hotter. It hasn't tightened rates that much. There's closed capital account money flowing in and contracting liquidity."

The article is hot off the press from last night EST. I should mention that I wrote it.

Consensus: we are seeing the beginning of a south Asian contagion, though Hong Kong and Japanese markets are unlikely to be affected long-term. More context to follow.

February 27, 2007

China: it was coming

I have to say, I saw China's steep decline coming at the beginning of the year:

Doubts over the sustainability of last year's boom raise the question of whether 2007 is the next 1997, when Thailand's currency devaluation sparked the so-called Asian contagion: bouts of panic-selling in Asian markets that spilled over into other emerging markets and, eventually, developing ones as well.

"What's often forgotten, I think, is that the way we correlate risk in Asia is very high," says Sean Darby, head of Asian strategy at Nomura Holdings in Hong Kong. "We're almost certainly due for a correction this year."

By tomorrow, we'll all have a clearer idea of how far the Chinese market declines are headed: will blog more. Meanwhile, the article helps explain some of the reasons for the decline.

February 26, 2007

Market Direction & Portfolio Positioning

Sundays are usually pretty quiet, and generally consist of a little preparing of things to do for the coming week, a few coffees at the great Italian coffee shop over the road from my apartment in the East Village where I live in Manhattan while reading the news and some research reports, culminating in four hours or so of Law & Order re-runs on the couch after lunch.

Not so this Sunday. A ton of work awaits me this week - several stories, papers, a video-story (more on this another time) and two overdue chapters of a novel - all of which needed attention, my Dad flew into NY on business, and graciously, thousands of new readers decided to stop by for a casual weekend post I'd written on Saturday about mistakes Europeans make when they're in the U.S.A. In total, there were 73 comments by the end of the day on the post.

I have said here before that hearing from readers is one of the principle reasons I write this blog, and I believe passionately that it's the key concept at the heart of journalism and the arts for that matter too. As my grandfather once told me, "you can have the most talented opera singer on the stage, and the most splendid orchestra behind her, but what are they without an audience? Quite."

So I want to kick this week off by focusing on a comment made on this blog by a reader called Don, as a response to a post I wrote on Friday called "What Does This Mean?" The post concerned the nature of business news, and specifically what kind of business news was useful for investment decision making and what kind was useless, with some general outlines on how to identify the former from the latter to enable clearer - and better - investment choices. Don had this to say in response:

While there are thousands and thousands of opinions on the market in general (and they are best ignored), there are only two behaviors...buying and selling. We seek these so called expert opinions because they provide a level of comfort in an uncertain world, especially if the opinions match the way our portfolio is arranged. Personally, I would rather have my portfiolio set up to match the behavior of market participants. Right now the buyers are in charge, so I stay long. When that changes, so do I.

I find several things particularly interesting about this comment. First of all, it represents the belief and behavior of lots of market participants at the same time as being the very belief and behavior that others abhor, in particular the  so called "experts" who always parrot the same piece of obvious wisdom, "buy cheap, sell high". Secondly, it is a strategy that has in part made some enormous amounts of money, and lost others nearly, or maybe all of their portfolio. In fact, it's the same kind of thinking which has brought down numerous hedge funds, most recently Amaranth and Latitude.

The biggest issue with the strategy is that although it doesn't look like it, it is in fact very high risk, because you are trying to engage in a guessing game without any reference to the fundamental state of the market or assets you are investing in. But still, that doesn't mean you can't make lots of money doing it. It is a perfect illustration of John Maynard Keynes' anecdote of the market being like a beauty contest with the grand prize of £10,000 for the reader who could spot the "prettiest girl". Instead of spending time choosing who one thinks is genuinely the prettiest girl, argued Keynes, the readers would instead be wondering who others think is the "prettiest girl". The problem is, when the market turns against you, it can often be harder than the comment makes clear to see that happening (like oil companies right now). But with lots of people in the market thinking the same way as reader Don, such a mentality becomes impossible to ignore, because it in fact impacts the direction of the market.

I think ultimately a portfolio is best divided between a slice of momentum and a a slice of fundamental; that is, by all means take positions in the current market direction, but also don't be afraid to compliment that with sound bets which look right to you, no matter what the market thinks. Most of the advice and news you read on this blog will be the latter kind, incidentally, because I'm a great contrarian, and I believe in looking the other way for maximum profit. Still, no matter how brilliant your fundamental and technical analysis, like the opera singer who needs an audience, you always need market momentum behind you, or all the greatest analyses in the world won't help. When what you think are great portfolio stocks aren't performing, that means taking a commercial stance at some point too, and recognizing your analysis is sometimes just not in line with what everyone is thinking.

"Timing" is to the market what "location" is to the real estate sector.

February 25, 2007

Nikkei 30,000?

The other day I made the point here that the Japanese were not likely to raise rates much by much more than a quarter-percent any time soon, since they were long-overdue a bull-run which has just got started, and were probably more concerned about stopping that run in its tracks than letting it oversell itself.

Justin Urquhart-Stewart, Director of Seven Investment Management and writing at the London Stock Exchange, makes a noteworthy observation about the potential rate hike in the Japanese economy:

What I find far more interesting is the expected impact of what such a small rise might have domestically in Japan. In the UK if rates rise we quite rightly fret about the impact on peoples’ borrowing and the increase in mortgage payments, as well as the effect on the vital level of consumer spending.

Not so in Japan. It has been estimated that a 0.25% rate hike could increase household income by 1.1 Trillion Yen (around £233 billion!) which is an approximate increase of 0.4% in household income. This in turn could further support consumer expenditure and consequently provide a timely fillip for the vital but struggling retail side of the economy. How quirky does this seem when compared to our heavily indebted consumer society? In Japan the growing army of actual and would-be pensioners have been saving their hard earned cash and, since the start of the depression in the early nineties, have veered away from the financial maelstroms of the Japanese property and stock markets. So an extra “bip” on the deposit rate can have a marked impact.

From an American or European standpoint, it's strange to imagine a world in which interest rate hikes mean good news for everyone, but when the majority of people are debt-free with cash in the bank, it pays off.

Most notably however, the observation re-enforces my previous point about buying Japanese equity at this level. This is because a rate-hike will make everyone in Japan feel little bit richer, as well as a little more secure about domestic growth prospects, and when we all feel that way, we tend to spend more and take more risks; in investment terms, the latter means we move from cash to equity positions.

Added to the prospect that the Japanese will keep the new 0.5% rate flat for quite some time, and you have a pretty perfect 2-year equity bull-run in place. With the Nikkei 225 at 18,188.42, it's catching up fast with the crucial 20,000 mark - having grown by 22.8% in the last year - but still a long way off from the time in the early 1990's when it topped 40,000, which is exactly where you want a market to be when you're buying aggressively: right in the middle with a competitive but not irresponsible upward growth curve.

In fact, I would say that the Nikkei 225 could well reach 30,000 within the next 12 months. Sound ridiculous? Think how ridiculous the phrase Dow 13,000 sounded only six months ago. In the right economic environment, markets often take off far quicker than anyone expects.

February 24, 2007

EU Faux Pas in the USA

As I was out having dinner with someone in a Manhattan restaurant last night, I began to think about how different we were as people, despite our common language and interests. When Sting wrote the lyric "Legal Alien", in many ways he really was conjuring up the best possible phrase for an Englishman in New York.

For the weekend then, I've decided to list seven of what I think are the most subtle but important mistakes English people and Europeans in particular make when they come to America. In fact, I think on many levels, these are some of the reasons for break-downs in political and business communications between the USA and the EU. If you can think of any more, post them in the comments section below.

So, if as a European you find yourself in the U.S.A., DO NOT:

1. Assume that your typically understated demeanor with be recognized and admired by your American colleagues. It won't. This is not to suggest that you should brag while in the company of Americans, but our trans-Atlantic brothers and sisters are very vocal about their achievements and positive proclivities, and you should take this as a license to do the same. The difference between Europeans and Americans here is that the latter actually want to hear about all the great, amazing things you've done, so you don't have to be afraid of selling yourself. In fact, if someone seems to be over-bragging about how brilliant they are, it's usually because you have not offered anything to the table yet in return, so take this as your cue to do so. However, a crucial disclaimer here: make sure you sell yourself in a way that is as deeply personal as possible (see 5), otherwise, being European, you risk coming off being somewhat aloof.

2. Politely respond to the question "how are you doing?" with a brief "fine, thanks" and walk away shyly without engaging in much further dialog. This is very rude, and Americans will just assume you are not interested in talking to them, or that you think something is wrong with them. If you're buying something, like a coffee, it's perfectly acceptable to respond with "how are you doing?" back, while not answering the question, and place your order. In Northern Europe especially, we are not naturally inclined towards rapport with people we do not know, and tend to get quite defensive when someone asks this question up front: remember, this is essentially a culture of immigrants, so think like one.

3. Try to exaggerate an overseas experience for dramatic effect. Or, for that matter, underestimate the intelligence of your American companion. Once you start getting into the swing of things, you'll realize how  a) generally untraveled your American colleagues are, and b) how much they enjoy listening to your overseas adventures as a result. In such situations, it is often tempting to add little fictional details to a place/event in order to enhance it for dramatic effect. Don't. There are two reasons for this. Reason one is that however brash they might come off at first, Americans are incredibly brilliant bull-shit detectors. Probably because of the largely commercial nature of the country, Americans are hard-wired to find you out, so play authentic. Secondly, as untraveled as your American companion may well be, remember that this is a culture of very recent immigration, and so someone probably has a third-cousin/half-brother/sister-in-law from the place you're talking about, or at least near-by. Essentially, this all boils down to a crucial key point, that you must never, ever forget. Do not underestimate the intelligence of American people. Just because they come off less "broadly trained" than you are, this does not mean they are not extremely savvy people. There's a reason this place has become the largest self-sufficient economy in the world in a tenth of the time it took European countries. 

4. Seize every point an American colleague is saying in a debate by analyzing and deconstructing his/her sentence structure word-by-word and pointing out the flaws in his/her logic. Your apparent logical brilliance will not be appreciated, but most of all, it won't be understood. You will in fact come off looking stupid. This temptation arises out of a two-fold dichotomy: Americans use very bold and political language to convey their points, and in such a situation Europeans are trained from a young age to take apart, bit-by-bit, what their opponent is saying and return that sentence as a direct challenge of whether they know what they are talking about or not. This is not the case in America: using bold and strong language is perfectly acceptable, and most Americans think you are just wasting time or don't get it if you continually defer back to empirical logic when arguing with them. By all means fine-tune your own sentences, but attack the concepts they are putting forward in debate, not their debating style.

5.  Hold back on sharing fairly intimate/personal stories on a first meeting. This will make you seem as if you have something to hide and will not endear you to people quickly. It is perfectly acceptable to talk about your qualities and faults with loquacious and detailed stories as if you had known the person for years. In Europe, this is somewhat inappropriate behavior, and in certain parts of Europe especially, it is guaranteed to send people running away quicker than you can order the next round of drinks. In America, however, it shows you are confident and happy with the person that you are, you have nothing to hide, and that you are genuinely interested in getting to know your colleagues.

6. Assume that anyone who is on some kind of anti-depressant or who has been on one/several is insane and that you shouldn't talk to them. Medication, and anti-depressants in particular, are pretty near popular culture in America, and loads of people have taken them. Be aware too that most Americans are fascinated by the effects of anti-depressants, and will happily talk about multiple types of drugs and their benefits/side-effects with great interest and relish. If someone tells you an experience about their time on Prozac, ask something like "did it help?" and then share a similar experience of a time when you were really depressed.

7. Assume that every American is pro-war in Iraq.
I shouldn't need to point this out, but it's still a huge stereotype. Americans have a whole diverse range of political views, and you'll encounter them in all their glorious and inglorious aspects, because they also love to talk about politics. In fact, politics is a very good conversation starter in America, so don't be afraid to ask someone who they are going to vote for at the next election right off the bat. But, do be aware that while not every American supports military combat elsewhere in the world, by far the majority believe that America itself has fundamentally very good intentions, and that the country really does want the best for everyone. This is not a concept you should challenge until you know someone at least quite well.

*UPDATE* Thanks for dropping by and for all your comments. This post - quite unsurprisingly - seems to have generated a strong emotional reaction in many cases. Due to the overwhelming number of comments here then, I'm going to list and further expound some of what I think are the best pieces of further advice given by the American readers themselves. If you have any more, or you agree or disagree with me, keep posting them in the comments below because I will respond.

First a quick blog promotion. This blog is about the global economy and specifically globalization's impacts on markets and visa versa. I occasionally get political but mostly try and keep the polemics as economically grounded as possible, so it's different in that respect. The following is for sure: what you read here is probably better advice than what you'll read elsewhere on the global economy, and America's situation within it, and you won't find many of the ideas expressed here elsewhere either. I'm a freelance financial journalist (go to my about page), and to make a success of being a freelancer, you have to write accurately, informatively, and you have to have an edge that others don't have, simple as that. You're in business for yourself. In other words, keep coming back. E-mail me or post a comment if you're interested in a perspective on something and you want me to write about it, and most likely I will. Hat tip to Glenn Reynolds for linking to me again, too.

Now, from readers (and with my explanations), some further DO NOT's:

8. Assume that because wealth is greatly admired and sought after in the United States, your inherited wealth will be similarly admired. It won't. This has to be one of the fundamental differences between continental Europe (excluding Scandinavia) and America. Americans like self-made people, people who got their hands dirty earning their money and have all the bruises to show for it. If you have made a lot of money yourself, fair play. If you have inherited wealth on the other hand, play it down if possible, because to American eyes, you haven't done anything to earn it. You can throw a lavish dinner party with the youngest and trendiest Lords and Ladies (such as would be greatly admired in London) of course, and while some Americans may appreciate the invitation, most who go along will do so in order to see the eccentric 'circus act' you've put on, not to get to know you in any meaningful way. The irony is, it is usually the people who have inherited wealth who are most self-conscious about displaying what they have in the United States. They should in fact be self-conscious about playing it cool, not playing it up.

9. Draw parallels between European pre-industrial revolution colonialism and America's post-world war II involvement in world economies and politics. This is guaranteed to get you thrown out of a conversation circle, unless you know the people you are talking to very well. It is also, however, an incorrect comparison, however easy it is for Europeans to draw parallels. Americans do not see themselves as colonizers of the world in the way Europeans once were, and in fact, they are right about this too. The American Empire has tended to economically try and dominate the world, rather than control it politically, whereas the Europeans were chiefly political in terms of their ambitions for individual countries (which is also why they ultimately lost them). If you disagree with this statement, just look at the vastly different intentions of the U.K. and the U.S.A. in Hong Kong, and for that matter, in China.

10. Make assumptions about America or American people based on what you have seen on Hollywood movies. Again, this shouldn't need to be re-iterated, but it's a classic fault, time and time again, of Europeans when they think of Americans. The best parallel I can give to show how inaccurate such portrayal of Americans and America is, is that given of the English or the French in such movies. Do all English drink tea and speak like they were educated at the most expensive boarding schools in the country? (Answer; maybe 1%)  Are all French red-wine drinking,pot-smoking miscreants? (Answer; this is a very specific sub-set of Parisians generally living within the wealthier arrondisements).

11. Assume that once you've been to one part of America you know it all. This may undermine some of my previous points, because they focus on generally broad aspects of the U.S.A, but it is true - America is an enormous country, and as a result, it's probably best to bear in mind how different the U.K. and Greece are. Double that distance and you haven't even covered the longitude of America.

12. Be afraid to ask for a pay rise. Bargaining and negotiating is at the heart of American culture, and is a major factor in what has driven this highly commercial and competitive country to number one economic status. In some cases, if you don't, you will just get left behind. In fact, as an example of this, an American friend of mine told me the other day that she "figured I should stay in the job a month before negotiating for more money." To most Europeans, you would be lucky after a year if you were able to negotiate a pay increase. Not so in the U.S.A. It's a deal-driven environment, and you should similarly have fun rainmaking and driving deals, wherever you are on the economic plateau.

**UPDATE** I've received a fair bit of e-mail from this post and thread, and there seems too to be quite a lot of other threads at different sites discussing this piece. This e-mail from reader Byron says something which it's especially worth remembering, I think:

Great article, well written and well treated.  This kind of clear, respectful, honest analysis of the differences in our two cultures is increasingly valuable these days as the US-EU transatlantic alliance should be one of the strongest forces for human rights worldwide, rather than the constant bickering match to which it recently seems to have degraded.  We have differences we need to overcome to accomplish that, and doing so requires respectful understanding and acceptance of our cultural, political, and historical differences.

Absolutely on-the-money. Building our trans-atlantic political and economic alliances to create a power center which is capable of doing bigger and better things is exactly what both Europe and the United States should be striving for, and it's what Britain and America have been doing since the fall of the British Empire and the rise of the American Empire.

In many cases though, economic reality speaks louder than all others, and that means it's time for the continental European countries - in particular France and Germany - to begin playing ball a little more. This will ultimately benefit these current naysayers economically, too. As an example of an economy which has successfully done so, Spain, prompted in this direction under Aznar's excellent leadership, derived massive growth both in terms of it's import/exports and capital market growth as a result. 

February 23, 2007

"What Does This Mean?"

Earlier today, I was talking to a good friend of mine who was wondering what do with her portfolio and she complained that she was further non-plussed by all the media coverage of stocks. Reading the financial news, I have a lot of sympathy for anyone with the job of actively managing money for a living or for their personal account, so I'll try and help out a little with what type of news piece to read and what not to read. Take a look at these two articles about exactly the same event - the oil price movement - this morning. One is from Marketwatch, while the other is from AP. The reason I pick out these two news organizations is not absolutely random either: Marketwatch is owned by Dow Jones, and the DJ people tend to work very closely with AP journalists. In a lot of bureaus, they actually share the same office, and in most, they share the same building.

Here are the lead and second paragraphs of both articles:

Marketwatch:
Crude erases 2007 losses as data extends rally
Larger-than-expected supply decline sends futures as high as $61.80 a barrel
NEW YORK (MarketWatch) -- Crude-oil futures extended their rally Friday, pushing the front-month contract into the black for the year, in a continued response to data showing a far bigger-than-expected decline in heating fuel during last week's bitterly cold snap, reducing unusually high stockpiles following a mild winter.
Oil also got a boost after some geopolitical flare-ups: Iran defied United Nations demands that it stop enriching uranium, and traders got jitters amid fresh violence in Nigeria's oil-rich Niger Delta region.

AP:
Oil Trading Slow on U.S. Inventory Drop
Oil trading slow as market reacts to surprising drop in U.S. gasoline, heating oil inventories

Oil trading was slow Friday as the market adjusted to a surprising drop in U.S. gasoline and heating oil inventories.
Light, sweet crude for April delivery nudged just 1 cent higher to $60.96 in light electronic trading on the New York Mercantile Exchange, midafternoon in Singapore.

Just for the record, this is bad business journalism in both cases. I hardly need to point out that one can infer completely different scenarios from these two articles about the movement of the oil price. This type of mistake is usually down to a failure of business journalists being educated in the subject they are writing about; namely, business. Both articles miss completely the main paragraph, too, as a result: what I call the "what does this mean?" graph. If you like, it's the "where should I trade?" explanation part of the article. An article is only as useful as a chart if there is no paragraph telling the reader what the news being reported means, and this is in almost every case the giveaway of the difference between business journalism written by someone who really understands what is going on and someone who doesn't quite get it.

A person who can tell you what something means understands the topic they are writing/speaking about, whereas someone who cannot does not. In the case of both these articles, the "what does this mean?" part of the story is side-stepped by inferring whether this is good or bad news into the headline, which is also a classic mistake (to be fair to the Marketwatch piece, there is a sort-of-meaning in the seventh paragraph, but it doesn't relate to the headline very well). A headline does not tell you what something means - it tells you what's going on. (Incidentally, this is not a comment about Dow Jones and Marketwatch, both of which are usually very reliable, although reading business news from the AP is almost always completely misleading, as I have pointed out before).

Now, the same story by Bloomberg:

Oil Is Little Changed After Rising on Fuel Supply, Iran Threat
By Eduard Gismatullin    
Oil traded little changed in New York after rising to the highest price this year after U.S. fuel inventories plunged and analysts said supplies may be disrupted if Iran is sanctioned again for developing nuclear capabilities.
U.S. stockpiles of distillates, including heating oil and diesel, fell 5 million barrels last week, or 3.8 percent, the biggest drop since September 2005, according to the Energy Department. The U.S. and European nations will meet next week to draft a second sanctions resolution against Iran, the second- largest Organization of Petroleum Exporting Countries producer.

Definitely less sensational, but it summarizes the complexity and ambiguity of what's going on really well, without jumping to a conclusion before all the facts have been laid out. Then, succinctly, follows the "what does this mean?" graph:

``The main risk to the oil price is either a boycott of trade, isolating Iran, or a military attack,'' because either would ``influence the production and supply of oil from Iran to the world market,'' said Thina Saltvedt, an analyst at Nordea Bank AB in Oslo. Distillate inventories ``will influence the price'' until winter ends in the Northern Hemisphere, she said.         

This gives a meaning to the story - the global supply-chain with specific emphasis on Iran - and a time-line, namely, when winter ends in the Northern Hemisphere. Now that's news you can use.

February 22, 2007

More Disruptions: Google and RIM

Google is going one further in taking on Microsoft:

Mountain View, Calif. - February 22, 2007 - Google Inc. (NASDAQ: GOOG) - today introduced Google Apps Premier Edition, a new version of Google’s hosted services for communication and collaboration designed for businesses of all sizes. Google Apps Premier Edition is available for $50 per user account per year, and includes phone support, additional storage, and a new set of administration and business integration capabilities.

It's about time. Recently I've noticed that as most of what I write is usually for e-mail anyway, and my gmail has an in-built spell check, I'm using Word less and less. As a result, I've become so comfortable with the font in Google's e-mail that when I gravitate back towards Word I tend to change it to simulate my gmail font, rather than sticking with Times New Roman. This is not something I had previously envisaged happening; at one point I never wanted to type in anything but Times New Roman. It's a classic example of a disruptive technology in action: it's technologically inferior, but it's cheaper and just more convenient so you end up making it a standard. Google however still has some way to go in terms of catching up with the full sophistication of a Word package, and the "docs and spreadsheets" application on the gmail is still just a basic extension of gmail itself, so it will be very interesting to see how this new application fares.

While on the subject of gadgets, I've noticed a lot of scathing criticism of the Blackberry phones - namely the Blackberry Pearl and the Blackberry 8800. "... Well done overall ... but this device's keyboard, a highly important feature, left me frustrated no matter how many e-mails I typed," wrote Katherine Boehret in yesterday's Wall Street Journal, in a product review of the Blackberry 8800. I've heard the same complaints elsewhere: principally that "the keyboard is too small", and "I don't like the trackball" (the blackberry's 'mouse'). Journalists have come down on Research In Motion (RIM) with no shortage of criticism for making these stylistic changes.

I have a Blackberry Pearl, and I find it very easy to use, so at first the criticism surprised me. But then I began to notice a common feature: all the lambasting was coming from people over the age of 35. What no one has succeeded in noticing is that the Pearl and the 8800 are not blackberries designed for existing blackberry users: rather, they are blackberries designed for the under-30's who want to step up to a blackberry from a smart phone but find the old model just too bulky. This demographic - of which I am a member - has been conditioned since the age of 15 on increasingly miniaturized hand-held devices, and therefore expects the same thing from a blackberry. Neither do we have a problem using tiny devices.

It's a great coup for RIM, which now secures a new, and younger, market segment - and one which practically lives through e-mail.   

February 21, 2007

Private To Public In 30 Seconds

John Neshiem has a revealing post up about venture capital:

Today I had tea in a quaint hotel in Carmel with an experienced investment banker from Hong Kong. Educated at a top American university, and quite professional, he was immediately impressive. He was interested in what the differences were between "private equity" and "venture capital".

I labored to explain it to him, but was not getting through.

Then he asked if he could tell me about an idea he had come up with for a startup. After he described it, I knew what to tell him.

He took about five minutes to describe his idea.

A venture capitalist can do it in 30 seconds.

That is the difference between a banker and a VC.

The fact that bankers are already -albeit unconsciously maybe - starting to wed the concepts of venture capital and private equity together says some very interesting things about what's to come in the private equity market.

This story also illustrates quite well the confusion - and the extent to which the confusion runs (up to the level of senior bankers) - over the concept of private equity. I encounter this confusion the whole time. So first, for those similarly baffled by the concepts of private equity and venture capital, venture capital is a means of financing a project while private equity is a type of business model. If I have an idea, and you're willing to give me $5 million for a stake in the company I'm starting up to carry out that idea, that's venture capital, and you become a venture capitalist. Now, there are two principal business models we can adopt in running the new company: either we can plan to list it on a market like the NASDAQ, in which case we're going to be running a public company, or we can plan to keep it private, in which case it's private equity.

Now consider that right now, the fad is in private equity. To be fair, it's easy to see why. You don't have to answer to lots of little shareholders, you don't have to file anything like the number of reports you do if you run a public company, and specifically you don't have to hold lots of meetings and announce what you're doing to the public every time you want to do something big like buy another company. With the tightening of regulations on listed companies over the last five years, the private equity model has become extremely attractive to lots of investors. One very senior PE dealmaker told me the other day that he sees the private equity boom continuing for at least another three to four years.

I don't doubt the mid-term buoyancy of the PE market, but there's a grand misconception right now that the private equity boom is self-sustaining. It's not, and it can't be. The reason is that capital has to find an outlet somewhere along the money-train.

It's worth looking back for a minute. Private equity today is very different from private equity in the days of the dot-com boom, when an investor made a private investment on the expectation of a rapid flotation. Here, the exit strategy was in cashing in your shares once other punters had bid them up several times over in price. Two or there years back the exit strategy was in a trade sale, like for the founders of YouTube, where you cashed in your chips in a share or cash payment (usually a combination of both) by a big company like Google. But today, as this story illustrates, there's no discussion of an exit strategy: private equity is just seen as a good thing to be in per se. That means that the only kind of financial reward you can expect from the business model is a substantial dividend payment. While this may all well and good - after all, it's the traditional method of running a business - the one-off monster sales of private equity companies create expectations of enormous returns by investors in private equity.

This is where the story is so poignant as a prophecy of things to come in the private equity field. The venture capital position immediately assumes a sale at some point. Without a sale of some kind, the type of quick turn-around big-return investments that investment bankers love to juice their balance sheets - and bonuses - are practically unachievable, and there are only so many companies the size of Google who can afford to buy a private start-up for $2 billion. So where's the next step? Obviously, the markets.

So, once the investment bankers who are getting in on all the action now discover that they can't sell all their private equity in the form of a trade sale, they'll be quick to push it onto the market. Some clever salesman will probably even bill it a private equity IPO', which makes no sense but will appeal to market punters nonetheless. The problem is, the true gems will obviously have been snapped up already by the Googles/Blackstones, so what comes to market will be more dubious-looking. If you think this is unlikely, look at Neisheim's comment again on what you have to do to make a successful pitch in the VC market: you have to do it in 30 seconds! How many of us can spot a truly great idea in 30 seconds? Does Warren Buffett look at a company for that amount of time before giving it the yay or nay? That's just about long enough the glance the cover of an annual report, and it's about as effective. Nesheim is right of course about the process, but it's the process itself that's so indicative of things to come.

It's the classic type of situation which creates a boom which quickly materializes into a bubble, with all the classic characteristics of a bubble too: distorting the original intent and business concept of the liquid that's keeping it together.

February 20, 2007

For What It's Worth

I wonder whether anyone still remembers all the fear surrounding the US economy in the last quarter of 2006? The doomsayers were predicting a never-ending hike in oil and gas prices, prompted by, among other reasons, Venezuela or Iran turning off the taps, political tension in the middle east, increased consumption: you name it, there was a reason. I remember, much to my frustration at the time, when I was trying to write an article with the premise that big declines in the oil price were almost a certainty, and I couldn't find an analyst who would say the oil price was due for a fall. It was at that point I knew the price was coming down: if there's one rule in the market, it is never say never, and when everyone is saying never, go the other way.

The other concern was GDP. I pointed out back then that too that it was in fact a healthy sign for the economy that GDP was down, because when you correlate this figure with private investment, they are pretty much inversely related right before a big bull run, after which they return to parity with one another as dividends and investment pays off in productivity.

The situation today?

Oil is at $58, and falling, the Dow is at 12,786.64 and the Nasdaq is pushing the crucial 2,500 mark by about 13 points. And what about GDP? Well, here's an indication:

LONDON (Dow Jones)--Economic growth in 30 of the world's richest countries stepped up a gear in the fourth quarter of 2006, thanks to buoyant activity in the euro zone, Japan and the U.S.

... The U.S. continued to account for the largest share of OECD (Organization for Economic Cooperation and Development) growth, contributing 1.2 percentage points to the 3.3% annual growth rate.

And for what it's worth, here's what happens next. The current US economic and market strength will continue at a bullish pace right up until about September/October, when a spew of economic data will show how in Q2 we got just a little ahead ourselves. This, combined with some instability created by a looming election, will prompt some of the big pension funds to throw money back into gold, and it will have a natural, short-term correcting effect for markets (which in all probability probably won't be needed so it's a time to buy then). However, because of this overreaction, we'll probably see that growth re-bound in the final quarter of the year as Q3 fundamentals show everyone that things are actually still in pretty good shape.

And while the Japanese may raise rates, as might China, don't expect too much discipline from the governments of these economies. When Asia has a run, she's usually more afraid of stopping that run too quickly than she is of letting it overheat, so though she might put in a quarter-percent rate hike here or there for show, it's not in keeping with the general ethos of the region, which tends to get a little overexcited about its own economic prospects (usually as a result of knock-on growth from the European region and the U.S.A.) In other words, right now, you want to be buying Japan.

Some more news on Hong Kong tomorrow.

Economics 2.0

Via According To Julie (which is a fantastic blog written by the daughter of a great IT professor who once taught me), here is the most stunning example of Economics 2.0. A coffee shop where the punters decide what to pay (LINK to Seattle Times article):

With its blood-red walls and black leather sofas, Kirkland's Terra Bite Lounge looks like any other coffee shop — until you get to the menu. There are no prices listed. Terra Bite doesn't have them.

You read that right: No prices. Customers pay what and when they like, or not at all — it makes no difference to the cafe employees, who are instructed not to peek when people put money in the metal lock box.

Julie has two posts on the subject which are both worth reading (POST 1, POST 2). As she points out, "Using a strict rational choice economic model, no one would pay ... However, the average price of coffee (or a "transaction" which could be anything from an espresso to a double mocha with a cookie and a bagel) is 3 dollars."

This is the start of a big paradigm shift for micro-economic theory, which affects the way we all consume, and ultimately live.

Everyone has their own theory as to why this works, but I have a feeling this is brought about by the same cultural shift open-source technology and the internet is responsible for. It's not a matter of guilt, neither is it a matter of the consumer becoming more generous; instead, this is an example of the consumer becoming more accustomed/educated to a world in which he or she takes responsibility for the longevity of the products and services he or she enjoys.

This is an extension of Apple's idea to start selling music online. The critics who asked "why would anyone buy it online when they can get it for free elsewhere?" missed the point, as pornography barons pointed out. People want to keep something in business that they like. People, through the advent of technology, have been conditioned to the fact that they have to contribute if they want to keep something in existence that they like. In fact, it's the business model of the blogosphere, where people donate to their favorite bloggers and click on their ads in order to keep them in business.

It's a new spin on the old adage: "if people like what you're doing, they will come back." However, instead of forcing the consumer to accept the same pricing-scheme day-in, day-out, you're just letting them choose how much/when instead. It's no different to the "3-for-1" deals you see everywhere, except you let your customers decide when they get their "1". And ingeniously, the customer trusts you, and hence likes you, better than anyone else.

This is the paradigm shift in micro-economics we are seeing everywhere right now, for which technology is principally responsible, and as people become more accustomed to the new business model, they act more responsibly, and you're more likely to see more of these kinds of business models around.

It's about choice and trust. You keep the same economic principles in place as you had before, but you apply them in a way that leaves more choice for and trust in the individual. In other words, you let your customers become your sponsors.